Operating Activities

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1 Operating Activities Revenues and Receivables Criteria for recognizing revenue o Remember that in order to recognize revenue, the company must have completed the activities necessary to produce and sell the goods and services. o From a financial reporting standpoint, this is one of the most critical areas. 1

2 SEC Action against Cylink Corporation The complaint alleges that in order to meet Cylink's ambitious revenue goals, the defendants caused the company to recognize revenue on numerous transactions in violation of Cylink's own revenue recognition policy, Generally Accepted Accounting Principles, or both. This included recognizing revenue: (1) on a transaction where the customer could cancel the order; (2) on orders from a distributor who was not credit worthy; and (3) on software product orders that were contingent on the customer's right to exchange the software for hardware. After the fraud was uncovered, Cylink issued restated financials that sharply reduced its results for the periods in question. For the first quarter of fiscal 1998, Cylink restated revenue from $15.8 million to $8 million (a 97.5% overstatement) and net income from continuing operations of $1.1 million to a net loss from continuing operations of $3.4 million. 2

3 SEC Action against Premier Laser Systems The complaint alleges that Hiebert caused Premier to overstate quarterly revenue by more than a third in its Form 10-Q for the company's fiscal third quarter ended December 31, It did so by recognizing $2.4 million in revenue from a purported sale of dental lasers to an entity that in fact did not place an order but merely entered into a non-binding letter of intent to market the lasers. The purported order was the largest Premier had ever received and, if it had been real, would have resulted in the company's first-ever quarterly profit. The complaint alleges that Hiebert failed to review adequately documentation supporting the purported sale. As a result, Premier's nowdeceased Executive Vice President was able to perpetrate the fraudulent scheme involving the creation of a fictitious customer order form and the shipment of 100 lasers to a warehouse. 3

4 Creating Allowances: Matching principle: attempt to match revenues and expenses in the period in which they occur. Example 1: In 2000 you make sales of $500,000. In 2001, customers who had purchased $55,000 on account returned the merchandise and therefore did not pay you $55,000. The sales are recorded in 2000 and the returns are recorded in Therefore, we have failed to match the sales and returns. As a result, we record an allowance based upon anticipated activity. In 2000, you would have to estimate the amount of sales returns. Assume that you anticipate 10% of sales will be returned, the appropriate entry would be: Dr. Sales returns $50,000 Cr. Allowance for sales returns $50,000 When the merchandise is returned, the correct entry would be: Dr. Allowance for sales returns $50,000 Dr. Sales returns 5,000 Cr. Accounts Receivable $55,000 4

5 Bad Debts A company can generate additional sales by extending credit to customers. However, not all of the customers will ultimately pay. Bad debts, customers that do not pay on their accounts, are a cost of doing business. Example: The firm has credit sales of $100,000. Dr. Accounts receivable $100,000 Cr. Sales revenue $100,000 Of that amount, the firm collected $93,000. The remaining $7,000 is written-off. Dr. Cash $93,000 Dr. Bad debt expense 7,000 Cr. Accounts receivable $100,000 A write-off occurs when the company ceases collection efforts. A problem occurs when the write-off occurs in a different period from the sale. 5

6 Example: During 2001, ABC has $100,000 in credit sales. It collects $75,000 on those sales. During 2002, ABC collects an additional $18,000 and writes-off $7,000. The entries would be: 2001 Dr. Accounts receivable $100,000 Cr. Sales revenue $100,000 Dr. Cash 75,000 Cr. Accounts receivable 75, Dr. Cash $18,000 Cr. Accounts receivable $18,000 Dr. Bad debt expense 7,000 Cr. Accounts receivable 7,000 The trouble with this approach is that it results in a poor matching of revenues and expenses. The revenue is recorded in 2001, but the expense is recorded in At the same time, it provides a misleading picture to users of financial statements. At the end of 2001, the firm is telling the readers of the financial statement that it expects to receive $25,000 in cash in the future. In fact, ABC probably had some idea that they would not be able to collect the full amount of their receivables. 6

7 As a result, ABC needs to set-up an allowance for bad debts, or doubtful accounts. This allowance represents the amount they are due to receive that they do not believe they will be able to collect. Example: Assume that at end of 2001, ABC expected that they would be unable to collect $5,000. The appropriate entries would be as follows: 2001 Dr. Accounts receivable $100,000 Cr. Sales revenue $100,000 Dr. Cash 75,000 Cr. Accounts receivable 75,000 Dr. Bad debt expense 5,000 Cr. Allowance for doubtful accounts 5, Dr. Cash $18,000 Cr. Accounts receivable $18,000 Dr. Bad debt expense 2,000 Dr. Allowance for doubtful accounts 5,000 Cr. Accounts receivable 7,000 7

8 The allowance for doubtful accounts is a contra-asset account. At the end of 2001, the firm would report that their ending accounts receivable, net of the allowance is equal to $20,000. Note that: Accounts receivable: $25,000 = Amount due from customers. Allowance for doubtful accounts: $5,000 = Amount we do not think we will be able to collect. Net accounts receivable: $20,000 = Amount due that we expect to collect. 8

9 Exercise 12-6 Fenton Co. reported gross accounts receivable at the end of 2001 of $3,650,000 and a total allowance for doubtful accounts of $450,000. During its fiscal 2002 year, it recorded sales of $18,600,000 on credit, and collected $18,750,000 from customers. It wrote off $165,000 of bad debts and estimated that it required an allowance for doubtful accounts at the end of 2002 equal to 3% of its 2002 sales. Prepare the required entries for