Chapter 10: Revenue Recognition and Valuation of Receivables Overview: What are receivables Recognition of accounts receivable Treatment of sales discounts Gross method, net method Valuation of accounts receivable Direct write-off method Allowance method Percentage-of-sales approach, percentage-of-receivables approach Recovery of accounts written-off Are bad debts really bad? Recognition of notes receivable Disposition of accounts receivable and notes receivable 1
Receivables: definition and categorization Definition: revenues recognized but not yet received, revenues on account receivables include any taxes the seller collects on behalf of the government gross of VAT Classification current receivables: expected to be collected within a year noncurrent receivables: all others trade receivables: amounts owed by customers for goods sold and services rendered nontrade receivables: arise from a variety of transactions e.g. interest, royalties, dividends, compensation for damages 2
Treatment of VAT Example invoice: Gross amount: 1000, including 25% VAT usually VAT has to be separately shown in the invoice revenue (1 + 25%) = 1000 revenue = 1000/1.25 = 800 Journal entries: Dr.: Customer 1000 Cr.: revenue 800 VAT 200 3
Trade Receivables Accounts receivable oral promises of the purchaser to pay usually collectible within 30-60 days represent open accounts (short-term extension of credit) accounts receivable account in general ledger control account summarizes total amount receivable 4
Importance of Accounts Receivable Receivables / Total assets Receivables / Current assets Manufacturing General Electric (Manufacturer) 0,35 1,03* Chevron (Oil drilling and refining) 0,09 0,47 Retail Supervalu (Grocery retail) 0,09 0,26 Tommy Hilfiger (Clothing retail) 0,09 0,26 Internet Yahoo (Internet search engine) 0,04 0,07 Cisco (Internet systems) 0,07 0,21 General services SBC Communications 0,10 0,03 (Telecommunications services) 0,04 0,24 Wendy's (Restaurant services) Financial services Bank of America (Banking services) 0,61 0,87 Merril Lynch (Investment services) 0,47 0,52 * includes note receivable 5
Revenue recognition revisited Accounting regulation (IAS 18: Revenues) Revenue is to be recognized when all of the following conditions are met it is probable that economic benefits will flow to the entity from the respective transaction the amount of revenue and the related costs can be measured reliably the significant risks and rewards of the transaction have been transferred to the buyer specific cases goods sold on consignment: consignor recognizes revenue only when consignee has sold to his customer right of the customer to return the goods: recognition depends on the amount of risk that customer will exercise this right (consignment on approval... return only if defective) warranty claims do not prevent revenue recognition but they lead to a provision (a separate debt item) 6
Recognition of Accounts Receivable usual way if a credit sale occurs record the sale as revenue and record an increase in accounts receivable Accounts Receivable Revenue XYZ XYZ basis for recognition exchange price, i.e. the amount due from the debtor exchange price can be found in the contract or on the invoice Discounts must be recognized interest not recognized, no discounting (immaterial) 7
Discounts Trade Discounts used to avoid frequent changes in catalogues allow for different prices for different quantities hide true invoice price from competitors revenue recognized is the net amount Sales Discounts offered to induce prompt payment usually 2% - 3% if payment occurs within 10 days, net amount due within 30 days foregoing the discount is expensive (in terms of opportunity costs!) e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!! 20 98 (1 + r) = 100 360 8
Note that discounts apply to VAT too both revenue and VAT amounts are reduced by the discount percentage Example: Invoice: 1000 + 200 VAT 2% discount used Customer pays: 1176 Journal entries: when revenue is recognized using the gross method Dr. Accounts receivable: 1200 Cr. Sales Revenue: 1000 VAT: 200 payment: Dr. Cash: 1176 Sales discount: 20 VAT: 4 Cr.: Accounts receivable: 1200 9
Two methods of accounting for sales discounts (1) Gross method initially recognize gross amount recognize sales discounts when they are taken (2) Net method initially recognize amount net of sales discount make correcting entries if sales discounts are forfeited from an accounting point of view net method preferable why? amount recognized closer to net realizable value from a practical point of view gross method preferable why? easy to apply, no additional calculation necessary 10
Gross Method Net Method I Sale of 4.000, terms 3/10, n/30 Accounts Receivable 4.000 Accounts Receivable 3.880 Sales 4.000 Sales 3.880 II Payment of 1.940 received within discount period: Cash 1.940 Cash 1.940 Sales Discounts 60 Accounts Receivable 1.940 Accounts Receivable 2.000 III Payment of 2.000 received after discount period: Cash 2.000 Accounts Receivable 60 Accounts Receivable 2.000 Sales Discounts Forefeited 60 Cash 2.000 Accounts Receivable 2.000 Note: The payment of 1.940 results in a reduction of 2.000 in the accounts receivable account under the gross method. 11
Valuation of Accounts Receivable important for financial statement presentation important also for internal decision making valuation at net realizable value not always equal to face value! Motivating examples 1. Installment sales allow purchase of goods too expensive to fully pay instantly in cash risk of default if consumers overestimate their financial capabilities When and what amount of (expected) credit losses should be recognized? 2. Businesses with high return ratios credit sales as, say, books are delivered to stores unsold copies are returned should general allowances be made upfront? 12
One important valuation aspect: payment behavior How do German companies evaluate the payment habits of their customers? 30 25 20 15 10 5 0 Manufacturing Construction Wholesale / Retailers Service Industries Bad 11,5 26,6 12,9 15 Good 27,4 21,4 23,9 26,9 Source: Creditreform, Figures from 2000 13
Valuation of Receivables: Gross method From book value (face value) to net realizable value Face value: nominal amount recognized when credit sale transaction is recorded Net realizable value (NRV): amount estimated to be collectible from outstanding receivables adjustments necessary for discounts returns, and expected losses from revenues (uncollectible accounts) NRV = face value adjustments for discounts adjustments for sales returns allowance for uncollectible accounts 14
Uncollectible Accounts Receivable represent loss of revenue expense due to selling on credit uncollectible accounts expense (also called bad debt expense) is recorded When should uncollectible accounts expense be recognized? either at the time when an account turns out to be uncollectible : direct write-off method or in the period of the sales: estimate of uncollectible accounts: allowance method 15
Direct Write-Off Method no entries until a specific account is deemed uncollectible loss recorded as credit entry for Accounts Receivable and debit entry for Bad Debt Expense (or uncollectible accounts expense) Bad Debt Expense Accounts Receivable XYZ XYZ Discussion facts are recorded, not estimates however, no matching of revenues and costs no net realizable value presentation of receivables on the balance sheet Apply only for individual amounts not material! 16
Allowance Method Bad Debt Expense recorded in the same period as the sale debit Bad Debt Expense and credit Allowance for Uncollectible (or Doubtful) Accounts Bad Debt Expense Allowance for Doubtful Accounts XYZ XYZ two approaches: percentage-of-sales or percentage-of-receivables Discussion involves estimates better matching of revenues and costs receivables recorded at their net realizable values This is the method that should be used (and must be used in many countries) 17
Treatment of direct write-offs when the allowance method is applied debit Allowance for Uncollectible Accounts credit Accounts Receivable estimated net realizable value of Accounts Receivable remains unchanged exception: unexpected high write-offs (major customer goes bankrupt) Allowance for Uncollectible Accounts 1.100 Accounts Receivable 1.100 a specific account is written-off 18
Effect of write-off on NRV illustrated: Balances Before Write-Offs Balances After Write-Offs Accounts Receivable 143.000 141.900 Less Allowance for Uncollectible Accounts 13.690 12.590 Estimated Net Realizable Value of Accounts Receivable 129.310 129.310 No effect on net realizable value of Accounts Receivable 19
Percentage-of-Sales (Income Statement) Approach Bad Debt Expense as a percentage of credit sales during the accounting period percentage determined from past experience and future expectations amount to be recognized = percentage uncollectible credit sales Example Credit sales amounted to 760.000 while 3%, on average, deemed uncollectible Uncollectible Accounts Expense 22.800 Allowance for Uncollectible Accounts 22.800 20
Percentage-of-Receivables (Balance Sheet) Approach allowances for doubtful accounts made depending on the aging schedule of outstanding receivables percentages for different age categories determined from past experience and future expectations NOTE: Percentage-of-receivable focus on balance sheet account Percentage-of-sales focus on income statement account Different focus of approaches: Percentage -of-sales approach implicitly assumes that annual credit sales are linearly related to bad debt amount! Percentage of-receivables approach assumes that a linear relationship exists between the amount of credit sales outstanding at the balance sheet date and the amount of bad debt 21
Example of an aging schedule under the percentage-of-receivables approach The (uncollected) credit sales of Paper Company in its first year of business amount to: Month Customer Amount Jan. Holm 10.000 Feb. Lowe 2.000 August Smith (I) 8.000 Nov. Miller 20.000 Dec. Baker 6.000 Cooper 1.000 Gardener 3.000 50.000 22
Aging schedule for year 1 (prepared on December 31, year 1): Age Amount Percentage Uncoll. category uncollectible amount 0 30 days 10,000 (B,C,G) 5% 500 31 90 days 20,000 (M) 10% 2,000 91 180 days 8,000 (S I) 15% 1,200 >180 days 12,000 (H,L) 25% 3,000 6,700 Targeted balance for Allowance for Uncollectible Accounts 23
Journal entries and accounts in year 1: Uncollectible accounts expense 6,700 Allowance for uncollectible accounts 6,700 Accounts Receivable Allowance for uncoll. accounts 50,000 6,700 Net realizable value of accounts receivable: 43,300 24
(uncollected) credit sales in year 2: Month Customer Amount Jan. Koller 2,000 March Deutsch 40,000 July Franco 6,000 August Weyer 1,000 Sept. Hunger 12,000 Nov, Smith (II) 9,000 Dec. Camillo 4,000 74,000 25
Other information for year 2: Payments received from outstanding year-1 receivables Holm 10,000 Miller 20,000 Smith (I) 8,000 Write-offs of year-1 receivables Cooper 1,000 Gardener 3,000 Open accounts from year 1 Baker 6,000 Lowe 2,000 26
Aging schedule at the end of year 2: Age Amount Percentage Uncoll. category uncollectible amount 0 30 days 4,000 (C) 5% 200 31 90 days 9,000 (S II) 10% 900 91 180 days 19,000 (F,W,H) 15% 2,850 >180 days 50,000 (K,D,B,L) 25% 12,500 Targeted balance for Allowance for Uncollectible Accounts 16,450 27
Determining bad debt expense for year 2: Targeted balance for allowance for u.a. 16,450 less credit balance from prior year 6,700 plus debits due to write-offs + 4,000 13,750 Accounts Receivable 50.000 74.000 82.000 1.000 3.000 10.000 20.000 8.000 Allowance for uncoll. Accounts 1.000 6.700 3.000 13.750 16.450 Red write-offs; blue collections yr.1; green adj. yr.2 28
Remarks Net realizable value of receivables at the end of year 2 82.000 16.450 = 65.550 In year 2: net realizable value of year-1 receivables after write-offs but before collections is the same as at the end of year 1, i.e. is equal to 43.300 Accounts written-off in year 2 accounted for just 200 of allowance for uncollectible accounts in year 1 Balance of 6.700 in Allowance for Uncollectible Accounts account from year 1 matters for determining bad debt expense (uncollectible accounts expense) in year 2 29
Example 2 of an aging schedule of receivables Company XYZ Percentage Required estimated to be Balance in Age Amount uncollectible Allowance less than 30 days old 65.000 3% 1.950 31-60 days old 35.000 6% 2.100 61-90 days old 12.000 15% 1.800 91-120 days old 14.000 22% 3.080 over 120 days old 17.000 28% 4.760 targeted balance of the Allowance for Uncollectible Accounts account: 13.690 Determination of Uncollectible Accounts Expense... subtract the current credit balance of Allowance for Uncollectible Accounts to determine Uncollectible Accounts Expense for the corresponding accounting period 30
Credit balance of 2.400 Allowance for Uncollectible Accounts Dec. 31 2.400 Dec. 31 adjustment 11.290 Dec. 31 balance 13.690 Targeted Balance for Allowance for Uncollectible Accounts: 13.690 Less Current Credit Balance of Allowance for Uncollectible Accounts 2.400 Uncollectible Accounts Expense 11.290 Dec. 31 Uncollectible Accounts Expense 11.290 Allowance for Uncollectible Accounts 11.290 31
Recovery of accounts receivable written-off allowance method reestablish the receivable written-off debit Cash and credit Accounts Receivable Accounts Receivable 1.100 Allowance for Uncollectible Accounts 1.100 Cash 1.100 Accounts Receivable 1.100 direct write-off method debit Cash credit Uncollectible Amounts Recovered 32
Economic evaluation of allowing for bad debt Two contrasting views: 1. In God we trust. All others pay cash. (anonymous) 2. If the percentage of uncollectibles is below some percentage of all receivables, our credit policy is too tight and we forego business. According to view #1, uncollectible accounts expense represents unnecessary expenses that reduce profits. According to view #2, uncollectible accounts expense is a necessary evil associated with credit sales but these credit sales are a means to increase and repeat business. in advance it is not known which accounts will turn bad 33
Recognition of Notes Receivable A promissory note is a written promise to pay a certain sum of money at a specific future date. payee holder of note; regards it as note receivable asset maker issuer of note; regards it as note payable liability terms are negotiable stronger legal claim than accounts receivable some notes are tradable short-term notes recorded at face value interest immaterial long-term notes recorded at present value of cash expected to be collected Accounting for notes receivable: similar to accounting for accounts receivable notable difference in recognition of interest topic will be dealt with under liabilities, i.e. notes payable 34
Disposition of Accounts Receivable and Notes Receivable growing popularity of credit sales soaked up cash of the selling companies means to accelerate receipt of cash: transfer accounts or notes receivable to another company, e.g. bank or factor finance charge associated with these transactions transfer of receivables via secured borrowing sales of receivables differ in some legal aspects and accounting treatment 35
Sale of Receivables An account receivable that ZiscoSys holds is sold to Deutsche Factors (a fictitious commercial factor). The receivable amounts to 15.000 and the factor takes a 4% finance charge. Journal entries that both companies would make as a result of the transaction. ZiscoSys Deutsche Factors Cash 14.400 Accounts Receivable 15.000 Loss on Sale of Receivables 600 Financing Revenue 600 Accounts Receivable 15.000 Cash 14.400 36