Accounting ch 5

Apply GAAP for proper revenue recognition

 Revenue recognized when earned
• Goods delivered
• Services performed
 Recorded at the amount of:
• Cash received, or
• Fair market value of assets received in the exchange
The revenue recognition principle is the basis for measurement and reporting in the revenue cycle. Revenue is the inflow
of resources (or reduction of liabilities) resulting from delivering goods/ services for customers. Revenue should be
recognized when it is earned, not before. The core principle for revenue recognition is that revenue should be
recognized when an entity transfers goods or services to customers in an amount that reflects the cash or fair market
value of other assets that the entity expects to receive in exchange for those goods or services.
The process of revenue recognition is based on contracts that a business has with outsiders.
 Contract (written or oral): An agreement between two parties that creates enforceable rights or performance
obligations
 Five steps: Identify the contract(s), Identify the performance obligation, Determine the transaction price,
Allocate the transaction price to the performance obligations, Recognize revenue when the entity satisfies the
obligations
 Ex: Assume Apple, Inc., delivers a truckload of iPhones to an AT&T Wireless warehouse in Florida. On the truck
are 30,000 iPhones, each of which Apple, Inc., sells to AT&T Wireless for $100 on account. Each phone cost
Apple $60 to produce.

Shipping Terms

• FOB (free on board) shipping point – ownership changes hands and revenue is recognized when goods leave the
shipping dock

• FOB (free on board) destination – ownership changes hands and revenue is recognized at the point of delivery to
the customer

The shipping terms in a sales contract dictate the date which the title, or ownership, of the goods transfers to the buyer.
A common shipping is FOB, which indicates the point at which the seller is free of ownership of the goods. After this
point, the buyer owns them and is responsible for losses if they get damaged, lost, or stolen. When goods are shipped
FOB shipping point, ownership changes hands and revenue is recognized when the goods leave the seller’s shipping
dock. When goods are shipped FOB destination, ownership changes hands and revenue is recognized at the point of
delivery to the customer.

 Ex: When AT&T fulfills its obligation to pay for the phones, Apple records the collection of the payment receipt.

Speeding up the cash flow from sales

 Strategies to shorten credit cycle and collect cash more quickly:

 Sales discounts for early payments
 Charge interest after a certain time period
 Adopt more effective credit and collection procedures
 Emphasize credit card or bankcard sales

Speeding cash flow from sales by accepting credit or debit card sales

 Ex: Suppose Apple Inc., sells a computer and peripheral devices for $5,000 at one of its stores, and the customer
pays with a VISA card. VISA’s fee is 2%. Apple Inc., records the sale, ignoring cost of goods sold

For retailers, a way to

speed up cash
collections is to accept
credit or debit card
sales. This strategy can
increase sales
dramatically, but the
added revenue comes at a cost, which is typically about 2% to 3% of the total amount of the sale.

The Apple Store enters the transaction in its accounting system via a point-of-sale terminal. The terminal, linked to a
VISA server, automatically credits Apple Inc.’s bank account for a discounted portion, say $4,900, of the $5,000 sale
amount. Two percent ($100) goes to VISA. To Apple Inc., the credit card discount is reported on the income statement
as interest expense.

Account for Sales Returns and Allowances

Sales Refunds, Returns, and Allowances

 Customer’s right to return unsatisfactory or damaged goods

 Credit memo – document authorizing a credit to the customer’s account receivable
 Retailers keep track of sales returns over time to make sure they are not excessive. Returned merchandise means
lost profits. Companies issue credit memos when customers return products they bought on account.

 Ex: Suppose Apple’s historical experience is that 1% of the items it sells eventually are returned. Assume
that Apple’s sales revenue for the month of June 2018 is $200 million. To estimate its sales returns and
adjust its inventory, Apple
would record the following
two entries at June 30
(assuming cost of goods sold
is 60% of sales):
 Companies are required to
estimate expected future
returns as a part of the end-
of-period adjusting entry process. This requires the company to (1) increase sales returns and recognize an
accrued liability for the sales prices of items expected to be returned; and (2) adjust the inventory and cost
of goods sold accounts for the cost of the items expected to be returned.

 Ex: Assume that in July 2018, Apple customers actually return $1,800,000 of inventory. Using the same cost
of goods sold percentage, the company would make the following entries:


As items are actually returned
in the future, the company
reduces its sales refund
payable account for the
amount of cash or accounts
receivable credit it gives back
to customers. Apple also debits
its inventory account for items
that are returned and put back
into inventory, and credits the company’s inventory returns estimated account by the same amount.

Account for Sales Discounts

 Businesses offer a percentage discount off sales price if customers agree to pay earlier than 30 days, these
incentives are called sales discounts
 Example of a sales discount - 2/10,n/30
o Seller will discount by 2% if the buyer pays within 10 days, 2/10
o If the buyer doesn’t pay within 10 days, it must pay the full amount within 30 days, n/30 (n=net)
o The typical credit cycle for most sales on account is 30 days. This means sellers typically expect
customers to pay their accounts in full within 30 days of receiving the goods or services.
 Ex: Ace Hardware makes sales of building materials to several large construction companies. To encourage
customers to pay within 10 days, Ace Hardware offers its customers a 2/10, n/30 discount on all sales. On June
30, Ace sells $100,000 of lumber on account to Sorrells Construction Company, and the lumber is delivered that
day. The cost of the lumber to Ace is $75,000.
 Step 3 of the revenue recognition model requires
that the seller set the price of the sale at the
amount the seller expects to receive from the
customer. The problem for Ace is deciding what
amount this is. The decision is usually based on a
company’s past experience with customers. Let’s
 assume that, in the construction industry, Ace does not expect its customers to take advantage of sales
discounts, but does offers discounts when they do pay in full within the discount period (10 days). In this case,
Ace would record the sale to Sorrells as above.
 Sorrells Construction pays its invoice to Ace Hardware in full, less the sales discount, on July 10. Record the
collection.
This method of recording sales
discounts is called the gross method.
We assume the gross method is used in
this chapter, as well as end-of-chapter
exercises and problems. An alternative
method for recording sales discounts is
the net method, which assumes that all
customers will pay within the discount
period. With the net method, all sales are recorded at the net amounts (in our illustration, $98,000), with
adjustments being required later for customers that fail to pay early.

Disclosure of Net Revenues on the Income Statement

Retailers, wholesalers, and

manufacturers typically disclose
sales revenue at the net amount,
which means after sales discounts,
sales returns and allowances have
been subtracted. Apple Inc.’s net
sales revenue for 2016, compared
with the last two years, is shown.

Account for accounts receivable

 Receivables: Monetary claims against others, Current assets, Sometimes called trade receivables

• Acquired by: Selling goods and services (accounts receivable), Lending money (notes receivable)

Journal entries to record receivables

The Accounts Receivable account in the general ledger shows the total amount receivable from all customers.
Companies also keep another accounts receivable ledger called a subsidiary ledger. The subsidiary ledger shows the
separate accounts for each individual
customer.

Managing and
Accounting for Receivables

 Companies risk not collecting some receivables when they sell on credit
 The risk of not collecting can be managed by:
o Run credit checks
o Extend credit only to creditworthy customers
o Separate cash handling and record-keeping
o Keep a close eye on customers’ payment habits
o Send second and third statements
o Have customers sign agreements for EFTs

Evaluate collectability using the allowance for uncollectible accounts

Credit Sales

 benefits: Customers can buy on credit, so sales and profits increase

 costs: Company cannot collect from some customers, Recorded as uncollectible-account expense

Allowance Method

 Records losses from failure to collect receivable

  Based on company’s past collection experiences
 Record Uncollectible-Account Expense
 Set up contra-account
 Allowance for Uncollectible Accounts
 Shows the amount the business expects not to collect

This method records losses from failure to collect receivables based on estimates developed from the company’s
collection experience. A company doesn’t wait to see which customers will not pay. Instead, it records the estimated
amount as Uncollectible-Account Expense and also sets up a contra-account to accounts receivable called Allowance for
Uncollectible Accounts. On the balance sheet, the Allowance for Uncollectible Accounts reduces gross receivables to
their net realizable value. The allowance shows the amount of the receivables the business expects not to collect.

The allowance shows how much of the

receivable has been expensed. It would be
shown on the balance sheet as shown

The income statement reports

Uncollectible-Account Expense among the
operating expenses, as shown

Two basic ways to estimate uncollectibles:

 Percent-of-sales method
o Uncollectible-account expense computed as a percent of revenue
o Income statement approach
 Aging-of-receivables method
o Specific accounts are analyzed based on how long they have been outstanding
o Balance sheet approach

Percent-of-Sales Method Ex: Assume Apple’s accounts have the following balances before the year-end adjustments:

The percent-of-sales method estimates a

business’s uncollectible account expense
as a percent of the company’s revenue.
This method is considered an income-
statement approach because it focuses on the amount of expense to be reported on the income statement.

Percent-of-Sales Method Ex: Apple’s credit department estimates uncollectible-account expense is .0002% of total
revenues, which are $215,639 million.
 The entry records uncollectible-
account expense for the year and
also updates the allowance.
Multiply the estimated %
uncollectible by the sales revenue in
order to get uncollectible account
expense.

Percent-of-Sales Method Ex:

The percent-of-sale method employs the expense recognition (matching principle) to estimate the cost that has been
incurred in order to earn a certain amount of revenue and to recognize both in the same period.

Aging-of-Receivables Method Ex: Suppose Apple’s receivables accounts show the following before the year-end
adjustments

The aging method is a balance-sheet approach bc it

focuses on what should be the most relevant/faithful
representation of accounts receivable as of the balance-
sheet date. Individual receivables from specific
customers are analyzed based on how long they have
been outstanding.

Aging Accounts Receivable of Apple Inc.

Apple’s computerized accounting system ages the

company’s accounts receivable. Apple’s gross
receivables total $15,807. Of this amount, Apple
expects not to collect $53 (shown in the bottom
right hand corner). Notice that the longer the account has been outstanding, the more likely Apple expects not to
collect the amount.

The aging method will bring the balance of the allowance account ($5) to the needed amount as determined by the
aging schedule ($53).

The aging method will bring the balance

of the allowance account: $5 million to
the needed amount as determined by the
aging schedule: $53 million. The lower
right corner of the aging schedule gives
the needed balance in the allowance
account. To update the allowance, Apple
would make this adjusting entry at year-
end.

The balance sheet can now report what Apple actually expects to receive from customers: $15,807 – 53. This is the net
realizable values of Apple’s accounts receivable.

Writing Off Uncollectible Accounts: At the beginning of the year, Apple had these accounts receivable (in millions):

Assume that at the beginning of fiscal 2017, Apple Inc.,

had these accounts receivable (amounts in millions).

Write Off Uncollectible Accounts Early in fiscal 2017, Apple, Inc.’s credit department determines that Apple, Inc., cannot
collect from RS and TM. Apple, Inc., then writes off these receivables.

Early in fiscal 2017, Apple, Inc.’s credit

department determines that Apple,
Inc., cannot collect from RS and TM.
Apple, Inc., then writes off these
receivables with the above entry.
Write Off Uncollectible Accounts

After the write-off, Apple’s accounts show these

amounts. Notice that accounts receivable net is still
$15,754. There is no effect on Net Income either. This is
because the write-off affects no expense account. The
allowance method recognized the expense in the
period that it was incurred, which is the same period in
which the sale took place.

Most companies use the percent-of-sales and aging-of-accounts methods together:

 For interim statements (monthly or quarterly), companies often use the percent-of-sales method because it is
easier and quicker to apply. The percent-of-sales method focuses on the uncollectible-account expense, but that
is not enough.
 At the end of the year, companies use the aging method to ensure that Accounts Receivable is reported at net
realizable value on the balance sheet. The aging method focuses on the amount of the receivables that is
uncollectible.
 Using the two methods together provides good measures of both the expense and the asset.

Direct Write-Off Method

 Alternative way to account for uncollectible receivables

 Records expense when specific customer’s account proves to be uncollectible
 Less preferable, not in conformance with GAAP
o No allowance for uncollectible, may overstate assets on the balance sheet
o Fails to recognize uncollectible accounts in the same period in which the related revenue is earned

The journal entry to write off RS and

TM using the direct write-off method is
as follows:

required method of accounting for

uncollectible accounts for federal
income tax purposes. It is one of
several sources of timing differences
that may arise between net income for
financial reporting purposes and net
income for federal income tax purposes.

Computing Cash Collections from Customers

 Receivables typically hold five items:

 If you know all
other items
except for
collections, you
can compute
collections by
solving for X.
$200 + $1,800 −
X − $100 = $400.
X = $1,500.

Account for notes receivable and interest revenue

Creditor Party to whom money is owed; lender

Debtor Party that borrowed and owes money; maker, borrower

Interest Cost of borrowing money; stated as annual percentage rate

Maturity Date Date at which debtor must pay the note

Maturity Value The sum of principal and interest

Principal Amount of money borrowed by the debtor

Term Length of time from when the note was signed to when payment must be made

Promissory Note: There are two parts to a note. The creditor has a note receivable while the debtor has a note payable.

Note the important parts: principal,

interest period start date, Payee
(Creditor), interest period end date
(maturity date), Maker (Debtor)
 Consider the promissory note
above. After Lauren Holland
signs the note, Continental Bank
gives her $1,000 cash. The bank
makes the following entry to
record the loan.

Continental Bank will accrue

9% interest revenue for four
months:

Continental Bank earns

interest revenue during
September, October,
November, and December.
At December 31, 2018, the
bank accrues 9% interest
revenue for four months.

Continental Bank reports these amounts in its financial statement at December 31, 2018 as follows:

The bank collects the note on February 28, 2019.

This entry zeros out the note receivable, interest

receivable, and records the interest revenue

earned in 2019.

Interest

 Rates usually expressed as an annual percent

 Fraction used for time periods less than an year:
Months/12, Days/365

Evaluate liquidity using three new ratios

  Quick (Acid-
Test) Ratio

Higher ratio
indicates
easier to pay
current
liabilities

What is
considered
acceptable
varies based on the industry

Managers, stockholders, and creditors care about the liquidity of a company’s assets. The current ratio measures an
organization’s ability to pay its current liabilities with its current assets. A more stringent measure of the ability to pay
current liabilities is the quick ratio (or acid-test). The quick ratio measures a company’s ability to pay its current liabilities
with its shorter-term assets—cash and other current assets that are only one step away from cash—marketable
securities and net receivables.

Apple’s quick ratio is 1.05, Indicates Apple has $1.05 quick

assets to pay each $1 of current liabilities

 The higher the quick ratio, the easier it is to pay an organization’s current liabilities. A benchmark for the quick
ratio is 1:1, which means the company can cover every dollar’s worth of current liabilities by cashing in its quick
assets. Apple Inc.’s quick ratio of 1.05 means that it has $1.05 of quick assets to pay each $1 of current liabilities,
which is considered to be healthy.

Accounts Receivable Turnover

Accounts receivable turnover tells a company how

long it takes to collects its average level of
receivables. It measures the ratio of net credit sales
to average net accounts receivable. The result shows
the number of times per year the company
completely collects its average accounts receivable. A
larger number is better for this ratio. Apple’s
accounts receivable turnover was 13.23, meaning Apple converted its average accounts receivable to cash 13.23 times
during the year.

Days’ Sales Outstanding

Once the accounts receivable turnover ratio is

computed, days’ sales outstanding can be calculated by
dividing the accounts receivable turnover ratio by 365.
This tells a company how long it takes to collect its
average level of receivables. Converted to days, it took Apple an average of 27.6 days (365 ÷ 13.23) to collect the
average customer account. A shorter number is better for this ratio.

Another way to computer days’ sales

outstanding. First, compute average daily
sales. Then divide by average net receivables for the period. You can see that this method merely rearranges the
equations in the body of the text, “going through the back door” to achieve the same result.