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Chapter 10: Revenue Recognition and Valuation of Receivables

The timing of revenue recognitionValuation of receivables; VAT

Accounting for bad debtRefinancing receivables before the due date

Receivables turnover

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Overview

What are receivablesRecognition of accounts receivable

Treatment of sales discounts• Gross method• Net method

Valuation of accounts receivable• Direct write-off method• Allowance method

Percentage-of-sales approachPercentage-of-receivables approach

• Recovery of accounts written-offAre bad debts really bad?Recognition of notes receivableDisposition of accounts receivable and notes receivable

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Receivables: definition and categorization

Definition: revenues recognized but not yet received, revenueson account

only what the accounting entity collects on its own account, not on behalf of others• net of VAT• agent: only the commission

Classificationcurrent receivables: expected to be collected within a year or thecurrent operating cycle (whichever is longer)noncurrent receivables: all others

trade receivables: amounts owed by customers for goods sold and services renderednontrade receivables: arise from a variety of transactions• e.g. interest, royalties, dividends, compensation for damages

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Treatment of VAT

Exampleinvoice: 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 800VAT 200

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Trade Receivables

Accounts receivableoral promises of the purchaser to payusually collectible within 30-60 daysrepresent „open accounts“ (short-term extension of credit)

„accounts receivable“ account in general ledgercontrol account

summarizes total amount receivable

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General Ledger Accounts ReceivableSubsidiary Record

Accounts ReceivableMiller

Bal. 6.300Bal. 500

MeierTotal

€ 6.300 Bal. 1.800

Mayor

adapted from Harrison/Horngren, p.228 Bal. 4.000

Summary of individual receivables

VAT

VAT: 80

VAT: 288

VAT: 640Bal. 1008

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Importance of Accounts Receivable - I

Source: Dun and Bradstreet, Industry Norms and Ratios, 1993-94

Accounts Receivable as a Percentage of Total Assets for Selected Industries

44,1%

28,0%

18,4%

5,1%

17,5%

40,2%

0,0% 10,0% 20,0% 30,0% 40,0% 50,0%

Advertising Agencies

Interstate Trucking

Auto and Home Supply

Grocery Stores

Pharmaceuticals

Household Appliances

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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

Importance of Accounts Receivable - II

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Revenue recognition revisited

Accounting regulation (IAS 18: Revenues) Revenue is to be recognized when all of the followingconditions are met

it is probable that economic benefits will flow to the entity from therespective transactionthe amount of revenue and the related costs can be measuredreliablythe significant risks and rewards of the transaction have beentransferred to the buyer

specific casesgoods sold on consignment: consignor recognizes revenue onlywhen consignee has sold to his customerright 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 leadto a provision (a separate debt item)

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Recognition of Accounts Receivable

usual way if a credit sale occursrecord the sale as revenue and record

an increase in accounts receivable

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 recognizedinterest not recognized, no discounting (immaterial)

Accounts Receivable € XYZ Revenue € XYZ

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Discounts

Trade Discountsused to avoid frequent changes in cataloguesallow for different prices for different quantitieshide true invoice price from competitors

revenue recognized is the net amountSales Discounts

offered to induce prompt paymentusually 2% - 3% if payment occurs within 10 days, netamount due within 30 daysforegoing the discount is expensive (in terms of opportunitycosts!)

e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!!

100)360201(98 =+ r

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Note that discounts apply to VAT too

both revenue and VAT amounts are reduced by the discountpercentageExample:

Invoice: 1000 + 200 VAT2% discount used• Customer pays: 1176

Journal entries:• when revenue is recognized using the gross method• Dr. Accounts receivable: 1200

Cr. Sales Revenue: 1000VAT: 200

• payment:• Dr. Cash: 1176

Sales discount: 20VAT: 4

Cr.: Accounts receivable: 1200

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Two methods of accounting for salesdiscounts

(1) Gross methodinitially recognize gross amountrecognize sales discounts when they are taken

(2) Net methodinitially recognize amount net of sales discountmake „correcting“ entries if sales discounts are forfeited

from an accounting point of view net method preferablewhy? amount recognized closer to net realizable value

from a practical point of view gross method preferablewhy? easy to apply, no additional calculation necessary

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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 1.940Sales 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 60Cash 2.000 Accounts Receivable 2.000

Note: The payment of € 1.940 results in a reduction of € 2.000 in the accounts receivable accountunder the gross method.

forfeited

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Valuation of Accounts Receivableimportant for financial statement presentationimportant also for internal decision makingvaluation at net realizable value• not always equal to face value!

Motivating examples1. 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 berecognized?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?

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One important valuation aspect: paymentbehavior

0

5

10

15

20

25

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How do German companies evaluate the payment habits of their customers?

Bad 11,5 26,6 12,9 15Good 27,4 21,4 23,9 26,9

Manufact-uring Construction Wholesale /

RetailersService

Industries

Source: Creditreform

, Figuresfrom2000

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Valuation of Receivables: Gross method

From book value (face value) to net realizable valueFace value: nominal amount recognized when credit saletransaction is recordedNet realizable value (NRV): amount estimated to be collectiblefrom outstanding receivablesadjustments necessary for

discountsreturns, andexpected losses from revenues (uncollectible accounts)

NRV = face value – adjustments for discounts– adjustments for sales returns– allowance for uncollectible accounts

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Uncollectible Accounts Receivable

represent loss of revenueexpense due to selling on credituncollectible accounts expense (also called bad debtexpense) is recorded

When uncollectible accounts expense should berecognized?

either at the time when an account turns out to be„uncollectible“: direct write-off methodor in the period of the sales: estimate of uncollectibleaccounts: allowance method

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Direct Write-Off Method

no entries until a specific account is deemeduncollectible

loss recorded as credit entry for Accounts Receivable and debit entry for Bad Debt Expense (or uncollectible accountsexpense)

Discussionfacts are recorded, not estimateshowever, no matching of revenues and costsno net realizable value presentation of receivables

on the balance sheetApply only for individual amounts not material!

Bad Debt Expense € XYZ Accounts Receivable € XYZ

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Allowance Method

Bad Debt Expense recorded in the same period as the sale

debit Bad Debt Expense and credit Allowance forUncollectible (or Doubtful) Accounts

two approaches: percentage-of-sales or percentage-of-receivables

Discussioninvolves estimatesbetter matching of revenues and costsreceivables recorded at their net realizable valuesThis is the method that should be used (and must be usedin many countries)

Bad Debt Expense € XYZ Allowance for Doubtful Accounts € XYZ

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Both direct write-off and allowance methodcombined

debit Allowance for Uncollectible Accountscredit Accounts Receivableestimated net realizable value of AccountsReceivable remains unchanged

exception: unexpected high write-offs (major customer goesbankrupt)

Allowance for Uncollectible Accounts 1.100 Accounts Receivable 1.100

a specific account is written-off

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Effect of write-off on NRV illustrated:

Balances BalancesBefore After

Write-Offs Write-Offs

Accounts Receivable € 143.000 € 141.900Less 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

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Percentage-of-Sales (Income Statement) Approach

Bad Debt Expense as a percentage of credit salesduring the accounting period

percentage determined from past experience and futureexpectationsamount to be recognized = percentage uncollectible × salesany previous balance in Allowance for UncollectibleAccounts is closed out: • Journal entries: Dr.: Allowance for Uncollectible Accounts;

Cr.: Uncollectible Accounts Expense

ExampleCredit sales amounted to € 760.000 while 3%, on average,deemed uncollectible

Uncollectible Accounts Expense 22.800 Allowance for Uncollectible Accounts 22.800

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Percentage-of-Receivables (Balance Sheet) Approach

allowances for doubtful accounts made depending on the agingschedule of outstanding receivables

percentages for different age categories determined from pastexperience and future expectations

NOTE:Percentage-of-receivable focus on balance sheet accountPercentage-of-sales focus on income statement

accountDifferent focus of approaches balance in allowance for

uncollectible accounts doesmatter (PoR) and doesnot matter (PoS), respectively!

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Example of an aging schedule under thepercentage-of-receivables approach

The (uncollected) credit sales of Paper Company in its first year of business amount to:

Month Customer AmountJan. Holm 10.000Feb. Lowe 2.000August Miller 20.000Nov. Smith (I) 8.000Dec. Baker 6.000

Cooper 1.000Gardener 3.000

50.000

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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 8,000 (M) 10% 800

91 – 180 days 20,000 (S I) 15% 3,000

>180 days 12,000 (H,L) 25% 3,0007,300

Targeted balance for Allowance for Uncollectible Accounts

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Journal entries and accounts in year 1:

Uncollectible accounts expense7,300

Allowance for uncollectible accounts7,300

Accounts Receivable Allowance for uncoll. accounts50,000 7,300

Net realizable value of accounts receivable: 42,700

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(uncollected) credit sales in year 2:

Month Customer AmountJan. Koller 2,000March Deutsch 40,000July Franco 6,000August Weyer 1,000Sept. Hunger 12,000Nov, Smith (II) 9,000Dec. Camillo 4,000

74,000

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Other information for year 2:

Payments received from outstanding year-1 receivables

Holm 10,000Miller 20,000Smith (I) 8,000

Write-offs of year-1 receivablesCooper 1,000Gardener 3,000

Open accounts from year 1Baker 6,000Lowe 2,000

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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% 12,50016,450

Targeted balance for Allowance for Uncollectible Accounts

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Determining bad debt expense for year 2:Targeted balance for allowance for u.a. 16,450

less credit balance from prior year – 7,300plus debits due to write-offs + 4,000

13,150Accounts Receivable Allowance for uncoll. accounts

50.000 1.000 1.000 7.3003.000 3.000

10.00020.0008.000

74.00022.900

82.000 26.200

Red – write-offs; blue – collections yr.1; green – adj. yr.2

13.150

16.450

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Remarks

Net realizable value of receivables at the end of year 282.000 – 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€ 42.700

Accounts written-off in year 2 „accounted“ for just € 200 of allowance for uncollectible accounts in year 1

Balance of € 7.300 in Allowance for Uncollectible Accountsaccount from year 1 matters for determining bad debt expense(uncollectible accounts expense) in year 2

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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% 1.95031 - 60 days old 35.000 6% 2.10061 - 90 days old 12.000 15% 1.80091 - 120 days old 14.000 22% 3.080over 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 forUncollectible Accounts to determine Uncollectible AccountsExpense for the corresponding accounting period

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Credit balance of € 2.400

Targeted Balance for Allowance for Uncollectible Accounts: € 13.690Less 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

Allowance for Uncollectible Accounts

Dec. 31 2.400Dec. 31 adjustment 11.290

Dec. 31 balance 13.690

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Recovery of accounts receivable written-off

allowance methodreestablish the receivable written-offdebit Cash and credit Accounts Receivable

direct write-off methoddebit Cashcredit Uncollectible Amounts Recovered

Accounts Receivable 1.100 Allowance for Uncollectible Accounts 1.100

Cash 1.100 Accounts Receivable 1.100

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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 tightand we forego business.

According to view #1, uncollectible accountsexpense represents unnecessary expenses thatreduce profits.According to view #2, uncollectible accountsexpense is a „necessary evil “ associated with creditsales but these credit sales are a means to increaseand repeat business.

in advance it is not known which accounts will turn bad

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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 assetmaker – issuer of note; regards it as note payable liabilityterms are negotiablestronger legal claim than accounts receivablesome notes are tradable

short-term notes recorded at face valueinterest immaterial

long-term notes recorded at present value of cash expected to be collectedAccounting for notes receivable:

similar to accounting for accounts receivablenotable difference in recognition of interest• topic will be dealt with under „liabilities“, i.e. notes payable

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Disposition of Accounts Receivable and Notes Receivable

growing popularity of credit sales soaked up cash of the selling companiesmean to accelerate receipt of cash:

transfer accounts or notes receivable to another company, e.g. bank or factor

finance charge associated with these transactionstransfer of receivables via

secured borrowingsales of receivables

differ in some legal aspects and accountingtreatment

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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 factortakes 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 15.000Loss on Sale of Receivables 600 Financing Revenue _ _600 Accounts Receivable 15.000 Cash 14.400

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Receivables Turnover

Two equivalent ratios

1. Turnover rate =

2. average credit period taken by customers

=

Sales on Accountaverage net accounts receivable

360 turnover rate