Chapter 6: Highlights
1. Generally accepted accounting principles (GAAP) are the methods of accounting that firms use to measure the results of their business transactions, with a principal aim of measuring net income for a period and financial position at the end of a period.
2. Standard-setting bodies within each country currently set GAAP. The Financial
Accounting Standards Board (FASB) sets acceptable accounting principles in the United
States. The International Accounting Standards Board (IASB) promotes the establishment of more uniform GAAP worldwide.
3. In some situations, GAAP permits alternative methods for reporting a particular transaction. In such cases, standard-setting bodies recognize that the economic effects of certain transactions may differ across firms and that a single method may not provide the best measure of earnings and financial position.
4. Standard-setting bodies generally provide broad guidelines rather than detailed rules for applying their pronouncements because (a) economic differences may exist between firms, and (b) firms should have latitude to apply pronouncements to reflect these economic differences.
5. The flexibility and latitude of GAAP do have economic consequences to managers, investors, lenders, and others.
6. Controls exist to constrain the opportunistic actions of management. In its audits, a firm’s independent accountant makes judgments about the appropriateness of the accounting principles a firm selects and the reasonableness of the way the firm applies the accounting principles. Another control is the oversight provided by government regulators, such as the Securities and Exchange Commission (SEC) in the United States.
7.
The term “quality of earnings” encompasses the following ideas:
(a) the representative faithfulness of earnings as a measure of value added.
(b) the ability managers have to use discretion in measuring and reporting earnings in their particular industry.
(c) the extent to which the managers have exercised this discretion.
(d) the extent to which earnings include unusual or nonrecurring items.
8. It is believed that managers will usually make choices that enhance current earnings and present the firm in the best light. By their selection of accounting principles or standards when GAAP allows a choice, by their use of estimates in the application of accounting principles, and by their timing transactions to recognize nonrecurring items in earnings, managers can influence the firm’s earning and its present value. To the extent managers

make choices enhancing currently reported income, analysts will say the firm has a lower quality of earnings. All the management choices that affect the quality of earnings affect when the firm reports its income, not its total amount, over time.
9. Under the accrual basis of measuring income, firms recognize revenue when (a) all, or a substantial portion, of the services expected to be provided have been performed, and (b) cash, or another asset whose cash equivalent value a firm can measure objectively, has been received. Satisfying the first criterion means that a firm can estimate the total expected cash outflows related to an operating activity. If a firm cannot estimate the total expected cash outflows, it will not know the amount of expense to match against revenue, and therefore it will not know the amount of income. Satisfying the second criterion means that a firm can estimate the amount of expected cash inflows from customers. If a firm cannot estimate expected cash inflows, it will not know the amount of revenues and therefore the amount of income.
10. Firms and independent accountants can make a more informed judgment about whether
(a) a firm had delivered a good or performed services, (b) the price is fixed or determinable, and (c) collectibility is reasonably assured if there is persuasive evidence that an arrangement exists. The arrangement may take the form of a contract, prior business dealings with a particular customer, or customary business practices by a firm and its industry.
11. Most firms satisfy the criteria for revenue recognition at the time of sale or delivery of goods and services. Recognizing revenues at the time of sale and properly matching expenses with revenues require firms to estimate the cost of uncollectible accounts, returns, and similar items and recognize them as income reductions at the time of sale.
12. When a firm extends credit, it will find that some customers never pay the amounts due.
The principal accounting issue with uncollectible accounts concerns when firms should recognize the loss from uncollectibles.
13. The direct write-off method recognizes losses from uncollectible accounts in the period when a firm decides that specific customers' accounts are uncollectible.
14. The direct write-off method has three shortcomings: (a) it does not usually recognize the loss from uncollectible accounts in the period in which the firm recognizes revenue, (b) it provides firms with an opportunity to manipulate earnings each period by deciding when particular customers' accounts are uncollectible, and (c) the amount of accounts receivable on the balance sheet under the direct write-off method does not reflect the amount a firm expects to collect in cash.
15. Generally accepted accounting principles do not allow the direct write-off method for financial reporting when losses from uncollectible accounts are significant in amount and are reasonably predictable. Income tax laws in the United States require firms to use the direct write-off method for income tax reporting.

16. When a firm can estimate the amount of uncollectibles with reasonable precision, GAAP requires firms to use the allowance method. The allowance method involves (a) estimating the amount of uncollectibles that will occur in connection with the sales of each period, and (b) making an adjusting entry that reduces the reported income on the income statement and reduces the Accounts Receivable on the balance sheet for the net amount of accounts the firm expects not to collect. The adjusting entry involves a debit to Bad Debts Expense to reduce income and a credit to Allowance for Uncollectible
Accounts, a contra account to Accounts Receivable.
17. Views differ as to the nature of the "Bad Debts Expense" account. Is it an expense account or a revenue contra account? Arguments for treating it as a revenue contra are persuasive, but treatment as an expense is more widely used in practice.
18. When a firm judges a particular account as uncollectible, it writes off the account by debiting Allowance for Uncollectible Accounts and crediting Accounts Receivable.
Writing off the specific account does not affect either net assets or income. The reduction in net assets and the affect on income takes place in the year of sale when the firm estimates the amount of eventual uncollectibles and records Bad Debts Expense and credits the Allowance for Uncollectible Accounts.
19. The allowance method for uncollectible accounts (a) provides a better matching of revenues and expenses in the period of sale, (b) reduces management’s opportunity to manipulate earnings through the timing of write-offs, and (c) results in reporting accounts receivable at the amount the firm expects to collect in cash in future periods. Because the allowance method requires firms to estimate the amount of future uncollectibles, a firm’s management could manipulate earnings by overstating or understating bad debt expense.
20. There are two basic approaches for calculating the amount of the adjustment for uncollectible accounts under the allowance method. The easiest method in most cases is to apply an appropriate percentage to total sales on account for the period. Another method, called aging the accounts, involves the analysis of customers' accounts classified by the length of time the accounts have been outstanding. The rationale is that the longer an account has been outstanding, the greater the probability that it will never be collected.
By applying judgment to the aging analysis, the accountant makes an estimate of the approximate balance needed in the allowance for uncollectible accounts at year end.
21. When a firm uses the percentage-of-sales method, the accountant adds the periodic provision for uncollectible accounts to the existing balance in the account, Allowance for
Uncollectible Accounts. When a firm uses the aging method, the accountant adjusts the balance in the account, Allowance for Uncollectible Accounts, to reflect the desired ending balance.
22. The allowance method requires estimates of uncollectible accounts. When the amount of actual uncollectible accounts differs from the estimated amount, the accountant corrects for the previous misestimates by adjusting the provision for bad debts during the current period. GAAP’s reasoning is that the making of estimates is an integral part of

measuring earnings under the accrual basis. Presuming that firms make conscientious estimates each year, adjustments for misestimates, although recurring, should be small.
23. Accountants use the allowance method when the firm knows that, at the time of sale, it will suffer some reduction in future cash flows but can only estimate the amount at the time of sale. The allowance method permits firms to reduce reported earnings in the period of sale to the amount of the expected net cash collections. Firms can use the allowance method when the customer has the right to return the product for a refund or when the customer has the right to repairs or replacement under warranty if the purchased product is defective.
24. Often, a seller of merchandise offers a reduction from the invoice price for prompt payment, called a sales discount or cash discount. The amount of sales discounts appears as an adjustment in measuring net sales revenue.
25. The return of merchandise by a customer in effect cancels the sale, so an entry that reverses the recording of the sale is appropriate. The account, Sales Returns, is a sales contra account on the income statement. GAAP does not allow a firm to recognize revenue from a sale when customers have the right to return goods unless the firm can reasonably estimate the amount of the return and does so, using an allowance method.
26. A sales allowance is a reduction in price granted to a customer, usually after customers have purchased goods and found them unsatisfactory or damaged. The effect of the allowance is to reduce sales revenue. It is desirable to accumulate the amount of such an adjustment in a Sales Allowances account.
27. In some cases, a firm may find itself temporarily short of cash and unable to obtain financing from its usual sources. In such cases the firm may assign, pledge, or factor its accounts receivable.
28. Firms assign accounts to a bank or finance company in order to obtain a loan. The borrowing company usually maintains physical control of the receivables, collects customers' remittances, and forwards the proceeds to the lending institution to liquidate the loan.
29. Firms may pledge accounts as collateral for a loan. If the borrower fails to repay the loan when due, the lending agency has the right to sell the accounts receivable in order to obtain payment.
30. Firms may factor accounts receivable, which is in effect a sale of the receivables to a bank or finance company. In this case, the firm sells accounts receivable to the lending institution, which physically controls the receivables and collects payments from customers.
31. If a firm has pledged accounts receivable, a footnote to the financial statements should indicate this fact. The collection of pledged accounts receivable will not increase the liquid resources available to the firm to pay general trade creditors. Accounts receivables

that the firm has factored or assigned do not appear on the balance sheet because the firm has sold them.
32. Contractors engaged in long-term construction projects may recognize revenue using the percentage-of-completion method or the completed-contract method.
33. Under the percentage-of-completion method, firms recognize a portion of the total contract price as revenue each period. Such firms also recognize corresponding proportions of the total estimated costs of the contract as expenses. The accountant measures the proportion of total work carried out during the accounting period either from engineers' estimates of the degree of completion or from the ratio of costs incurred to date to the total costs expected for the entire contract. The percentage-of-completion method follows the accrual basis of accounting because of the matching of expenses with related revenues.
34. Under the completed contract method, firms recognize revenue when the project is completed and sold. The total costs of the project become expenses in the period when the firm recognizes revenue.
35. In some cases, firms use the completed contract method because the contracts take a short time to complete. Firms also use the completed contract method when they have not found a specific buyer while construction progresses or when uncertainty obscures the total costs the contractor will incur in carrying out the project even when the firm has a contract with a specific price.
36. The percentage-of-completion method provides information on the profitability of a contractor as construction progresses while the completed contract method reports all income from contracts in the period of completion. GAAP requires the use of the percentage-of-completion method whenever firms can make reasonable estimates of revenues and expenses.
37. Because the percentage-of-completion method requires estimates of revenues and expenses prior to completion, its use provides management with the opportunity to manage earnings through its estimates of total expenses or its estimates of the degree of completion of the project. For this reason, most analysts view earnings reported under the percentage-of-completion method as having lower quality than earnings under the completed contract method, at least with respect for the need to make estimates.
38. When substantial uncertainty exists at the time of sale regarding the amount of cash or cash equivalent value of assets that a firm will ultimately receive from customers, the firm delays the recognition of revenues and expenses until it receives cash. Such sellers recognize revenue at the time of cash collection using either the installment method or the cost-recovery-first method. GAAP permits the seller to use the installment method and the cost-recovery-first method only when the seller cannot make reasonably certain estimates of cash collection.

39. The installment method recognizes revenue as firms collect cash and recognizes portions of the total cost as expenses in the same portion as to total revenue recognized.
40. The cost-recovery-first method is appropriate when substantial uncertainty exists about cash collection. Under this method, firms match the costs of generating revenues dollar for dollar with cash receipts until they recover all such costs. When cumulative cash receipts exceed total costs, firms report profit on the income statement.
41.
To summarize, a firm can recognize revenue when it has delivered products or services to customers so long as the firm can estimate with reasonable statistical certainty the events remaining to complete the transaction. When significant uncertainty exists at the time of delivery about the events remaining to complete the transactions, firms must delay revenue recognition until the uncertainties resolve to the level of reasonable statistical certainty.
42.
In evaluating a firm's past profitability and projecting its likely future profitability, the analyst must consider the nature of income items. Does the income item result from the firm's primary operating activity or from an activity incidental or peripheral to the primary operating activities? Is the income item recurring or nonrecurring?
43. Revenues and expenses result from the recurring primary operating activities of a business. Gains and losses result from either peripheral activities or nonrecurring activities. Firms report revenues and expenses at gross amounts, whereas gains and losses appear at net amounts.