Accounts receivable
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Chapter 10: Revenue Recognition and Valuation of Receivables The timing of revenue recognition Valuation of receivables; VAT Accounting for bad debt Refinancing receivables before the due date Receivables turnover 1 Overview z What are receivables z 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 z Are bad debts really bad? z Recognition of notes receivable z Disposition of accounts receivable and notes receivable 2 Receivables: definition and categorization z Definition: revenues recognized but not yet received, revenues on account z only what the accounting entity collects on its own account, not on behalf of others • net of VAT • agent: only the commission Classification current receivables: expected to be collected within a year or the current operating cycle (whichever is longer) 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 3 Treatment of VAT z 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 4 Trade Receivables z Accounts receivable oral promises of the purchaser to pay usually collectible within 30-60 days represent „open accounts“ (short-term extension of credit) z „accounts receivable“ account in general ledger Æ control account summarizes total amount receivable 5 Summary of individual receivables General Ledger Accounts Receivable Subsidiary Record Accounts Receivable Miller Bal. 6.300 Bal. VAT: 500 80 Meier Total € 6.300 Bal. 1.800 VAT: 288 Mayor VAT adapted from Bal. 1008Harrison/Horngren, p.228 Bal. 4.000 VAT: 640 6 Importance of Accounts Receivable - I Accounts Receivable as a Percentage of Total Assets for Selected Industries Household Appliances 40,2% 17,5% Pharmaceuticals Grocery Stores 5,1% Auto and Home Supply 18,4% 28,0% Interstate Trucking 44,1% Advertising Agencies 0,0% 10,0% 20,0% 30,0% 40,0% 50,0% Source: Dun and Bradstreet, Industry Norms and Ratios, 1993-94 7 Importance of Accounts Receivable - II Receivables / Total assets Receivables / Current assets Manufacturing General Electric (Manufacturer) Chevron (Oil drilling and refining) 0,35 0,09 1,03* 0,47 Retail Supervalu (Grocery retail) Tommy Hilfiger (Clothing retail) 0,09 0,09 0,26 0,26 Internet Yahoo (Internet search engine) Cisco (Internet systems) 0,04 0,07 0,07 0,21 0,10 0,04 0,03 0,24 0,61 0,47 0,87 0,52 General services SBC Communications (Telecommunications services) Wendy's (Restaurant services) Financial services Bank of America (Banking services) Merril Lynch (Investment services) * includes note receivable 8 Revenue recognition revisited z Accounting regulation (IAS 18: Revenues) Revenue is to be recognized when all of the following conditions are met z 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) 9 Recognition of Accounts Receivable z usual way if a credit sale occurs record the sale as revenue and record an increase in accounts receivable Accounts Receivable Revenue z € XYZ € XYZ basis for recognition Ö 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) 10 Discounts z Trade Discounts used to avoid frequent changes in catalogues allow for different prices for different quantities hide true invoice price from competitors z 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!) Î e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!! 20 98(1 + 360 r ) = 100 11 Note that discounts apply to VAT too z both revenue and VAT amounts are reduced by the discount percentage z 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 12 Two methods of accounting for sales discounts z (1) Gross method initially recognize gross amount recognize sales discounts when they are taken z (2) Net method initially recognize amount net of sales discount make „correcting“ entries if sales discounts are forfeited from an accounting point of view Ö net method preferable why? amount recognized closer to net realizable value from a practical point of view Ö gross method preferable why? easy to apply, no additional calculation necessary 13 Gross Method Net Method I Sale of € 4.000, terms 3/10, n/30 Accounts Receivable Sales 4.000 Accounts Receivable 4.000 Sales 3.880 3.880 II Payment of € 1.940 received within discount period: Cash Sales Discounts Accounts Receivable 1.940 60 Cash Accounts Receivable 1.940 1.940 2.000 III Payment of € 2.000 received after discount period: Cash Accounts Receivable 2.000 Accounts Receivable 2.000 Sales Discounts forfeited Forefeited Cash Accounts Receivable 60 60 2.000 2.000 Note: The payment of € 1.940 results in a reduction of € 2.000 in the accounts receivable account under the gross method. 14 Valuation of Accounts Receivable z 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? 15 One important valuation aspect: payment behavior How do German companies evaluate the payment habits of their customers? 30 25 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 20 16 Valuation of Receivables: Gross method z From book value (face value) to net realizable value z Face value: nominal amount recognized when credit sale transaction is recorded z Net realizable value (NRV): amount estimated to be collectible from outstanding receivables z adjustments necessary for z discounts returns, and expected losses from revenues (uncollectible accounts) NRV = face value – adjustments for discounts – adjustments for sales returns – allowance for uncollectible accounts 17 Uncollectible Accounts Receivable z represent loss of revenue expense due to selling on credit uncollectible accounts expense (also called bad debt expense) is recorded z When uncollectible accounts expense should 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 18 Direct Write-Off Method z 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 z € 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 Æ Apply only for individual amounts not material! 19 Allowance Method z 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 € XYZ Allowance for Doubtful Accounts € XYZ z two approaches: percentage-of-sales or percentage-ofreceivables 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) 20 Both direct write-off and allowance method combined z z z 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 Accounts Receivable 1.100 1.100 a specific account is written-off 21 Effect of write-off on NRV illustrated: Balances Before Write-Offs Balances After Write-Offs Accounts Receivable Less Allowance for Uncollectible Accounts € 143.000 13.690 € 141.900 12.590 Estimated Net Realizable Value of Accounts Receivable € 129.310 € 129.310 No effect on net realizable value of Accounts Receivable 22 Percentage-of-Sales (Income Statement) Approach z 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 × sales any previous balance in Allowance for Uncollectible Accounts is closed out: • Journal entries: Dr.: Allowance for Uncollectible Accounts; Cr.: Uncollectible Accounts Expense z Example Credit sales amounted to € 760.000 while 3%, on average, deemed uncollectible Uncollectible Accounts Expense Allowance for Uncollectible Accounts 22.800 22.800 23 Percentage-of-Receivables (Balance Sheet) Approach z 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: z Percentage-of-receivable z Percentage-of-sales Æ focus on balance sheet account Æ focus on income statement account z Different focus of approaches Æ balance in allowance for uncollectible accounts does matter (PoR) and does not matter (PoS), respectively! 24 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 Jan. Feb. August Nov. Dec. Customer Holm Lowe Miller Smith (I) Baker Cooper Gardener Amount 10.000 2.000 20.000 8.000 6.000 1.000 3.000 50.000 25 Aging schedule for year 1 (prepared on December 31, year 1): Age category Amount Percentage uncollectible 0 – 30 days 10,000 (B,C,G) 5% 500 31 – 90 days 8,000 10% 800 20,000 (S I) 15% 3,000 12,000 (H,L) 25% 3,000 91 – 180 days >180 days (M) Uncoll. amount 7,300 Targeted balance for Allowance for Uncollectible Accounts 26 Journal entries and accounts in year 1: Uncollectible accounts expense 7,300 Allowance for uncollectible accounts 7,300 Accounts Receivable 50,000 Allowance for uncoll. accounts 7,300 Net realizable value of accounts receivable: 42,700 27 (uncollected) credit sales in year 2: Month Jan. March July August Sept. Nov, Dec. Customer Koller Deutsch Franco Weyer Hunger Smith (II) Camillo Amount 2,000 40,000 6,000 1,000 12,000 9,000 4,000 74,000 28 Other information for year 2: z Payments received from outstanding year-1 receivables Holm Miller Smith (I) z Write-offs of year-1 receivables Cooper Gardener z 10,000 20,000 8,000 1,000 3,000 Open accounts from year 1 Baker Lowe 6,000 2,000 29 Aging schedule at the end of year 2: Age category Amount 0 – 30 days 4,000 (C) 31 – 90 days 9,000 (S II) Percentage uncollectible Uncoll. amount 5% 200 10% 900 91 – 180 days 19,000 (F,W,H) 15% 2,850 >180 days 25% 12,500 16,450 50,000 (K,D,B,L) Targeted balance for Allowance for Uncollectible Accounts 30 Determining bad debt expense for year 2: Targeted balance for allowance for u.a. less credit balance from prior year plus debits due to write-offs Accounts Receivable 50.000 1.000 3.000 16,450 – 7,300 + 4,000 13,150 Allowance for uncoll. accounts 1.000 3.000 7.300 10.000 20.000 8.000 74.000 82.000 Red – write-offs; blue – collections yr.1; green – adj. yr.2 13.150 22.900 26.200 16.450 31 Remarks z Net realizable value of receivables at the end of year 2 82.000 – 16.450 = 65.550 z In year 2: net realizable value of year-1 receivables after writeoffs but before collections is the same as at the end of year 1, i.e. is equal to € 42.700 z Accounts written-off in year 2 „accounted“ for just € 200 of allowance for uncollectible accounts in year 1 z Balance of € 7.300 in Allowance for Uncollectible Accounts account from year 1 matters for determining bad debt expense (uncollectible accounts expense) in year 2 32 Example 2 of an aging schedule of receivables Company XYZ Age Amount less than 30 days old 31 - 60 days old 61 - 90 days old 91 - 120 days old over 120 days old € 65.000 35.000 12.000 14.000 17.000 Percentage estimated to be uncollectible 3% 6% 15% 22% 28% targeted balance of the Allowance for Uncollectible Accounts account: z Required Balance in Allowance 1.950 2.100 1.800 3.080 4.760 € 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 33 Credit balance of € 2.400 Allowance for Uncollectible Accounts Dec. 31 Dec. 31 adjustment 2.400 11.290 Dec. 31 balance 13.690 Targeted Balance for Allowance for Uncollectible Accounts: Less Current Credit Balance of Allowance for Uncollectible Accounts Uncollectible Accounts Expense Dec. 31 Uncollectible Accounts Expense Allowance for Uncollectible Accounts € 13.690 2.400 € 11.290 11.290 11.290 34 Recovery of accounts receivable written-off z allowance method reestablish the receivable written-off debit Cash and credit Accounts Receivable z Accounts Receivable Allowance for Uncollectible Accounts 1.100 Cash Accounts Receivable 1.100 1.100 1.100 direct write-off method debit Cash credit Uncollectible Amounts Recovered 35 Economic evaluation of allowing for bad debt z Two contrasting views: „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. 1. z z 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 36 Recognition of Notes Receivable z A promissory note is a written promise to pay a certain sum of money at a specific future date. z payee – holder of note; regards it as note receivable Æ asset maker – issuer of note; regards it as note payable Æ liability terms are negotiable stronger legal claim than accounts receivable some notes are tradable short-term notes recorded at face value interest immaterial z long-term notes recorded at present value of cash expected to be collected z 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 37 Disposition of Accounts Receivable and Notes Receivable z z growing popularity of credit sales soaked up cash of the selling companies mean to accelerate receipt of cash: z z 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 38 Sale of Receivables z z 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 Cash Loss on Sale of Receivables Accounts Receivable Deutsche Factors 14.400 600 15.000 Accounts Receivable Financing Revenue Cash 15.000 _ _600 14.400 39 Receivables Turnover z Two equivalent ratios 1. Sales on Account Turnover rate = average net accounts receivable 2. average credit period taken by customers 360 = turnover rate 40
