9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
- According to the revenue recognition principle, a company will recognize revenue when a product or service is provided to a client. The revenue must be reported in the period when the earnings process completes.
- According to the matching principle, expenses must be matched with revenues in the period in which they are incurred. A mismatch in revenues and expenses can lead to financial statement misreporting.
- When a customer pays for a product or service on a line of credit, the Accounts Receivable account is used. Accounts receivable must satisfy the following criteria: the customer owes money and has yet to pay, the amount is due in less than a company’s operating cycle, and the account usually does not incur interest.
- When a customer purchases a product or service on credit, using an in-house account, Accounts Receivable increases and Sales Revenue increases. When the customer pays the amount due, Accounts Receivable decreases and Cash increases.
- When a customer purchases a product or service with a third-party credit card, such as Visa, Accounts Receivable increases, Credit Card Expense increases, and Sales Revenue increases. When the credit card company pays the amount due, Accounts Receivable decreases and Cash increases for the original sales price less the credit card usage fee.
9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
- Bad debt is a result of unpaid and uncollectible customer accounts. Companies are required to record bad debt on financial statements as expenses.
- The direct write-off method records bad debt only when the due date has passed for a known amount. Bad Debt Expense increases (debit) and Accounts Receivable decreases (credit) for the amount uncollectible.
- The allowance method estimates uncollectible bad debt and matches the expense in the current period to revenues generated. There are three ways to calculate this estimation: the income statement method, balance sheet method/percentage of receivables, and balance sheet aging of receivables method.
- The income statement method estimates bad debt based on a percentage of credit sales. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
- The balance sheet method estimates bad debt based on a percentage of outstanding accounts receivable. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
- The balance sheet aging of receivables method estimates bad debt based on outstanding accounts receivable, but it considers the time period that an account is past due. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
- Receivable ratios are best used to determine quick debt collection and lending practices. An investor, lender, or management may use these ratios—in conjunction with financial statement review, past performance, industry standards, and trends—to make an informed financial decision.
- The accounts receivable turnover ratio shows how many times receivables are collected during a period and converted to cash. The ratio is found by taking net credit sales and dividing by average accounts receivable for the period.
- The number of days’ sales in receivables ratio shows the expected number of days it will take to convert accounts receivable into cash. The ratio is found by taking 365 days and dividing by the accounts receivable turnover ratio.
9.4 Discuss the Role of Accounting for Receivables in Earnings Management
- Companies may look to report earnings differently to improve stakeholder’s views of financial position. Earnings management works within GAAP to accomplish this, while earnings manipulation ignores GAAP.
- Companies may choose to manage earnings to improve income level, increase borrowing opportunities, decrease tax liabilities, and improve company valuation for sales transactions. Accounts receivable is often prey to earnings manipulations.
- Earnings management can occur in several ways, including changes to bad debt estimation methods, percentage uncollectible figures, and category distribution within the balance sheet aging method.
- To understand company performance and unveil any management or manipulation to earnings, ratio analysis is paramount. Number of days’ sales in receivables ratio, and trend analysis, are most commonly used.
9.5 Apply Revenue Recognition Principles to Long-Term Projects
- Long-term construction projects may recognize revenue under the percentage of completion method or the completed contract method. The percentage of completion method distributes cost and revenues based on the amount of estimated contract completion during the period.
- Real estate installment sales require periodic payment from buyers. The installment method takes into account risk and distributes revenue based on a percentage of gross profit realized each period.
- With multi-year magazine subscriptions, customers pay in advance for subscription services, and the amount reported for revenue each period is reasonably estimated, until any disruption to the contract occurs. At that time, a new estimation will be distributed over the life of the subscription.
- In a combined equipment purchase with accompanying service contract, the customer pays for the contract up front, but there is no guarantee that service will be provided. Thus, a company may distribute estimated service revenues over the life of the contract or defer recognition and associated expenses until the contract period is complete.
9.6 Explain How Notes Receivable and Accounts Receivable Differ
- Accounts receivable is an informal agreement between customer and company, with collection occurring in less than a year, and no interest requirement. In contrast, notes receivable is a legal contract, with collection occurring typically over a year, and interest requirements.
- The terms of a note contract establish the principal collection amount, maturity date, and annual interest rate.
- Interest is computed as the principal amount multiplied by the part of the year, multiplied by the annual interest rate. The entry to record accumulated interest increases interest receivable and interest revenue.
- An honored note means collection occurred on time and in full. Recording an honored note includes an increase to cash and interest revenue, and a decrease to interest receivable and notes receivable.
- A dishonored note means collection did not occur on time or in full. In this case, a note and the accumulated interest would be converted to accounts receivable.
- When a company cannot collect on account, the company may consider selling the receivable to a collection agency. They will sell the receivable at a fraction of the value in order to apply resources elsewhere.
- If a customer cannot pay its accounts receivable on time, it may renegotiate terms that include a note and interest, thereby converting the accounts receivable to notes receivable. in this case, accounts receivable decreases, and notes receivable and cash increase.