Receivables and Revenue

Learning Objectives

• Apply GAAP for proper revenue recognition

• Account for sales returns and allowances

• Account for sales discounts

• Account for accounts receivable

• Evaluate collectability using the allowance for uncollectible accounts

• Account for notes receivable and interest revenue

• Evaluate liquidity using three new ratios

• Analyze receivables collectibility using an aging schedule created with an Excel pivot table

GAAP for Proper Revenue Recognition

Revenue Recognition Principles

Revenue is recognized when it is earned, which occurs when goods are delivered or services are performed. The amount recorded is either the cash received or the fair market value of assets received in exchange. According to GAAP, companies are entitled to receive amounts from customers for delivering goods or performing services.

• Contract: An agreement between two parties creating enforceable rights or performance obligations.

• Five-Step Model:

  1. Identify the contract(s)

  2. Identify the performance obligation(s)

  3. Determine the transaction price

  4. Allocate the transaction price to the performance obligations

  5. Recognize revenue when the entity satisfies the obligations

• Example: Apple Inc. recognizes revenue when control of products is transferred to customers, typically when products are shipped. For services, revenue is recognized over time as services are delivered.

Shipping Terms and Revenue Recognition

• FOB Shipping Point: Ownership and revenue recognition occur when goods leave the shipping dock.

• FOB Destination: Ownership and revenue recognition occur at the point of delivery to the customer.

• Example: If Apple delivers iPhones to AT&T under FOB Shipping Point, revenue is recognized when the phones leave Apple’s dock.

Sales Returns and Allowances

Accounting for Returns and Allowances

Customers may return unsatisfactory or damaged goods. Companies with significant return experience estimate returns and record them as a reduction of revenue in the same period as the sale, consistent with the matching principle.

• Sales Returns & Allowances: Contra revenue account with a debit balance.

• Sales Refunds Payable: Liability account representing estimated refunds.

• Example: If Apple expects 1% of sales to be returned, it records estimated returns at period end.

Price Protection Allowances

Companies may grant allowances for price reductions after sale. These must be estimated and reserved for in the period of the price change, not when refund requests are received.

Sales Discounts

Accounting for Sales Discounts

Sales discounts are incentives for customers to pay early. They are recorded in a contra revenue account.

• Example: 2/10, n/30 means a 2% discount if paid within 10 days; otherwise, full payment is due in 30 days.

• Income Statement: Sales Revenue – Sales Returns & Allowances – Sales Discounts = Net Revenue

• Example Calculation: If a customer pays $2,000 invoice within discount period, the cash received is $1,960 ($2,000 x 98%).

Accounts Receivable

Types of Receivables

Receivables are monetary claims against others and are classified as current assets. They are acquired by selling goods/services (accounts receivable) or lending money (notes receivable).

• Subsidiary Ledger: Keeps record of individual customer balances.

• Risk Management: Credit checks, monitoring payment habits, and separating cash handling from record-keeping help manage collection risk.

Allowance for Uncollectible Accounts

Allowance Method

The allowance method estimates uncollectible accounts based on past experience. It uses a contra account to reduce accounts receivable to net realizable value (NRV).

• Net Realizable Value (NRV):

• Example: Apple’s balance sheet reports accounts receivable net of allowance for uncollectible accounts.

• Contra Account: Allowance for Uncollectible Accounts is used because the specific customer who will not pay is unknown.

Reporting Receivables and Expenses

• Balance Sheet: Receivables are reported at net realizable value.

• Income Statement: Uncollectible-account expense is reported as an expense, not a reduction of revenue.

Estimating Uncollectibles

• Percent-of-Sales Method: Expense is computed as a percent of revenue (income statement approach).

• Aging-of-Receivables Method: Specific accounts are analyzed based on how long they have been outstanding (balance sheet approach).

• Example: Aging schedule for Apple Inc.

• Allowance Adjustment: The aging method adjusts the allowance to the needed amount as determined by the aging schedule.

Comparison of Methods

• Percent-of-Sales: Adjusts allowance by the amount of uncollectible-account expense.

• Aging-of-Receivables: Adjusts allowance to the amount of uncollectible accounts receivable.

Notes Receivable and Interest Revenue

Key Terms

• Creditor: Party to whom money is owed (lender).

• Debtor: Party who owes money (borrower).

• Interest: Cost of borrowing money, stated as an annual percentage rate.

• Maturity Date: Date on which the debtor must pay the note.

• Maturity Value: Sum of principal and interest.

• Principal: Amount borrowed.

• Term: Length of time from signing to payment.

Promissory Note Example

• Exhibit: Example of a promissory note.

• Interest Calculation:

Liquidity Ratios

Quick (Acid-Test) Ratio

The quick ratio measures a company’s ability to pay current liabilities using its most liquid assets. The benchmark is 1:1, but industry standards may vary.

• Formula:

• Example: Apple Inc.’s quick ratio calculation.

Accounts Receivable Turnover

This ratio shows how many times per year a company collects its average accounts receivable. A higher turnover indicates faster collection.

• Formula:

• Days’ Sales Outstanding (DSO):

• Example: Apple Inc. collected its average accounts receivable 14.48 times per year, with a DSO of 25.2 days.

Aging Schedule and Pivot Tables

Analyzing Receivables Collectibility

An aging schedule categorizes receivables by how long they have been outstanding, helping to estimate uncollectible accounts. Pivot tables summarize large data sets for analysis.

• Example: Pinkettle Company’s outstanding invoices.

• Aging Schedule: Summarizes receivables by age and estimates uncollectibles.

Summary Table: Allowance Methods

Key Formulas

• Net Realizable Value:

• Quick Ratio:

• Accounts Receivable Turnover:

• Days’ Sales Outstanding:

• Interest Revenue:

Practice Applications

• Estimate sales returns and allowances based on historical data.

• Apply sales discounts and calculate net revenue.

• Use the allowance method to estimate and report uncollectible accounts.

• Analyze receivables using aging schedules and pivot tables.

• Evaluate liquidity using quick ratio and accounts receivable turnover.