Cornerstones of Financial & Managerial Accounting

Rich/Jones/Heitger/Mowen/Hansen

Chapter 5

Learning Objectives

LO1.Explain the criteria for revenue recognition.

  • Revenue is recognized when it is:
  • realized or realizable
  • earned
  • The terms “realized” and “realizable” mean that the selling price is fixedand determinable and collectibility is reasonably assured.
  • Revenue is considered earned when delivery has occurred or services havebeen provided.

LO2.Measure net sales revenue.

  • The appropriate amount of revenue to recognize is generally the cashreceived or the cash equivalent of accounts receivable.
  • However, companies often induce customers to buy by offering:
  • sales discounts
  • sales returns
  • sales allowances
  • Sales discounts are reductions of the normal selling price to encourageprompt payment.
  • Sales returns occur when a customer returns goods as unsatisfactory.
  • Sales allowances occur when a customer agrees to keep goods with minordefects if the seller reduces the selling price.
  • These events are recorded in contra-revenue accounts that reduce gross salesto net sales.

LO 3.Describe internal control procedures for merchandise sales.

  • Since sales revenues have a significant effect on a company’s net income, internal control procedures must be established to ensure that the amountsreported are correct.
  • Typically sales are not recorded until a three-way match is performedbetween the:
  • customer purchase order (which indicates that the customer wants thegoods)
  • the shipping document(which indicates that thegoods havebeenshipped to the customer)
  • the invoice (which indicates that the customer has been billed

LO4.Describe the principal types of receivables.

  • Receivables are classified along three different dimensions:
  • accounts and notes receivable
  • trade and non-trade receivables
  • current and noncurrent receivables

LO5.Measure and interpret bad debt expense and the allowance for doubtful accounts.

  • The primary issues in accounting for accounts receivable are when and howto measure bad debts (i.e., accounts that will not be paid).
  • GAAP requires receivables to be shown at net realizable value on the balancesheet.
  • Further, the matching principle says that an expense should be recognized inthe period in which it helps generate revenues.
  • Consequently, we must estimate and recognize bad debt expense in theperiod the sale is made—even though we do not know which accounts willbe uncollectible.
  • The estimate is made by using either:
  • the credit sales method or
  • the aging method
  • The credit sales method estimates the bad debt expense directly.
  • The aging method estimates the ending balance needed in the allowance fordoubtful accounts, and bad debt expense follows.

LO6.Describe the cash flow implications of accounts receivable.

  • Companies can increase the speed of cash collection on receivables by factoring, or selling, their receivables.
  • The buyer of the receivables will charge a fee to compensate themselves forthe time value of money, the risk of uncollectability, and the tasks of billingand collection.
  • Receivables may also be packaged as financial instruments or securities andsold to investors. This is referred to as securitization.
  • A special case of selling receivables is accepting credit cards like MasterCardand Visa.

LO7.Account for notes receivable from inception to maturity.

  • Notes receivable are recognized for the amount of cash borrowed or goods/services purchased.
  • This is the principal amount of the note receivable.
  • Any excess of amount repaid over principal is recognized as interest revenuein the period the interest was earned.

LO8.Analyze profitability and asset management using sales and receivables.

  • Because sales revenue is such a key component of a company’s success, analysts are interested in a large number of ratios that incorporate sales.
  • Many of these ratios attempt to measure how much the company is makingon sales. These are called profitability ratios.
  • Gross profit percentage
  • Operating margin percentage
  • Net profit margin
  • Analysts are also concerned with asset management. Asset managementrefers to how efficiently a company is using the resources at its disposal.
  • One of the most widely-used asset management ratios is accounts receivableturnover.