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.