Chapter 10: Revenue Recognition and Valuation of ... 1 Chapter 10: Revenue Recognition and Valuation...

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Transcript of Chapter 10: Revenue Recognition and Valuation of ... 1 Chapter 10: Revenue Recognition and Valuation...

  • 1

    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

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    Overview

    What are receivables 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 Are bad debts really bad? Recognition of notes receivable Disposition of accounts receivable and notes receivable

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    Receivables: definition and categorization

    Definition: revenues recognized but not yet received, revenues on account

    receivables include any taxes the seller collects on behalf of the government • gross of VAT

    Classification current receivables: expected to be collected within a year 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

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    Treatment of VAT

    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

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    Trade Receivables

    Accounts receivable oral promises of the purchaser to pay usually collectible within 30-60 days represent „open accounts“ (short-term extension of credit)

    „accounts receivable“ account in general ledger control account

    summarizes total amount receivable

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    Receivables / Total assets Receivables / Current assets

    Manufacturing General Electric (Manufacturer) 0,35 1,03* Chevron (Oil drilling and refining) 0,09 0,47

    Retail Supervalu (Grocery retail) 0,09 0,26 Tommy Hilfiger (Clothing retail) 0,09 0,26

    Internet Yahoo (Internet search engine) 0,04 0,07 Cisco (Internet systems) 0,07 0,21

    General services SBC Communications 0,10 0,03 (Telecommunications services) 0,04 0,24 Wendy's (Restaurant services)

    Financial services Bank of America (Banking services) 0,61 0,87 Merril Lynch (Investment services) 0,47 0,52

    * includes note receivable

    Importance of Accounts Receivable

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    Revenue recognition revisited

    Accounting regulation (IAS 18: Revenues) Revenue is to be recognized when all of the following conditions are met

    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)

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    Recognition of Accounts Receivable

    usual way if a credit sale occurs record the sale as revenue and record

    an increase in accounts receivable

    basis for recognition 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)

    Accounts Receivable € XYZ Revenue € XYZ

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    Discounts

    Trade Discounts used to avoid frequent changes in catalogues allow for different prices for different quantities hide true invoice price from competitors

    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!)

    e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!!

    100) 360 201(98 =+ r

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    Note that discounts apply to VAT too

    both revenue and VAT amounts are reduced by the discount percentage 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

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    Two methods of accounting for sales discounts

    (1) Gross method initially recognize gross amount recognize sales discounts when they are taken

    (2) Net method initially recognize amount net of sales discount make „correcting“ entries if sales discounts are forfeited

    from an accounting point of view net method preferable why? amount recognized closer to net realizable value

    from a practical point of view gross method preferable why? easy to apply, no additional calculation necessary

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    Gross Method Net Method

    I Sale of € 4.000, terms 3/10, n/30

    Accounts Receivable 4.000 Accounts Receivable 3.880 Sales 4.000 Sales 3.880

    II Payment of € 1.940 received within discount period:

    Cash 1.940 Cash 1.940 Sales Discounts 60 Accounts Receivable 1.940 Accounts Receivable 2.000

    III Payment of € 2.000 received after discount period:

    Cash 2.000 Accounts Receivable 60 Accounts Receivable 2.000 Sales Discounts

    Forefeited 60 Cash 2.000 Accounts Receivable 2.000

    Note: The payment of € 1.940 results in a reduction of € 2.000 in the accounts receivable account under the gross method.

    forfeited

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    Valuation of Accounts Receivable 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?

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    One important valuation aspect: payment behavior

    0

    5

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    How do German companies evaluate the payment habits of their customers?

    Bad 11,5 26,6 12,9 15 Good 27,4 21,4 23,9 26,9

    Manufact- uring Construction

    Wholesale / Retailers

    Service Industries

    Source: C reditreform

    , Figures from 2000

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    Valuation of Receivables: Gross method

    From book value (face value) to net realizable value Face value: nominal amount recognized when credit sale transaction is recorded Net realizable value (NRV): amount estimated to be collectible from outstanding receivables adjustments necessary for

    discounts returns, and expected losses from revenues (uncollectible accounts)

    NRV = face value – adjustments for discounts – adjustments for sales returns – allowance for uncollectible accounts

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    Uncollectible Accounts Receivable

    represent loss of revenue expense due to selling on credit uncollectible accounts expense (also called bad debt expense) is recorded

    When should uncollectible accounts expense 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

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    Direct Write-Off Method

    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)

    Discussion facts are recorded, not estimates however, no matching of revenues and costs no net realizable value presentation of receivables

    on the balance sheet Apply only for individual amounts not material!

    Bad Debt Expense € XYZ Accounts Receivable € XYZ

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    Allowance Method

    Bad Debt Expense recorded in the same period as the sale

    debit Bad Debt Expense and credit Allowance for Uncollectible (or Doubtful) Accounts

    two approaches: percentage-of-sales or percentage-of- receivables

    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)

    Bad Debt Expense € XYZ Allowance for Doubtful Accounts € XYZ

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    Treatment of direct write-offs when the allowance method is applied

    debit Allowance for Uncollecti