ACCOUNTS RECEIVABLE & REVENUE RECOGNITION Accounting ASW Summer 2007

Issue: What to do about bad debts? So far: Accounts Receivable 340 Sales Revenue 340

Two potential approaches Direct write-off method Allowance method Problem 6.21

Direct Write-Off Method Only allowed for financial reporting if bad debts are immaterial, but required for tax At the time of sale: No entry When the account is deemed uncollectible: Bad Debt Expense 1.8 Accounts Receivable 1.8

If the account is later collected: Accounts Receivable 1.8 Bad Debt Expense 1.8 Cash 1.8 Accounts Receivable 1.8 (The entry is made through accounts receivable rather than directly to cash for a record of the accounts receivable having been collected.)

Problems with Direct Write-Off Accounts Receivable are overstated (in terms of expected receipts) Net income is overstated Revenue and expenses are not matched Discretion affecting net income in when to call “uncollectible”

Allowance Method Generally required for financial reporting Record bad debts estimate at time of sale to expense and account receivable contra Bad Debt Exp. ($340 x 3%) 10.2 Allow. for Doubtful Accts. (AR contra) 10.2 Net income effect at time of sale

When the account is deemed uncollectible: All. for Doubtful Accts. 1.8 Accounts Receivable 1.8 No net income or total asset effect at the time of write-off

If the account is later collected: Accounts Receivable 1.8 All. for Doubtful Accts. 1.8 Cash 1.8 Accounts Receivable 1.8

Advantages of allowance method - Matches revenue and expenses in period of sale - Records net accounts receivable at expected cash collection Problem with allowance method - Discretion in estimating bad debt expense - Only works well if your estimates are good Problem 6-21

How to estimate bad debts under the allowance method Percentage of sales Aging of accounts receivable Observation of large accounts Often use all three together

Other Applications Sales returns Cash discounts Sales allowance

ACCOUNTS RECEIVABLE AND BAD DEBTS T-ACCOUNTS (Gross) Accounts Receivable Beg. Bal. Credit Sales Collections Write-offs Ending Bal. Allowance for Doubtful Accounts Beg. Bal. Write-offs Bad Debt Exp. Ending Bal.

Income Recognition Issues Review of revenue recognition criteria –provided all (or substantial portion) of goods or services –have received an asset which can be measured Issue: What if completion spans several periods?

Long-Term Contracts Construction spans several periods Customers and terms decided in advance May satisfy revenue recognition criteria before completion Problem 6-33 –$200M contract, –Costs of $42M, $54M and $24M in years 1-3

Completed Contract Method Delay revenue recognition until completed For our example, –recognize no income or expense in years 1&2 –accumulate costs in “construction in progress” account (just like “work in progress”) –recognize $200M in revenue and $120M in expense in year 3

Often used if: –construction in period is too short to justify spreading –buyer or terms are not set –total cost (and hence income) is too uncertain

Percentage Completion Method Generally preferred by companies Only used if: –construction spans multiple periods –contract terms are set and collection is likely –total cost (and profit) are reasonably estimable

Recognize revenue each period in proportion to costs during the period In our example, –35% of costs occur in year 1, so 35% of revenue, costs and net income would be recognized in year 1 –45% of revenue, costs and NI in year 2 –20% of revenue, costs and NI in year 3