ACCOUNTS RECEIVABLE REVENUE RECOGNITION Accounting ASW Summer 2007

ACCOUNTS RECEIVABLE & REVENUE RECOGNITION Accounting ASW Summer 2007

Issue: What to do about bad debts? • So far: Accounts Receivable 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 Cash 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. Cash 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 Allowance for Doubtful Accounts Beg. Bal. Credit Sales Beg. Bal. Collections Write-offs Bad Debt Exp. Write-offs 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 – $200 M contract, – Costs of $42 M, $54 M and $24 M 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 $200 M in revenue and $120 M 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