Chapter 7: Highlights
1.Under the accrual basis of measuring income,firms recognize revenue when (a) all, or a substantial portion, of the services expected to be provided have been performed, and (b) cash, or another asset whose cash equivalent value a firm can measure objectively, has been received. Satisfying the first criterion means that a firm can estimate the total expected cash outflows related to an operating activity. If a firm cannot estimate the total expected cash outflows, it will not know the amount of expense to match against revenue, and therefore it will not know the amount of income. Satisfying the second criterion means that a firm can estimate the amount of expected cash inflows from customers. If a firm cannot estimate expected cash inflows, it will not know the amount of revenues and therefore the amount of income.
2.Firms can make a more informed judgment about whether (a) a firm had delivered a good or performed services, (b) the price is fixed or determinable, and (c) collectibility is reasonably assured if there is persuasive evidence that an arrangement exists. The arrangement may take the form of a contract, prior business dealings with a particular customer, or customary business practices by a firm and its industry.
3.Most firms satisfy the criteria for revenue recognition at the time of sale or delivery of goods and services. Recognizing revenues at the time of sale and properly matching expenses with revenues require firms to estimate the cost of uncollectible accounts, returns, and similar items and recognize them as income reductions at the time of sale.
4.When a firm extends credit, it will find that some customers never pay the amounts due. The principal accounting issue with uncollectible accounts concerns when firms should recognize the loss from uncollectibles.
5.When a firm can estimate the amount of uncollectibles with reasonable precision, both U.S. GAAP and IFRS require firms to use the allowance method. This method involves estimating the amount of uncollectible accounts receivable associated with each period’s sales. The allowance method (a) estimates the amount of uncollectibles that will occur in connection with the sales of each period, and (b) makes an adjusting entry that reduces the reported income on the income statement and reduces the Accounts Receivable on the balance sheet for the net amount of accounts the firm expects not to collect. The adjusting entry involves a debit to Bad Debts Expense to reduce income and a credit to Allowance for Uncollectible Accounts, a contra account to Accounts Receivable.
6.When a firm judges a particular account as uncollectible, it writes off the account by debiting Allowance for Uncollectible Accounts and crediting Accounts Receivable. Writing off the specific account does not affect either net assets or income. The reduction in net assets and the affect on income takes place in the year of sale when the firm estimates the amount of eventual uncollectibles and records Bad Debts Expense and credits the Allowance for Uncollectible Accounts.
7. The write off of specific customer’s accounts has no effect on the income statement. The income statement is affected when Bad Debts Expense is recorded (the adjusting entry at the end of the accounting period). The write off of specific customer’s accounts also has no effect on Accounts Receivable, net (Accounts Receivable less Allowance for Uncollectibles).
8.There are two basic approaches for calculating the amount of the adjustment for uncollectible accounts under the allowance method. The easiest method in most cases is to apply an appropriate percentage to total sales on account for the period. Another method, called aging the accounts, involves the analysis of customers' accounts classified by the length of time the accounts have been outstanding. The rationale is that the longer an account has been outstanding, the greater the probability that it will never be collected. By applying judgment to the aging analysis, the accountant makes an estimate of the approximate balance needed in the allowance for uncollectible accounts at year end.
9.When a firm uses the percentage-of-sales method, the accountant adds the periodic provision for uncollectible accounts to the existing balance in the account, Allowance for Uncollectible Accounts. When a firm uses the aging method, the accountant adjusts the balance in the account, Allowance for Uncollectible Accounts, to reflect the desired ending balance.
10.The allowance method requires estimates of uncollectible accounts. When the amount of actual uncollectible accounts differs from the estimated amount, the accountant corrects for the previous misestimates by adjusting the provision for bad debts during the current period. Both U.S. GAAP and IFRS firms to reflect any changes in estimates prospectively. Presuming that firms make conscientious estimates each year, adjustments for misestimates, although recurring, should be small.
11. Accounts Receivable appears on the Balance Sheet at the amount expected to be collected.
This net amount is computed as follows:
Accounts Receivable, net = Accounts Receivable – Allowance for Uncollectibles
12. Transaction affecting Accounts Receivable are as follows:
Beginning balance
+ New credit sales
- Collections from customers
- Accounts Receivable written off
= Ending balance
13. Typical ratios used in analyzing the collectability of accounts receivable and the adequacy of the bad debts expense are the accounts receivable turnover ratio, the days receivable outstanding, and the write off percentage.
14.In some cases, a firm may find itself temporarily short of cash and unable to obtain financing from its usual sources. In such cases the firm may use accounts receivable as collateral for a loan, factor its accounts receivable, a firm may transfer the accounts receivable to a separate entity (securitization).
15.Firms may use their accounts receivable as collateral for a loan at a bank or finance company. The borrowing company usually maintains physical control of the receivables, collects customers' remittances, and forwards the proceeds to the lending institution to liquidate the loan.
16.Firms may factor accounts receivable, which is in effect a sale of the receivables to a bank or finance company. In this case, the firm sells accounts receivable to the lending institution, which physically controls the receivables and collects payments from customers.
17.Firms may transform their accounts receivable into securities held by investors. The firm transfers accounts receivable to a separate entity, which then issues debt securities to investors. The firm then remits the cash received from customers to investors as cash is received. The firm may be obligated to make payments to investors if securities is the customers fail to make sufficient payments to pay the principal and interest on the debt securities.
18. If a company gives customers the right to return products and the firm can reasonably estimate the amount of returns at the time of the sale, U.S. GAAP and IFRS require the firm to use the allowance method to estimate and recognize the effect of the returns. The selling firm will debit a contra revenue and credit the allowance for sales returns for the expected amount of returns.
19. Since some firms have uncertainty concerning cash collections or are required to provide substantial services after the time of the sale, there may be sufficient uncertainty to preclude the firm from recognizing revenue at the time of the sale. Instead, some firms may recognize revenue sometime after the sale.
20. Some firms may collect cash prior to providing goods or services. Since cash was collected but goods or services are still owed, this transaction represents a deferred performance obligation, a term for these types of liabilities. Common account titles are:
Advances from Customers, Deferred Revenues or Unearned Revenues.
21.When substantial uncertainty exists at the time of sale regarding the amount of cash or cash equivalent value of assets that a firm will ultimately receive from customers, the firm delays the recognition of revenues and expenses until it receives cash. Such sellers recognize revenue at the time of cash collection using either the installment method or the cost-recovery-first method. Both U.S. GAAP and IFRS permits the seller to use the installment method and the cost-recovery-first method only when the seller cannot make reasonably certain estimates of cash collection.
22.The installment method recognizes revenue as firms collect cash and recognizes portions of the total cost as expenses in the same portion as to total revenue recognized.
23.The cost-recovery-first method is appropriate when substantial uncertainty exists about cash collection. Under this method, firms match the costs of generating revenues dollar for dollar with cash receipts until they recover all such costs. When cumulative cash receipts exceed total costs, firms report profit on the income statement.
24.Contractors engaged in long-term construction projects may recognize revenue using the percentage-of-completion method or the completed-contract method.
25.Under the percentage-of-completion method, firms recognize a portion of the total contract price as revenue each period. Such firms also recognize corresponding proportions of the total estimated costs of the contract as expenses. The accountant measures the proportion of total work carried out during the accounting period either from engineers' estimates of the degree of completion or from the ratio of costs incurred to date to the total costs expected for the entire contract. The percentage-of-completion method follows the accrual basis of accounting because of the matching of expenses with related revenues.
26.Under the completed contract method, firms recognize revenue when the project is completed and sold. The total costs of the project become expenses in the period when the firm recognizes revenue.
27.Firms use the completed contract method when the outcome of the contract is in doubt because of a lack of reliable estimates of either costs or the cash to be collected.
28.The percentage-of-completion method provides information on the profitability of a contractor as construction progresses while the completed contract method reports all income from contracts in the period of completion. IFRS requires the use of the percentage-of-completion method whenever firms can make reasonable estimates of revenues and expenses.
29.Because the percentage-of-completion method requires estimates of revenues and expenses prior to completion, its use provides management with the opportunity to manage earnings through its estimates of total expenses or its estimates of the degree of completion of the project. For this reason, most analysts view earnings reported under the percentage-of-completion method as having lower quality than earnings under the completed contract method, at least with respect for the need to make estimates.
30.In some cases, firms use the completed contract method because the contracts take a short time to complete. Firms also use the completed contract method when they have not found a specific buyer while construction progresses or when uncertainty obscures the total costs the contractor will incur in carrying out the project even when the firm has a contract with a specific price.
31. To summarize, a firm can recognize revenue when it has delivered products or services to customers so long as the firm can estimate with reasonable statistical certainty the events remaining to complete the transaction. When significant uncertainty exists at the time of delivery about the events remaining to complete the transactions, firms must delay revenue recognition until the uncertainties resolve to the level of reasonable statistical certainty.
32. In evaluating a firm's past profitability and projecting its likely future profitability, the analyst must consider the nature of income items. Does the income item result from the firm's primary operating activity or from an activity incidental or peripheral to the primary operating activities? Is the income item recurring or nonrecurring?
33..Revenues and expenses result from the recurring primary operating activities of a business. Gains and losses result from either peripheral activities or nonrecurring activities. Firms report revenues and expenses at gross amounts, whereas gains and losses appear at net amounts.