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ACCOUNTS RECEIVABLE & REVENUE RECOGNITION Accounting ASW Summer 2004 Issue: What to do about bad debts? So far: Accounts Receivable 420 Sales Revenue 420 Two potential approaches Direct write-off method Allowance method

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ACCOUNTS RECEIVABLE & REVENUE RECOGNITION

Accounting ASW

Summer 2004


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Issue: What to do about bad debts?

  • So far:

    Accounts Receivable 420

    Sales Revenue 420


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Two potential approaches

  • Direct write-off method

  • Allowance method

  • Problem 6.13


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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 1.2

    Accounts Receivable 1.2


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If the account is later collected:

Accounts Receivable 1.2

Bad Debt Expense 1.2

Cash 1.2

Accounts Receivable 1.2

(The entry is made through accounts receivable rather than directly to cash for a record of the accounts receivable having been collected.)


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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”


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Allowance Method

  • Generally required for financial reporting

  • Record bad debts estimate at time of sale to expense and account receivable contra

    Bad Debt Expense 8.4

    Allow. for Doubtful

    Accts. (AR contra) 8.4

  • Net income effect at time of sale


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If the account is later collected:

Accounts Receivable 1.2

All. for Doubtful Accts. 1.2

Cash 1.2

Accounts Receivable 1.2


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  • 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 6-13


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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


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Other Applications

  • Sales returns

  • Cash discounts

  • Sales allowance


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(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.

ACCOUNTS RECEIVABLE AND BAD DEBTS T-ACCOUNTS


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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?


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Long-Term Contracts

  • Construction spans several periods

  • Customers and terms decided in advance

  • May satisfy revenue recognition criteria before completion

  • Problem 6-22 (slightly different #’s):

    • $4M contract,

    • Costs of $0.8M, $2.0M and $0.4M in years 1-3


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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 $4.0M in revenue and $3.2M in expense in year 3


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  • 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


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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


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