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ACCOUNTS RECEIVABLE & REVENUE RECOGNITION

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ACCOUNTS RECEIVABLE & REVENUE RECOGNITION Accounting ASW Summer 2006 Issue: What to do about bad debts? So far: Accounts Receivable 340 Sales Revenue 340 Two potential approaches Direct write-off method Allowance method

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Presentation Transcript
issue what to do about bad debts
Issue: What to do about bad debts?
  • So far:

Accounts Receivable 340

Sales Revenue 340

two potential approaches
Two potential approaches
  • Direct write-off method
  • Allowance method
  • Problem 6.21
direct write off method
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

slide5
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
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
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
slide8
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
slide9
If the account is later collected:

Accounts Receivable 1.8

All. for Doubtful Accts. 1.8

Cash 1.8

Accounts Receivable 1.8

slide10
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
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
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.

ACCOUNTS RECEIVABLE AND BAD DEBTS T-ACCOUNTS
income recognition issues
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
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
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
slide17
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
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
slide19
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
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