Chapter 5 – Receivables and Revenue: Comprehensive Study Notes

Chapter 5 – Receivables and Revenue

Part I: Apply GAAP for Proper Revenue Recognition

Revenue recognition is a fundamental principle in financial accounting, ensuring that companies report income in accordance with Generally Accepted Accounting Principles (GAAP). This section outlines the core concepts and steps for recognizing revenue from contracts with customers.

• Revenue Recognition Principle: Revenue should be recognized when an entity transfers goods or services to customers in an amount that reflects the cash or fair market value of other assets that the entity expects to receive in exchange for those goods or services.

• Five-Step Model for Recognizing Revenue:

  1. Identify the contract(s) with the customer.

  2. Identify the performance obligation(s) in the contract.

  3. Determine the transaction price.

  4. Allocate the transaction price to the performance obligation(s) in the contract.

  5. Recognize revenue when (or as) the entity satisfies a performance obligation.

• Trade Discount: A reduction in the price of a product or service as an incentive to a business customer to buy it.

• FOB Shipping Point: When goods are shipped FOB (free on board) shipping point, ownership changes hands and revenue is recognized when the goods leave the seller’s shipping dock.

• Speeding Up Cash Collections: Retailers can speed up cash collections by accepting credit card or debit card sales.

Part II: Account for Sales Returns and Allowances

Sales returns and allowances are important adjustments to revenue, reflecting the reality that not all sales are final. Companies must account for these to present accurate financial statements.

• Credit Memo: A document authorizing a credit to the customer’s account receivable on the seller’s books.

• Expected Future Returns: At the end of the period, companies estimate and record expected future returns as part of the adjusting entry process.

• Sales Refund Payable Account: When items are returned, companies reduce the sales refund payable account for the amount of cash or accounts receivable credit given back to customers.

Part III: Account for Sales Discounts

Sales discounts are incentives offered to customers to encourage early payment. These discounts affect the amount of revenue recognized.

• Sales Discount Terms (e.g., 2/10, n/30): This means the seller is willing to discount the order by 2% if the buyer pays within 10 days of the invoice date; otherwise, the net amount is due within 30 days.

• Late Payment: If the buyer does not pay within the discount period, the full amount is due.

• Net Sales Revenue: Sales revenue is typically disclosed at the net amount, which means after sales discounts and sales returns and allowances have been subtracted.

Part IV: Account for Accounts Receivable

Accounts receivable represent monetary claims against others, typically arising from credit sales. Proper management and accounting for receivables are crucial for liquidity and financial health.

• Receivables: Monetary claims against others.

• Journal Entry for Service Revenue on Account:

  • Accounts Receivable XXX

  • Service (or Sales) Revenue XXX

• Journal Entry for Lending Money on a Note Receivable:

  • Notes Receivable XXX

  • Cash XXX

• Accounts Receivable vs. Notes Receivable: Accounts receivable arise from credit sales of goods or services; notes receivable arise from lending money to others.

• Risk of Credit Sales: The biggest risk is not collecting some receivables.

• Maximizing Cash Flow from Customer Payments: Monitor customer payment habits, send reminders, and encourage automatic payments via EFTs.

Part V: Evaluate Collectability Using the Allowance for Uncollectible Accounts

Not all receivables are collected; companies must estimate and account for uncollectible accounts (bad debts) using appropriate methods.

• Allowance Method: The best way to measure uncollectible accounts expense.

• Methods to Estimate Uncollectibles:

  1. Percent-of-sales method

  2. Aging method

• Percent-of-Sales Method: Takes an income statement approach, focusing on the amount of expense to be reported on the income statement.

• Journal Entry Example (Percent-of-Sales):

  • Uncollectible-Account Expense 73

  • Allowance for Uncollectible Accounts 73

• Aging-of-Receivables Method: Individual receivables from specific customers are analyzed based on how long they have been outstanding, net realizable value, percentage paid off, and number of purchases.

• Journal Entry Example (Aging Method):

  • Uncollectible-Account Expense 76

  • Allowance for Uncollectible Accounts 76

• Write-Offs Under Allowance Method: A write-off of uncollectibles has no effect on total assets, current asset, net accounts receivables, or net income.

• Direct Write-Off Method: Not in compliance with US GAAP because it does not use an allowance for uncollectibles and fails to match expenses with related sales revenue.

• Federal Income Tax: The direct write-off method is required for federal income tax purposes.

Part VI: Account for Notes Receivable and Interest Revenue

Notes receivable are formal written promises to pay a certain amount of money at a future date, often with interest. Understanding key terms and calculations is essential.

• Key Terms:

  • Creditor: The party to whom money is owed.

  • Debtor: The party that borrowed and owes money on the note.

  • Interest: The cost of borrowing money.

  • Maturity Date: The date on which the debtor must pay the note.

  • Maturity Value: The sum of principal and interest on the note.

  • Principal: The amount of money borrowed by the debtor and lent by the creditor.

  • Term: The length of time from when the note was signed by the debtor to when the debtor must pay the note.

• Parties to a Note: The creditor has a note receivable; the debtor has a note payable.

• Interest Calculation Formula:

  • $\text{Principal} \times \text{Rate} \times \text{Time} = \text{Amount of Interest}$

Part VII: Evaluate Liquidity Using Three Key Ratios

Liquidity ratios help assess a company's ability to meet short-term obligations. Accounts receivable turnover and days' sales outstanding (DSO) are crucial for evaluating receivables management.

• Quick (Acid-Test) Ratio Formula:

  • $\frac{\text{Cash} + \text{Cash Equivalents} + \text{Short-Term Investments} + \text{Net Current Receivables}}{\text{Total Current Liabilities}}$

• Accounts Receivable Turnover: Shows the number of times per year a company completely collects its average accounts receivable.

• Accounts Receivable Turnover Formula:

  • Net credit sales / Average net accounts receivables

  • Net credit sales / Net cash sales

  • Net credit sales / Average net accounts receivable

  • Total sales / Net credit sales

• Days' Sales Outstanding (DSO) Ratio: Computed by dividing 365 by the accounts receivable turnover ratio.

  • $\text{DSO} = \frac{365}{\text{Accounts Receivable Turnover}}$

Key Tables

Below is a summary table of methods for estimating uncollectible accounts:

Method	Approach	Key Feature
Percent-of-Sales	Income Statement	Estimates expense as a percentage of sales
Aging Method	Balance Sheet	Analyzes receivables by age to estimate uncollectibles

Additional info: These notes expand on worksheet answers by providing definitions, formulas, and context for each concept, ensuring a comprehensive understanding for exam preparation.