Receivables and Revenue: Financial Accounting Study Notes (Chapter 5)

Receivables and Revenue

Revenue Recognition

Revenue is the inflow of resources resulting from delivering goods or rendering services to customers. In financial accounting, revenue should be recognized when it is earned, typically according to the five-step model established by accounting standards.

• Step 1: Identify the contract(s) with the customer.

• Step 2: Identify the performance obligation(s) in the contract.

• Step 3: Determine the transaction price.

• Step 4: Allocate the transaction price to the performance obligations.

• Step 5: Recognize revenue when (or as) the entity satisfies its performance obligation(s).

Example: A company delivers goods to a customer and recognizes revenue when control of the goods passes to the customer.

Sales and Shipping Terms

Sales Discounts and Shipping

Sales discounts are reductions in the price of a product or service offered as an incentive to customers, often for early payment. Shipping terms in a sales contract dictate the date on which the title, or ownership, of goods passes from seller to buyer.

• FOB Shipping Point: Ownership changes hands and revenue is recognized when the goods leave the seller's shipping dock.

• FOB Destination: Ownership changes hands and revenue is recognized at the point of delivery to the buyer.

Example: If goods are shipped FOB shipping point, the buyer owns the goods once they leave the seller's dock and is responsible for any losses during transit.

Receivables: Key Terms

Sales Returns and Allowances

Customers have the right to return unsatisfactory goods for refund, credit, or exchange. These are recorded as sales returns or allowances and reduce total revenue.

Sales Discounts

Businesses may offer discounts to customers who pay their accounts earlier than the standard credit period (e.g., 30 days) to accelerate cash flow.

Reporting Revenue on the Income Statement

Retailers, wholesalers, and manufacturers report net sales, which is the sales amount after deducting sales discounts, returns, and allowances.

Accounts Receivable

Accounts receivable are amounts owed by customers for goods or services sold on credit. They are classified as current assets and sometimes called trade receivables.

• Liquidity: Accounts receivable are the third most liquid asset after cash and short-term investments.

Example: A company sells goods on credit and records the amount due from the customer as accounts receivable.

Uncollectible Accounts: Allowance Method

Bad Debt Expense

Not all customers pay their debts. The expense associated with uncollectible accounts is called bad debt expense or doubtful account expense.

• Allowance Method: Estimates uncollectible accounts expense and records it on the balance sheet as Allowance for Uncollectible Accounts.

• Percentage of Sales Method: Estimates bad debt expense as a percentage of sales. This is an income statement approach.

• Aging of Receivables Method: Estimates uncollectible accounts based on the age of receivables. This is a balance sheet approach.

Example: A company estimates that 3% of its credit sales will be uncollectible and records this amount as bad debt expense.

Journal Entries for Bad Debts

Recording Estimates (Allowance Method)

• Bad Debt Expense (Debit)

• Allowance for Doubtful Accounts (Credit)

This entry records the estimate of expected bad debts.

Direct Write-Off Method

Under this method, the company waits until a specific customer's receivable is deemed uncollectible and writes it off. Note: The direct write-off method is not in conformity with U.S. GAAP because it does not match expenses with revenues.

• Bad Debt Expense (Debit)

• Accounts Receivable - Customer Account (Credit)

This entry writes off the uncollectible account of a specific customer.

Worked Example: Bad Debt Estimation and Write-Off

Estimating Bad Debts

On December 31, Watson Company has accounts receivable of $900,000 and no current balance in the allowance for uncollectible accounts. Using the aging-of-receivables method, the company estimates doubtful accounts at 3%.

• Bad Debt Expense: $27,000

• Allowance for Doubtful Accounts: $27,000

Writing Off Specific Accounts

After collection attempts, Watson Company writes off a $3,000 receivable from Mrs. Jackson.

• Allowance for Doubtful Accounts: $3,000

• Accounts Receivable - Mrs. Jackson: $3,000

Notes Receivable & Definitions

Key Terms

• Creditor: The party to whom money is owed (also called lender).

• Debtor: The party that borrowed and owes money (also called borrower).

• Interest: The cost of borrowing money, stated as an annual rate.

• 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.

• Term: The length of time from when the note was signed to when it is due.

Notes due within 1 year are considered current assets; those due after 1 year are considered long-term assets.

Analyzing Liquidity Using Ratios

Quick Ratio

The quick ratio measures a company's ability to pay current liabilities using its most liquid assets.

• Formula:

$\text{Quick Ratio} = \frac{\text{Cash and Cash Equivalents} + \text{Short Term Investments} + \text{Net Current Receivables}}{\text{Total Current Liabilities}}$

A quick ratio of 1 is considered healthy, indicating the company can cover its current liabilities with its quick assets.

Accounts Receivable Turnover

This ratio shows the number of times per year a company collects its average accounts receivable.

• Formula:

$\text{Accounts Receivable Turnover} = \frac{\text{Net Sales}}{\text{Average Net Accounts Receivable}}$

Days Sales Outstanding

Days sales outstanding (DSO) shows the turnover ratio in number of days.

• Formula:

$\text{Days Sales Outstanding} = \frac{365}{\text{Accounts Receivable Turnover}}$

Comparison Table: Receivables Ratios

The following table compares the accounts receivable turnover and days sales outstanding for two companies.

Company	Quick Ratio	Accounts Receivable Turnover	Days Sales Outstanding
AbbVie	0.86	4.89	71.51
Johnson & Johnson	0.55	--	61.06

Additional info: The table above is inferred from fragmented data; Johnson & Johnson's accounts receivable turnover is not provided in the original notes.