Chapter 5



Cornerstones of Financial & Managerial Accounting

Rich/Jones/Heitger/Mowen/Hansen

Chapter 5

Learning Objectives

LO1. Explain the criteria for revenue recognition.

• Revenue is recognized when it is:

• realized or realizable

• earned

• The terms “realized” and “realizable” mean that the selling price is fixed and determinable and collectibility is reasonably assured.

• Revenue is considered earned when delivery has occurred or services have been provided.

LO2. Measure net sales revenue.

• The appropriate amount of revenue to recognize is generally the cash received or the cash equivalent of accounts receivable.

• However, companies often induce customers to buy by offering:

• sales discounts

• sales returns

• sales allowances

• Sales discounts are reductions of the normal selling price to encourage prompt payment.

• Sales returns occur when a customer returns goods as unsatisfactory.

• Sales allowances occur when a customer agrees to keep goods with minor defects if the seller reduces the selling price.

• These events are recorded in contra-revenue accounts that reduce gross sales to net sales.

LO 3. Describe internal control procedures for merchandise sales.

• Since sales revenues have a significant effect on a company’s net income, internal control procedures must be established to ensure that the amounts reported are correct.

• Typically sales are not recorded until a three-way match is performed between the:

• customer purchase order (which indicates that the customer wants the goods)

• the shipping document (which indicates that the goods have been shipped to the customer)

• the invoice (which indicates that the customer has been billed

LO4. Describe the principal types of receivables.

• Receivables are classified along three different dimensions:

• accounts and notes receivable

• trade and non-trade receivables

• current and noncurrent receivables

LO5. Measure and interpret bad debt expense and the allowance for doubtful accounts.

• The primary issues in accounting for accounts receivable are when and how to measure bad debts (i.e., accounts that will not be paid).

• GAAP requires receivables to be shown at net realizable value on the balance sheet.

• Further, the matching principle says that an expense should be recognized in the period in which it helps generate revenues.

• Consequently, we must estimate and recognize bad debt expense in the period the sale is made—even though we do not know which accounts will be uncollectible.

• The estimate is made by using either:

• the credit sales method or

• the aging method

• The credit sales method estimates the bad debt expense directly.

• The aging method estimates the ending balance needed in the allowance for doubtful accounts, and bad debt expense follows.

LO6. Describe the cash flow implications of accounts receivable.

• Companies can increase the speed of cash collection on receivables by factoring, or selling, their receivables.

• The buyer of the receivables will charge a fee to compensate themselves for the time value of money, the risk of uncollectability, and the tasks of billing and collection.

• Receivables may also be packaged as financial instruments or securities and sold to investors. This is referred to as securitization.

• A special case of selling receivables is accepting credit cards like MasterCard and Visa.

LO7. Account for notes receivable from inception to maturity.

• Notes receivable are recognized for the amount of cash borrowed or goods/services purchased.

• This is the principal amount of the note receivable.

• Any excess of amount repaid over principal is recognized as interest revenue in the period the interest was earned.

LO8. Analyze profitability and asset management using sales and receivables.

• Because sales revenue is such a key component of a company’s success, analysts are interested in a large number of ratios that incorporate sales.

• Many of these ratios attempt to measure how much the company is making on sales. These are called profitability ratios.

• Gross profit percentage

• Operating margin percentage

• Net profit margin

• Analysts are also concerned with asset management. Asset management refers to how efficiently a company is using the resources at its disposal.

• One of the most widely-used asset management ratios is accounts receivable turnover.

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