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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