REVENUE RECOGNITION AND

RECEIVABLES

Financial Accounting – Lecture 5

Eric Floyd– Fall 2020

 •2

PREVIEW OF THE NEXT 6 WEEKS

§ Course to date has focused on general concepts.
1. Basic financial statements and bookkeeping.
2. Difference between cash and accrual/deferral basis of accounting.

§ Very important that you understand the basic mechanics (the first
four weeks)!

§ Now moving to the applied principles part of the course:

1. Application of GAAP.
2. What are the “principles” that govern how the amounts on the
financial statements are determined?
3. How much flexibility does the firm have when applying these rules?
4. Inferring events using financial statements and notes.
 •3
REVIEW
§ Week 2 presented the definitions of revenue and expenses:
§ Revenue is net assets (assets minus liabilities) that the firm receives
from its customers when it sells goods or renders services.
§ Expenses are net assets consumed in generating revenues. We
match the consumption of any assets, in time, with the revenue
recognized.

§ Revenue increase net income (and therefore retained earnings) and

expenses decrease net income (and therefore retained earnings).
§ This week we expand the criteria for recognizing and measuring
revenue!

§ The principles under IFRS and US-GAAP are very similar. As this
course focus on principles I will not dig into any differences between
IFRS and US-GAAP.
 •4
OPERATING PROCESS FOR A
MANUFACTURING FIRM
§ When has a firm earned revenue?

§ Potentially at all five points in time!

 •5
REVENUE RECOGNITION PRINCIPLE
§ Revenue is recognized (recorded) when both:
1. The seller has substantially performed its obligation to the
customer; that is, the revenue has been earned, and
2. The firm has received cash, a receivable, or some asset capable of
reasonable measurement; that is, the revenue is measurable.

§ Why do we care so much about revenue recognition?

• Large impact on bottom line (net income).
• Gray area.
• Large proportion of SEC enforcements (>40%) .

§ Revenue may be recognized before or after cash collection (= accrual

accounting).
 •6
REVENUE RECOGNITION GUIDANCE
§ More guidance is needed. Five steps approach (ASC 606):

1. Identify the contract(s) with a customer

- Is the contract legally enforceable?
2. Identify the performance obligations in the contracts
3. Determine the transaction price (see example on next slide)
4. Allocate the transaction price to the performance obligations in
the contract
- Do you have market prices for separate components?
5. Recognize revenue when (or as) the entity satisfied the
performance obligations
- Is revenue earned?

§ Most firms recognize revenue at delivery

 •7

SUBSTANCE OVER FORM

§ Definition: Financial statements should show the overall financial
reality of the entity (economic substance), rather than the legal form of
transactions (form).

§ Grossing up revenue (e.g., hospitals).

§ Promise to repurchase an item and refund guarantees via side

letters.

§ Guiding principle: Risks & rewards of ownership must be transferred to

recognize a sale.
 •8
EXPENSE RECOGNITION PRINCIPLE
§ Expenses are matched to the revenues that they generate.
• Since the firm only expends assets (causing expenses) in
anticipation of revenue, fair measurement of net income calls for
matching those expenses against revenue.
• Expenses are recognized in the period in which revenue is
recognized.
 •9
INCOME RECOGNITION AT THE TIME OF SALE
(DELIVERY)
§ Often the criteria for revenue recognition are satisfied at the time of
sale.
§ To recognize revenue at the time of sale firms must estimate the effect
of certain events after the sale, including:
§ Customers not able/willing to pay (uncollectible accounts).
§ Returns, and Warranty services.

§ If the firm is unable to estimate these it cannot recognize revenue at

the time of sale !!
 • 10
HOW DO UNCOLLECTIBLE ACCOUNTS
AFFECT REVENUE RECOGNITION?
§ For credit sales, revenue is recognized (credited) at the time of the sale
even thought the customer has not paid cash.
§ Instead, an account receivable is established (debited).
Revenue (RE) Accounts receivables (A)
XXX XXX

§ An account receivable is an asset that represents a promise to pay.

§ Not all customers are able or willing to fulfill their promise.
§ When a customer defaults, the account becomes valueless and must
be credited and removed.
 • 11
RECOGNITION OF UNCOLLECTIBLE
ACCOUNTS
§ When should the firm recognize the loss from uncollectible accounts?
1. In the year it deems the particular accounts to be uncollectible?
(direct write-off method)
- What happens when the sale occurs in one period, but the write-off occurs in another
period?
- Provides an opportunity to manage earnings by allowing managers to choose when to
write-off customer accounts.
- The amount of Accounts Receivable on the Balance Sheet will not be reported at the
amount expected to be collected in cash.
- Only allowed if write-offs are immaterial.

2. In the year of the sale? (allowance method)

- GAAP require this method if write-offs are material.
 • 12

QUESTIONS
§ Direct write-off vs. allowance method:

• GAAP does not allow the Direct write-off method whereas this
method is required for tax accounting. Why do you think there is a
difference between tax rules and GAAP?

• What are managers’ incentives to over- or underestimate the

allowance account?
 • 13
SUMMARY OF ACCOUNTS AFFECTED BY
CREDIT SALES
Allowance for Uncollectible
Accounts Receivable, Gross (A) Accounts Receivable (CA) Note that Accounts
B.B. B.B. Receivable, Gross and
Allowance for
Uncollectibles are
New credit sales Cash received shown as one line on
from customers New charges the balance sheet:
Accounts Receivable,
Write-offs Write-offs
net.

E.B. E.B.

Cash (A) Bad Debt Expense (RE) Revenues (RE)

B.B.

Cash received New charges New credit

from customers sales

E.B.
 • 14
REAL WORLD EXAMPLE:WALMART
 • 15
RECOGNITION OF UNCOLLECTIBLE
ACCOUNTS:
ALLOWANCE METHOD
§ Recognize expenses at time of sale:

§ Estimate future uncollectible amounts (next slide)

§ Set up contra-receivable account:
Dr. Bad Debt Expense (RE) XXX
Cr. Allowance for Uncollectible A.R.(CA)XXX
=> The effect is that the expense match associated revenue.

§ When account is deemed uncollectible (e.g., customer bankrupt),

reduce allowance account:
Dr. Allowance for Uncollectible A.R. (CA) XXX
Cr. Accounts Receivable (A) XXX
=> There is no effect on income or Accounts Receivables, net.
 • 16
ESTIMATING THE NECESSARY ALLOWANCE
§ Two methods for determining the necessary allowance both based on
prior historical data.

§ Income Statement approach: Percentage of Sales method

§ Tells you how much to expense for the period.
§ Estimate the percentage of credit sales expected to go uncollected,
apply to the total credit sales made during the period, e.g., 2% of
credit sales.

§ Balance sheet approach: Aging of accounts receivable method

§ Tells you the desired ending balance for the allowance account – Not
the expense to record.
§ Adjust allowance account to get to ending balance (other side of the
entry is Bad Debt Expense, just like the other method).
 • 17
AGING ACCOUNTS RECEIVABLE
• York Company’s accounts receivable balances:

Age of Accounts Balance Receivable

0-30 Days $1,200,000
31-60 Days 255,000
61-120 Days 75,000
More than 120 Days 30,000

• Recent collections experience suggests the following percentages should be used to

compute the estimate of the amount that will prove uncollectible: 0-30 Days, 0.5%; 31-60
Days, 1.0%; 61-120 Days, 10.0%; and more than 120 Days, 30.0%.

• With this method we estimate the ending balance on the “Allowance for
Uncollectible Accounts Receivable” account.
 • 18
COMPARING THE TWO ESTIMATION
METHODS

Percentage-of-sales Method Aging of Accounts Method

Allowance for Uncollectible A.R. (CA) Allowance for Uncollectible A.R. (CA)
B.B. B.B.

New provision New provision

(estimated) (Plug)
Write-offs Write-offs

E.B. (plug) E.B. (estimated)

 • 19
RECONSTRUCTING EVENTS WHEN
USING THE ALLOWANCE METHOD
• Selected data from the accounts of Seward Company after adjusting
entries but before closing entries appear below.

January 1 December 31
Accounts Receivable (A) $82,900 Dr. $87,300 Dr.
Allowance for Uncollectible Accounts (CA) 8,700 Cr. 9,100 Cr.
Bad Debt Expense (RE) 4,800 Dr.
Sales (RE) 240,000 Cr.

The firm makes all sales on account. There were no recoveries during
the year of accounts written off in previous years.
Give journal entries for:
1) Sales on account, 2) Recognition of bad debt expense, 3) Write-off of
uncollectible accounts, and 4) Collection of cash from sales on account.
 • 20
Set-up the necessary T-accounts! Accounts Receivable, net

(C.A.)

(R.E.) (R.E.)
 • 21

INCOME RECOGNITION BEFORE DELIVERY

§ Long-term projects (planes, ships, buildings).
• Production covers several accounting periods and firm can
reasonably estimate future costs.
• Price set in advance and periodic payments are often made.
§ “Percentage of completion” method most common.
• Revenue and expenses recognized as work performed.
 • 22
PERCENTAGE OF COMPLETION
§ Long-term construction companies often earn revenue based on the
percentage of work completed
§ For example, a contract to pave a road is earned as the pavement is laid
Measuring the percentage of completion on a contract:
1. Engineering estimates
2. Cost-to-cost method
3. Units-of-delivery method
4. Units-of-work performed
§ Expenses are matched against this revenue and recognized in proportion.
• Example – Cost-to-cost method:
Current Revenue =
Cost to date Revenue
= ´ Contract Price -
Cost to date + Estimated Cost to Complete recognized earlier
 • 23

INCOME RECOGNITION AFTER “SALE”

§ Long-term payments (e.g., franchisees).
• Uncertainty over collection of future cash.

§ Installment method.
• Revenues and expenses recognized as cash collected, with
expense recognition based on proportion of cash collected.

§ A common example is a rent-to-own store:

• The customer takes possession of an asset and pays periodic
payments like rent.
• The customer may return the asset and stop payments at any
time.
• After a set number of payments ownership of the asset is given.
 • 27
UNIFYING PRINCIPLE FOR REVENUE
RECOGNITION
•A firm can recognize revenue when it has delivered products or services to
customers so long as the firm can estimate with reasonable certainty the events
remaining to complete the transaction (such as collecting cash, accepting returns,
making warranty repairs and replacements).

•When significant uncertainty exists at the time of delivery about the events
remaining to complete the transactions, firms must delay revenue recognition until
the uncertainties resolve to the level of reasonable statistical certainty.
 • 25
A BEGINNER’S GUIDE TO MANIPULATING
THE BOOKS
 • 26
IMAGINE YOU ARE ONE OF THE BAD
MANAGERS

§ Most managers are honest but some are not…

§ Why might we want to manipulate the accounting numbers?

§ What could be our motive?
§ Who might we want to trick?

§ How difficult do you think it is?

 • 27
HOW TO MANIPULATETHE BOOKS

•ΔAssets = ΔLiabilities + ΔShareholders’ Equity

•If no dividends and capital contributions:

•Net income = ΔShareholders’ Equity = ΔAssets - ΔLiabilities

§ Questions:
1. How can we overstate net income this year?
2. What fictive transaction do you suggest? (cash, inventory,
receivables, bank debt, warranties?)
3. What happens next year?
 REVERSING ERRORS • 28
Permanen
t account
(balance Temporary

Revenue (RE)
sheet) account

Fictive asset (e.g., receivable)

(income

Year 1
statement)

B.B. Year 1 B.B. 0

Net Income (NI) Year 1
Fictive asset no. 1 XX XX
(e.g., receivable)

Revenue (RE)
E.B. Year 1 = B.B. Year 2
Year 2
B.B. 0
True balance
+ XX If error detected XXXX
XXXX
then NI Year 2
Fictive asset no. 2 To overstate NI in year 2 we
YY YY
(e.g., receivable) need to invent one more asset
E.B. Year 2 = B.B. Year 3

If XX undetected in Yr. 2:
True balance + XX + YY

§ To continuously overstate income we need to continuously “invent” fictive

assets or “forget” liabilities.
§ When the “error” is detected it reverses. That is, net income decreases in the
period when the error is detected (alternatively; restatement).
 • 29
OVERSTATING REVENUES IS A SLIPPERY
SLOPE
• Problem is that you have “borrowed” from the future, so now period
two income will be lower than it would otherwise have been, creating
the incentive to commit more fraud.
§ To continuously overstate income we need to continuously borrow from the
future.
§ Eventually the future catches up with you.

• Why manipulate earnings if you know it hurts future profitability (and

ultimately reverses)?

• How can we avoid ending up on a slippery slope towards fraud?

 • 30
SIGNALS OF ISSUES WITH REVENUE
§ More than 40% of SEC enforcement actions include revenue recognition!!
§ These signals do not necessarily imply aggressive accounting but often need
additional investigation (ask questions?).
§ Revenue recognized too early, may be signaled by:
1. Unusual increase in non-current receivables as a percentage of revenue.
2. An unusual increase in unbilled accounts receivable as a percentage of all
receivables needs to be investigated.
3. Unusual increase in credit sales as a percentage of revenue, especially
accompanies by a decline in the allowance for uncollectible accounts
(buying own goods with own money).

§ Revenue may also be recognized too late. If the business is booming it is

tempting to save revenues for tomorrow:
§ Building up reserve accounts (e.g., allowance for bad debt, provision for
returns); and releasing reserves into income in later periods (reserves grow
quicker then revenues).