1. ACCOUNTS RECEIVABLE & REVENUE RECOGNITION Accounting ASW Summer 2006

2. Issue: What to do about bad debts? • So far: Accounts Receivable 340 Sales Revenue 340

3. Two potential approaches • Direct write-off method • Allowance method • Problem 6.21

4. Direct Write-Off Method • Only allowed for financial reporting if bad debts are immaterial, but required for tax • At the time of sale: No entry • When the account is deemed uncollectible: Bad Debt Expense 1.8 Accounts Receivable 1.8

5. If the account is later collected: Accounts Receivable 1.8 Bad Debt Expense 1.8 Cash 1.8 Accounts Receivable 1.8 (The entry is made through accounts receivable rather than directly to cash for a record of the accounts receivable having been collected.)

6. Problems with Direct Write-Off • Accounts Receivable are overstated (in terms of expected receipts) • Net income is overstated • Revenue and expenses are not matched • Discretion affecting net income in when to call “uncollectible”

7. Allowance Method • Generally required for financial reporting • Record bad debts estimate at time of sale to expense and account receivable contra Bad Debt Exp. ($340 x 3%) 10.2 Allow. for Doubtful Accts. (AR contra) 10.2 • Net income effect at time of sale

8. When the account is deemed uncollectible: All. for Doubtful Accts. 1.8 Accounts Receivable 1.8 • No net income or total asset effect at the time of write-off

9. If the account is later collected: Accounts Receivable 1.8 All. for Doubtful Accts. 1.8 Cash 1.8 Accounts Receivable 1.8

10. Advantages of allowance method - Matches revenue and expenses in period of sale - Records net accounts receivable at expected cash collection • Problem with allowance method - Discretion in estimating bad debt expense - Only works well if your estimates are good • Problem 6-21

11. How to estimate bad debts under the allowance method • Percentage of sales • Aging of accounts receivable • Observation of large accounts • Often use all three together

12. Other Applications • Sales returns • Cash discounts • Sales allowance

13. (Gross) Accounts Receivable Beg. Bal. Credit Sales Collections Write-offs Ending Bal. Allowance for Doubtful Accounts Beg. Bal. Write-offs Bad Debt Exp. Ending Bal. ACCOUNTS RECEIVABLE AND BAD DEBTS T-ACCOUNTS

14. Income Recognition Issues • Review of revenue recognition criteria • provided all (or substantial portion) of goods or services • have received an asset which can be measured • Issue: What if completion spans several periods?

15. Long-Term Contracts • Construction spans several periods • Customers and terms decided in advance • May satisfy revenue recognition criteria before completion • Problem 6-33 • $200M contract, • Costs of $42M, $54M and $24M in years 1-3

16. Completed Contract Method • Delay revenue recognition until completed • For our example, • recognize no income or expense in years 1&2 • accumulate costs in “construction in progress” account (just like “work in progress”) • recognize $200M in revenue and $120M in expense in year 3

17. Often used if: • construction in period is too short to justify spreading • buyer or terms are not set • total cost (and hence income) is too uncertain

18. Percentage Completion Method • Generally preferred by companies • Only used if: • construction spans multiple periods • contract terms are set and collection is likely • total cost (and profit) are reasonably estimable

19. Recognize revenue each period in proportion to costs during the period • In our example, • 35% of costs occur in year 1, so 35% of revenue, costs and net income would be recognized in year 1 • 45% of revenue, costs and NI in year 2 • 20% of revenue, costs and NI in year 3