Chapter 5: Current Assets and Revenue Recognition

From Financial Accounting Textbook
Jump to: navigation, search

Learning Objectives[edit]

  • Learn about current assets
  • Learn about cash
  • Learn about internal controls
  • Learn about accounts receivables
  • Learn how to reconcile a bank account
  • Learn about revenue recognition

Current Assets[edit]

Current assets are short-term assets which are expected to be sold or consumed within 12 months or the operating cycle, whichever is longer. Cash is considered a current asset. An operating cycle is the amount of time it takes for a company to make an initial outlay of cash (ie. to buy raw materials), produce the product and then sell the product. An operating cycle begins with cash being spent to perform the business's primary function and ends when cash has been received for the product. The operating cycle can exceed 12 months, for example, with manufacturing large industrial equipment or aircraft. Thus, an asset can be classified as a current asset even if it exceeds the 12 month requirement.

The following is a list of assets which are generally classified as current:

Cash

Inventory

Accounts recievable

Short-term investments

Prepaid expenses

Cash equivalents (undeposited checks, money market funds, highly liquid investments with a maturity of 3 months or less etc.)

Note that the above list does not apply to all companies. If the asset will not be sold or consumed within 12 months or the operating cycle, whichever is longer then it is not classified as a current asset. Instead the asset would be classified as a long-term asset or another asset classification.

Current assets are reported on the balance sheet in order of liquidity. Liquidity means the amount of time it takes for the asset to be sold and converted into cash. Cash is always reported first since it is by definition the most liquid current asset. Likewise, only the current portion of the asset must be reported as current. For example, if a certain amount of cash is being set aside to repay a long-term liability then that portion of the cash cash would be reclassified as a long-term asset.

We will cover the accounting aspects of each of the above current assets next.

Cash[edit]

Cash consists of paper fiat money, coin money, money orders and similar financial instruments. Negotiable financial instruments used to transfer money are also classified as cash. These would include certified checks and cashier's checks.

Cash is the first account to be listed in the current asset section due to liquidity. Cash equivalents are also included in the cash section. Cash equivalents are highly liquid assets that have a maturity of 3 months or less and the definition also includes common financial instruments like undeposited checks and money market funds.

If cash is restricted for purposes that exceed 12 months or the operating cycle (assuming it is longer) then that amount of cash would be reclassified to an account called restricted cash and be reported as a long-term asset.

Accounts Receivable[edit]

Only receivables that are expected to be collected within 12 months or the operating cycle, whichever is longer should be reported as current. The account should be reported net of any noncollectable amounts. For example, if you have $1,000 of accounts receivable and you estimate that $100 of the receivables will not be collectible then the accounts receivable should be reported as $900.

Inventory[edit]

Inventories need to be reported as current assets along with the cost flow assumption (FIFI or LIFO) and valuation method used (lower of cost or market or lower of cost or net reliable value). Inventory cost flow assumptions and inventory valuation is discussed in chapter 8 about inventory valuation.

Short-Term Investments[edit]

Short-term investments, or trading securities, are classified as current assets if they are expected to be sold within 12 months or the current operating cycle, whichever is longer. Trading securities are valued at fair value with fair value being determined by the value of the security in an active market (i.e. a stock market). Other forms of securities or investments are classified as current or noncurrent based on when or if the management plans to sell the investment or security. Chapter 9 discusses further details about accounting for investments and securities.

Prepaid Expenses[edit]

Prepaid expenses are classified as current if they are expected to be incurred (used up) within 12 months or the current operating cycle, whichever is longer. For example, if a company has prepaid 24 months of rent and the company uses the 12 month classification for current assets then only 12 months worth of the prepaid expense would be classified as a current asset. It is important to note that prepaid expenses are an asset so they will be reported at the remaining value. For example, if the 12 months of prepaid rent is valued at $12,000 and one month has passed then the prepaid rent would be reported at $11,000.

All prepaid expenses should be aggregated together and reported as a single amount.

A closer Look at Cash[edit]

The cash account requires extra analysis due to three factors: bank overdrafts, cash equivalents, restrictions on cash and the petty cash account.

Bank Overdrafts: When the cash account goes into the negative due to overdraft protection or through a check being written for more than the amount in the cash account then the account is said to be over drafted. When this situation occurs, the bank is in essence lending money to the company or customer. Since a liability is being created, a current liability needs to be recorded in the amount of the over drafted amount. For example, if the cash account is at -233 then a current liability for 233 needs to be recorded. The current liability is classified as an accounts payable. When evaluating the cash account, it is important to make sure to combine all cash accounts together. For example, if the company has -233 in their checking account but has 233 in the savings account then the overall cash account is not considered to be over drafted.

Cash Equivalents: Cash equivalent are assets which are short-term and highly liquid. To meet this criteria, the asset needs to be easily convertible into a known amount of cash and so close to their maturity that their value dose not change due to changes in the interest rate. This ultimately means only assets with a maturity of 3 months or less will qualify for cash equivalent classification. Money market funds and treasury bills are good examples of cash equivalents. Despite the name, it is important to note that cash equivalents are not cash and therefore the value of a cash equivalent can change over time.

Restricted Cash: Restricted cash is any amount of cash that has been set aside for a specific purpose. For example, a company might know that a new factory building will need to be constructed in one year. The company will start setting cash aside to help finance the construction of the new factory. When this cash is set aside, it is no longer available for general use by the business. Restricted cash can be classified as either a current asset or long-term asset depending on when the funds will be used. If the funds will be used within 12 months then it should be classified as a current asset. Anything over 12 months would be classified as a long-term asset. The restricted cash account should have a note disclosing what the cash will be used for. Restricted cash can be created simply by a decision of management or by legal obligations.

Petty Cash: Petty cash is a special account that is established to pay small and often recurring expenses such as postage, mailing supplies, and office supplies. At an individual level, each expense is small but if all of these expenses were aggregated then it would result in a significant amount. To make these expenses less of a burden to pay with a check, we use a petty cash account instead. In practice, the petty cash account is funded by transferring a specific amount of authorized cash into that account. These funds could be kept in physical cash to allow for ease of payment for expenses. When the employee makes the purchase, they keep receipts or record the transaction in a petty cash journal. When the funds in the petty cash account need to be replenished, another transfer is made to the account. At another periodic interval, the transactions in the petty cash account would be summarized in a journal entry. In total, there are two journal entries for the petty cash account: one journal entry to record funding or replenishing the account and another entry to record the actual expenses that have occurred.

The following journal entry illustrates how to setup the petty cash account:

Petty Cash Setup JE.png

The above journal entry represents the cash account decreasing by $1,000 while petty cash increases by $1,000. The only time petty cash is debited is when the account is setup or when the account limit is increased. If the account limit is decreased then it would be credited.

At the end of the month, the petty cash receipts journal would be reviewed and the following journal entry would be used to record the expenses. The following is an example journal entry:

Petty Cash Expense JE.png

It is important to note that we do not debit petty cash to record the purchases. We only debit the purchases accounts instead and credit cash. This process would occur on a periodic basis. When we credit cash, the petty cash account is being replenished.

Internal Controls[edit]

As discussed in chapter 1, all companies must establish strategic goals and objectives for the company to reach for. These strategic goals could be customer satisfaction, maximization of profits or minimization of risk. So how does a company actually go about making sure these goals are actively being achieved? The answer is the company does that by establishing a system of internal controls for the company. The internal controls are actively monitored and evaluated to make sure they are working and that efficient business operations are achieved.

To help companies create effective internal controls, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) created an integrated framework for internal controls. An integrated framework is essentially a set of policies that allow companies to create effective internal controls. When COSO was creating the internal controls integrated framework, they started by defining the objectives of the framework. According to COSO, the objectives of the integrated framework are designed to provide reasonable assurance that the company can do the following:

  • Improve the effectiveness and efficiency of operations
  • Reliability of financial reporting
  • Compliance with applicable laws and regulations

Achieving the above three goals requires the company to be able to achieve the five key elements of internal control. Those five elements are the following:

  • Control environment
  • Risk assessment
  • Control procedures
  • Monitoring
  • Information and communication

We will now briefly explain each of the 5 key elements followed by talking about some specific examples of internal controls. The study of internal controls is a very complex topic. Entire courses are dedicated entirely to the study of internal controls.

Control Environment[edit]

The control environment is the set of processes, standards, and structures that provide the basis for carrying out internal control across the organization. The board of directors and senior management establish the tone at the top regarding the importance of internal control including expected standards of conduct for employees.

Management reinforces expectations at all levels of the business. The control environment comprises the ethical values of the organization. The management establishes all operational goals and guidelines throughout the business. The resulting control environment has a pervasive impact on the overall system of internal control and their efficiency.

An effective control environment consists of the following 5 principles:

  • The business demonstrates a commitment to ethical values.
  • The board of directors demonstrates independence from management and has oversight of the development and performance of internal control.
  • Management establishes structures, reporting lines, and appropriate authorities and responsibilities in the pursuit of business objectives.
  • The business has a commitment to attract, develop, and retain competent individuals in compliance with business objectives.
  • The business holds employees accountable for their internal control responsibilities.

Following the 5 principles will create an effective control environment for the business.

Risk Assessment[edit]

Every business operates in a risky environment. The threat of hacking, changing laws, changing market conditions and market competition are all examples of risk factors that could adversely impact the business. The business management must constantly be evaluating their business for these risk factors, both internally and externally, and establish policies that counter them before they adversely impact the business.

Four principles exist for risk assessment:

  • Outline suitable objectives
  • Evaluate and analyzes risk
  • Evaluate fraud risk
  • Identifies and evaluates significant change

Control procedures[edit]

After the risks have been identified from the risk assessment step, management must implement controls to counter the potential risks. These are company polices which will directly counter the risks and make sure the business is able to achieve their stated strategic goals.

Three principles exist for control procedures:

  • Develop and implement control activities
  • Develop and implement general controls over technology
  • Implement controls through policies and procedures

Examples of internal controls could be mandatory vacations for employees, hiring competent employees, separation of duties, cross oversight of key business activities, or access control policies.

Monitoring[edit]

After the internal controls are implemented they must be continually monitored to make sure the internal controls are being applied correctly and effectively. An effective tool used to evaluate the effectiveness of internal controls is to perform tests to see if they are being applied. For example, if you have a security employee at the front desk who must check each employee's badge prior to gaining access the building then you could perform a test by trying to gain access to the building without showing your employee badge. If the security employee insists on seeing the badge then you know the internal control is being applied correctly. Internal auditors are employees who are hired directly by the company to verify if the internal controls are being followed correctly. If the polices are not correctly followed then the internal auditor will submit a report to management to suggest new policies be applied.

Three principles exist for monitoring:

  • Use relevant information
  • Communicates internally
  • Communicates externally

Information and communication[edit]

When deficiencies or changes in the internal control system are detected, information must be correctly communicated to those who best to correct the deficiency. Often times, it is management who is responsible for correcting any identified deficiencies. It is important to note that information can also come externally from the company. For example, changes in new laws or regulations might be identified and brought to the attention of management. It is management's responsibility to adjust their business operations effectively in response to these changes. Failure to do so could jeopardize the achievement of the company's ability to achieve their stated strategic goals.

Two principles exist for information and communication:

  • Conduct ongoing evaluations
  • Identifies and communicates deficiencies

Internal Controls over Cash[edit]

For most businesses, cash is considered one of their most important assets because it allows the company to conduct transactions on a daily basis, pay employees, and pay expenses. Without a sufficient supply of cash coming into the business, the business would fail to achieve its stated strategic goals. Cash also tends to be a target of high fraud risk both from inside the company (from employees) or externally from cyberattacks or malicious activities; therefore, it is crucial that all companies implement effective internal controls over cash.

In our discussion of internal controls over cash, we will discuss the relevant internal controls based on the natural flow of cash a business. That is, we will start by discussing how the business can control cash from the time it has been received until the time it has been spent or paid to investors.

Internal Controls over Cash Receipts[edit]

Businesses receive cash in three main ways from customers: in physical cash or coins, by mail (checks) or by electronic fund transfers (EFT). The goal of internal controls over cash receipts is to make sure all cash received by any of the above means is correctly deposited into the company bank account without any of the money being misallocated or stolen. The types of fraud schemes that have been developed around misallocation of cash receipts has increased in scope and complexity as more technology is being used to process cash receipts.

Internal Controls over Physical Cash[edit]

The goal of internal controls over physical cash is to make sure the physical cash received from the customer is ultimately deposited into the company's bank account. A commonly used piece of equipment used to control physical cash is a cash register. A cash register is used to calculate the amount of money to be charged for goods and services as well as collect cash from customers for storage in the cash register drawer.

A cash register is an effective method of internal control for several reasons. First, a cash register allows the store to determine how much to charge a customer by scanning each item's bar code. Second, the cash register's drawer allows for the safe storage of cash as it is collected from customers. At the end of the employee's shift the cash drawer is counted (often by a supervisor) and then reconciled (compared) to the amount of cash as recorded by the cash machine. Any discrepancies should be investigated and correcting actions should be taken if theft or inconsistencies in polices are found. After the cash is collected the cash will be stored in a secure safe until an armored car employee picks up the cash for transfer to the bank. When each one of these steps occurs there is a risk of fraud or theft of the cash occurring.

The following are examples of risks to the collection of physical cash:

1. Customers could manipulate the cash register machine by changing the bar code on the item's package through the use of a sticker. This results in the cash register calculating the incorrect amount of cash to be collected from the customer.

2. When the cash is given to the cashier, the employee could steal the cash instead of placing it into the cash drawer.

3. The supervisor could steal the cash instead of placing it in the safe.

4. An impersonating armored car employee (using a fake ID card) could steal the cash when it is being collected.

5. The armored car truck could be robbed while in transit to the bank.

6. Bank employees could steal the cash when it is being transferred to the bank.

This is just a brief list of ways the cash could be stolen. Often times, individuals trying to steal cash will go great length to conceal their methods. It is important for every business to continually monitor the collection of cash and to continuously improve their cash internal controls.

In certain situations the cash collections will only be off by an immaterial amount. In situations like this a special account is used called cash short and over. For example, let's say the cash register records cash receipts of $5,000 but the cash drawer only has 4,990.82 of physical cash. We cover the shortfall by debiting the cash short and over account as follows:

Internal Controls over Cash JE.png

If a surplus of cash is received (for example by customer's agreeing to forfeit the money by saying "keep the change") then the cash short and over would be credited instead.

Internal Controls over Mailed Checks[edit]

Businesses often use invoices to request payment from customers. These types of transactions are often performed for business to business transactions. When the customer wants to pay the invoice, they have the option of mailing a check to the business. When the customer mails the check they include a remittance advice to let the company know which invoice they are paying. If a remittance advice is not included then the employee will need to create a placeholder remittance advice to record the check properly. The proper flow of processing mailed checks is as follows:

1. An employee opens incoming mail and removes all checks and remittances advices. The check and remittance advice are verified to be matching. If the remittance advice is not correct then it should be corrected. The remittance advice serves as a source document to verify deposits occurring in the accounting records. The employee stamps the checks with "for deposit only".

2. The employee then transfers the summary ledgers and the remittance advices to the accounting department. The physical checks are delivered to a separate department for depositing in the bank account. Keeping the recording and depositing functions separate is an important control for reducing the risk of fraud.

3. The finance department prepares a bank deposit slip and then transfers the checks to the bank.

4. An employee in the accounting department then updates the customer accounts to reflect the funds received.

5. After the bank deposits the checks, the bank will return the deposit slips with the amount of funds received.

In every step of the process, internal controls are implemented to detect and reduce fraud. Due to the increasing use of computers in office environments the risk of fraud has increased due to more sophisticated schemes being developed.

Internal Controls over Electronic Funds Transfers (EFT)[edit]

Electronic funds transfers is an increasingly common way for companies to receive payment for their services. With EFT payments, the customer simply wires the funds to the company by electronic methods or by use of a payment processing service. Accepting payments by EFT means is probably the best way to companies to reduce the risk of fraud. The primary reason for this is due to less employees handling the funds. However, there are risks to EFT payments due to the more sophisticated methods by which the funds are received. For example, if the programming for the EFT is compromised then funds can still be siphoned off. Another big risk to EFT is that amount of funds that can be stolen by electronic means is often higher than ordinary theft. It is important for businesses to continually make sure their computer systems are secure and not compromised. It is wise for companies to hire the services of a skilled computer security team to make sure your computer systems are secure.

Internal Controls over Cash Expenses[edit]

Internal controls need to be placed over any purchases the business makes. The reason for this is to prevent the company from spending money on fraudulent transactions. For example, various schemes exist around check fraud schemes, paying fake "ghost" employees, or over payment schemes.

The system of internal controls over cash expenses should achieve the following objectives:

1. Cash payments are being made for the lowest price possible for the same product. For example, the products/services purchased should be at an arm's length terms or market-rate terms.

2. All expenses should be properly authorized by those who are designated to authorize them.

To achieve these objectives, properly designed internal controls need to be implemented. The following are examples of typical internal controls which are implemented over cash expenses: voucher system, separation of duties, computerized internal controls (blocks or flags payment transactions based on a pre-defined set of criteria).

Voucher System: A voucher system is simply a set of procedures and documents used to record and authorize approvals. A voucher system can be implemented to approve all expense payments over a certain amount. It could also be used to restrict authorization to a specific department or employee. Before any payments are made, the proper authorizations must be obtained. Separation of duties is important for an effective voucher system.

Separation of duties: Separation of duties simply means that different employees are responsible for different parts of the approval process. The same department or employee cannot authorize the whole transactions. Separation of duties could also mean one employee authorizes the transaction while the other employee simply verifies the transaction and verifies the signor is the person who has been designated to authorize the transaction.

Computerized Internal Controls: With the increasing use of computer systems in accounting departments and businesses. The computer can be programmed to perform internal controls. For example, the computer can be programmed to only authorize transactions going to certain bank accounts, vendors or employees. The system can also be programmed to flag any suspicious activities.

Companies should implement all three forms of internal controls to create an effective internal control system for cash.

Reconciliation of Bank Accounts[edit]

All companies use bank accounts to safely store their cash. Therefore it is important to make sure the bank account records are accurate with your accounting records. We do this by reconciling the bank account or verifying it for accuracy and consistency with the accounting records.

The process of reconciling the bank account begins by acquiring a copy of the bank statement for the applicable month. These bank statements are usually sent by postal mail but more commonly they are now entirely online. The bank account statement will list the beginning period balance followed by a listing of all deposits into the account. It will then list all transactions going out of the account. These expenses could be bank fees, internal bank account transfers or transfers to pay bills as authorized by the company. The final line on the bank statement is the ending period balance. The ending period balance will roll over to the following month to become the beginning period balance. An example bank statement is provided below:

Bank Statement.png

Positive increases in the bank account can occur for any of the following:

  • Deposits into the bank by EFT payment or check deposits
  • Interest earned on the account balance
  • If the company takes out a loan from the bank then the funds will be deposited into the account
  • Corrections for errors

Negative adjustments in the bank account can occur for any of the following:

  • Payments made by EFT or check to pay expenses
  • Bank fees
  • Withdrawal of cash from the account by an employee
  • Corrections for errors

Occasionally adjustments to the bank account will be made by the bank. For example if a check has been rejected then it will be most likely rejected due to insufficient funds (NSF) by the customer's bank. This means the customer has written a check to pay an invoice but the funds were not sufficient to cover the check. Other adjustments will be for error corrections (EC), service charges/bank fees (SC), and miscellaneous adjustments (MS).

Overview of Bank Reconciliation[edit]

The bank reconciliation process begins by taking the ending cash balance per the accounting records and comparing it to the ending cash balance per the bank statement for the same month. The goal of the bank reconciliation process is to identify the sources of differences between the two balances to record any differences. The bank reconciliation should occur at the end of every month. The primary cause for a variance between the two ending balances is from timing differences. The other cause could be from recording errors or bank errors. For timing differences the timing difference could be from transactions being recorded in the accounting records but not recorded by the bank. The opposite could be true where the bank records a transaction but the accounting records do not reflect this transaction.

The following are the most common sources of recording errors or bank errors:

  • Errors: A bank or recording error could be caused by human fault or some other issue. Errors will need to be investigated to see if corrective action needs to be taken to correct the error.
  • Bank Fees: Bank fees are charged directly by the bank for the depositor (company that owns the bank account) for using various bank services. Bank fees will need to be recorded in the accounting records.
  • Non-Sufficient Funds (NSF) Checks: These are checks which have not cleared the bank because the company that issued the check did not have sufficient funds in their account. The accounting records will need to be adjusted to account for NSF checks.
  • Bank Interest: Banks will give interest to depositors as a way to encourage customers to keep money in the account. The bank interest payments will need to be recorded in the accounting records.
  • Outstanding Checks: When a check is written, it is recorded as a credit immediately on the company's accounting records as a reduction in cash. The check is then mailed to the recipient before being deposited. This process can take a few days to several weeks to occur. During this time, the bank has not recorded the check being issued. The easiest way to verify outstanding checks is to simply verify canceled checks per the bank statement with the check register or to simply verify on the bank statement if the check has been recorded.
  • Deposits in Transit: Deposits in transit are the opposite of outstanding checks. Deposits in transits are checks that have been received by the company but have not been deposited in to the bank account.

To account for the above, we will use the bank reconciliation formula:

Bank Reconciliation Formula.png

Example of Bank Reconciliation[edit]

The best way to wrap your mind around how a bank reconciliation works is by example.

On January 31st, the company received its monthly bank statement for the month of January. As seen below:

Bank Statement.png

Additional facts:

  • Outstanding checks of $500 at the end of the month.
  • The company received a check for $300 that was recorded in the accounting records but not deposited in the bank.
  • The cash balance per the accounting records at the end of January 30th, 2019 was $5,229.57.

At this point, the accountant needs to reconcile the bank statement to the accounting records to make sure all relevant information is recorded in the accounting records. To help facilitate this task, we use a bank reconciliation worksheet.

Bank Reconciliation Worksheet.png

As we can see from the above worksheet, we begin by reconciling the bank statement which includes adding deposits and subtracting outstanding checks. We conclude by calculating the adjusted cash balance. We then move on to reconciling the cash account per the accounting records. This is accomplished by taking the most recent cash balance and then adjusting it for transactions which have not been recorded. These adjustments include adding interest earned, deducting bank fees and deducting NSF checks. We conclude by calculating the adjusted cash balance. Important to note is that the adjusted cash balance per the bank statement and cash account are the same.

In addition to reconciling the two cash balances, we will need to apply the following journal entries to account for the bank fees, interest earned and NSF check to correctly adjust the cash account. Take note that each of the following journal entries requires either a debit or credit to the cash account.

Bank fees:

The following journal entry needs to be applied due to the bank charging us a fee to use their services. The bank fee is an expense to the company and it is paid with cash.

BankFeeJE.png

NSF Check:

When the bank receives a check they adjust the associated customer's account receivable by crediting it. When the check comes back as NSF the company will need to reverse the original journal entry that was made when the check was originally received. The cash account is credited because the original journal entry was for a debit to cash.

NSFCheckFee.png

Interest earned:

Interest is viewed as income so it will need to be recorded in the accounting records. This is accomplished by simply debiting cash and crediting interest income.

InterestIncomeJE.png

After the above journal entries are posted, the bank reconciliation is complete.

A closer Look at Accounts Receivables[edit]

As previously discussed, receivables can exist in a variety of forms. The terminology used for each type of receivable is important because there are different accounting issues for each type that must be handled properly. There are two types of receivables, accounts receivables and notes receivable:

  • Accounts Receivable: Accounts receivable are created when customers purchase merchandise on account. Informal credit is granted to the customer who may use this informal credit to purchase products before paying for them. After the purchase has been made, the seller will issue an invoice to the customer to collect money to get the receivable paid. Customarily, no interest is charged on the outstanding balance of the account receivable. Accounts receivables could be created through ordinary trade which are called trade receivables or they may be created for any other reason that is not related to trade which are called nontrade receivables. Depending on when the money is to be repaid, accounts receivable can be classified as either current or noncurrent. Any money that is to be repaid within 365 days is considered current while any portion of the receivable that is to be repaid after 365 days is classified as noncurrent. The receivable can also be classified as current if the operating cycle extends beyond 365 days.
  • Notes Receivable: A note receivable is a more formal form of credit that is issued to the customer. Notes receivables are distinctly different from an account receivable because interest is generally charged on notes receivables. A note receivable is also routinely documented through a formal signed contract. The signed contract explicitly states how much principle is due, what the stated interest rate is and the term (time period) the money is to be repaid over. Notes receivables will also be classified as either current or noncurrent.

In regards to accounts receivables, there are three primary issues that must be addressed:

  • Valuation of the Receivable: The account receivable must be valued at net realizable value. What this means is the company must determine how likely it is that the account receivable will actually be collected from the customer. Likewise, the matching principle must be maintained by matching expenses with revenue. Key issues in this area are sales discounts (discussed in chapter 7), sales returns (discussed in chapter 7) and uncollectible accounts.
  • Determination of Bad Debts: Each customer might not repay the full amount of the balance on their account. The company must make a reasonable estimate of how likely it is that the account will be collected. The estimated amount of bed debt must be allocated to the period incurred through the use of an allowance account.
  • Recording Bad Debts: When an amount is determined the company must record the uncollectible portion of the account recievable as a bad debt. The recording of bad debt expense will impact the income statement in the period incurred. This is done to make sure the matching principle is not violated.

We will now discuss how to calculate each of the above areas.

Accounts Receivable Bad Debts[edit]

As the company operates its business making sales a certain portion of these sales will be made on account which will increase the balance in the accounts receivable account. Companies record their accounts receivables based on a customer by customer basis in a subsidiary ledger. This subsidiary ledger lists the current outstanding balance of each account. Due to the natural nature of business, not all customer will be able to repay the entire amount of the outstanding account receivable. As required by the matching principle, the company is to record the amount of expense associated with revenue as it is generated. For accountants, this presents a very tough problem because we do not know how much of the account will be collectible at the time the sale is made.

The allowance method is used to solve this unknown variable. The allowance method allows accountants to create a reasonable estimate of the bad debt and then record the estimated bad debt in the period the sale was made. For certain accounts, only a portion of the account will need to be recorded as a bad debt while other accounts will need to be recorded entirely as a bad debt. This effectively allows for the matching principle to not be violated. The accounts receivables should be evaluated periodically throughout the year.

Two new accounts will be used for recording bad debts:

  • Allowance for Doubtful Accounts: This account is a balance sheet account used to reduce the value of the accounts receivable account to net realizable value. The allowance for doubtful accounts is a contra-asset account because it reduces the value of an asset account.
  • Bad Debt Expense: This is an income statement account designed to recognize the uncollectible portion of accounts receivable. It is reported as a selling expense.

Estimation Methods for Bad Debt Expense[edit]

Multiple methods exist for estimating bad debt expense. We will review two basic methods that are used to estimate our bad debt expense: the percentage of credit sales method and the account receivable aging method. The estimation of bad debt expense will occur at the end of the accounting period when the books are being closed. An adjusting entry is used to record the bad debt expense. These types of estimates are calculated using the allowance method which effectively means we are going to use the allowance for doubtful accounts to record our estimate of bad debt expense in the period incurred.

Percentage of Credit Sales Method: This method uses the company's historical percentage of credit sales that have resulted in becoming bad debts. For example, a company might use the past 3 years of credit sales data to determine how much of these sales resulted in bad debts. If the company earned $1,000,000 in credit sales which resulted in $25,000 of bad debts then their bad debt percentage is 2.5% (25,000/1,000,000). This percentage is then used to calculate the current period's bad debts which will be recorded to the allowance for doubtful accounts. Using our previous example, if the company earned 100,000 of credit sales then their current period's estiamted bad debt would be $2,500 calculated as 2.5% of $100,000.

Example:

A company has the following credit sale data from the past 5 years:

Credit Sales Bad Debt Credit Sales
Year 1 $15,000 $500
Year 2 $20,000 $700
Year 3 $22,000 $2,200
Year 4 $25,000 $3,200
Year 5 $27,000 $4,800

The company's policy is to use the 2 more recent years to determine their bad debt percentage (year 5 and year 4). Based on this policy the bad debt credit percentage would be calculated as follows:

($4,800 + $3,200) / ($27,000 + $25,000) or $8,000 / $52,000 = 0.1538 (15.38%)

If their current year credit sales were $32,000 then the current year's bad debt expense would be calculated as follows:

$32,000 * .1538 = $4,921.60

The $4,921.60 would be added to our allowance for doubtful accounts.

Account Receivable Aging Method: This method uses the amount of time the account receivable has been outstanding to determine the likelihood of the account turning into a bad debt. Generally, the longer the account goes unpaid by the customer, the more likely the account is to never be paid. In order to implement this estimation method, we need to separate our accounts receivable by days the account has been outstanding. Most companies use 30 day intervals to perform the estimation. For example, we will have an estimation for 30 days, 60 days, 90 days and 120+ days. We will use the historical calculation of how much of these group of accounts results in bad debt during that time period.

Example:

Company A is using the accounts receivable aging method to calculate their bad debt expense. The accounting department has performed the analysis to determine how much of each account is likely to become a bad debt during that time period. The following calculation is used to determine the bad debt expense:

Total amount of AR Estimated Percentage Uncollectible Bad Debt Expense Calculation
Not overdue $10,000 5% $10,000 X .05 = $500
30 days overdue $25,000 8% $25,000 X .08 = $2,000
60 days overdue $15,000 12% $15,000 x .12 = $1,800
90 days overdue $17,000 16% $17,000 x .16 = $2,720
120+ days overdue $35,000 20% $35,000 x .20 = $7,000
Total: $14,020

Based on the above calculation, our total bad debt expense would be estimated to be $14,020. It is important to note that this would be our final balance in the allowance for doubtful accounts. If a balance was already in the account then the bad debt expense would be adjusted accordingly. For example if the allowance account already had a credit balance of $2,000 then our bad debt expense would only be $12,020 ($14,020 - $2,000).

Direct Write off Method: The direct write off method does not record any bad debt expense until the account is completely worthless. For financial accounting purposes, this method is not acceptable because it violates the matching principle. Compliance with the matching principle is required for accrual accounting. Accrual accounting is required for GAAP compliant financial statements which means using the direct write off method will make your financial statements not be acceptable for GAAP purposes. The direct write off method is only used for tax reporting purposes.

Recording Bad Debt Expense[edit]

Now that we know how to estimate our total bad debt expense for the period, it is now time to record it through a journal entry. We record our estimated bad debt expense as follows:

Bad Debt Expense JE.png

The accounting impact of this entry is the allowance for doubtful accounts decreases assets while the bad debt expense decreases stockholder's/owner' equity. The bad debt expense decreases net income. In regards to the balance sheet, the allowance for doubtful accounts is always subtracted from the balance of the account receivable to arrive at net realizable value or net book value.

Completely Worthless Accounts[edit]

Occasionally accounts will be completely uncollectible due to changing financial conditions of a company. For example, you might be owed money from a company that filed for bankruptcy. When it is determined that the account is no longer collectible it must be written down to zero. We do this by booking a journal entry that removes the specific account receivable and removes the associated amount in the allowance for doubtful accounts. The following entry is booked:

Worthless Account JE.png

Debiting the allowance account reduces the account and crediting the account receivable account reduces the value of that account. This entry does not impact the income statement because the income statement impact was already previously recorded with the bad debt expense adjusting entry. Also total assets is not impacted because both accounts are classified as assets (a contra asset account is classified as an asset account).

Financial Statement Presentation of Bad Debt Expense and Allowance for Doubtful Accounts[edit]

Reporting accounts receivables must be done on the balance sheet and income statement. The balance sheet reports receivables at net realizable value (also referred to as net book value) which means the account receivable is reported net of the allowance for doubtful accounts. For example, if your account receivable balance is $100,000 and our allowance for doubtful accounts is $20,000 then we would report $80,000 for net receivables. Net receivables is reported as a single line on the balance sheet classified as a current asset in most situations.

For the income statement, bad debt expense is reported as an expense. If the amount of bad debt expense reported is material then a supplementary disclosure schedule must be prepared.

The following balance sheet and income statement show the impact of accounts receivable related activity:

CH5 Balance Sheet.png


CH5 Income Statement.png

Revenue Recognition[edit]

Revenue is a critical economic measure used by financial analysts and investors to determine how well a company is performing. Based on the matching principle and accrual accounting we only recognize revenue when it is earned. This idea is simple in theory but can be difficult to determine for complex transactions or different business situations. The standard setters have created a robust framework for us to use regarding revenue recognition.

At a fundamental level, revenue recognition is created from analyzing changes in asset and liability accounts to determine the best way to recognize revenue. For most transactions, the revenue recognition is clear while other transactions can be more complex. The goal of revenue recognition is to recognize revenue that is consistent with the transfer of goods or services and the amount of money relevant to each good or service.

To accomplish this goal, we use the following five-step model:

1. Review the transaction contract

2. Determine the distinct performance contract obligation is present

3. Determine the exchange of money in the contract

4. Allocate the exchange of money to the contract performance obligation

5. Revenue is recognized when each distinct performance obligation is completed

When the 5 step process is completed we will be recognizing revenue in the period the performance obligation is completed.

Revenue Recognition Process Illustrated[edit]

We will now illustrate the five-step revenue process to help analyze it and learn it better. For this illustration we will be using Titan Manufacturing inc and their customer Western Appliance Inc. Titan Manufacturing is in the business of manufacturing washing machines while Western Appliance is in the business retailing appliances.

In our illustration, Western Appliance requires 100 washing machines to be built to be sold in their store. Titan and Western agree to the price of $100 for each washing machine over the life of the contract. Titan currently has 10 washing machines in stock and western has purchased all of them for immediate delivery to Western's retail store with shipping terms FOB shipping point. A contract was signed and dated on the date the deal was agreed to by both companies.

Step one: Review the contract[edit]

The first step in the revenue recognition process is to review the contract.

In order to do this we must understand what a contract is and how to review it properly. To understand what a contract is we must go to business law to learn what a contract is and determine if a legally binding contract exists for the transaction. For a contract to be legally binding it must have the following characteristics:

1. Lawful consideration is paid in the contract. Consideration is any form of payment of money, goods or services used to conduct a transaction.

2. An offer and acceptance has been performed. The buyer and seller have agreed to form the contract. The seller or buyer have made an offer and the other party has accepted the offer. This process must have mutual consent and either party cannot be under duress (fear) to enter the contract.

3. Agreement is certain in terms of rights and obligations. The buyer and seller in the contract know the terms of the contract and understand what their rights and obligations are in terms of satisfying the contract terms. One element of this is that the payment terms must be declared.

4. The exchange of consideration is reasonably certain. The buyer has the ability to pay when the seller has competed the contract.

When we review the above four factors and then compare them to the facts of the illustration, we can see that a valid contract has been established.

Step two: Determine the distinct performance contract obligation is present[edit]

Assuming step one has been satisfied, we can move on to step two which is to determine the distinct performance obligations of the contract. When evaluation the contract for this step we need to determine if the contract consists of one single obligations or multiple obligations. For example, the contract could consist of an appliance service contract as well as the sale of appliances. In that case, the service contract would be separate from the sale of the appliance because it can be performed without the sale of the appliance and vice versa.

Using our specific example, we can see that the contract consists of the sale of multiple appliances over a period of time. The contract explicitly states the price of each appliance to be $100 for each appliance. When the product is shipped to the customer (Western Appliance), the dealer (Titan Manufacturing) would record revenue of $1,000 because the 10 appliances were shipped. Even though the entire value of the contract is $10,000 we would only record $1,000 of revenue. As the contract is performed, Titan will record $100 revenue as each appliance is shipped.

Step three: Determine the exchange of money in the contract[edit]

In our example contract, the price is easily determined because it is explicitly declared in the contract ($100 for each appliance). More complexities arise when financing is involved in the contract or when the contract's consideration consists of something else other than a standard monetary unit.

Step four: Allocate the exchange of money to the contract performance obligation[edit]

Our example is straight forward since no allocation is needed. We have one product being sold at a fixed price. Allocation is needed when multiple products or services are being sold. This because more complex if explicitly stated prices for each product or service are not stated. In situations like this, the accountants must use reasonable estimates for the price of each product or service. Financial statement auditors and regulators often scrutinize these estimates due to the potential for abuse. Every company has the incentive to overstate revenues due to the incentive to increase the share price or overall value of the company. Investors generally regard more revenue as being a positive for the company. As accountants, we have a fiduciary duty to make sure external users of financial statements and financial information are not mislead.

Step five: Revenue is recognized when each distinct performance obligation is completed[edit]

We recognize revenue only when the performance obligations is completed. In this case, the term completed has a very specific meaning. In regards to revenue recognition, a performance obligations is considered completed when the control of the service of product has shifted to the customer. In the case of our example, when the appliance is shipped to the customer, the customer has control of the appliance because the legal terms of the contract are FOB: shipping point.

This concludes our discussion revenue recognition. We have outlined the high level overview of revenue recognition. Within accounting, revenue recognition is extremely complex due to the various ways a contract can be formed. More advanced courses on financial accounting will dive in deeper regarding all the nuances that are involved with revenue recognition for complicated transactions.