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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.