Chapter 5:

Receivables and Revenue

Reporting, and Analyzing Sales
Cornerstones of Financial Accounting,
Third Canadian Edition
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 Learning Objectives
1. Apply revenue recognition criteria to a retail, service, or
manufacturing business.
2. Measure and report sales revenue net of sales discounts and
sales returns.
3. Explain the principal types of receivables.
4. Measure and report bad debt expense and the allowance for
doubtful accounts.
5. Explain the cash flow implications of accounts receivable.
6. Account for notes receivable.
7. Explain internal control procedures for merchandise sales.
8. Calculate profitability and asset management ratios.

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 1 Timing of
Revenue Recognition
► While cash-basis accounting recognizes revenue in the
period payment is received (as on your tax return), accrual-
basis accounting recognizes revenue when it is
►realized or realizable, which means that non-cash
resources (such as inventory) have been exchanged for
cash or near cash (accounts receivable) and
►earned, which means the earnings process is
substantially complete.

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 1 Conditions under IFRS (IAS 15)
► IFRS 15 requires the application of a five-step model framework
before revenue can be recognized.
► The guiding principle of IFRS 15 is that an entity can recognize
revenue to record the transfer of promised goods or services to
customers in an amount that reflects the consideration to
which the entity expects to be entitled in exchange for the
goods or services provided.
► The five-step model in IFRS 15, with a comparison to ASPE, is
summarized as follows.

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 1 Conditions under IFRS (IAS 15)
(continued)
► IFRS 15 Step 1—Identify the contract with the customer. Five
conditions must be met before revenue can be recognized relating to
contract approval, identifiability of contractual rights of the parties,
payment terms, existence of commercial substance, and
collectability. Under ASPE, revenue is recognized where there is
persuasive evidence of a purchase and sale agreement which is
usually, but not always, specified in writing.
► Step 2—Identify the performance obligations in the contract. At the
inception of the contract the entity must assess the goods and
services promised to the customer. Under ASPE, revenue is usually
applied to each transaction, although it may be necessary to apply
revenue recognition criteria to separate components of a single
transaction to reflect the substance of the transaction.

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 1 Conditions under IFRS (IAS 15)
(continued)
► Step 3—Determine the transaction price. ASPE does not
contain explicit guidance on transaction price determination,
but typically consideration is in the form of cash, receivables, or
other financial instruments (which must be valued at fair
market value).
► Step 4—Allocate the transaction price to the performance
obligations in the contracts. Unknown selling prices must be
estimated using identified methods. ASPE contains guidance
where a single sale involves multiple products or services but
does not prescribe a methodology for allocating revenue to
these separate products or services.

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 1 Conditions under IFRS (IAS 15)
(continued)
► Step 5—Recognize revenue when (or as) performance obligations are
performed by the entity. Revenue is recognized as control is passed, either
over time or at a point in time. Under ASPE, revenue is generally recognized
when three conditions are met: i) the significant risks and rewards of
ownership of the goods have been transferred to the purchaser by the
seller or, in a service contract, services have been rendered; ii) the amount
of revenue can be reliably measured and is not uncertain; and iii) payment
to the seller is probable. The significant risks and rewards of ownership of
the goods have been transferred to the purchaser by the seller.
► The amount of revenue can be readily measured.
► The seller has not retained continuing managerial involvement to the degree
usually associated with ownership or effective control over the goods sold.
► It is probable that the economic benefits (usually payment) associated with the
transaction will flow to the seller.
► Cost incurred or to be incurred with respect to the transaction can be reliably
measured.
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 2 Amount of
Revenue Recognized
► The appropriate amount of revenue to recognize is generally
the cash received or the cash equivalent of the receivable.
► Four changes to sales revenues are
►sales discounts
►credit card discounts
►sales returns
►sales allowances

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 2 Sales Discounts and
Credit Card Discounts
► To encourage prompt payment, businesses may offer a sales
discount.
► This discount is a reduction of the normal selling price and is
attractive to both the seller and the buyer.
► For the buyer, it is a reduction to the cost of the goods and
services.
► For the seller, the cash is more quickly available and
collection costs are reduced.

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 2 Sales Discounts
(Continued)
► Sales invoices use a standard notation to state discount and
credit terms.
► For example, the invoice of a seller who expects payment in 30
days and offers a 2% discount if payment is made within 10
days would bear the notation 2/10, n/30 (which is read “2/10,
net 30”).
► Most companies record the sale and the associated
receivable at the gross (pre-discount) amount of the invoice.
► When a discount is taken, the amount of the discount is
recorded in a contra-revenue account called Sales Discounts.

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 Cornerstone 5-1
2
Recording Sales Discounts

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 Cornerstone 5-1
2
Recording Sales Discounts
(Continued)

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 2 Recording Sales Discounts
(Continued)
► It is also important to monitor changes in how customers use
sales discounts.
► Customers who stop taking sales discounts may be
experiencing cash flow problems and may be potential credit
risks.
► Sales discounts must be distinguished from both trade and
quantity discounts.
► A trade discount is a reduction in the selling price granted by the
seller to a particular class of customers.
► A quantity discount is a reduction in the selling price granted by
the seller because selling costs per unit are less when larger
quantities are ordered.

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 2 Sales Returns and Allowances
► Occasionally, a customer will return goods as unsatisfactory.
► Sometimes, a customer may agree to keep goods with minor
defects if the seller is willing to make an “allowance” by reducing
the selling price.
► When goods or services arrive late, or in some other way are
rendered less valuable, a customer may be induced to accept the
goods/services if a price reduction, called a sales allowance, is
offered by the seller.
► In these cases, a contra-revenue account called Sales Returns and
Allowances is used to record the price reduction.
► Merchandise or goods returned by the customer to the seller are
sales returns and are also recorded in the Sales Returns and
Allowances account.

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2 You Decide
Sales Returns and Allowances

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 3 Types of Receivables
► Receivables are typically categorized along three different dimensions:
► Accounts or trade receivable or notes receivable: A “note” is a legal
document given by a borrower to a lender stating the timing of repayment
and the amount (principal and/or interest) to be repaid. Accounts
receivable, on the other hand, do not have a formal note.
► Other receivables include interest receivable, loans due from directors or
company officers, advances to employees, loans to subsidiaries, sales taxes,
and income taxes recoverable from government entities.
► Current or noncurrent receivables: Although in practice both accounts and
notes receivable are typically classified as current, accounts receivable are
typically due in 30 to 60 days and do not have interest, while notes
receivable have interest and typically are due in anywhere from 3 to 12
months.
► Trade or nontrade receivables: Trade receivables are due from customers
purchasing inventory in the ordinary course of business, while nontrade
receivables arise from transactions not involving inventory.

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 4 Valuation of Accounts Receivable
and Accounting for Bad Debts
► IFRS requires accounts receivable to be shown at their “net
realizable value,” which is the amount of cash the company
expects to collect after consideration is given to receivables
whose collection is impaired.
► When customers do not pay their accounts receivable, bad
debts result (also called uncollectible accounts or impaired
accounts).
► There are two methods to record bad debt expense:
►the direct write-off method
►the allowance method

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 4 Direct Write-Off Method
► The direct write-off method waits until an account is deemed
uncollectible before reducing accounts receivable and
recording the bad debt expense.
► Since accounts are often determined to be uncollectible in
accounting periods subsequent to the sale period, the direct
write-off method is inconsistent with the matching concept.
► Therefore, this method can be used only if bad debts are
immaterial under IFRS.

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 4 Allowance Method
► In the allowance method, bad debt expense is recorded in the
period of sale, which allows it to be properly matched with
revenues according to the matching concept.
► The result is that bad debt expense is recognized before the
actual default.
► An account established to “store” the estimate of potentially
uncollectible accounts is known as the Allowance for Doubtful
Accounts.
► When a specific account is ultimately determined to be
uncollectible under the allowance method, it is written off by a
debit to the Allowance account and a credit to accounts
receivable.
► Under the allowance procedure, two methods commonly used
to estimate bad debt expense are the percentage of credit sales
method and the aging method.

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4 Percentage of
Credit Sales Method
► The simpler of the two methods for determining bad debt
expense is the percentage of credit sales method.
► Using past experience, a company estimates the percentage
of the current period's credit sales that will eventually
become uncollectible.
► This percentage is multiplied by the total credit sales for the
period to calculate the estimated bad debt expense for the
period:
Total Credit Sales × Percentage of Credit Sales Estimated
to Default = Estimated Bad Debt Expense

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 Cornerstone 5-2
4 Estimating Bad Debt Expense Using
the Percentage of Credit Sales Method

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 Cornerstone 5-2
4 Estimating Bad Debt Expense Using
the Percentage of Credit Sales Method (Continued)

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 Cornerstone 5-2
4 Estimating Bad Debt Expense Using
the Percentage of Credit Sales Method (Continued)

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 4 Aging Method
► Under the aging method, bad debt expense is estimated by
determining the collectability of the accounts receivable rather
than by taking a percentage of total credit sales.
► At the end of each accounting period, the individual accounts
receivable are categorized by age.
► Then an estimate is made of the amount expected to default in
each age category based on past experience and expectations
about how the future may differ from the past.
► Since the objective of the aging method is to estimate the ending
balance in the allowance for doubtful accounts, any existing
balance in the allowance account must be considered when
determining the amount of the adjusting entry.

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 Cornerstone 5-3
4 Estimating the Allowance for
Doubtful Accounts Using the Aging Method

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 Cornerstone 5-3
4 Estimating the Allowance for
Doubtful Accounts Using the Aging Method
(Continued)

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 Cornerstone 5-3
4 Estimating the Allowance for
Doubtful Accounts Using the Aging Method
(Continued)

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 Comparison of Percentage of
4
Credit Sales Method and
Aging Method
► When deciding which method to use, it is important to
recognize that the underlying differences between the
percentage of credit sales method and the aging method is
what is being estimated.
► The percentage of credit sales method is primarily
concerned with appropriately estimating bad debt expense
on the income statement.
► The aging method is a statement of financial position
approach that analyzes the accounts receivable to estimate
its net realizable value.

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4 You Decide
Are Bad Debts Always Bad?
Should Increased Discounts Be
Offered to Customers?

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 5 Cash Management:
Factoring Receivables
► An increasingly common practice is to factor, or sell,
receivables.
► When receivables are factored, the seller receives an
immediate cash payment reduced by the factor's fees.
► The factor, the buyer of the receivables, acquires the right to
collect the receivables and the risk of uncollectibility.
► In a typical factoring arrangement, the sellers of the
receivables have no continuing responsibility for their
collection.
► Securitization occurs when large businesses and financial
institutions frequently package factored receivables as
financial instruments or securities and sell them to investors.

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 5 Cash Management:
Credit Cards
► Bank credit cards, such as Visa and MasterCard, are really just a special
form of factoring.
► The issuer of the credit card (i.e., the bank) pays the seller the amount of
each sale less a service charge (on the date of purchase) and then collects
the full amount of the sale from the buyer (at some later date).
► The advantages of this arrangement are
► Sellers receive the money immediately.
► Sellers avoid bad debts because as long as the credit card verification
procedures are followed, the credit card company absorbs the cost of
customers who do not pay.
► Recordkeeping costs lessen because employees are not needed to
manage these accounts.
► Sellers believe that by accepting credit cards, their sales will increase.

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 5 Cash Management:
Debit Cards
► A debit card authorizes a bank to make an immediate electronic
withdrawal (debit) from the holder's bank account.
► The debit card is used like a credit card except that a bank
electronically reduces (debits) the holder's bank account and
increases (credits) the merchant's bank account for the amount
of a sale made on a debit card.
► Debit cards are disadvantageous to the card holder since
transactions cannot be rescinded by stopping payment.
► Debit cards are advantageous to banks and merchants through
reduced transaction-processing costs.

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6 Notes Receivable
► Notes receivable are receivables that generally specify an
interest rate and a maturity date at which any interest and
principal must be repaid.
► The amount lent is the principal.
► The excess of the total amount of money collected over the
amount lent is called interest.

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 6 Calculating Interest
► Interest can be considered compensation paid to the lender
for giving up the use of resources for the period of a note (the
time value of money).
► The interest rate specified in the note is an annual rate.
Therefore, when calculating interest, you must consider the
duration of the note using the following formula:

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6 Cornerstone 5-4
Accounting for Notes Receivable

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 Cornerstone 5-4
6
Accounting for Notes Receivable
(Continued)

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 7 Internal Control Over Sales
► For sales revenues, internal controls normally involve the
following documents and procedures:
►Accounting for a sale begins with the receipt of a purchase
order or some similar document from a customer. The order
document is necessary for the buyer to be obligated to
accept and pay for the ordered goods.
►Shipping reports and billing documents are prepared based
on the order document. Billing documents are usually called
invoices.
►A sale and its associated receivable are recorded only when
the purchase order, shipping, and billing documents are all
present.

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 Internal Controls for
7
Recording Sales Revenue

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 8 Analyzing 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 profitability ratios attempt to measure the
return the company is earning on sales.
► There are three common profitability ratios:
►Gross Profit Margin = Gross Profit ÷ Net Sales
►Operating Profit Margin = Operating Income ÷ Net Sales
►Net Profit Margin = Net Income ÷ Net Sales
► Analysts also like to look at the operating margin and net profit
margin percentages to see how much is left from a sales dollar
after paying for the product and all its operations.

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 8 Analyzing Receivables
► Analysts are also concerned with asset management. Asset
management refers to how efficiently a company is using the
resources at its disposal.
► Two of the most widely used asset management ratios are accounts
receivable turnover and average collection period.
► Accounts receivable turnover = Net sales ÷ Average net accounts receivable
► Average collections period = Average net accounts receivable / 365 days
► The first ratio provides a measure of how many times average trade
receivables are collected during the period, and the second measures
how long the average collection period is.
► Changes in these ratios over time are also very important.
► For example, a significant reduction in receivables turnover may indicate that
management is extending credit to customers who are not paying.

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 Cornerstone 5-5
8 Calculating the Gross Profit Margin,
Operating Margin, Net Profit Margin, Accounts
Receivable Turnover, and Average Collection
Period Ratios

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 Cornerstone 5-5
8
Calculating the Gross Profit Margin, Operating
Margin, Net Profit Margin, Accounts Receivable
Turnover, and Average Collection Period Ratios
(Continued)

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 Cornerstone 5-5
8
Calculating the Gross Profit Margin, Operating
Margin, Net Profit Margin, Accounts Receivable
Turnover, and Average Collection Period Ratios
(Continued)

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