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7-1 Notes
CHAPTER 7
REVENUE RECOGNITION, RECEIVABLES, AND ADVANCES FROM
CUSTOMERS
I. Learning Objectives
1. Understand and apply the criteria for recognizing revenue, including the timing
of the recognition and measurement of revenue.
2. Understand the relation between revenues (an income statement account) and
both accounts receivable (an asset) and advances from customers (a liability).
3. Understand the measurement of accounts receivable, including the allowance for
uncollectible accounts and the allowance for sales returns.
II. Organization of Class Sessions
Begin the coverage of this chapter by reviewing and expanding the criteria for
recognizing and measuring revenues that Chapter 4 introduces. These criteria in U.S.
GAAP and IFRS are broadly similar. Coverage of Appendix 7.1 is recommended
because it describes certain differences between U.S. GAAP and IFRS guidance for
revenue recognition.
We will spend most of the time in this chapter applying the principles of revenue
and expense recognition, including the timing of the recognition and measurement
under the accrual basis of accounting. We begin with revenue recognition at the time
of sale and examine the problem of uncollectible accounts in depth. We then consider
cases when revenue recognition may precede or occur after the time of sale. This
chapter presents an abrupt change for students from the seemingly precise nature of
accounting studied in Chapters 1 to 6 to the more judgmental nature of selecting and
applying accounting principles in Chapters 7 to 14. We find it useful to point out this
transition to students, preferably before they read Chapter 7.
We will also cover a brief review of generally accepted accounting principles
(GAAP). Most of this material appears in Chapter 1, but students will probably have
forgotten what they have read regarding GAAP since that time.
III. Lecture Outline
1. Understand and apply the criteria for recognizing revenue, including the
timing of the recognition and measurement of revenue.
To serve as a basis for the discussion of revenue recognition, we place the
following diagram on the board or a transparency:
Notes 7-2
Point
of
Acquisition
Point
of
Sale
Period of
Holding
Receivable
Period
of
Production
Point
of Cash
Collection
Firms could conceivably recognize revenue at any of the times above. The
criteria used in accounting to decide the revenue recognition question are as follows:
A. A firm has performed all, or a substantial portion, of the services it expects to
provide.
B. The firm has received cash, or some other asset whose cash equivalent value it
can measure objectively, such as a receivable.
For most businesses, accounting recognizes revenue at the time the firm sells
goods or renders services. In some cases, either earlier or later recognition is
appropriate. We have the class discuss the appropriate time for revenue recognition
for each of the firms in either Exercise 7.16, 7.17, or 7.18. In each case, we attempt
to draw a line similar to that above for the earnings process. The solution to
Problem 7.18 includes detailed outlines of the direction we try to steer the discussion
in each case. Many students find it helpful to work a numerical problem computing
income under the various methods before attacking Exercise 7.16, 7.17, or 7.18.
Exercises 7.18 and 7.19, and Problems 7.38, 7.39, and 7.40 are excellent for this
purpose.
Chapter 4 emphasizes that the accrual basis of accounting provides superior
measures of operating performance relative to the cash basis. Students tend to
concentrate on the matching attributes of the accrual basis (the timing issue) and
forget that the cash flows play an important role as well (the measurement issue).
We like to choose a student earlier in the term and refer to this concept by that
student’s name, such as the Smith Principle or the Jones Principle. Each time a
question arises in class that suggests that a student has not remembered the
concept, we turn to Smith or Jones and ask them to remind the class of the principle.
We then have the misguided student apply the principle to answer his or her own
question. After a few iterations of this process, students seem to grasp and apply
the concept without much effort. Later chapters of the text emphasize the concept
as well.
2. Understand the relation between revenues (an income statement account)
and both accounts receivable (an asset) and advances from customers (a
liability).
Accrual accounting separates the recognition of revenue from the receipt of
cash. Revenue recognition criteria point to the seller’s:
A. Performing its obligations to the customer and
7-3 Notes
B. Receiving assets that are, or can be converted to, cash.
As a result of applying revenue recognition criteria, the seller may recognize
revenue before, or after, or at the point of cash collection. A customer may exchange
a promise of future payment for goods and services; the seller recognizes such
promises as accounts receivable, classified as a current asset on the seller’s balance
sheet. (The same amount is an account payable on the buyer’s balance sheet.) The
fact that some customers will not pay their obligations means that the balance sheet
carrying value of Accounts Receivable should show, not the gross amount owed, but
that amount less an estimate of the portion of accounts receivable that the seller will
not collect. Later, this chapter describes the accounting procedures, called the
allowance method, for these estimated uncollectible amounts.
Sometimes the customer pays the seller cash before receiving the goods or
services. The seller has increased both its assets (specifically its cash) and its
obligations (it has not performed its obligations and therefore cannot recognize
revenue). The seller recognizes a liability, advances from customers, for products
and services in the amount of cash received. When the seller has performed its
obligations, it will recognize revenue and reduce its liability.
3. Understand the measurement of accounts receivable, including the
allowance for uncollectible accounts and the allowance for sales returns.
Accounts receivable appear on the balance sheet at the amount the firm
expects to collect. This net amount is the gross amount of receivables less the
amount in the Allowance for Uncollectibles
Students have considerable difficulty understanding the rationale and
accounting procedures for the allowance method for uncollectible accounts. We
spend considerable class time trying to deal with their difficulties.
A. Begin by setting up the following situation. A furniture manufacturing firm
produced a couch at a cost of $400. It sold the couch to a customer on July 1,
Year 10 for $1,000. The customer paid $250 at the time of sale and agreed to pay
the remainder in three annual installments beginning July 1, Year 11. Each
payment will also include interest, which we will ignore in this illustration. The
customer made the required payments on July 1, Year 11 and Year 12 but
refused to make the final payment on July 1, Year 13 because the couch fell
apart. Ask: What amount of income did the furniture manufacturer make from
manufacturing and selling the couch? Students should see that total income
must equal cash inflows of $750 minus cash outflows of $400, or $350. Then, ask
students to indicate the pattern of income assuming that the firm used the
allowance method for uncollectible accounts.
Allowance Method:
Revenue of $1,000 and expense of $650 ($400 + $250) in Year 10.
Then ask why GAAP generally requires the allowance method. Students
should see that the allowance method better matches the loss from uncollectible
accounts against the revenue recognized from the sale. Students usually
Notes 7-4
understand the matching argument but counter with the following: How can the
firm know at the time of sale that it will not collect the full amount? If it knew it
would not collect the full selling price, perhaps it would not have made the sale.
In any case, estimating the amount of possible uncollectible accounts is
subjective. Use of the allowance method provides management with an
opportunity to play games with earnings. These issues must be dealt with if
students are to understand the allowance method. The key is the degree of
predictability of uncollectible accounts. If experience with similar sales in the
past provides reasonable estimates of likely uncollectible accounts, the
arguments regarding subjectivity can be addressed. If experience does not
provide an adequate basis for estimating uncollectibles, then perhaps the firm
should not recognize revenue at the time of sale but instead use the installment
method or cost-recovery-first method
B. Having dealt with the timing of the debit to Bad Debt Expense, we turn next to
the account credited. We ask why firms do not credit Accounts Receivable
directly at the time of providing for estimated bad debts under the allowance
method. Students should see that the firm at the time of making the provision
does not know which customers will not pay. Furthermore, at this time no
particular customer’s account is uncollectible. The account credited, Allowance
for Uncollectible Accounts, might more appropriately be labeled Allowance for
Uncollectibles. This title communicates that the firm will not collect some portion
of gross accounts receivable, which is the objective of the allowance method.
(Question 7.6 and Problems 7.38,7.39 and 7.40)
C. Finally, discuss the journal entry to write off a particular customer’s account.
Students should see that the write off has no income effect in the year of the
write off and that total assets do not change.
We assign several problems to get students to apply the allowance method.
(Exercises 7.13, 7.14, 7.15, 7.16, 7.17, and 7.18 and Problems 7.22, 7.23, 7.24,
7.25, and 7.31) and for bad debt expense and accounts written off, but to answer
questions about the performance of the firm in extending credit and managing
credit risk. (Problems 7.28, 7.29, and 7.30)
Some arrangements permit the customer to return goods, issues arise due to
both performance (has the seller performed all its obligations?) and asset
measurement. Sales Returns is a contra revenue account debit to Sales Returns
reduces Sales Revenue, Net, and therefore reduces income. Allowance for Sales
Returns account is a contra account; like Allowance for Uncollectibles, it
accumulates subtractions from Accounts Receivable, Gross. The balance in the
Allowance for Sales Returns is the firm’s estimate of the receivables that it will
cancel or the cash that it will pay to satisfy customers who return their
merchandise.
7-5 Notes
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