9
Revenue Chapter Cycle: Sales, Receivables, and Cash
SOLUTIONS 1. The two revenue recognition criteria are: a. the promised work has been substantially completed (i.e., the company has done something), and b. cash, or a valid promise of future payment, has been received (i.e., the company has received something of value in return). If a company has not met the first criterion, then the company has not actually performed the economic activity. If the second criterion is not met, then the company is not sure that its economic efforts will be rewarded with an increase in company assets. 2. Revenue would be recognized by the seller as follows: a. McDonald's sells you a Big Mac and some fries--at the time of sale because the goods and services have been provided and McDonald's has collected the cash. b. A bank loans you money to buy a house--as time passes and the interest on the loan accrues. The bank does its work by allowing the borrower to use the bank's money. Of course, the bank would only recognize the accrued interest if it were reasonably sure that the borrower would pay. c. A health club signs you to a twelve-month membership--evenly over the twelve-month membership period as the health club provides membership services. Again, this is true only if the health club collects the cash in advance or is reasonably sure it can collect the cash. d. Wal-Mart sells you goods and you pay for them with your MasterCard--at the time of sale because Wal-Mart has provided the goods and has also received its cash instantly from MasterCard. e. A college accepts you as a student for the upcoming semester--as the college provides education services and as the college becomes convinced that it will collect the tuition fee from you in cash. 3. A cash sale increases the amount of cash on the seller's balance sheet and also increases the retained earnings portion of the seller's stockholders' equity. A cash sale also increases the sales revenue reported on the seller's income statement. Overall, the accounting equation is kept in balance because the increase in the asset cash is matched by an increase in the retained earnings portion of equity. A credit sale would have the same impact on the financial statements as a cash sale, except that the asset increased would be accounts receivable instead of cash. With a credit policy that is so loose that everyone can obtain credit, a company runs the risk of having more bad debts, bookkeeping costs, and implicit interest carrying charges than can be paid for from the increased revenue generated by the loose credit policy. With a credit policy that is too restrictive, a company runs the risk of turning away potentially profitable credit customers. Sales discounts are cash reductions offered to customers in an attempt to ensure that they make prompt payment on their accounts. A sales discount is offered in order to reduce the amount of cash tied up in the form of accounts receivable. In addition, sales discounts may reduce bad debts by encouraging credit customers to pay soon, thus reducing the chances that they might never pay at all.
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Chapter 9 1
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Sales discounts are reported in the income statement as a reduction from the amount of gross sales. Accordingly, gross sales minus sales discounts equal net sales. This is not necessarily a good policy because, together with elimination of bad debts, the controller may have eliminated the opportunity for additional sales to potentially creditworthy customers. There is a trade-off to be made between the bad debts and additional sales. As long as the incremental revenue exceeds the incremental cost of sales plus incremental bad debts, credit should be extended to the customer. Under the allowance method, the expenses of uncollectible accounts are matched against the sales revenues for the same period. The realizable value of accounts receivable is reduced by an increase in the allowance for uncollectible accounts. This is accomplished by estimating the amount of the bad debt expense using either the percentage-of-sales method or the accounts receivable aging method. The allowance method of accounting for uncollectible accounts is preferable to the practice of recording bad debts when it becomes clear that the customer has defaulted (often referred to as the direct write-off method) because the allowance method provides a better matching of revenues and expenses. The allowance method ensures that the bad debt expense is recognized in the period in which the sale took place and the receivable was generated, not in the period in which management determined that the customer was unwilling or unable to pay. The problem with the direct write-off method is that it may be the following year before management discovers that a sale made in the current year is not collectible. Waiting to record the bad debt expense in the following year violates the matching convention.
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The allowance for bad debts account keeps track of estimated bad debts and actual bad debts. The account is credited when an estimate for bad debt expense is recorded. The allowance account is debited when an account is actually written off. The percentage of sales method relies on historical or industry data to estimate what fraction of total credit sales will ultimately be uncollectible. The total credit sales for the year are multiplied by the percentage to determine estimated uncollectible accounts. The aging method involves examining the accounts still unpaid at the end of the year, looking to see whether the accounts are past due and by how much, and directly estimating how much of those accounts will ultimately be uncollectible. The insight behind the aging method is that the chances that an account will ultimately prove to be uncollectible increase as that account gets older. Based on an aging schedule, each category of past due receivables is multiplied by the estimated percentage of uncollectible accounts. By adding up the amounts for each category, we receive an estimate for uncollectible accounts.
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The estimation of bad debts decreases total assets (by increasing allowance for bad debts) and decreases stockholders' equity (by increasing expenses). The actual write-off of accounts has no effect on the accounting equation--the decrease in the allowance for bad debts is balanced by a decrease in accounts receivable, resulting in no change in the net receivable balance. No. Except under the direct write-off method, the amount of bad debts is an estimate. Hence, it is possible that either the estimate was too low, or during this particular year there may have been more than the usual defaults on loans. In either case, the prior year's financial statements should not be corrected. Over time, an overestimate of bad debt expense in one year would be expected to be balanced by underestimates in other years.
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Chapter 9 2
13.
The estimated liability for warranties keeps track of future estimated warranty expenses and actual warranty expenses. The account is credited when you estimate future warranty expense. The account is debited when you actually pay for a warranty. This discovery isn't an actual mistake. Warranties are based on estimates. At the time of the initial estimate, the company made its best guess of warranty expense. If the estimate for warranties was too low last period, management should determine if the estimate for warranties should be increased for future sales. The purpose of separation of duties is to make it difficult for theft or errors to occur unless two or more people are involved. For example, if the cash records are maintained by an employee who also has access to the cash itself, cash can be stolen or "borrowed" and the employee can cover up the shortage by falsifying the accounting records. The primary difference between assigning and factoring receivables is the ownership of the receivables. When assigning receivables for collateral on a loan, the company still maintains actual ownership of the receivables. When factoring the receivables, the receivables are actually sold to another company. Factoring receivables shifts the collection risk away from the company receiving the money. Because the factor assumes the collection risk, they charge the company a fee. Foreign currency exchange rates are used to express transactions in local currency in terms of U.S. dollars and vice versa. For example, if the exchange rate is $1 = 1.15 Euros, and if one wishes to change 100 U.S. dollars into Euros, one will receive $100 1.15 = 115 Euros, and if one wishes to change 100 Euros to U.S. dollars, one will receive 100 euros/1.15 = $89.96. Foreign currency exchange rates are used to determine the amount at which a foreign currency transaction should be recorded in U.S. dollars. In this situation the British pound increased in value from $1.50 to $1.53. This means the required payment will amount to more money in U.S. dollars. The exchange gain is $1,500 or 50,000 ($1.53 $1.50). U.S. companies can avoid the risk associated with foreign currency transactions by denominating all transactions in U.S. dollars. As discussed in Chapter 13, another way to avoid foreign currency risk is to naturally hedge foreign currency items by incurring both assets and liabilities in the same foreign currency. In addition, some companies reduce foreign currency risk through the use of derivative contracts. Receivable turnover represents the number of times the average receivable has been collected during a given year. The larger this number, the faster the collection has been. The average collection period is simply a derivative of the receivable turnover and represents the average amount of time that elapses between a sale and the collection of cash. The receivable turnover and the average collection period are inversely related. During an economic recession, a typical department store may experience decreasing turnover and hence an increase in the average collection period. One measure of the quality of receivables is the relationship between the bad debt allowance and the total amount of receivables. As a general rule, the bad debt allowance, as a percentage of total receivables, should be stable from year to year. Any change indicates a change in either the type of credit customers a business is attracting or a change in the economic circumstances of existing customers.
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Chapter 9 3
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A cash budget is an important tool in helping management plan its cash needs. Estimating cash and credit sales, and most important, estimating the pattern of the collection of outstanding accounts receivable are key to the cash receipts budgeting process. The collection pattern for receivables is a function of such factors as industry, firm size, and the firm's credit policies. The ongoing aging of individual accounts receivable also plays an important role in budgeting cash receipts.
EXERCISES E 9-1 Recording Sales and Cash Collection 1. Accounts Receivable Consulting Revenue To record revenue for consulting services. Cash Accounts Receivable To record the collection of cash in November. 2. 3. Assets increased by $22,000 through providing services in November. The collection of cash has no effect on assets because one asset increases while another asset decreases. 22,000 22,000
6,000 6,000
E 9-2 Recording Sales and Cash Collection 1. Accounts Receivable Consulting Revenue To record revenue for consulting services. Cash Accounts Receivable To record the collection of cash. 2. Equation Assets = Liabilities + Owners' Equity E 9-3 Revenue Recognition In order to decide when revenue should be recognized, we must consider the following two revenue recognition criteria: Is the work done? Is the cash collected or collectible? Work done: The work is not done when James Dee signs the contract to do the job. If past history shows that the amount of free guarantee is not a large amount, then the work is done, or virtually done, when the job is completed. Cash collected or collectible: If past history shows that customers generally are reliable in paying, then we do not have to wait until the cash is collected 30 days after the job is completed before recognizing revenue.
Chapter 9 4
24,000 24,000 24,000 24,000
Increase/Decrease/No Effect Increase No effect Increase
Amount $24,000 $24,000
In summary, if past history shows that the free guarantee work is not significant and customers are fairly reliable in paying, then revenue should be recognized at the time job is completed, which is option (c). Because the work is guaranteed for five years, James Dee should also set up an Estimated Warranty account to recognize the future liability for re-cleaning jobs. E 9-4 Evaluating a Credit Policy Change Increase in Sales Increase in Cost of Goods Sold (70%) Increase in Gross Profit Implicit interest cost of Accounts Receivable ($112,000 10% = $11,200) Estimated Bad Debts Cost of new employee to manage accounts Increase in Income Amount $300,000 210,000 90,000 (11,200) (26,000) (50,000) $ 2,800
Although the new credit policy will provide an estimated increase in profits of $2,800, the increase isn't a very large amount. Management needs to determine the accuracy of estimates. If the estimated bad debts are higher than estimated, the company may actually lose money through this credit policy change. E 9-5 Impact of Sales Discounts 1. 2. $300 250 (1 0.02) = $300 250 = $73,500 Net sales if paid seven days after the sale. $75,000 Net sales if paid 20 days after sale.
E 9-6 Accounting for Bad Debts 1. a. Estimated bad debt expense of $2,500 has been recorded by the company. b. Receivables from customers in the amount of $250 have been written off as uncollectible.
2. Gross Accounts Receivable Increase (Decrease) $(250) $(250) Allowance for Bad Debts Increase (Decrease) $2,500 (250) $2,250 Net Accounts Receivable Increase (Decrease) $(2,500) $(2,500)
Item a. b. Total
Net Income Increase (Decrease) $(2,500) $(2,500)
E 9-7 Sales, Cash Collection, and Bad Debts Transaction 1. Sales during year 2. Cash collected on account 3. Establishment of allowance for bad debts Assets = +2,500,000 No Effect 57,000 Liabilities + No Effect No Effect No Effect Equity +2,500,000 No Effect 57,000
Chapter 9 5
E 9-8 Financial Statement Impact of Bad Debts 1. The effect of the March 15, 2006 transaction on the Balance Sheet is to increase Accounts Receivable by $55,000. The increase in Sales will also eventually increase Retained Earnings by $55,000. The increase in Sales will also increase Sales on the Income Statement by $55,000. This transaction will not impact the cash flow statement. The December 31, 2006 adjusting entry will impact the Balance Sheet by decreasing Net Receivables by $33,250 ($950,000 0.035). The expense will eventually decrease Retained Earnings by $33,250. The Expense will also impact the Income Statement by increasing expenses by $33,250. This transaction will not impact the Cash Flow statement. On February 4, 2007, Stallon will write off $36,000 of the receivable from Sonat because only $4,000 ($40,000 0.10) will be collectible. This write-off will reduce gross receivables by $36,000 and the allowance by $36,000, resulting in no changes in net receivables. There is no impact on the Income Statement or Cash Flow Statement. Note that, in this case, the amount of bad accounts actually written off ($36,000) exceeds the amount of the allowance that was established ($33,250). Remember that the $33,250 was an estimate of future uncollectible accounts; the estimate will not always exactly match the actual events. Over the course of years, one would expect the estimate to be too low sometimes and too high sometimes. The November 12, 2007 transaction will not affect Total Assets on the Balance Sheet. One asset is increasing (Cash) while another asset is decreasing (Accounts Receivable). This transaction has no impact on the Income Statement. Cash will increase by $4,000 and this will be reflected in the operating activities section of the Statement of Cash Flows.
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E 9-9 Bad Debt Write-Offs Allowance for bad debts, beginning of 2006 Estimated new bad debts for 2006 Allowance for bad debts, ending of 2006 Actual amount written off during 2006 E 9-10 Accounts Receivable Aging 1. Category Less than 30 days 31 to 60 days 61 to 90 days Over 90 days Amount $366,000 72,000 24,000 27,000 Percentage 0.02 0.12 0.35 0.80 Total $ 7,320 8,640 8,400 21,600 $45,960 $ 1,350 7,200 (1,800) $ 6,750
Total Estimated Uncollectible Accounts 2. Bad Debt Expense Allowance for Bad Debts To record estimated allowance for bad debts. 3. 45,960
45,960
The Net Accounts Receivable balance at December 31, 2006 is $443,040 ($489,000 $45,960).
Chapter 9 6
E 9-11 Recording Warranties 1. Balance at beginning of year Current year estimate (0.04 150 jobs $600 per repair) Actual warranty repairs Balance at end of year 2. $2,500 3,600 (1,800) $4,300
The balance at the end of the year represents estimated future warranty repairs stemming from jobs that have already been completed.
E 9-12 Factoring Accounts Receivable 1. Transaction Factoring Receivables Assets $10,000 Liabilites No Effect Owners' Equity $10,000
The net impact on assets arises because the asset accounts receivable decreases by $100,000 and the asset cash increases by $90,000. The reduction in equity occurs because the $10,000 difference between the face value of the receivables and the cash received is reported as a factoring expense or a loss on factoring. 2. Malone wouldn't have to account for this bankruptcy. Because the receivables were factored "without recourse," Russell Financing assumed all of the collection risk for the receivables. Russell Financing will have to account for the bankruptcy.
E 9-13 Foreign Currency Transaction 1. 2. 3. 500,000 Swiss Francs $180,000 (500,000 $0.36) Optical will recognize an Exchange Loss on December 31, 2006 of $10,000 (500,000 [$0.38 $0.36]). The value of the Swiss Franc decreased from $0.38 on November 12 to $0.36 on December 31. Optical will recognize an Exchange Loss on January 5, 2007 of $5,000 (500,000 [$0.36 $0.35]). The value of the Swiss Franc decreased again, from $0.36 on December 31 to $0.35 on January 5. The amount of sales will be recorded as $190,000 (500,000 $0.38). This represents the dollar amount of the sale on the date of the sale. The cash collected from customers will be $175,000 (500,000 $0.35) for this collection in 2007. The $15,000 difference between the sale amount of $190,000 and the cash collected of $175,000 is reflected in the cumulative exchange loss of $15,000 recognized in connection with this transaction.
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E 9-14 Financial Statement Impact of Bad Debts Let us analyze the two transactions: (a) Writing off the accounts receivable will not alter the net accounts receivable. Also, the write-off has no impact on net income. (b) Recognition of bad debt expense (and a corresponding increase in the allowance for bad debts) will cause the net accounts receivable to decrease. In addition, net income will also decrease.
Chapter 9 7
Entry a 1. Effect on current ratio 2. Effect on return on sales 3. Effect on return on assets No effect No effect No effect
Entry b Decrease Decrease Decrease*
* The recognition of bad debt expense reduces both total assets and net income, by the same amount. Since return on assets is almost always less than 100%, the net effect is a reduction in return on assets. E 9-15 Interpreting Accounts Receivable Ratios 1. Accounts receivable turnover = Sales/Average accounts receivable = $3,825,000/([$710,000 + $820,000]/2) = $3,825,000/$765,000 = 5 times
Average collection period = 365/Receivable turnover = 365/5 = 73 days 2. Accounts receivable turnover represents the company's effectiveness in collecting accounts receivable. The larger the sales as compared with the accounts receivable average balance, the shorter the period that accounts receivable remain uncollected. The average collection period represents the average age of accounts receivable, or the average amount of time that elapses between a sale and the collection of cash. The average accounts receivable balance is used to provide a more accurate representation of accounts receivable for the year. If a company had unusually high receivables at the end of the year, using the year-end balance for receivables would not provide an accurate ratio.
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E 9-16 Using Accounts Receivable Ratios Average collection period 34.76 Accounts receivable turnover Accounts receivable turnover 10.5 Sales E 9-17 Measuring Accounts Receivable Quality 2004 7.27% 2005 6.54% 2006 6.00% = = = = = = 365/Accounts receivable turnover 365/Accounts receivable turnover 365/34.76 = 10.5 times Sales/Average accounts receivable Sales/$80,000 10.5 $80,000 = $840,000
Allowance for Bad Debts = Accounts Receivable
It appears that the creditworthiness of Tullis' customers has increased because the allowance for bad debts has become a smaller percentage of accounts receivable.
Chapter 9 8
E 9-18 Forecasting Cash Receipts Hillerman's Department Store Estimated Cash Receipts August Cash sales (20%) Received from sales in: June (0.8 0.17 $85,000) July (0.8 0.70 $68,000) (0.8 0.17 $68,000) August (0.8 0.10 $80,000) (0.8 0.70 $80,000) September (0.8 0.1 $100,000) Totals $16,000 11,560 38,080 6,400 44,800 8,000 $82,048 September $20,000 9,248
$72,040
E 9-19 Forecasting Cash Receipts CeCe's Gift Shop Planned Net Cash Receipts for May and April May Cash sales Check VISA/MasterCard American Express Total
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April
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$ 7,500 1,4752 14,7753 5,7904 $29,540 $ 7,500 $ 1,500 (15) (10) $ 1,475
$ 5,0005 9836 9,8507 3,8608 $19,693
0.25 $30,000
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0.05 $30,000 Less: Estimated bad checks (0.01 $1,500) Service charge (40* $0.25)
* $1,500/$37.50 = 40 checks
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50% of Sales Less: 1.5% fee
$15,000 (225) $14,775 $ 6,000 (210) $ 5,790 $ 5,000 $ 1,000
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20% of Sales Less: 3.5% fee 0.25 $20,000 0.05 $20,000
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Chapter 9 9
Less: Estimated bad checks (0.01 $1,000) Service charge (27* $0.25) * $1,000/$37.50 = 27 checks
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(10) (7) $ 983
50% of Sales Less: 1.5% fee
$ 10,000 (150) $ 9,850 $ 4,000 (140) $ 3,860
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20% of Sales Less: 3.5% fee
PROBLEMS P 9-20 Revenue Recognition 1. In order to decide when revenue should be recognized, we must consider the following two revenue recognition criteria: Is the work done? Is the cash collected or collectible? Work done: The work is not done when the order is received. If past history shows that the amount of free repairs is not a large amount, then the work is done, or virtually done, when the ship is delivered to the customer. You could also argue that the work is done bit by bit during the four-year construction period. Cash collected or collectible. If past history shows that customers generally are reliable in paying for ships, then we do not have to wait until the cash is collected during the 10-year payment period before recognizing revenue. In summary, if past history shows that the repairs are not significant and customers are fairly reliable in paying, then revenue should be recognized at the time the ship is delivered to the customer, which is choice (d). In addition, you could also argue for proportionate recognition during the four-year construction period, which is choice (c). When the revenue is recognized, an estimated liability for future free repairs should also be recognized (along with an associated expense). 2. ANALYSIS: First of all, note that the entire world should be nervous when Congress decides to get into the accounting standard-setting business. The argument in favor of method (f) is that no one would ever be deceived by deceptive revenue recognition because no revenue would be recognized until after the cash was in hand and the guarantee period was over. This view ignores the fact that there are two sides to a transaction. Yes, it is true that this rule eliminates the possibility of overly optimistic revenue recognition. But the rule also guarantees overly pessimistic revenue recognition. This bill can make it impossible for shipbuilding companies to produce financial statements that accurately reflect their economic activity. The general point is this: Overly conservative accounting rules may protect some financial statement users, but such rules also may harm other financial statement users and this would violate the underlying concepts that lead to fair presentation of financial statements.
Chapter 9 10
P 9-21 Revenue Recognition 1. Revenue cannot be recognized until the company has substantially completed its performance. Although the memberships are nonrefundable, the membership is for the lifetime of the person. The revenue should be spread over the estimated life of the individual. ANALYSIS: In attempting to raise additional investment funds, Judy and her partners wish to portray the performance of their tennis club in the best light possible. If potential investors or lenders are nervous about Ho Man Tin Tennis Club's economic viability, the investment funds may be offered on very unfavorable terms. Thus, Judy and her partners would like to recognize as much revenue as possible. Timing is very important since the investment funds are being raised now; revenue recognized next year or the year after won't improve the financial statements given to potential investors and lenders now.
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P 9-22 Evaluating a Credit Policy 1. Total additional sales Less: Un-collectibles $100,000 0.05 = $5,000 $60,000 0.10 = $6,000 $90,000 0.20 = $18,000 Less: Total additional expenses Deduct: Cost of goods sold $250,000 0.70 = $175,000 Additional income before taxes $250,000 $ 5,000 6,000 18,000
(29,000) $221,000 (34,000) $187,000 (175,000) $ 12,000
As shown above, a less stringent credit policy may improve the profitability of the firm. It should be noted that the sales to Class C customers do not generate any additional income since the total expenses for $90,000 sales are $94,000*, so the firm's losses on these sales will be $4,000. *$90,000 (0.20 + 0.70) + $13,000 = $94,000 2. ANALYSIS: The president should consider the need for liquidity of the firm and its ability to raise cash to meet obligations as they become due. An increase in sales would increase the cash flow of the firm and make control of accounts receivable become very important. The accounts receivable control measures should be reviewed and evaluated and improvement should be made as needed. If possible, the president should consider sales to Class A and Class B customers. The risk of collection from Class C customers is very high, which makes sales to this group a potentially unprofitable venture. From a marketing standpoint, the president should consider whether it is best to try to mimic the credit policies of competing companies. An alternative is to maintain high credit standards and use this as a marketing point.
P 9-23 Sales Discounts 1. Although customers can get a 1 percent discount by paying their bill before 10 days, the balance has to be paid within 70 days. Because of the time value of money, customers benefit more by waiting until 70 days to pay their bills instead of paying within 10 days to receive the discount. The annual interest cost for missing this discount is only 6 percent (0.01 sales discount 6 [number of 60-day periods in a 365-day year]). It is more beneficial for people to wait 70 days to pay rather than pay within 10 days.
Chapter 9 11
2. Extra Days 20 40 90 20 Sales Discount 0.02 0.02 0.03 0.01 Number of Extra-Day Periods/Year 18 9 4 18 Annual Interest Cost 0.36 0.18 0.12 0.18
a. b. c. d.
Answer c would not induce customers to pay early because the annual interest cost of keeping the cash (and forgoing the sales discount) is less than the 15 percent short-term interest rate. 3. ANALYSIS: Recall that sales discounts are accounted for as a reduction in the net sales amount. Thus, the most obvious impact of granting sales discounts to customers is a reduction in net sales. Ms. Grant may be focusing on this cost of the sales discounts, without considering the benefits of more rapid receipt of cash and reduction in bad debts because customers have an incentive to pay early. It may be the case that Ms. Grant is correct and that the benefit of offering the sales discounts is outweighed by the cost--this is an empirical question that would require further analysis.
P 9-24 Accounting for Credit Sales and Bad Debts 1. We can determine the actual amount written off by comparing the beginning and ending balances in the allowance account for 2006 and the estimated bad debts for the year: Allowance for bad debts, beginning $ 2,025 Bad debt expense for 2006 10,800 Allowance for bad debts, ending (2,700) Actual amount written off for 2006 $ 10,125 Accounts Receivable, beginning Sales for 2006 Accounts Receivable, ending Reduction in accounts receivable balance Reduction caused by account write-offs Cash collected from customers during 2006 $ 58,500 270,000 (68,625) $ 259,875 (10,125) $ 249,750
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3. Accounts Receivable 270,000 Sales To record total sales for the year. This assumes that all sales were on account.
270,000
Cash 249,750 Accounts Receivable 249,750 To record cash collections for the year. See part 2 for the calculation of this amount. Allowance for Bad Debts 10,125 Accounts Receivable To write off the uncollectible accounts. See part 1 for the calculation of this amount.
10,125
Chapter 9 12
Bad Debt Expense Allowance for Bad Debts To record the estimated bad debt expense for 2006. 4.
10,800 10,800
ANALYSIS: Hartvigsen Sightseeing, Inc. can use its $68,625 in Accounts Receivable to get $30,000 in cash within three days in the following ways: a. Offer big sales discount incentives to customers to pay their accounts in cash quickly. These discounts would have to be quite large (well over 10%) to get customers to act quickly enough. b. Factor the receivables. c. Assign the receivables as collateral for a short-term loan. Option (c) looks the best because it would probably be the least costly. This option would allow Hartvigsen to continue collecting its accounts in the normal course of business. The interest that would be paid on the short-term loan would probably be lower than the cost associated with either factoring or offering large sales discounts.
P 9-25 Bad Debt Expense 1. Accounts Receivable Sales To record credit sales for the year. Cash Accounts Receivable To record collections on accounts. 2. 1,700,000 1,700,000
1,737,500 1,737,500
The allowance account begins each accounting period with a credit balance. As specific accounts receivable are deemed uncollectible, they are written off by reducing the allowance account and also reducing Accounts Receivable. Whenever more specific accounts are written off than were previously estimated in the allowance account, the allowance account would have a debit balance. This also happens when bad accounts are both created and written off in the same period--the write-off may be made before the actual bad debt estimate is recorded at the end of the period.
3. Bad Debt Expense 34,000 Allowance for Bad Debts To record bad debt expense for the year using the percentage of sales estimation. ($1,700,000 0.02 = $34,000). 4. Bad Debt Expense 37,200 Allowance for Bad Debts To record bad debt expense for the year using the aging method of estimation. ($34,800 + $2,400 = $37,200). 37,200 34,000
Note: The existing debit balance of $2,400 is added in this case because it reflects, in a sense, a negative balance in the allowance account. The adjusting entry amount must be enough to get the balance up to zero and then to a positive balance of $34,800.
Chapter 9 13
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Partial Balance Sheets Percentage-of-Net-Sales Method (3) Accounts receivable Less: Allowance for bad debts Net accounts receivable *$522,500 = $560,000 + $1,700,000 $1,737,500 **$31,600 = $34,000 $2,400 Aging Method Method (4) Accounts receivable Less: Allowance for bad debts Net accounts receivable *34,800 = $37,200 $2,400 The adjusting entry recorded by the percentage-of-net-sales method is based on the credit sales (net), and the amount of adjustment is not affected by the existing balance in the allowance account. With the aging method, the emphasis is on the valuation of accounts receivable, and the unadjusted balance of the allowance for bad debts is considered in recording the adjustment. NOTE: These calculations ignore the potential ipact of write-offs on the accounts receivable balance. $522,500* (31,600)** $490,900
$522,500 (34,800)* $487,700
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ANALYSIS: Hard-Rock should not make the mistake of thinking that the whole purpose of business is to minimize the amount in accounts receivable. With this approach, a company would insist on strictly cash sales, causing the accounts receivable balance to be zero. The point of credit policy and cash management is to maximize the profitability of the company. The fact that the accounts receivable balance has declined says nothing about profitability. Other information that should be examined is the amount of accounts written off during the year, the average collection period, the cost of offering sales discounts, and so forth.
P 9-26 Analysis of Bad Debts and Write-offs 1. Transition Recognition of bad debt expense Actual write-offs 2.
Assets Decrease No Effect
Liabilities No Effect No Effect
Owners' Equity Decrease No Effect
One must infer the amount of actual bad debts written off by analyzing the Allowance for Bad Debts. Given the account's beginning and ending balances, as well as the amount of bad debt expense for the year, we can infer that $916 million was written of during 2005 and $973 million was written off during 2006 (Beginning balance + Bad debts expense Ending balance = Amount written off for the year). Allowance for bad debts, beginning of 2005 Bad debt expense for 2005 Allowance for bad debts, of ending 2005 Actual amount written off for 2005 Allowance for bad debts, beginning of 2006 Bad debt expense for 2006 Allowance for bad debts, ending of 2006 Actual amount written off for 2006 $ 3,554 885 (3,523) $ 916 $3,523 950 (3,500) $ 973
Chapter 9 14
3.
ANALYSIS: As of the end of 2006, Punkinhead Bank estimates that it has $3,500 million in bad loans in its portfolio. Thus, it may come as no surprise to investors in early 2007 if Punkinhead announces that it has specifically identified a $600 million loan that is bad. However, it is also possible that this large loan of $600 million was not included in the allowance estimate at the end of 2006; if this is so, this announcement will be a surprise to investors and Punkinhead's stock price would decline.
P 9-27 The Aging Method 1. Category Less than 30 days 31 to 60 days 61 to 90 days Over 90 days Total 2. Bad Debt Expense 11,770 Allowance for Bad Debts To adjust the allowance for bad debts to the appropriate ending balance. ($13,520 + $8,250 [write-offs] $10,000 [beginning] = $11,770) 3. 4. 11,770 Amount $147,000 33,000 5,000 7,500 Percentage 0.01 0.10 0.40 0.90 Total $1,470 3,300 2,000 6,750 $13,520
The net Accounts Receivable balance as of December 31, 2006 is $178,980 ($192,500 $13,520). ANALYSIS: Since we know that the accounts receivable balance is $192,500, we could compute the total volume of credit sales if we also knew the average collection period. We can estimate the average collection period using the aging information, as follows: Fraction of Accounts in Category $147,000/$192,500 $33,000/$192,500 $5,000/$192,500 $7,500/$192,500 Contribution to Weighted Average 11.45 days 7.71 days 1.95 days 4.68 days 25.79 days
Average Life of Accounts in Category 15 days 45 days 75 days 120 days Estimated average collection period
Note: For the first three categories, the average life of the accounts in the category is assumed to be the midpoint of the category interval. For example, the average life of the accounts in the 0 to 30 day category is assumed to be 15 days. For the accounts over 90 days, the 120-day average life assumption is somewhat arbitrary. Average collection period = 365/ (Sales/Accounts receivable) Estimated Credit Sales = (365 $192,500)/25.79 = $2,724,409
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P 9-28 Accounting for a Warranty Liability 1. Estimated warranty liability, beginning of 2005 Warranty expense for 2005 ($500,000 0.12) Actual warranty repairs for 2005 Estimated warranty liability, ending of 2005 Estimated warranty liability, beginning of 2006 Warranty expense for 2006 ($625,000 0.12) Actual warranty repairs for 2006 Estimated warranty liability, ending of 2006 2. 0 60,000 (10,600) $ 49,400 $ 49,400 75,000 (22,450) $101,950 $
ANALYSIS: Mathematically, assuming that sales and repairs occur evenly throughout the year is the same as assuming that all sales and repairs occur on one day exactly halfway through the year. 2005 sales still under warranty for 6 months as of the end of 2006: ($500,000 1/2 0.09) 2006 sales still under warranty for 18 months as of the end of 2006: ($625,000 0.09) + ($625,000 1/2 0.03)
$22,500 65,625 $88,125 $101,950 88,125 $13,825
Ending balance in liability account Predicted future warranty expense Difference
This difference is fairly large. The estimates from the manufacturer may need to be adjusted. P 9-29 Assignment and Factoring of Accounts Receivable Impact on Assets 1. Factoring 2. Assigning $20,000* + $500,000 Impact on Liabilities none + $500,000 Impact on Net Income $20,000** none***
* The net amount of accounts receivable given up is $520,000 ($600,000 $80,000). The cash received is $500,000, resulting in a net decrease in assets of $20,000. ** The $20,000 is a factoring expense or loss on factoring. *** There is no immediate impact on net income. Of course, interest on the loan would reduce net income as it accrues. 3. ANALYSIS: Jas should consider how long it will take to collect the cash on the accounts receivable. If the collection period is short, then Jas will be able to repay the loan before incurring significant interest charges. If the expected collection period is long, then Jas might be better off to get the $500,000 in cash now and forgo the extra $20,000 in expected cash collections in order to avoid interest over the long collection period. Jas should also consider whether the estimated allowance for bad debts accurately reflects the amount of cash that will be collected from the $600,000 in accounts. In addition, Jas should consider the potential impact on its financial statement ratios. Using the receivables as collateral for a loan will increase the reported amount of debt and also increase the debt ratio.
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P 9-30 Foreign Currency Transaction 1. a. When the proceeds from sales are receivable in U.S. dollars, there are no special difficulties. The journal entries are recorded in dollars, as stated. 5/10 Accounts Receivable Sales To record sales on account. No journal entry required. 50,000 50,000
6/30 7/18
Cash 50,000 Accounts Receivable 50,000 To record collection on account. b. No exchange gain/loss is recognized on June 30 because the sale was denominated in U.S. dollars. c. No exchange gain/loss is recognized on the date of payment because the sale was denominated in U.S. dollars. 2. a. When sales are receivable in Euros, the recorded amount of the receivable must be restated and any exchange gain or loss, if incurred, must be accounted for. 5/10 Accounts Receivable Sales To record sales on account [(43,478 euros $1.15) = $50,000]. 50,000 50,000
b. An exchange gain of $2,174 is recognized on June 30 ([$1.20-$1.15] x 43,478). Accounts receivable is increased by this gain at June 30. The adjusted accounts receivable is $52,174. c. An exchange gain of $434 is recognized on July 18 ([$1.21 x 43,478 Euros = $52,608 cash received] [$52,174 amount of accounts receivable as of June 30]) 3. ANALYSIS: The economic factors influencing exchange rates are numerous and not completely understood. Factors frequently mentioned in the business press are trade deficits, strength of a country's banking system, governmental stability, and so forth. In the long run, a key determinate of exchange rates is the relative rates of inflation in the respective countries. Predicting the movement of future exchange rates is exactly like predicting tomorrow's movement in the Dow Jones Industrial Average--no one can tell in advance what the Dow will do, but after the fact everyone has an explanation for why it is obvious that the Dow did what it did.
P 9-31 Analysis of Accounts Receivable Quantity and Quality 1. Accounts Receivable Turnover (Sales/Avg. Accounts Receivable) Average Collection Period (365/Accounts Receivable Turnover) 2005 7.71 ($1,350/[($165+$185)/2]) 47.3 days 2006 6.95 ($1,425/[($185+$225)/2]) 52.5 days
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2.
Management needs to evaluate the accounts receivable collection policy. The average collection period has increased by 5 days in 2006. The industry average for average collection period is 48.0 days (365 days / 7.6). Megabyte is now collecting its receivables more slowly than other companies in the industry--this warrants some investigation. ANALYSIS: Accounts Receivable Turnover = Sales/([Beginning A/R + Ending A/R]/2) 7.6 = $1,425/([$185 + Ending A/R]/2) Ending A/R = ([$1,425 2]/7.6) $185 = $190 If Megabyte had been able to achieve the industry average in accounts receivable turnover of 7.6, the ending balance in accounts receivable for 2006 would have decreased from $225 to $190. This reduction could potentially increase Megabyte's net income by reducing its need for external, interest-bearing financing. Of course, increasing accounts receivable turnover also might drive away some credit customers who don't like the more rapid collection of receivables.
3.
P 9-32 Analysis of Accounts Receivable Quantity and Quality 1. 2004 Allowance for Bad Debts = Accounts Receivable 6.00% 2005 6.67% 2006 4.00%
The data actually suggest an increase in creditworthiness of customers because the allowance for bad debts, as a percentage of accounts receivable, has declined. 2. ANALYSIS: There is some cause for alarm in the data because MaScare's average collection period has increased dramatically: 2005 365/(Sales/Average accounts receivable) 81.1 days 2006 113.0 days
It seems very odd that MaScare would have a lower percentage of bad accounts in its accounts receivable and yet have such an extended collection period. This increase in the average collection period is quite troubling and merits further investigation. P 9-33 Accounts Receivable for Microsoft and IBM Microsoft and IBM 1. 2. 3. (in millions) $32,187/[($5,129 + $5,196)/2)] = 6.23 times; 365 days/6.23 = 58.6 days (in millions) $89,131/[($25,911 + $27,609)/2)] = 3.33 times; 365 days/3.33 = 109.6 days ANALYSIS: Microsoft deals almost strictly with selling software while IBM is involved in selling software and hardware. The major difference relates to IBM's hardware sales. IBM sells computers to distributors who must then turn around and sell those computers to end users. This process takes time and IBM allows distributors additional time to pay for the computers.
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P 9-34 Budget of Cash Receipts 1. Gardner Company Cash Collections Budget For the Months of April, May, and June 2006 April Cash sales (30% of Sales) $169,500 Received from sales in: Feb (0.7 $300,000 0.2) 42,000 Mar (0.7 $500,000 0.2) 70,000 (0.7 $500,000 0.2) Apr (0.7 $565,000 0.6 0.5 0.98) 116,277 (0.7 $565,000 0.6 0.5) 118,650 (0.7 $565,000 0.2) (0.7 $565,000 0.2) May (0.7 $600,000 0.6 0.5 0.98) (0.7 $600,000 0.6 0.5) (0.7 $600,000 0.2) June (0.7 $567,000 0.6 0.5 0.98) (0.7 $567,000 0.6 0.5) Total Cash Collections $516,427 2. May $180,000 70,000 June $170,100
79,100 79,100 123,480 126,000 84,000 116,689 119,070 $568,959
$578,580
ANALYSIS: The best way to convince the bank's senior loan officer that Gardner's forecasts are reasonable is to show that past forecasts have been accurate. Gardner could assemble sales data from past months and demonstrate that the cash collection period has matched the assumptions used in generating the April, May, and June cash collection budget. In addition, Gardner can increase the credibility of the sales forecasts by showing how accurate past sales forecasts have been.
APPLICATIONS AND EXTENSIONS SOLUTIONS
Deciphering Actual Financial Statements Deciphering 9-1 (McDonald's) 1. In its "Revenues" note, McDonald's disclosed that only $6,039 million of its $17,140 million in 2003 revenue was generated in the United States. Thus, McDonald's recognizes more revenue from operations outside the United States. 2. Recall that a large portion of McDonald's operations relates to franchise fees collected from franchisees and from affiliates. This is the part of McDonald's business that creates the Accounts and Notes Receivable. 3. As discussed in (2), the Accounts and Notes Receivable are created by McDonald's dealings with is franchisees and affiliates. Thus, the appropriate revenue number to use in calculating average collection period is the revenue from franchisees. The calculation of 2003 average collection period is as follows:
Chapter 9 19
Average collection period
= = =
365/(Sales/Average accounts receivable) 365/($4,345.1/ [$734.5 + 855.3]/2) 66.8 days
Note that the computed amount of average collection period would be much different if all revenues were included in the calculation. But such a calculation would be misleading. 4. The $21.5 billion in future minimum payments expected to be received by McDonald's in connection with its agreements with franchisees certainly represents a future economic benefit. The rights to receive the payments are guaranteed to McDonald's by contract, so it seems safe to say that McDonald's controls the payments. The big question is whether the payments are the result of a past transaction or event. Some might argue that the signing of the franchise contracts is a past event. However, the payments come about because of future sales and future occupancy by franchisees. So, the $21.5 billion is not recognized as an asset because it does not fit the definition of an asset. This accounting treatment illustrates that conservatism still lies behind many accounting rules. If the $21.5 billion in cash flows were payments to be made by McDonald's, they might be recognized as a liability. This is the treatment afforded some long-term leases (discussed in Chapter 14). Deciphering 9-2 (Sears) 1. For 2000, Sears' average collection period was 176 days (Accounts Receivable Turnover of 2.07 divided into 365 days). The accounts receivable amount used in the calculation is the net amount of credit card receivables (credit card receivables less the allowance for uncollectible accounts). This 176-day average collection period seems large when we think of credit terms such as "net 30 days," but you can see from the income statement that Sears makes almost 11% of its revenue from the granting of credit ($4,389/$40,937). 2. Bad debt expense (provision for uncollectible accounts) for Sears in 2000 amounted to $884 million. That amount is 20% of their credit revenue ($884/$4,389). While 20% may seem like a large amount of bad debt expense, remember that Sears still netted 80% of that revenue. 3. Other costs associated with Sears' credit sales are the bookkeeping and administrative costs of maintaining customer accounts and the implicit interest cost associated with supporting these unpaid accounts. The bookkeeping costs would be reported in the income statement under the selling and administrative expense category. The implicit interest cost is part of total interest expense. 4. Sears' best customer is the one who buys a lot on credit, never pays their bill on time (incurring extra interest and penalties), never completely pays off their account, but faithfully pays the minimum amount each month. Sears' earns a lot of "credit revenue" off this kind of customer. Sears' worst customer is the one who also buys a lot on credit and delays making payment, but ultimately does not pay the bill at all. Deciphering 9-3 (Wal-Mart) 1. Wal-Mart's average collection period: 2 days (365 days/181.6 A/R turnover; A/R turnover = $256,329/[$1,254 + $1,569]/2) 2. Wal-Mart's A/R as a percentage of current assets: 3.6% ($1,254/$34,421) 3. Wal-Mart's revenue from sources other than sales: 0.9% ($2,352/$258,681) 4. While both companies may be in the retail business, they use credit in different ways. Wal-Mart does most of its business in cash (or credit sales financed by VISA or MasterCard). Historically, Sears had its own in-store credit card and financed customer purchases of high dollar items (such as appliances
Chapter 9 20
or home electronics). These two companies illustrate two completely different strategies concerning the use of consumer credit. Deciphering 9-4 (Nordstrom's) 1. "Provisions" is the same as "Bad Debt Expense." "Charge-offs" is another term for actually writing off an account as uncollectible. 2. The entry to record the period's bad debt expense would be: Bad Debt Expense Allowance for Bad Debts The entry to record the actual write-off of bad debts would be: Allowance for Bad Debts Accounts Receivable 27,975 27,975
30,040 30,040
3. Remember that the amount expensed for the period relates to bad debts created in the current period--those bad debts won't be specifically identified until some time in the future. The actual amount written off during a period normally relates to bad debts arising from sales made in a prior period. International Financial Statements: Samsung 1. Net sales in trillions of Korean won Exchange rate (end of year) Net sales in billions of U.S. dollars
1997 91.519 1,695 54.0
1996 74.641 845 88.3
Because of the drastic decline in the value of the won during 1997, Samsung's sales, in terms of U.S. dollars, actually declined in 1997. A more accurate conversion from won to dollars could be made if the average exchange rate for the year were used instead of the end-of-year exchange rate. 2. 1996 Average collection period = = = = = = 365/(Sales/Accounts receivable) 365/(74.641/6.233) 30.5 days 365/(Sales/Accounts receivable) 365/(91.519/10.064) 40.1 days
1997 Average collection period
3.
The lengthening of the average collection period in 1997 is consistent with the belief that Samsung's Asian customers suffered from the economic crisis during that period and were accordingly a bit slower in paying their bills. It is also likely that Samsung's accounts payable balance increased in 1997 as it attempted to manage its cash flow by lengthening its own payment period to its suppliers. And, in fact, Samsung's accounts payable balance increased by 50% in 1997.
4.
Chapter 9 21
Business Memo: A Conflict of Interest To: Station Manager, XCAL Subject: Station's Commission Plan The compensation package currently being provided by XCAL seems reasonable, but it may not be in the best interest of XCAL. XCAL should either do away completely with the commission aspect of the compensation or delegate the responsibility of verifying the financial statements to a disinterested party. The person who presents and analyzes these statements should not be the same one who is selling advertising. There is definitely a conflict of interest. In addition, the station should take a detailed, not a cursory, look at the financial statements of the prospective clients. Another idea is to have commissions based in part on the ultimate collection of the receivables. Research: Revenue Recognition for Web Search Engines Another web search engine is http://www.msn.com, which is owned and operated by Microsoft. In its 2003 annual report, Microsoft reports the following with respect to its recognition practice for proceeds received in connection with its MSN search engine: "Online advertising revenue is recognized as advertisements are displayed." Ethics Dilemma: How Flexible Is Accounting Judgment? John must make sure that the estimates being made are reasonable and are consistent with prior years' estimates. It is not uncommon for estimates to be changed, but any changes that significantly modify the financial results would need to be disclosed and discussed in a note to the financial statements. If the changes being proposed are not reasonable, then what John would be proposing would be wrong. The objective of financial statements is to fairly represent the financial situation of a firm. If the controller knowingly makes estimates and assumptions that result in the financial statements not fairly reflecting the performance of the firm, then he would be doing something wrong; he could be held civilly and criminally liable should financial statement users rely on those financial statements and incur a loss. The Debate: The Direct Write-off Method vs. the Allowance Method The following points can be made by each group: The Direct Write-Off Method More reliable method. An amount would only be recognized as an expense when we are certain that collection will not occur. Does not require estimation.
The Allowance Method Properly matches expenses with the revenues in the period those revenues were earned. The direct write-off method may result in expenses being matched with revenues earned in prior periods. Although estimation involves uncertainty, it provides more relevant information than simply waiting until an account goes bad.
Chapter 9 22
Cumulative Spreadsheet Project 1. Average collection period is 14.08 days
Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Long-term debt Total liabilities Stockholders' Equity Paid in capital Retained earnings (as of 12/31) Total liab. and equities
Forecasted 2007
10 27 153 190 199 9 380
14 38 214 266 279 16 529
74 10 84 207 291
104 29 133 207 340
50 39 380
137 52 529
Retained earnings (as of 1/1) + Net income Dividends Retained earnings (as of 12/31) Income Statement Sales Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income Statement of Cash Flows Operating Activities Net income Depreciation
31 8 0 39
39 13 0 52
700 519 181 5 155 21 9 12 4 8
980 727 253 7 217 29 9 20 7 13
13 7
Chapter 9 23
Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash 2. a. Average collection period is 9.06 days Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Long-term debt Total liabilities Stockholders' Equity Paid-in capital Retained earnings (as of 12/31) Total liab. and equities Retained earnings (as of 1/1) + Net income Dividends Retained earnings (as of 12/31)
11 61 30 22
80
19 0 87 0 106 4 Forecasted 2007
10 27 153 190 199 9 380
14 24 214 252 279 16 515
74 10 84 207 291
104 22 126 207 333
50 39 380 31 8 0 39
130 52 515 39 13 0 52
Income Statement Sales
700
980
Chapter 9 24
Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income Statement of Cash Flows Operating Activities Net income Depreciation Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash
519 181 5 155 21 9 12 4 8
727 253 7 217 29 9 20 7 13
13 7 3 61 30 8
80
12 0 80 0 92 4
b.
Average collection period is 20.00 days Year 2006 Balance Sheet Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Forecasted 2007
10 27 153 190 199 9 380
14 54 214 282 279 16 545
74 10 84
104 37 141
Chapter 9 25
Long-term debt Total liabilities Stockholders' Equity Paid-in capital Retained earnings (as of 12/31) Total liab. and equities Retained earnings (as of 1/1) + Net income Dividends Retained earnings (as of 12/31)
207 291
207 348
50 39 380 31 8 0 39
145 52 545 39 13 0 52
Income Statement Sales Cost of goods sold Gross profit Depreciation expense Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income Statement of cash Flows Operating Activities Net income Depreciation Change in A/R Change in inventory Change in A/P Cash from operating activities Investing Activities Purchase of new PPE Financing Activities New short-term loans payable New long-term debt New paid-in capital Cash dividends Cash from financing activities Net change in cash
700 519 181 5 155 21 9 12 4 8
980 727 253 7 217 29 9 20 7 13
13 7 27 61 30 38
80
27 0 95 0 122 4
Chapter 9 26
3.
Forecasted cash flow from operating activities is related to the forecasted average collection period as follows: 14.08 days Cash flow from operating activities $22 9.06 days $8 20.00 days $38
As you can see, the slower the expected cash collections, the more negative the forecasted cash from operating activities in 2007. Internet Search: Boeing Company This solution was developed using information available on Boeing's Web site on May 14, 2004. 1. The Phantom Works is a special unit of Boeing devoted to advanced research and development. The unit is modeled after the famous Skunk Works at Lockheed. The Phantom Works has 4,000 employees and services other divisions at Boeing as well as doing work directly for NASA and for the Department of Defense. 2. A 717-200 sells for between $35.5 million and $39.5 million. A 777-300ER sells for between $203.5 million and $231.5 million. 3. Sales (in millions) Accounts receivable 2002 Average collection period = = = = = = 2003 $50,485 4,515 365/(Sales/Accounts receivable) 365/($54,061/$5,007) 33.8 days 365/(Sales/Accounts receivable) 365/($50,485/$4,515) 32.6 days 2002 $54,061 5,007
2003 Average collection period
4. Boeing has numerous revenue recognition criteria depending on the type of contract. The following information is taken from its 2003 annual report: We recognize sales for commercial airplane deliveries as each unit is completed and accepted by the customer. Sales recognized represent the price negotiated with the customer, adjusted by an escalation formula. The amount reported as cost of sales is determined by applying the estimated cost of sales percentage for the total remaining program to the amount of sales recognized for airplanes delivered and accepted by the customer during the quarter. You Be the Analyst! Ratios Related to Accounts Receivable The data for this solution were gathered on June 25, 2004. Of course, solutions will differ depending on when this exercise is completed.
Chapter 9 27
1.
Boeing's accounts receivable days for the most recent five years is as follows. 2003 34.66 2002 37.34 2001 37.52 2000 35.69 1999 25.83
Accounts Receivable Days
The level of accounts receivable days in 2003 is lower than the values in the preceding three years, but substantially higher than the value in 1999. 2. The average collection period formula can be written as follows. = Accounts Receivable / (Sales / 365)
Average collection period
Using Boeing's ending accounts receivable balance for 2003, the calculation is as follows: Average collection period = = $4,714 / ($50,485/ 365) 34.08 days
This does not exactly match the 34.66 days reported in Thomson Ratios. Using Boeing's average accounts receivable balance for 2003, the calculation is as follows: Average collection period = = (($4,714 + $5,007)/2) / ($50,485/ 365) 35.14 days
Again, this does not exactly match the 34.66 days reported in Thomson Ratios. It is not unusual to be unable to exactly recreate the calculations used to generate reported ratio values. In this case, the discrepancy may be because the reported accounts receivable amount is net of the allowance for bad debts; the Thomson Ratios calculation may use the gross accounts receivable amount. 3. For the year ended December 31, 2003, the value of Boeing's accounts receivable days was 34.66. For the same year, the mean value for Boeing's industry group was 48.90 days. The company with the highest value was Raytheon with 69.08 days. The company with the lowest value was Boeing itself with 34.66 days. Test Your Intuition As you might expect, not all software companies support this revenue recognition practice; they would prefer to recognize all of the revenue from a software sale immediately at the time of the sale. Microsoft, on the other hand, has been very supportive of the rule. Why do you think Microsoft supports the rule that many other software firms oppose? Microsoft's revenues have increased at a rapid rate over the past several years. Microsoft does not need to use accounting methods to inflate reported revenue. Microsoft's competitors, on the other hand, need all the help they can get as they try to compete against Microsoft. Thus, Microsoft would support a rule that slows the recognition of revenue because it would affect their competitors more than it would themselves. So, why don't all credit customers always pay early in order to get sales discounts? For example, utility companies often offer residential customers a discount for paying early--why doesn't everyone always pay early?
Chapter 9 28
For some credit customers, particularly those owing small amounts, the amount saved by carefully tracking sales discount dates is not worth the effort. For a large company, it makes sense to monitor sales discount dates in order to save, say, $3 million. For a residential utility customer, it may not make economic sense to carefully construct a bill-paying system that will only save $3 in sales discounts. Is it possible for the ending balance in the Allowance for Bad Debts account to be a debit? Explain what that would mean. No. An ending debit balance in the Allowance for Bad Debits would mean that you expected customers to pay MORE than they actually owe you! This is unlikely to happen. Without looking at any reference source, state your opinion on each of the 10 currencies included in Exhibit 9-6: has the currency increased or decreased in value since May 12, 2004 when Exhibit 9-6 was compiled? Check your judgment using a reference source such as The Wall Street Journal or http:// www.yahoo.com. As an illustration, the change in exchange rates from May 4, 2001 to May 12, 2004 is discussed below. Exchange rate May 4, 2001 0.651 0.121 0.894 0.128 0.021 0.008 0.108 0.035 0.578 1.440 Exchange rate May 12, 2004 0.721 0.121 1.190 0.128 0.022 0.009 0.086 0.034 0.773 1.772
Country (currency) Canada (Dollar) China (Renmibi) Euro Hong Kong (Dollar) India (Rupee) Japan (Yen) Mexico (Peso) Russia (Ruble) Switzerland (Franc) United Kingdom (Pound)
Between May 2001 and May 2004, most European currencies strengthened against the U.S. dollar. This trend is highlighted by the rise in the value of the euro. Both the Chinese renminbi and the Hong Kong dollar remained stable, reflecting the policy of those governments to maintain their currencies at a certain rate pegged to the U.S. dollar. Business Context 9.1: ZZZZ Best 1. Assume for a moment that all sales are bogus, and then sales and accounts receivable would be equal--a situation that would attract the attention of any financial statement reader. The higher the amount of fictitious sales being recorded, the more out of line accounts receivable would be. An aging of receivables would indicate that collections are not being made. Also, the existence of sales without any associated cash inflow would be very suspicious. In addition, an increase in sales could be expected to be accompanied by an increase in accounts payable (after all, whatever we are selling must have been purchased). If sales are fraudulent, then there would be little relationship between payables and sales. Interpreting financial results with a degree of healthy skepticism alerts the reader to abnormal relationships between accounts.
Chapter 9 29
2.
Instead of asking ZZZZ Best to take him to some restoration sites, the auditor could have made surprise visits to the sites. Also, an awareness of the restoration industry would have alerted the auditor to the unusual size of these contracts. Most restoration contracts are not anywhere near as large as those being claimed by ZZZZ Best.
Data Mining 9.1: Bank Credit Losses 1. With the exception of JP Morgan Chase in 2001, the bad debt expense is less than the amount of loans written off in each of the three years presented for each bank. Normally, we would expect the opposite to be true--write-offs are usually less than bad debt expense because, in a growing company, the bad debt expense for this year is an estimate of the higher write-offs that are expected in future years (arising from this year's sales). Although write-offs may be larger than bad debt expense in any given year, it is very unusual to experience this situation year after year. 2. The loan loss recoveries are the reason that write-offs exceed bad debt expense in each year. It appears that banks are very aggressive in writing off bad loans. However, writing off a loan does not mean that the bank gives up on collecting the loan amount. From the data given, it can be seen that between 12% and 16% of loans written off are eventually collected. From an accounting standpoint, the recovery of a loan previously written off involves restoring the account receivable and also restoring the allowance that was eliminated when the loan was initially written off.
3. January 1, 2001 balance Add 20012003 bad debt expense Add 20012003 recoveries Subtract 20012003 write-offs December 31, 2003 balance JP Morgan Chase $3,665 + 8,803 + 1,177 (9,460) $4,185 Citicorp $8,561 +24,830 + 4,582 (29,362) $8,611 Bank of America $6,365 + 10,880 + 2,124 (13,171) $6,198
Data Mining 9.2: Valuing a Foreign Currency Portfolio 1. Number of currency units purchased 1969 francs 5,821 marks 3,681 yen 370,370 pounds 417 2. U.S. dollar value 1979 francs marks yen pounds Total $1,448 2,140 1,556 927 $6,071 1989 $ 979 2,114 2,593 665 $6,351 1998 $1,042 2,210 3,296 694 $7,242
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3.
The value of the U.S. dollar declined, overall, in each decade. This can be seen through the following analysis: If the $4,000 in currency had been left in the form of U.S. dollars, it would still have been worth $4,000 at the end of each decade. Because the dollars were exchanged for the foreign currencies, the value of the portfolio was worth more than $4,000 (see part 2). Accordingly, the value of the foreign currencies went up relative to the U.S. dollar, meaning that the value of the dollar went down.
Web Search On January 14, 2004, Yahoo announced that its revenue for fiscal 2003 was $1.6 billion. As of May 14, 2004, the total market value of Yahoo's stock was $36.5 billion. This means that, at that time, Yahoo was worth 23 ($36.5 billion/$1.6 billion) times its sales. Usually we speak of P/E multiples in the range of 10 to 40. Here we see a company with a price-to-sales multiple of 23. This price-to-sales ratio is down substantially; in 1999, the price-to-sales ratio of Yahoo was 170, reflecting the much greater growth expectations that existed before the Internet shakeout.
Chapter 9 31