The revenue principle provides that companies should recognize revenue when it is a) realized or realizable and b) when it is earned.

Revenue is realized when the company exchange goods and services for cash or receivables. Revenue is realizable when products are received are readily convertible to known amounts of cash or receivables, and revenue is earned when company has substantially accomplished what it must do to be entitled to the benefits represented by revenues. Means, when the earning process is complete or virtually complete.

The below are summary for four transactions are recognized as revenue in accordance with principal:

 

Type of transaction

Sale of product from inventory

Rendering a service

Permitting use of an asset

Sale of asset other than inventory

Description of revenue

Revenue from sales

Revenue from frees or services

Revenue from interest, rents and royalties

Gain or loss on disposition

Timing of revenue recognition

Date of sale (Date of delivery)

Services performed and billable

As time passes or assets are used

Date of sale or trade in

 Departure from the sale basis:

Date of delivery is varied between industry to others and deliverables to other, therefore, the following four cases are considered as departure from sale basis.

 When trade or manufacturing companies sell their products specially overseas, the revenue recognized at point of delivery. Selling products to overseas customers arise the revenue recognition at point of delivery either (based on INCOTERMS 2000 or sales contract which will be discussed later in this section) which the revenue is recognized because it is being realized or realizable and being earned at determined point.

                Sales with buyback agreements

If there is repurchase terms in agreement at set price which covers all cost of inventory plus related holding costs, there is no sale and the inventory and liability remain on seller’s book.

                Sales when right of return exists

There are three methods of revenue recognition for high ratio of retuned goods if the right of return will lead the seller to carry the risks of ownership.

a)      Postponing the sales until all return privileges have expired.

b)      Recording sales and offset the sales by the allowance of estimated future sales returns.

c)       Recording the sale and its returns when they occurred.

The revenue recognition of high ratio of returned goods is recognized if all of the following six conditions are met:

1)      Sell price is substantially fixed or determined.

2)      Buyer paid or is obliged to pay the price and not associated in condition of resale of goods

3)      Buyer carries the risk of owning the goods such as theft, physical damages of goods.

4)      Buyer acquiring the good for resale has economic substance apart from that provided by seller

5)      Seller has no significant obligations for future performance to directly bring about resale of the product by buyer.

6)      Seller can reasonably estimate the amount of future returns

Even If the six conditions are not met, sales and revenue cost of sales must be recognized either when return privileges has substantially expired or when six conditions are met, whichever occurs first.

Revenue recognition at point of delivery based on Incoterms 2000

Incoterms 2000 or Sale and Buy contract impact on the revenue recognition for the seller and inventory asset recognition for buyer. Revenue recognition for selling products to overseas customers depend on the delivery terms, if the incoterms 2000 is stated into contract of sale and buy, the revenue recognition will be varied from delivery term to other. There are four group for delivery terms, and each group has different seller’s & buyer’s obligations, contract of carriage and insurance, loading and unloading, checking, packaging, freight and insurance costs, transfer of risk. In this section, the most common delivery terms will be explained in below summarized comparison

 

Group

Terms

Seller’s Obligation

Buyer’s Obligation

Costs carried by seller

Delivery Point

Transfer Risk

“E”

EXW (Ex Work…named place)

Seller makes the goods available to the buyer at named place of seller’s country, or any place which best suits seller’s purpose

Buyer should packaging the goods, load them into vehicle from the named place or seller’s premises to port of exporter to be delivered to buyer’s

Buyer should directly contact shipping and insurance company to deliver the goods

All costs relating to goods to be available to the named place that include:

Cost of Checking activities (such as checking quality, measuring, weighing, counting) except pre-shipment cost

Cost of packaging activities which is required for transport of goods.

Seller’s premises or any place within seller’s area.

All risks of loss or damages to goods to the named placed agreed between buyer and seller is carried by seller and after this point

“F”

FCA (Free Carrier … named place)

Seller makes the goods available to carrier appointed by the buyer

Seller delivers the goods cleared for export, carrier nominated by buyer.

And seller is only responsible for loading the goods to the named place.

Packaging and checking cost except for pre-shipment inspection costs, if it is not mandated by authority of exporter’s country.

Loading/collecting costs onto the trucks

 

All cost of Export customs formalities (e.g. duties, charges) if it is applicable.

At any point within seller’s country that can be carried by the carrier

Seller must bear all the risks of loss or damages to goods for carriage till it is delivered to carrier.

 

FOB (Free On Board … named port of shipment)

Seller makes the goods available to carrier appointed by the buyer.

Seller is responsible for delivering the goods pass ship’s rail at named port of shipment .

Seller is responsible for clearing the goods fro export

Packaging and checking cost except for pre-shipment cost if is mandated by authorities of country of export

Loading/collecting costs onto the trucks

Unloading costs to the port quay

All cost of Export customs formalities (e.g. duties, charges) if it is applicable.

At the named port of shipment and on the board vessel nominated by buyer

Seller must bear all the risks of loss or damages to goods for carriage till they pass ship’s rail at the name of port of shipment.

“C”

CFR (Cost and Freight … named port of destination)

Seller makes the goods available at named place and has a contract for shipping without assuming the risk of loss or damage to the goods or additional costs due to events occurring after shipment and dispatch

Seller is responsible for delivers when the goods pass the ship’s rail in port of shipment

Seller is responsible to costs and freight to bring goods to the named port of destination.

Seller must clear the goods for export

Seller must contract on usual terms at his own exp for the carriage of goods by usual route or ship-going carrier

Packaging and checking cost except for pre-shipment inspection costs, if it is not mandated by authority of exporter’s country.

Loading/collecting costs onto the trucks

Unloading costs to the port quay

Loading costs to the board.

All cost of Export customs formalities (e.g. duties, charges), if applicable under contract of carriage

Freight Cost

On board the vessel at the port of shipment within agreed period.

Seller must bear all the risks of loss or damages to goods for carriage till they pass ship’s rail at the name of port of shipment

 

CIF (Cost, Insurance and Freight … named port of destination)

Seller makes the goods available at named place and has a contract for shipping and insurance without assuming the risk of loss or damage to the goods or additional costs due to events occurring after shipment and dispatch

Seller is responsible for delivers when the goods pass the ship’s rail in port of shipment

Seller is responsible to costs and freight to bring goods to the named port of destination.

Seller must clear the goods for export

Seller must contract on usual terms at his own exp for the carriage of goods by usual route or ship-going carrier

Seller must contract for insurance and provide the buyer with insurance policy

Packaging and checking cost except for pre-shipment inspection costs, if it is not mandated by authority of exporter’s country.

Loading/collecting costs onto the trucks

Unloading costs to the port quay

Loading costs to the board

All cost of Export customs formalities (e.g. duties, charges), if applicable under contract of carriage.

Freight Cost

Insurance cost

Unloading cost to quay of importer’s port

On board the vessel at the port of shipment within agreed period.

Seller must bear all the risks of loss or damages to goods for carriage till they pass ship’s rail at the name of port of shipment

“D”

DDU (Delivered Duty Unpaid … named place of destination)

Seller makes the goods available to the named place and bear all the risks and costs needed to bring the goods to the place of destination except for the cost of duty

Sellers is responsible for delivering the goods to the buyer, but not cleared for import, not unloaded from any arriving means of transport at the named place of destination.

Packaging and checking cost except for pre-shipment inspection costs, if it is not mandated by authority of exporter’s country.

Loading/collecting costs onto the trucks

Unloading costs to the port quay

Loading costs to the board

All cost of Export customs formalities (e.g. duties, charges)

Freight Cost

Insurance cost

Unloading cost to quay of importer’s port

Customs Brokerage charges

Loading costs onto the trucks to be delivered to the buyer’s premise

Unloading the cost from trucks to the buyer’s premises

At the disposal of the buyer’s place of destination on any arriving means of transport at place of destination but not unloaded

Seller must bear all the risks of loss or damages to goods for carriage till the goods be available on arriving means of transport but not unloaded

 

DDP (Delivered Duty Paid … named place of destination

Or EXW to EXW

Seller makes the goods available to the named place and bear all the risks and costs needed to bring the goods to the place of destination.

The seller’s is responsible to deliver the goods to the buyer’s premise or named place destination but unloaded

Packaging and checking cost except for pre-shipment inspection costs, if it is not mandated by authority of exporter’s country.

Loading/collecting costs onto the trucks

Unloading costs to the port quay

Loading costs to the board

All cost of Export customs formalities (e.g. duties, charges)

Freight Cost

Insurance cost

Unloading cost to quay of importer’s port

Customs Duty

Customs Brokerage charges

Loading costs onto the trucks to be delivered to the buyer’s premise

Unloading the cost from trucks to the buyer’s premises

At the disposal of the buyer’s place of destination on any arriving means of transport at place of destination but not unloaded

Seller must bear all the risks of loss or damages to goods for carriage till the goods be available on arriving means of transport but not unloaded

 Revenue should be recognized by seller when the risks of loss or damage to goods transferred to buyer at the specific point of delivery because revenue is earned at the point of delivery. Buyer’s obligations at the point that the seller completely meet his obligations.

 Revenue can be recognized prior to completion and delivery such as long-term construction contract  and long-term project that use percentage-of-completion or completed contract method.

Percentage of Completion Method.

This method is used when estimates of progress toward completion, revenue, costs are reasonably dependable and all the following terms are met:

1.       There is contractual enforceable rights for deliverables to be provided by seller and received by buyer, and the manner of settlement not in one lot, but in different amount when they meet the contractual terms.

2.       Buyer can satisfy all obligations under the contract.

3.       Seller or contractor can perform the contractual obligations.

The common methods to computing progress toward completion are Input measures (cost-to-cost basis, labor hours worked) and output measures (Units-of-delivery method,

Most of the company use the cost-to-cost basis which compares costs incurred to date with most recent estimate of total costs required to complete the contract. The below formula for percentage of completion, cost-to-cost basis:

Percentage Complete = Costs incurred to date / Most recent estimate of total costs

To calculate the revenue and estimated total gross profit by applying the percentage complete as the below formula

Revenue (or Gross profit) to be recognized to date = Estimated total revenue (or gross profit) *                                                                                                                                       Parentage complete

To find the amounts of revenue and gross profit recognized each period, we need to subtracts total revenue or gross profit recognized in prior periods as the below formula

Current-period revenue (or gross profit) = Revenue (or gross profit) to be recognized to date – Revenue                                                                                                                   (or gross profit) recognized in prior periods

The below formula for computing the unbilled revenue.

Unbilled Revenue = Current-period revenue – billing to date

The accounting entries under percentage-of-completion method are as follow:

a.       To record actual cost of the current period, accountant will do the below accounting entry

Dr. Construction in Process

Cr. Inventory

     Cash

     Accounts Payables

b.      To record progress billings, the accounting entry will be as follow:

Dr. Accounts Receivables

Cr. Billing on Construction in Process

c.       To recognize revenue and gross profit

Dr. Construction in Process                    (current period estimated gross profit)

      Construction Expenses                      (Current period cost)

Cr. Revenue from long-term contract (current period revenue)

d.      To record completion of the contract

Dr. Billing on Construction in Process

Cr. Construction in Process

e.      To recognize loss in the current period on profitable contract.

Dr. Construction Expenses                   (Current period cost)

Cr. Revenue from long-term contract (current period revenue)

      Construction in Process                     (Loss)

Revenue recognition before delivery is not only for construction industry, it can be applied for any project business that has characteristics of job-costing system for producing products based on customer’s specifications that is required deliverables to be inspected in specific area or date before shipment or delivery date.

Completed-Contract Method.

This method is used if one of the following conditions are met.

1.       If the contract can be performed in the short-term.

2.       If the three conditions of percentage-of-completion are not met.

3.       If there is an inherent hazards in the contract beyond the normal.

Under this method, entity records cost of construction and recognize the revenue from long-term/short-term contracts, which accumulate costs into contracts in process account, and make no interim expense and revenue to income statement, therefore, there is no gross profit. It is disadvantage to use this method if the period of contracts covered more than one accounting period.. Under this method, entity make the following accounting entries:

1) When activities performed for performing a contract and expenses incurred, the following accounting entry will be as follow

Dr. Construction in Process

Cr. Inventory

      Cash

      Accounts Payables

2) When entity billed customers, the following entry will be s follow

Dr. Accounts Receivables

Cr. Billing on Construction in Process

3) During the year of completion, the accounting entry will be as follow

a) To record the cost of construction

Dr. Cost of construction

Cr. Construction in Process

b) To recognize the revenue and record it in the books

Dr. Billing on Construction in Process

Cr. Revenue from construction contracts.

4) Company can recognize the loss on an unprofitable contract in the year of completion through the following entry, if there is no revenue and billing.

Dr. Loss from construction contracts

Cr. Construction in Process

 Sometimes the risk of collectable sales is high and it is not reasonably certain, therefore, revenue recognition is deferred. Two methods are not recognized revenue until entity collect the money, they are; a) Installment-sales method, b) cost-recovery method, and there is one method that does not recognize the revenue even if the cash received prior the completion of transactions which consider the cash received as deposit, this method is called “deposit method”. And they are explained in more details.

a) Installment-Sales Accounting Method

This method is applied if there is no reasonable estimate for certainty of collectability; therefore, entities recognize revenue and costs of sales but defer recognizing the proportional gross profit until the period of cash collection is made on the basis of no received cash from sales.

To compute the realized and unrealized gross profit is through the following formula

Installment Sales                                                                                                                                              xxxxxx

Cost of installment Sales                                                                                                                                 xxxxx

Gross Profit                                                                                                                                                          xxxxx

Rate of gross profit current year = Gross Profit / Installment Sales                                                 xx%

Realized Gross Profit of current yr= Cash Collections during year * Rate of Gross profit current yr

Unrealized Gross Profit = Gross Profit – Realized Gross Profit

Under the Installment-Sales method, the accounting entry will be as follow:

1) During the year and when sales invoice is issued and items released from warehouses, the entity book journalizing sales, cost of sales, and the installment of cash as follow.

a) To record the sales

Dr. Installment accounts receivables

Cr. Installment Sales

b) To record the cost of goods sold

Dr. Cost of installment Sales

Cr. Inventory

c) To record cash collected from customer.

Dr. Cash

Cr. Installment accounts receivables, 200x-1 (last period)

Cr. Installment accounts receivables, 200x (Current period)

2) At the end of the year, Company applies the rate of gross profit current year to cash collections to get the realized and unrealized gross profit as per the above formula.

3) After reaching realized and unrealized gross profit, company closing the cost of installment to installments sales and gross profit then journalizes the realized and unrealized gross profit as the following entry.

a) To book closing the cost of installment to installments sales and gross profit

Dr. Installment Sales

Cr. Cost of installment sales

      Deferred Gross Profit, 200x (current period)

b) To remove the realized gross profit from gross profit and book the unrealized gross profit.

                Dr. Deferred Gross Profit, 200x-1 (last period)

                      Deferred Gross Profit, 200x (current period)

Cr. Realized Gross Profit on Installment Sales

In case, there is interest on installment contract which stated that seller should charge buyer an interest on the unpaid balance. Both seller and buyers should set up payment schedule that consists of equal installments and interests and principal as the below schedule.

 

Date

Fixed Cash Installments

Interest @ 10%

Installments receivables

Unpaid balance

Realized Gross Profit @ 20% Gross Profit Margin

1/1/01

0

0

0

10,000

0

1/1/02

5,761

1000

4,761

5,239

1,047.80

1/1/03

5,761

522

5,239

0

 

Total

11,522

1,522

10,000

0

1,047.80

 The gross profit is computed separately from interest, gross profit and interest are recognized at time of cash receipts. Computation of interest should be stopped for uncollectible installment accounts receivables that lead to reverse the current year accrued interest and charge the prior years’ interests to the loss account.

If the company faces uncollectible installment accounts receivables, the company should refer to the installments-sales contract, if the contract stated that company has the right to repossess the goods if the customers delay the cash payments for specific period, and resale the repossessed the goods, it can recover the uncollectable accounts by reselling the repossession of the goods, but if the experience of the company or the company noticed that it can not repossessed the goods, it should close the uncollectable goods into the bad debt expenses and credit the installments expenses. The accounting entries for the both cases as follow.

To records the repossessed goods, remove applicable deferred gross profit

Dr. Repossessed Inventory.(Best estimate for market fair value – deferred gross profit)

      Deferred Gross Profit

      Loss on Repossession (Cost of reconditioning and difference between uncollected amount and fair market value)

Cr. Installment accounts receivables, 200x-1 (last period)

      Installment accounts receivables, 200x (Current period)

The formula for computing the loss on repossession is as follow:

Balance of installment accounts receivables                                                        xxx

Less: Deferred Gross Profit                                                                                         xxx

                Uncovered Cost                                                                                                                xxx

Less: The best estimated fair value of repossessed goods                             xxx

                Loss (Gain) on repossession                                                                        xxx

a)      To record the resale of repossessed goods

Dr. Installment accounts receivables, 200x-1 (last period)

      Installment accounts receivables, 200x (Current period)

Cr. Repossession of goods solds. (at cost + loss)

     Loss from resale of repossessed goods (loss)

b)      To record the bad debts expenses

Dr. Bad debt expense

                                Cr. Installments Accounts Receivables, 200x-1

 

b) Cost-Recovery Method

The reason of using this method is the same reason of using Installment-Sales Method that is referring to high uncertainty of collectable receivables. This method recognizes no gross profit until cash received from buyer exceeds the cost of goods sold, after recovering all costs of goods sold, seller recognize the gross profit by the additional cash collection. The schedule of computing the deferred and realized gross profit under cost-recovery method as follow:

 

 

200x

200x-1

200x-2

Cash Collection

700

300

200

Revenue

1,200

0

0

Cost of goods sold

800

0

0

Deferred Gross Profit

400

 

 

Realized Gross Profit (Cash call to date – Cost of goods sold)

0

200

200

Deferred gross profit balance (end of period)

400

200

0

 The accounting entries for recording the realized gross profit, closing cost of sales into the sales, deferred gross profit is the same in the installment-sales method.

c) Deposit Method

Under this method, the seller receive a cash before the sales transaction is completed or performing the contract. Therefore, the cash received recorded as deposit by the following accounting entry.

Dr. Cash

Cr. Refundable deposit /Customer Advance

When the sales transactions is completed and the ownership and risk are transferred to the buyer the seller do the following entry

Dr. Accounts Receivables

Cr. Sales

(To record sales)

 

Dr. Cost of goods sold

Cr. Inventory

(To Record the cost of goods sold)

 

Dr. Customer Advance

Cr. Accounts Receivables

(To close customer advances after completing the sales transactions)

 Franchises

Franchisor generates the revenue from the sale of initial franchises and related assets or services and from continuing fees based on the operations of franchises. Franchisor provides franchisee the following:

a.       Assistance in site selection such as analyzing location, negotiating lease

b.      Evaluation of potential income

c.       Supervision of construction activity; such as obtaining finance, designing building and construction.

d.      Assistance in the acquisition fixtures and equipment.

e.      Bookkeeping and advisory services such as setting us franchise records, advising on income, real estate and taxes.

f.        Employee and management training

g.       Quality control

h.      Advertising and promotion

Initial franchise fee is payment for establishing the franchise relationship and providing some initial services by franchisor to franchisee. The franchisor records this initial fee as revenue when franchisor makes substantial performance of services that are required under the contract and collection of fee is reasonably assured. The accounting entry will be as follows:

a)      If there is reasonable expectation that franchisor may refund the down payment and if the substantial future services remain to be performed by franchisor. The unearned revenue and the accounting entry will be as follow:

The initial Franchise Fees (Cash+Notes Receivables)                                                        xxxxx

Discount on Notes Receivables = Face value of Notes Receivable – PV of NR           xxx

Unearned Initial Franchise Fees                                                                                                                xxxxx

Dr. Cash                                                              

      Notes Receivables                                     (Face Value)

Cr. Discount on Notes Receivables          

      Unearned Franchise Fees                     

b)      If the initial down payment is not refundable and still there is some services need to be performed by franchisor, and there is reasonably assurance for collecting the fees. The accounting entry will be as follow

Dr. Cash                                                               (Non refundable part of fees, or no future service required)

      Notes Receivables                                     (Face Value)

Cr. Discount on Notes Receivables          

      Unearned Franchise Fees                      (Collection is uncertain)

      Revenue from franchise fees                               (Non refundable part of fees, or no future service required)

 

Consignment

The consignment is used by manufacturers or wholesalers which deliver the goods and retain the title to the goods until they are sold. The risk of ownership is carried by the seller not buyer or agent until the goods are sold. The mediated buyer or agent is called consignee and the first seller is called the consignor, the consignor should record the goods delivered to consignee and record the consigned goods sold and record any costs paid by consignee to sell the goods. Consignee should not record any transactions except when the goods are sold or used by him and back charge to consigner by cost associated to resale to third parties. The following entry is made by both consignor and consignee as follow:

 

Consignor

Consignee

a) Shipment of consigned merchandise

Dr. Inventory on consignment

Cr. Finished Goods Inventory

No entry

b) Payment of freight costs by consignor

Dr. Inventory on consignment

Cr. Cash

No entry

c) Payment of advertizing by consignee

No entry

Dr. Receivable from consignor

Cr. Cash

d) Sales of consigned merchandise

No entry

Dr. Cash

Cr. Payable to consignor

e) Notification of sales and expenses and remittance of amount due

Dr. Cash

     Advertising Expenses

    Commission Expenses

Cr. Revenue from consignment sales

Dr. Payable to Consignor

Cr. Receivable from consignor

      Commission revenue

      Cash

f) Adjustment of inventory on consignment for cost of sales

Dr. Cost of goods sold

Cr. Inventory on consignment

No Entry

 Receivables are claims held against customers and others for money, goods, or services. For financial statements receivables are either classified undercurrent (short-term) or noncurrent (long-term) assets based on the period of time that is taken to collect such receivables. Nontrade receivables arise from a variety of transactions. Some examples as follow

    • Advances to officers or employees
    • Advances to subsidiaries
    • Deposit paid to cover potential damages or losses
    • Deposit paid as a guarantee of performance or payment
    • Dividends and interest receivable
    • Claims against

a)      Insurance companies

b)      Defendants under suit

c)       Governmental bodies for tax refunds

d)      Common carriers for damaged or lost goods

e)      Creditors for returned, damaged or lost goods

f)       Customers for returnable items (Crates or containers)

g)      Advances to Creditors or suppliers

Recognition of accounts receivables:

The amount of accounts receivables is initially recognized is the exchange price between two parties after deducting the trade discounts and secondly recognized by deducting the cash discount from the above initial amount.

Some Companies recording the accounts receivable based on gross method which the cash discount is recorded later within recording the payments made within the allowable discount period, but some companies record the accounts receivable based on net method which accounts receivables are recording after deducting cash discount, and the cash discount that was not earned is recorded as cash discount forfeited, this method is applied for Companies’ receivables that are used and normally pay their due amounts within discount period.

Theoretically, any revenue after the period of sale is interest revenue. In practice, companies ignore interest revenue related to accounts receivable because the amount of the discount is not usually material in relation to the net income for the period. The professional specifically excludes from present value considerations.

Companies value and report short-term receivables at net realizable value-the net amount they expect to receive in cash. Determining net realizable value requires estimating both uncollectible receivables and any returns or allowances to be granted and net method help in measuring the accounts receivable at net realizable value.

 

Gross Method

Net Method

When sale is occurred

 

Dr. Accounts Receivable (Gross)

Cr. Sales                                 (Gross)

Dr. Accounts Receivable    (net)

Cr. Sales                                 (net)

Payment is received within discount period

Dr. Cash                                 (net)

       Sales Discount               (disc)

Cr. Account Receivable      (Gross)

Dr. Cash                                                 (net)

 

Cr. Accounts Receivable     (net)

Payment is received after the discount period

Dr. Cash                                 (Gross)

Cr. Accounts Receivable     (Gross)

Dr. Cash                                 (net)

Cr. Accounts Receivable      (net)

Dr. Cash                                 (disc)

      (Unearned/ Forfeited) Sale Discount (disc)

 

 

Gross

Net Method

Sales presentation in income statement

The below items should be deducted from sales

-          Sales cash Discount

-          Allowance of sales returns

 

Accounts Receivables Presentation in Balance sheet

 

The below items should be added to Accounts receivables

-          Unearned/ Forfeited Sale cash Discount

-          Interest on accounts

-          Finance charges

 Methods for recording uncollectable accounts receivables

Direct write-off method: No entry is made until a specific account has definitely been established as uncollectable. Then the loss is recorded as follow

                Dr. Bad debt expenses

                                Cr. Accounts Receivables

During collection of accounts receivable written off, the following entry will as follow

                Dr. Cash

                Cr. Revenue-Uncollectible Amounts Recovered.

Allowance Method: An estimate is made of the expected uncollectible accounts from all sales made on account of from total of outstanding accounts receivables. This estimate is entered as an expense and an indirect reduction in accounts receivables (via an increase and decrease allowance account) in the period in which the sale is recorded. The doubtful debt is recorded as follow

                Dr. Bad debts expenses

                Cr. Allowance for doubtful debts

If there is specific account receivable that need to be written off, the following entry will be as follow:

                Dr. Allowance for doubtful debts

                Cr. Accounts Receivables

During collection of accounts receivable written off, the following entry will as follow

                Dr. Accounts Receivables

                Cr. Allowance for doubtful debts

When the cash received from a/r previously wrote off, the following entry will be as follow

                Dr. Cash

                Cr. Accounts Receivables.

 

For calculating the doubtful debts, the Company should apply one of the following approach

1.       Percentage-of-Sales (Income Statement) Approach

If there is a fairly relationship between previous years’ credit sales and bad debts, the Company can use income statement approach. This approach achieves a proper matching of cost and revenue.

2.       Percentage-of-Receivables (Balance Sheet) Approach

Using past experience, a company can estimate the percentage of its outstanding receivables that will become uncollectible, without identifying specific accounts. This procedure proves reasonably accurate estimate of A/R’s realizable value. Company may set up an aging schedule of accounts receivable which applies different percentage based on past experience to the various age categories. This approach results in more accurate valuation of receivables on the balance sheet.

The allowance for doubtful debts is established when both conditions are met. Otherwise, there is no requirement for establishing the allowance

a.       There is information exist prior to date of financial statement indicates that it is probable that accounts receivables have been impaired at the balance sheet date.

b.      The amount of impairment of accounts receivables can be reasonably estimated.

Notes Receivables

Notes Receivables are formal written promissory notes to pay a certain sum of money at a specific future date that can be sold or transferred to others. Such notes are classified into two catagories:

-          Interest-bearing Notes

To compute the reported notes receivables, the prevailing effective market interest rate should be considered to apply it on the carrying amount of receivables and add the actual interest of carrying after convert it to present value.

To compute discount or premium take out the cash proceeds from above

-          Zero-interest-bearing notes (noninterest-bearing)

To compute the reported notes receivables, the prevailing effective market interest rate should be considered to apply it on the carrying amount of receivables.

To compute discount or premium take out the cash proceeds from above

The maturity amount of noninterest –bearing note receivable is its face amount.

 

Notes receivables are considered fairly liquid, even if they are for long-term because companies may easily convert them to cash. Although, they might pay a fee to do so.

Companies generally record short-term notes at face value (less allowances) because the interest implicit in the maturity value is immaterial, therefore, they are not subject to premium or discount amortization.

Any long-term notes receivables should be recorded and reported at present value of cash they expect to collect. But when note receivable or payable arises in the ordinary course of business and is due in customary trade terms not exceeding 1 year, the interest element should not be recognized.

Financial institutions and other companies stop accruing interest income on receivables that are doubtfully collected or decisions was made to remove it from ledger as bad debts. Also, and the interest income of this receivable that is accrued in the current year is reversed and the interest income related to prior years is charged to loss account.

Long-term Notes Receivables Recognition

Notes that are issued at face value are notes which their stated interest rate (Coupon rate or face rate) is equal to market rate (Effective-interest rate). Therefore, the acquiring and interest revenue accounting entries will be as follow

                Dr. Notes Receivables                                    (At face value)

                Cr. Cash                                                                (At face value)

To records the receipts of note

                Dr. Cash                                               (Stated interest * Face Value of Note)

                Cr. Interest Revenue                      (Stated interest * Face Value of Note)

 

Notes that are not issued at face value are notes which their stated interest rate is different from market rate which lead the notes receivables are subject to premium or discount amortization. Therefore, the acquiring and interest revenue for Zero-Interest-Bearing Notes are accountingly recorded as follow:

                Dr. Notes Receivables    (At face value)

                     Discount on NR            (Diff btwn face value of note and Present value of Note @ market rate)

                Cr. Cash                                (Present value of Note @ market rate)

To records the receipts of note

                Dr. Discount on NR          (PV of Note @ market rate * market rate)

                Cr. Interest Revenue      (PV of Note @ market rate * market rate)

 

And the acquiring and interest revenue for Interest-Bearing Notes are accountingly recorded at premium amortization if the stated interest is higher than market rate or at discount amortization if the stated interest is lower than market rate.

a) Face value of Note

b) Present Value of principle @ market rate

c) Present Value of interest (Face Value * Stated Interest) @ market Value

d) Present Value of Note (b+c)

e) If a>d is at discount, but if a<b, it will be at premium.

The “Discount on Notes Receivables” account is a credit account in nature, but “Premium on Notes Receivables” account is a debit account in nature.

Interest revenue should include the amortized discount/premium but interest receivable should not.

Dispositions of Accounts & Notes Receivables

In normal course of business, companies collect accounts and notes receivable when due and then remove them from the books. However, the growing size and significance of credit sales and receivables has lead to accelerate the receipt of cash from receivables, the owner may transfer accounts or notes receivables to another company for cash. The transfer of receivables to a third party for cash happens in one of two ways:

1.       Secured borrowings

A company often uses receivables as collateral in a borrowing transaction. In fact, a creditor often requires that the debtor designate (assign) or pledge receivables as security for the loan. If the loan is not paid when due, the creditor can convert the collateral to cash – that is, to collect the receivables. The following accounting entries of transferor’s and transfee’s ledger will be as follow

 

Company

Bank

Transfer of accounts receivables and issuance of note

Dr. Cash

     Finance Charge

Cr. Notes Payables

(Face value – finance charges)

 

(Charges and fees)

(Face value)

Dr. Notes Receivables

     Finance Revenue

Cr. Cash

(Face value)

(Charges and fees)

 

(Face value – finance charges)

Collection from accounts receivables within cash discount period and returns

Dr. Cash

      Cash Discount

      Sales Returns

Cr. Accounts Receivable

 

 

 

No entry

 

Remitted collections plus accrued interest to the bank

Dr. Interest Expense

      Notes Payable

Cr. Cash

 

Dr. Cash

Cr. Interest Revenue

      Notes Receivables

 

Collection from receivables and bad debts

Dr. Cash

      Bad debts

Cr. Accounts Receivable

 

 

No entry

 

Remitted the balance due plus interest

Dr. Interest expense

      Notes Payables

Cr. Cash

 

Dr. Cash

       Interest Revenue

Cr. Notes Receivables

 

  

1.       Sales of receivables

A common type is a sale to factor. Factors are finance companies or banks that buy receivables from businesses for a fee and then collect the remittances directly from the customers. In either factoring or a securitization (securitization takes a pool of assets such as credit card receivables. Mortgage receivables, or car loan and sells shares in these pools of interest and principal payments) transaction, a company sells receivables on either a without recourse or with recourse basis. There are three criteria must be met before control is deemed to be surrendered

1- Transferred assets are beyond the reach of transferor and its creditors,

2- Transferee has obtained the right to pledge or exchange the assets or interests

3- Transferor does not maintain effective control through (If this point is achieved, the sale is without Recourse. If not, the sale is with recourse)

a) An agreement to repurchase or redeem the assets prior to maturity,

b) Ability unilaterally to benefit from causing the holder to return specific assets, or

c) Agreement making it probable that the transferee will require repurchase

If the above three conditions are met, a sale occurs. Otherwise, transferor should consider the transactions as secured borrowing. And the transferor should (1) derecognize assets when control has been relinquished, (2) recognize assets controlled and liabilities incurred, (3) derecognize liabilities when they have been extinguished, and (4) recognize gain or loss in earnings and initially measure at fair value any assets obtained and liabilities incurred.

a)      Sale without Recourse

When buying receivables without recourse, the purchaser assumes the risk of collectability and absorbs any credit losses. Factors and Company should creating reserve account for any probable cash discount, sales returns, bad debts that is adjusted by actual events when they are incurred. In nonrecourse transactions, the accounting entries will be as follow:

 

Company

Commercial Factors

Dr. Cash

      Due from Factor

      Loss on Sales of AR

Cr. Accounts/Notes Rec

Supplementary amount

 

(Reserves for any probable loss)

Finance Charges

Face Value

Dr. Accounts/Notes Rec

Cr. Due from Factor

      Loss on Sales of AR

      Cash

Face Value

 

(Reserves for any probable loss)

Finance Charges

Supplementary amount

  

a)      Sale with Recourse

It is continuing control involvement that qualifies as participating interest. In other words, for receivables sold with recourse, the seller guarantees payment to the purchaser to the event they debtor fails to pay, the seller has a continuing involvement with the receivable. For calculating the net proceeds and for accounting entries, please see below:

 

Description

Partial Amount

Full Amount

Cash Received

 

 

Add: Due from factor

 

 

Less: Recourse Obligation

 

 

Net Proceeds

 

 

 

Description

Full Amount

Carrying (book) Value of Receivables

 

Less: Net Proceeds

 

Loss on sale of receivables

 

 

Company

Commercial Factors

Dr. Cash

      Due from Factor

      Loss on Sales of AR

Cr. Accounts/Notes Rec

      Recourse Liability

Cash Received

 

(Reserves for any probable loss)

Finance Charges

Face Value

 

Fair Value

Dr. Accounts/Notes Rec

Cr. Due from Factor

      Loss on Sales of AR

      Cash

Face Value

 

(Reserves for any probable loss)

Finance Charges + recourse Liabli

Supplementary amount

 When transferred accounts receivable are collected, the cash should be remitted to the transferee. The accounts receivables transferred should be decreased by the amount collected and note should be decreased by amount remitted minus interest

If there is an legal suit in the court between the company and a customer, if the case is won for the Company, company should back charge all its legal costs to customer’s account, but if the case was lost against the Company, the all those costs will be expenses.

 Prepaid expenses:

 Some expenses are paid in advances however they have not been incurred yet such as some rent and Telecom expenses, for the accounting entries, please see the below entries:

Dr. Prepaid expenses

Cr. Cash

To record the expenses are paid in advance.

Dr. Expenses

Cr. Prepaid expenses

To record the amortization of prepaid expenses over period of time.