Recap. Lecture 6. Recap. Jiri Novak, IES UK 1. Accounts Receivable. 6.1 Accounts Receivable

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1 Lecture 6 Jiri Novak IES, UK 2 Recap Inventories items held for sale (merchandise) or used in manufacturing (raw materials, work in progress, finished goods) specific identification method impractical, used rather infrequently (e.g. old cars, antiques) cost flow assumption determines how the costs of goods available for sale is distributed between the ending inventory and COGS FIFO(first in first out), LIFO(last in first out), AC(average cost) Recap Bias in Financial Statements FIFO uses old prices for determining COGS, i.e. it overstates gross margin, and produces a good estimate of inventory value on BS LIFO uses recent prices for determining dt ii COGS, i.e. it produces a good gross profit estimate in IS, understates the inventory value on BS leading to LIFO reserve (LFR = Iv F Iv M ) and LIFO effect 6.1 gross profit (IS) inventory (BS) FIFO overstated OK LIFO OK understated 3 Balance Sheet notes payable cash current maturities of l t debt marketable securities accounts payable accounts receivable accrued liabilities inventories unearned revenue prepaid expenses long term debt deferred taxes property, plant & equipment contributed capital intangible assets retained earnings Credit most sales are not done for cash but on credit ( on account ), i.e. the customer pays later credit terms: 2/10, net 30 customer must pay in 30 days, gets 2% discount if pays in 10 days Balance Sheet accounts receivable 700 cash 700 Income Statement sales 5 6 Jiri Novak, IES UK 1

2 Net Realizable Value accounts receivable (AR) represent the amount of cash the company expects to collect for its sales, i.e. they must be recorded net of the estimate of sales that will be adjusted for: bad debt customers may sometimes fail to pay for the goods and services they purchased (low priority, no collateral) sales returns and allowances customers may sometimes cancel their purchase or return the goods due to the product guarantee provided Direct Write Off Method when some receivable is identified as uncollectible AR are reduced (Cr) and the corresponding bad debt expense (Dr) is recognized allowance for uncollectible accounts (AUA) is set up and a related expense recorded already at revenue recognition when receivables are identified as uncollectible AR are reduced (Cr) against AUA (Dr) 10 Direct Write Off receivables are recorded at the full amount if some debts are identified as uncollectible, accounts receivable (As) are written off against bad debt expense (Ex) account receivable that was previously writtenoff is ready to be collected after all Bad Debt Expense allowance for uncollectible accounts (AUA) is regularly created at sale as individual AR are identified as uncollectible they are eliminated against AUA AUA 720 Bad Debt Expense 12 account receivable that was previously writtenoff is ready to be collected after all accounts receivable are collected for cash AUA 720 Cash Bad Debt Expense Jiri Novak, IES UK 2

3 Comparison allowance method uses a subjective estimate of expected bad debts to recognize the expected expense immediately at revenue recognition expense matching (relevance) verifiable (reliability) direct write off allowance Use financial accounting if bad debts can be reasonably estimated, allowance method required due to its relevance (expense matching) tax accounting direct write off required because it is more reliable (does not depend on subjective estimates), which limits manipulation... general tendency to accentuate reliability more in tax accounting than in financial accounting tax financial Incentive Compatibility financial accounting ( dating game ) managers tend to report high earnings, the allowance requirement prevents them from artificially i boosting net income tax accounting ( begging game ) managers tend to report low taxable income, direct write off requirement prevents them from using excessive allowance to artificially depress taxable income Income Statement Approach certain percentage of credit sales estimated by management based on past experience with collections, customer quality, state of economy, etc. drawback is if the company is consistently better (worse) in collecting its receivables than expected AUA will be excessive (insufficient) Balance Sheet Approach desired ending level of AUA is first determined and the allowance is incremented so that this level of AUA is reached single percentage applied to the entire AR aging of accounts different percentages for different classes of accounts depending on how much overdue they are, e.g. 1% for <30 days, 3% for 30 days, 10% for > days specific analysis of individual accounts expected < realized bad debts additional uncollectible AR (As) debts are written off against bad debt expense (Ex) as in the direct write off method expected > realized bad debts remaining reserve can be considered in determining the level of bad debt allowance for future periods (balance sheet approach) Jiri Novak, IES UK 3

4 Label allowance for uncollectible accounts, or allowance for doubtful accounts, or allowance for bad debts Disclosure on BS receivables are typically disclosed net of allowances for doubtful accounts (see Cisco) detailed disclosure is often included in footnotes Returns 6.2 Returns & Allowances Occurrence customers can cancel their purchase or request a price concession in case the delivered goods are damaged or do not meet the pre contracted parameters this is essentially a reduction in previously contacted sales and that is also how it is treated 22 Returns Returns Treatment sales returns and allowances (SRA) is a contrarevenue account offsetting sales (that is why we refer to net sales ) the treatment to bad debts, but for the fact that the returned goods increase inventory and thereby decrease COGS AR or cash are credited (reduction in cash or receivables), SRA is debited (reduction in sales) Iv are debited (goods returned), COGS are credited (reduction in matching costs) Transaction Analysis merchandise purchased for 720 sold to a customer for (no sales returns expected) one quarter of the goods is returned because it has been shipped to a wrong customer 200 Inventories COGS SRA Jiri Novak, IES UK 4

5 Returns Questions Allowance for Returns and Allowances at the time of sale estimated SRA is recorded and an contra asset allowance for sales returns and allowances (ASRA) is created when goods are returned AR are eliminated against ASRA (i.e. no IS effect) Direct Write Off vs. Allowance The treatment of bad debts differs in financial accounting and tax accounting. Discuss at least two reasons why the two accounting types require different treatment. Assets 30 Liabilities, Equity ASRA SRA Questions Question of Perspective 27 Analysis of bad debt expense can give valuable insights into the economic situation of the firm. Would you expect managers to have a tendency to report too high or too low allowances for bad debts? How would you measure whether firm estimates of its receivables correctly? What conclusions can you make if you observe AR increase faster than sales? What if a firm has higher AR/NS than its industry peers? Extra Appropriateness of Bad Debt Expense bad debt expenset 1 appropriateness net write offst bad debt expense p represents p an estimate of future net write offs from current credit sales the ratio measures how realistic these estimates were, from which one can draw conclusions about the adequacy of current bad debt allowance 30 Jiri Novak, IES UK 5

6 Turnover net sales ARTO AR days y in accounts receivable = 365 / ART measures the average number of days it takes to collect receivables values higher than industry average indicate poor working capital management an increase over time may indicate problems with collecting receivables (as a consequence of selling to less solvent customers), or perhaps overstatement of revenues ( channel stuffing ) Inventory Turnover ITO = Iv t 1 /Sl t Iv t, t 1 /COGS t better to use COGS because sales include gross margin that is unrelated to holding inventories Receivables Turnover ARTO = AR t 1 /Sl t AR t, t 1 /crsl t use credit sales, as cash sales do not generate AR Payables Turnover APTO = AP t 1 /Sl t AP t, t 1 /purchases t use inventory purchases directly related to AP Consistency when comparing AR with sales, one should exclude all receivables not related to sales (information may be provided in the footnotes) sales should exclude non operating revenues (e.g. interest revenue) or gains (e.g. on sale of PP&E) Seasonality the level of AR at the end of the year may be smaller than the average balance during the year to mitigate this distortion calculate the average AR during the year using quarterly data 34 Operating Cycle OC = Iv days + AR days measures the time from the purchase of inventory to the ultimate collection of the receivables generated from the sales Cash to Cash Cycle CCC = Iv days + AR days AP days 0 raw material purchased 30 AP paid 120 goods sold CCC 1 AR collected Jiri Novak, IES UK 6