SECTION X. ACCOUNTING FOR SALES REVENUE AND ACCOUNTS RECEIVABLE

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1 SECTION X. ACCOUNTING FOR SALES REVENUE AND ACCOUNTS RECEIVABLE A. IAS 18 AND OTHER ACCOUNTING ISSUES IAS 18 Revenue addresses the accounting treatment of revenue arising from ordinary activities. Revenue is defined as gross inflow of economic benefits arising from ordinary activities of the enterprise when those inflows result in increases in equity, except for increases in equity due to contributions from equity participants. Amounts collected on behalf of third parties (e.g. sales taxes and VAT) are not economic benefits flowing to the enterprise and are not considered revenue. Key issues in accounting for revenue are: How to measure revenue recognized and When to recognize revenue the primary issue relating to revenue. Measurement Revenue should be recognized at the fair value of the consideration received or receivable. When goods or services are exchanged for goods and services of a similar nature and value the exchange is not considered as one that generates revenue. When goods or services are exchanged for dissimilar goods or services, the exchange is recognized as one that generates revenue. The amount of revenue is the fair value of the goods or services received adjusted for any cash or cash equivalents transferred in the exchange. Timing Sale of goods Revenue is recognized when all of the following conditions have been met: Transfer to the buyer of the significant risks and rewards of ownership; Enterprise no longer has management involvement or effective control of the goods; The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the sale will flow to the enterprise; The costs incurred (or to be incurred) relating to the sale can be measured reliably. Sale of services Revenue is recognized when all of the following conditions have been met: The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the sale will flow to the enterprise; The stage of completion of the transaction can be measured reliably; The costs incurred (or to be incurred) relating to the sale can be measured reliably. Revenue may also arise from the use by others of assets of the enterprise yielding interest, royalties or dividends. Revenue should be recognized on the following bases: Interest on a time proportional basis. 111

2 Royalties on an accrual basis in accordance with the relevant agreement. Dividends when the shareholder s right to receive payment is established. Disclosure The enterprise should disclose: The accounting policies adopted for recognition of revenue. The amount of each significant category of revenue (i.e. goods, services, interest, royalties and dividends). The amount of revenue arising from exchanges of goods or services in each category. Contingent liabilities and contingent assets (IAS 37). These would arise from warranty costs, claims, penalties or possible losses. An appendix is attached to IAS 18 that describes a number of situations and illustrates how the standard should be applied. IAS 18 does not apply to revenue arising from leases (IAS 17), dividends from investments in associates accounted for under the equity method (IAS 28), insurance contracts of insurance enterprises, changes in the fair value of financial assets and liabilities (IAS 39), changes in the value of other current assets, certain transactions relating to agricultural activity (IAS 41) and extraction of mineral ores. OTHER ACCOUNTING ISSUES RELATING TO REVENUE AND SALES: Expenses In accordance with the matching principle, costs and expenses incurred in earning revenue are recognized in the same period as the revenue earned. The expenses may be direct expenses (e.g. cost of goods sold); period expenses (e.g. administrative salaries); or allocated expenses (e.g. depreciation). Bad Debt Expense Credit sales and Accounts Receivable from customers is, for many enterprises, a significant part of their business and a material part of revenue and current assets. When customers purchase on account, the probability that they will pay the amount they owe is less than 100%, because for a variety of reasons some customers do not pay. If the sale is recorded at face value both Revenue and Assets are overstated. Therefore, both IAS and Mongolian Guidelines require recognition of the amount of the sales and receivables that will not be collected. This is accomplished by the use of a contra asset account Allowance for Doubtful Accounts. It is a violation of the Matching Principle to simply write off Accounts Receivable when they finally prove to be uncollectible (Direct Method). Using this method, in most cases the sale (revenue) would be recorded in one period and later in another period after all attempts to collect had been exhausted, the bad debt expense would be recognized. Revenue and expense would not be matched. To avoid this, the Allowance Method is required whereby an estimate of uncollectibles is recorded in bad debt expense and in the Allowance for Doubtful Accounts. This action does not affect the individual customer accounts in the Accounts Receivable subsidiary ledger. The Allowance is a contra account to Accounts Receivable. It appears on the Balance Sheet as a credit amount reducing Accounts Receivable. The effect is to match the expense to the period of the sale and to avoid overstatement of the asset Accounts Receivable. 112

3 There are two ways to estimate bad debt expense for the allowance method. The enterprise can choose which method to use but once the method has been chosen it should be applied consistently. One way is based on a percentage of total credit sales (emphasizes matching); the other way is based on a percentage of the accounts receivable balance (emphasizes net realizable value of the asset). Both are acceptable for IAS and Mongolian accounting (Methodology for Financial Statement Preparation Part 2 Balance Sheet paragraph 10.) Example: If annual credit sales are Tog 150,000,000 and the company history indicates that approximately 2 % of these sales will not be collectible, then bad debt expense for the year would be estimated at 3,000,000. The entry would be: Dr Bad Debt Expense 3,000,000 Cr Allowance for Doubtful Accounts 3,000,000 If the balance of Accounts Receivable is 35,000,000 and the balance in the Allowance account was 0 before estimating the bad debt expense then the Balance Sheet would show: Accounts Receivable 35,000,000 Less Allowance for Doubtful Accounts (3,000,000) Net Accounts Receivable 32,000,000 To use the percentage of Accounts Receivable approach, receivables are usually analyzed by age (e.g. current, overdue < 30 days, days, days, etc.) and a percentage based on past collection experience applied to arrive at an estimate of the uncollectible portion of the balance in Accounts Receivable. This amount is compared to the current balance in the Allowance for Doubtful Accounts and the necessary entry is made to adjust the Allowance to the calculated amount. Example: The Accounts Receivable balance at 31 December is 2,500,000 and Allowance for Doubtful Accounts has a credit balance of 15,000. Analysis of an aging schedule indicates that 4% of the receivables are likely to be uncollectible. 4% of 2,500,000 = 100,000. The balance in the Allowance at year end should be 100,000. The entry would be: Dr Bad Debt Expense 85,000 Cr Allowance for Doubtful Accounts 85,000 The Balance Sheet would show: Accounts Receivable 2,500,000 Less Allowance for Doubtful Accounts (100,000) Net Accounts Receivable 2,400,000 Using either method for estimating bad debt expense and the allowance to be shown on the Balance Sheet, the accounting entries for writing off uncollectible accounts is the same. The Allowance is provided because the exact identity of the individual accounts that will be uncollectible is not known at the time the estimate is made. When an account is proven to be uncollectible, the following entry is made to write it off. Dr Allowance for Doubtful Accounts XXX Cr Accounts Receivable (customer M) XXX Suppose that miraculously Customer M pays after all. The entries would be: To reinstate the Receivable: Dr Accounts Receivable (customer M) XXX Cr Allowance for Doubtful Accounts XXX 113

4 And to record the cash receipt: Dr Cash XXX Cr Accounts Receivable (customer M) XXX See Mongolian Guidelines for entries. Bad Debt Expense Exercise 1 Cyber Software Co. estimates its uncollectible amount based on an analysis of Accounts Receivable. On 31 December the following aging schedule for the company s Tog 2,400,000 outstanding receivables was prepared: Estimated uncollectible Days Amount % Amount Current not due 1,000,000 2 % 20, days past due 600,000 4 % 24, days past due 300, % 30, days past 100, % 40,000 due 121 or more days 400, % 360,000 2,400, ,000 The Allowance for Doubtful Accounts presently has a 200,000 credit balance. 1. What entry should be made to record the estimate of uncollectible accounts? 2. Prepare the entry to write off the following accounts: i. Customer M 6,000 Togrogs ii. Customer K 15,000 Togrogs 3. Prepare the entries to record the subsequent receipt of 10,000 from Customer K. He is not expected to pay more. 4. What circumstances would cause the Allowance for Doubtful Accounts to have a debit balance prior to adjustment? 114

5 Bad Debt Expense Exercise 2 Smart Copy Printing Company estimates its uncollectible accounts based on the percentage of its credit sales. In 2002, Smart Copy had sales of Tog 180,000, % of these were credit sales. Past experience shows that 3% of credit sales are not collectible. The Allowance for Doubtful Accounts has a credit balance of Tog 80, What entry should be made to record the estimate of uncollectible accounts? 2. What consideration is given to the balance in Allowance for Doubtful Accounts? How is this different from the entry made when using the Percentage of Accounts Receivable for estimating uncollectible accounts? 115

6 SOLUTION Bad Debt Expense Exercise 1 1a. What entry should be made to record the estimate of uncollectible accounts? Dr Bad Debt Expense 274,000 Cr Allowance for Doubtful Accounts 274,000 Desired balance is 474,000 credit Adjustment required is 274,000. 1b. Prepare the entry to write off the following accounts: i. Customer M 6,000 Togrogs ii. Customer K 15,000 Togrogs Dr Allowance for Doubtful Accounts 21,000 Cr Accounts Receivable Customer M 6,000 Cr Accounts Receivable Customer K 15,000 1c. Prepare the entries to record the subsequent receipt of 10,000 from Customer K. He is not expected to pay more. Dr Accounts Receivable Customer K 10,000 Cr Allowance for Doubtful Accounts 10,000 And Dr Cash 10,000 Cr Accounts Receivable Customer K 10,000 1d. What circumstances would cause the Allowance for Doubtful Accounts to have a debit balance prior to adjustment? This will happen when the actual uncollectible accounts that are written off exceed the estimated allowance. Bad Debt Exercise 2 2a. Dr Bad Debt Expense 2,160,000 Cr Allowance for Doubtful Accounts 2,160,000 2b. The estimate based on credit sales estimates bad debts based on credit sales for the period. The percentage of Accounts Receivable estimates the net collectible amount of accounts receivable and adjusts the Allowance accordingly. 116

7 B. METHODOLOGY FOR CONVERTING SALES ACCOUNTING Issues to Review In order to convert the sales accounting system of an entity, accountants must have knowledge of the following subjects: Definition of revenue. Accounting treatments for revenue recognition. Method to account for the Value Added Tax for goods sold as well as the Excise Tax. Accounting entries for cash and credit sales. Accounting method for the sales returns and discounts. The following formula for cost flows of cost of goods sold: Add: Equal: Subtract: Equals to: Beginning balance of finished goods Cost of goods produced (purchased) Cost of goods available for sale Ending balance of finished goods Cost of goods sold Accounting method for recording sales on credit. Accounting method for recording bad debt expense and allowance for bad debt. Accounting method to recognize and record sales on consignment. Accounting for unearned revenue. Please review IAS 11 for recognizing revenue in the construction industry. Accountants should learn about these issues by studying IAS and the guidelines approved by Minister of Finance and Economy. This knowledge will be a prerequisite for converting the sales accounting system of an enterprise that intends to implement IAS. Accounting for receivables is discussed in Part 3 of Chapter 2 of the Accounting Guidelines approved by Resolution No. 116 by Minister of Finance, and accounting for sales revenue is discussed in Part 11 of Chapter 5 of the same Guidelines. Main Problems and Weaknesses in Sales Accounting Problems and Weaknesses Cost of goods sold is not recorded separately and is included in the sales and administrative costs. Even if the cost of goods sold is recorded, it does not meet the cost formula requirement. The VAT on sales is included in the total sales amount rather than recorded separately as a payable. The VAT recorded on the books of the company differs from the amount of VAT Impact on Financial Statements Gross profit and expenses are misstated. The accuracy and fairness of financial statement are impaired. Sales revenue for the period is overstated and VAT tax payable and profit are also misstated. The balance of VAT tax payable is likely to be incorrect and the fairness 117

8 reported to the tax authority. If sales are made on consignment, revenue is recognized when goods are transferred to a sales agent. Unearned revenue is not recorded correctly. and reliability of financial statements are impaired. Because revenue is recognized at a wrong time, sales revenue and profit are reported incorrectly. Revenue is recorded in the wrong period. Suggested Steps for Converting Sales Accounting System It is recommended that the following general steps be followed in order to convert the sales accounting system. We recommend that the following steps be used specifically by those enterprises which have converted their previous financial statements to IAS and are producing new reports: 1. Verify whether sales revenue was invoiced in the correct amount. Verify that sales invoices and other supporting documents are valid for prior periods. 2. Verify whether the sales revenue invoiced is recorded in appropriate accounts; 3. Review the appropriateness of the new main and sub accounts used for sales accounts, which usually include sales revenue, VAT payable, accounts receivable and cash accounts; 4. Review whether or not there are accounts receivable balances at the beginning of the period from sales made in prior periods. Ascertain whether these receivables have been collected during the current account period in order to verify the validity of the receivables and correctness of recording. 5. Review whether the VAT is invoiced and accounted for separately when sales are invoiced. 6. Determine if there is discrepancy between the VAT recorded in the accounts and the VAT tax report. 7. On the basis of the above reviews, the accountant needs to identify major accounting issues and errors requiring special attention during conversion of the sales accounting to comply with the approved guidelines. New accounting policies and methods for sales are defined in order to meet IAS requirements. The old practices that resulted in accounting errors should be eliminated. 8. The sales for the current accounting period are recognized in compliance with IAS and correctly reflected in the related journals and ledgers. If sales are made in cash, the sales revenue is reflected in the Cash Receipts Journal. If sales are made on credit, the revenue is recorded in the Sales Journal. Attention should be paid to dividing the total amount invoiced (in case of sales on credit) or the total amount received (in case of cash sales) into sales revenue and VAT payable (VAT applicable to sales). 9. Journal entries for sales revenue are recorded in the General Ledger at the end of an accounting period. Specific considerations: Some entities may not have invoiced any VAT on sales when sales were made, or VAT was recorded incorrectly even if it was invoiced. Possible reasons for that may be lack of awareness of the requirements of the tax laws and proper accounting methods for recording VAT. For such enterprises, a major part of the sales accounting conversion will be accounting and reporting 118

9 sales revenue and VAT payables based on correct accounting methods and treatments. This action will result in eliminating errors and discrepancies between the company s books and the VAT reports. Result of Conversion of the Sales Accounting System The entity should achieve the following results from converting the sales accounting system: Sales revenue is recognized in the correct amount and correct accounting period; Cost of goods sold is appropriately stated and accounted for; VAT on sales is invoiced according to the stated rules and is appropriately accounted for; VAT on sales as recorded agrees with the VAT tax reported to the tax authorities. The validity of the VAT payable balance is confirmed by the VAT report approved by tax authorities. Accounts receivable are recorded in detail with regard to sales on credit; reconciliation of receivables is made; and bad debt expense is accounted for in accordance with a selected method. 119

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