Week 5 Account Receivable Flashcards
Operating Cycle
Almost all companies have an identifiable cycle of activities that reflect the ongoing operations of the business. This repetitive cycle of events is commonly referred to as Operating Cycle
Example: Retail companies buy inventory > sell inventory > receive payment
Operating Cycle
Walmart vs Ford
Walmart customers pay in debit or cash so sales are recognized right away as they do not extend credit to customers.
Ford will extend credit to customers through its financing subsidiary and recognizes sales when payment is received.
Revenue
Refers to the inflow of assets (such as cash, accounts receivable, or bartered asset)
Since revenue recognition increases shareholders wealth, it is also considered to be a primary driver of company share price and a key driver of company value.
Recognized
Revenue could be reported on the income statement as having been earned at the point in time at which a company provides goods or services
Revenue Recognition Guidance: ASC 606
1) There has been a transfer of goods or services to customers
2) That the company is entitled to consideration from the customer in exchange for those goods or services
Revenue Recognition Guidance: ASC 606
5 Step Model
1) Identify the contract with a customer
2) Identify the separate performance obligations in the contract
3) Determine the transaction price
4) Allocate the transaction price (if necessary)
5) Recognize revenue when (or as) the entity satisfies a performance obligation
Revenue Recognition by Retail and service companies
Point of sale or completion of service - Customers pay with cash, debit card or check
Point of cash collection - When account payment is not reasonably assured, companies instead recognize revenue at the point of cash collection
Installment Method
(Point of cash collection) Revenue is recognized only to the extent of any cash received.
Under the installment method, the company will recognize only the initial down payment as revenue and record cost of goods sold for the percent paid up front.
Accounts Receivable
refers to short term (usually 30, 60 or 90 days in duration) credit arrangements that are typically interest free
Notes Receivable
refer to credit that is longer term for large amounts and consequently, is likely to involve interest charges
Opportunity Cost
Charging interest on a notes receivable
Revenue Recognition over time
That is, revenue is recognized in proportion to the completion each fiscal period
unbilled account receivable
an internal billing for revenue, which, for contractual reasons, is not yet sent to a customer for payment, but for all practical purposes is an amount owed by the customer
Deferred Revenue
Revenue whose recognition on the income statement has been deferred to the future until other criteria have been met
Rear-end loading
Rear-end loading of revenues (deferral of the income statement recognition of certain revenues until a later fiscal period) reduces the total level of revenues currently recognized, and thus reduces currently reported operating income
Earnings Reserve
Enabling the firm to manage its reported earnings and consistently meet or exceed wall streets earnings expectations
Recognizing revenue at a point in time
Recognizes all the gross profit in the year of completion
Net realizable value
An amount that reflects the expected net collectability of the total accounts receivable balance.
The account reflects the expectation of receiving cash at a later date for a sale made at an earlier date.
Percentage of credit sales method
A company estimates its expected future credit losses as a function of the relationship between its historical credit losses and its historical credit sales.
Allowance for uncollectible accounts
A contra-account on the balance sheet to reflect the amount of the outstanding receivables that are not expected to be collected
Aging Method
The focus is on the balance sheet and specifically how much is owed to the company as of the balance sheet date.
A company first categorizes its outstanding accounts receivable according to how much time has elapsed since the credit sale took place.
Write-off of uncollectible accounts
Executed by reducing accounts receivable and adjusting the the allowance for uncollectible accounts for an equivalent amount
Sales Discounts
Duration
To maximize the return on a company’s investment un accounts receivable, and thus, the firms overall profitability, it is important to keep the duration of interest free loans as short as possible.
Sales Discounts
Credit Terms / Trade Terms
2/10, n/30
The term “2/10’ indicates that if a customer pays their bull within ten days of purchase, they will be given a 2% reduction in the gross purchase price. Term n/30 (net 30) indicates that if the customer fails to take advantage of the the quick payment, the full purchase price is expected within 30 days of the sales transaction
Sales Discount
Is reported on the income statement as a deduction from gross revenue. This is a contra-revenue account.
Receivable Collection Period
365 Days / Net Sales/Account receivable
Sales Returns
Customer returns are typically estimated on the basis of recent historical experiences. Sales returns can be a serious problem in some companies. The most effective way to manage this problem is through a program of continuous quality control of manufacturing processes to ensure the production of high-quality goods
Factoring
The process of selling accounts and notes receivables. Factors convert a company’s receivables into cash at their face value less a service charge and a charge for the time value of money
Receivables that are sold with recourse
Means that if a factor is unable to collect on a particular account or not receivable, the factor has the right to return the uncollectable receivable to the seller and recover its money directly from the seller.
Receivables that are sold without recourse
The factor assumes all risk of collection and thus will charge a considerably higher fee (such as 12 to 15%) to compensate for the potential loss associated with any uncollectable receivable.
Pledging
A common form of financing for most companies because it is a lower-cost option than factoring. Company uses its receivables as collateral to obtain bank financing
Special purpose entities or special purpose vheicals
To sell receivables to a private legal entity created by a company for the exclusive purpose of buying its receivables.
Securitization
In essence, an SPE or SPV acts like a company-owned factor. The SPE borrows money from investors to form a financial services company and then uses the borrowed funds to buy accounts and notes receivable from its parent company.
The advantage over pledging is that the parent company does not increase its leverage.
Front end loading
Recognizing revenue prematurely.
