Notes

Net Sales is the top line of the Income Statement. Coordinating Sales and cash collections from customers also involves managing bad debts, which affect selling, general, and administrative expenses on the Income Statement and cash and accounts receivable on the Balance Sheet. Net Sales, accounts receivable, and cash are what we are focusing on.

The First Issue faced by firms is "When a revenue should be recorded?" According to the Revenue Recognition Principle, revenues should be recorded when they are earned namely when the delivery of goods has occurred and services have been delivered. The point at which title (ownership) changes hands is determined by the shipping terms in the sales contract. When goods are shipped FOB (Free On Board) Shipping Point, title changes hands at shipment, and the buyer normally pays for shipping. When they are shipped FOB Destination, title changes hands on delivery, and the seller normally pays for shipping. Revenues from goods shipped FOB Shipping Point are normally recognised at shipment. Revenues from goods at FOB Destination are normally recognised at delivery.

• Kellogg's recognises sales upon delivery of its products to customers, that is, Kellogg's will recognise revenues when products are delivered. If you keep reading the footnote, Kellogg's says that: "Revenue, which includes shipping and handling charges billed to the customer". Hence, Kellogg's follows a FOB Shipping Point model where the buyer is the one paying for the shipping.
• Apple considers the iPhone as delivered when the software updates had been provided to the end user. Yet, the updates occur two years after the selling. Hence, when iPhones are sold, Apple will not recognise the full amount of revenues in one accounting period as part of that revenue (namely the part related to the software updates) will be earnt in subsequent period. In this way, Apple does not immediately recognise the full amount of revenues in the income statement, even though it had collected the money. They justify their choice saying that such practice ensure that revenue wasn't counted ahead of delivering a full product. Thus, we observe a large amount of deferred revenues in the balance sheet. The same practice is maintained for Apple TV, iPad and Mac. Moreover, Apple's deferred revenues also include high margin sales of support contracts such as AppleCare (as they are sold upfront and recognised as income over time as they expire) as well as gift cards for iTunes and App Store. It is important to notice that other peers did not use a similar practice. Above all Apple's deferred revenues is far greater than the recently released quarterly earnings of Microsoft, Samsung or Google.

The Second Issue faced by firms is "For which amount should I record the revenues?" Some sales practices differ depending on whether sales are made to businesses or consumers. There is a variety of methods to motivate both groups of customers to buy its products and make payments for their purchases.

Kellogg's states that: " Revenue is reported net of applicable provisions for discounts, returns, allowances, and various government withholding taxes".

Hence, the gross amount of revenue is reduced in case of:

• Sales Discount, if the customer pays in advance, Kellogg's can offer a cash discount. Such discounts are offered to encourage prompt payments. This is a benefit because immediate cash payment improves firms' liquidity and reduces the risk that the customer will not pay later.
• Sales Return and Allowances, reduction of sales revenues for returns of or allowances for unsatisfactory goods. Retailers and consumers have a right to return unsatisfactory or damaged merchandise and receive a refund or an adjustment to their bill. Such returns are often accumulated in a separate account called Sales Returns and Allowances and must be deducted from gross sales revenue in determining net sales.
• Credit Card Discounts, fee charged by the credit card company for its services. Firms may decide to accept credit cards for a variety of reasons:
  • Increasing customer traffic
  • Avoiding the costs of providing credit directly to consumers, including record keeping and bad debts
  • Lowering losses due to bad checks
  • Avoiding losses from fraudulent credit card sales
  • Receiving money faster

Some companies decide to report credit card discounts as part of spellings, general, and administrative expenses.

Credit card discounts, sales discounts, sales returns and allowances are accounted for separately to allow managers to monitor the costs of credit card use, sales discount and returns.

Classifying Receivables Receivables may be classified in three common ways. First, they may be classified as either an account receivable or a note receivable. An account receivable is created by a credit sale on open account. A note receivable is a promise in writing (a formal document) to pay a specified amount of money, called the principal, at a definite future date known as the maturity date and a specified amount of interest at one or more future dates. The interest is the amount charged for use of the principal. Second, receivables may be classified as trade or nontrade receivables. A trade receivable is created in the normal course of business when a sale of merchandise or services on credit occurs. A nontrade receivable arises from transactions other than the normal sale of merchandise or services. Third, in a classified balance sheet, receivables also are classified as either current or noncurrent (short term or long term), depending on when the cash is expected to be collected.

Accounting for Bad Debts When a company extends credit to its commercial customers, it knows that some of these customers will not pay their debts. The expense recognition principle requires recording of bad debts expense in the same accounting period in which the related sales are made. The company resolves this problem by using the allowance method to measure bad debt expense. The allowance method is based on estimates of the expected amount of bad debts.

Bad debt expense is the expense associated with estimated uncollectible accounts receivable. An adjusting journal entry at the end of the accounting period records the bad debt estimate. The credit is made to a contra-asset called Allowance for Doubtful Accounts. As a contra-asset, the balance in Allowance for doubtful accounts is always subtracted from the balance of the asset accounts receivable.

Throughout the year, when it is determined that a customer will not pay its debts, the write-off of that individual bad debt is recorded through a journal entry. Notice that this journal entry did not affect any income statement accounts. It did not record a bad debt expense because the estimated expense was recorded with an adjusting entry in the period of sale. Also, the entry did not change the net book value of accounts receivable since the decrease in the asset account (Accounts Receivable) was offset by the decrease in the contra-asset account (Allowances for Doubtful Accounts). Thus, it also did not affect total assets.

Accounts Receivable (Gross) includes the total accounts receivable, both collectible and uncollectible. The balance in the Allowance for Doubtful Accounts is the portion of the accounts receivable balance the company estimates to be uncollectible. Accounts Receivable (Net) reported on the balance sheet is the portion of the accounts the company expects to collect (or its estimated net realizable value).

When receivables are material, companies must employ the allowance method to account for uncollectibles. These are the steps in the process:

• The end-of-period adjusting entry to record the estimate of bad debt expense and increase the allowance for doubtful accounts.
• Writing off specific accounts determined to be uncollectible during the period to eliminate the specific uncollectible account receivable and decrease the allowance for doubtful accounts.

The adjusting entry reduces net income as well as net accounts receivable. The write-off affects neither.

Estimating Bad Debts The bad debt expense amount recorded in the end-of-period adjusting entry often is estimated based on either:

• Percentage of Credit Sales Method, bases bad debt expense on the historical percentage of credit sales that result in bad debts. The average percentage of credit sales that result in bad debts can be computed by dividing total bad debt losses by total credit sales.
• Aging of Accounts Receivable, relies on the fact that, as accounts receivable become older and more overdue, it is less likely that they will be collected. Based on prior experience, management would then estimate the probable bad debt loss rates for each category, for example, not yet due, 2%; 1 to 90 days past due, 10%; over 90 days, 30%.

In order to determine the bad debt expense to be reported in the income statement, we take the difference between the value of the allowance for doubtful accounts at the end of the period (4,050$) and value of allowance for doubtful accounts at the beginning of the period (3,600$). The difference is 450$ and represents the bad debt expense to be recorded.