revenue and customers-related balance sheet concepts · risks and risk sharing 4 ... (receivables,...

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© 1991–2013 NavAcc LLC, G. Peter & Carolyn R. Wilson

Revenue and Customer-Related Balance Sheet Concepts

Revenue and CustomeRs-Related BalanCe sheet ConCepts

TABLE OF CONTENTS

Framing the Issues 3

Revenue Recognition Criteria 3

Risks and Risk Sharing 4

Credit Risk 4

Customer Preference Risk and Demand Risk 7

Accounting Implication of Risks 10

Deferred Revenue 13

Receivables 16

Discounts for Early Payments 16

Interest Income 17

Writing off Bad Debts 18

Example 18

Recovering Write-offs 22

Replenishing the Allowance 22

Example 23

Analyzing Bad Debts 27

Searching for Bad Debt Information 27

Interpreting Disclosed Numbers 28

Measuring and Calibrating Credit Risk 30

Warranties 32

Standard Warranties 33

Example 34

Extended Warranties 37

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Navigating Accounting ®

Product Returns 38

Introduction 38

What Do I See? 38

What Happens When Products are Returned? 39

Allowance for Product Returns 42

Beginning Returns Allowance Balances 43

Using Returns Allowance 45

Replenishing Returns Allowance 45

Balance Sheet Presentation and Entries 46

Allowance Components Reported Separately 46

Allowance Components Netted 50

Financial Statement Effects 51

Allowance By-Passed 53

Allowance not Recognized 54

Outsiders’ Challenge 55

Take-Aways 62

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FRAMING THE ISSUES Here we take a deeper look into revenue recognition, the related risks, and the consequences for accounting. The judgments around revenue recognition are extremely complex. These issues often involve challenging business and accounting decisions and users of financial statements need to understand these when interpreting related disclosures.

Revenue ReCognition CRiteRia Recall from the Income Statement chapter that revenue must be deferred until four criteria are met:

1. Persuasive evidence of an arrangement: Companies can only recognize revenue when there is persuasive evidence the related sales arrangement and documentation follows normal business practice for the industry. In some industries, this means the buyer must have a purchase order approved by the appropriate level of management. In other cases, formal purchase orders are not required to establish a legitimate sale occurred.

2. Delivery has occurred or service has been rendered: Companies can only recognize revenue when products or services have been delivered. In applying this criteria, the SEC generally requires customer acceptance. Additionally, sellers must have sufficient information to reliably estimate product returns and establish related allowances before revenue can be recognized (as discussed later in this chapter).

3. Fixed or determinable sales price: This criteria aims to prevent revenue recognition when the ultimate price of a product or service is unknown or can not be estimated reliably.

4. Collectibility is reasonably assured: This criteria differs from the other three in that it centers on the customer’s performance obligation in a sales arrangement — to pay for the good or service — rather than on the seller’s performance obligations.

These criteria apply to a broad range of sales arrangements; but they do not apply to contexts where revenue recognition is guided by specific GAAP such as banking, leasing, and motion picture productions. In fact, U.S. GAAP has over 160 standards that guide revenue recognition. Moreover, applying the four criteria often requires considerable judgment because the SEC recognizes they can not always be interpreted literally.

For example, retailers often allow customers to return products for a full refund for a specified return period. Thus, strictly speaking, prices are not fixed at sales dates (they may end up being $0 if a customer

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returns products) and thus, customers have not really accepted them. The SEC permits companies to recognize revenue at the sales date in these situations, providing they can reliably estimate returns, which can require considerable judgment, as do many of the revenue recognition criteria.

Risks and Risk shaRingApplying the four revenue recognition criteria or industry-specific revenue recognition GAAP, is often complex. Generally, this complexity is due to provisions in the sales arrangements specifying how sellers and buyers assume risks, share risks, or try to protect themselves from bearing risks.

This section focuses on two risks particularly important to revenue recognition and related balance sheet accounts (receivables, deferred revenues and various allowances discussed later in this chapter): credit risk and customer preference or demand risk.

Credit RiskIn addition to being one of the four criteria for revenue recognition, reasonable assurance of collectibility is a necessary condition for staying in business: a business could quickly find itself in bankruptcy if it failed to collect a big chunk of its receivables.

While few companies are driven to bankruptcy by customers failing to pay their bills, companies with significant receivables can suffer large decreases in profitability even if a relatively small portion of their customers stop paying their bills.

For example, Harley Davidson (HD) reports approximately $5.5 billion of gross receivables on its balance sheet at the end of 2009, which represents nearly 60% of its assets. Some of these receivables are associated with product sales: HD bills independent dealers and distributors outside the US and Canada when it sells them motorcycles. Revenues associated with these sales should only be recognized when HD is reasonably certain it will collect the related receivables and can reliably estimate the amounts that will not be collected — the bad debts.

The biggest portion of HD’s receivables are related to loans or leases. For these receivables, HD should only recognize related interest revenue if it is reasonably assured it will collect the interest and principal on these loans and can reliably estimate the related bad debts.

HD also recognized approximately $180 million of bad debt expense for 2009. We will discuss this type of expense in great detail later in the chapter. For now, all you need to know is bad debt expense tends to increase when customers are less likely to pay their bills.

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• HD’s$180millionbaddebtexpensewasverysignificantrelative to its $196 million of pretax operating income for 2009. To put this in perspective, bad debt expense could have wiped out HD’s pretax income if it had increased by about 3% of HD’s $5.5 billion of ending receivables.

• Thus,anoutsidervaluingHD’sstockoraninsidermanaging its receivables should carefully assess the risk of this occurring, which is called credit risk.

• Additionally,HDmustcarefullyassesscreditriskwhendeciding whether to recognize revenue.

Credit risk refers to the possibility a debtor — usually a customer for a receivable — will not make payments on time, fail to meet covenants, or default on the debt altogether. When these events occur, creditors can usually take one or more legal actions to try and minimize their losses. For example, they can take the debtor to court or seize the collateral, providing the expected benefits from these actions exceed the expected costs. Credit risk depends on two factors that can offset or aggravate each other, depending on the context:

• Collateral risk: the risk the value of the collateral will decline. By definition, this risk pertains to the asset serving as collateral.

• General credit risk: the risk associated with the debtor’s overall capacity to meet an obligation from its combined assets. This risk is less severe for agreements where the creditor has seniority — is paid earlier in the event of bankruptcy.

To understand how these risks can offset or aggravate one another, consider a motorcycle loan from Harley Davidson, which is reported as a financing receivable on HD’s balance sheet. If the value of the motorcycle appreciates dramatically during the loan period, HD’s credit risk is essentially zero, regardless of the debtor-customer’s general credit risk: HD can avoid losses by repossessing the motorcycle, if the customer is foolish enough to default on the loan (rather than sell the motorcycle, pay the loan, and keep the balance).

Similarly, if the value of the motorcycle depreciates completely, HD will not be overly concerned if the customer has low general credit risk with several other valuable assets and few other obligations: HD can threaten to take the customer to court if the customer tries to default on the loan.

Both of these examples illustrate that these two risks can offset each other in some contexts. However, they can also aggravate each other if the value of the debtors’ assets are correlated.

Credit risk is more problematic for some companies than others, depending on the portion of total assets that are receivables or other

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debtor-creditor arrangements such as debt investment securities, the length of these agreements, the nature of the collateral, and the debtors’ financial circumstances.

For companies with large receivables balances, estimating the allowance for bad debts requires considerable judgment and slight changes in the assumptions can have dramatic financial-statement consequences. You will know a company’s estimates for bad debts require significant judgment if this is identified and discussed in the company’s Management Discussion and Analysis (MD&A) sections of their annual reports.

In response to the 2002 accounting scandals, the SEC requires companies to identify and discuss their most critical accounting estimates in their MD&A, where two criteria must be met for an estimate to be deemed critical:

• Theestimaterequiresthecompanytomakeassumptionsaboutissuesthat are highly uncertain at the time when the estimates are made. This criterion directly relates critical accounting estimates to risks.

• Differentestimatesthecompanyreasonablycouldhaveusedforthe current reporting period, or changes in accounting estimates reasonably likely to occur from period to period, have a material impact on the company’s financial statements and disclosures.

Over 30% of the Fortune 100 companies (largest 100 companies measured by sales) and over 50% of Fortune 900-950 companies included bad debt estimation as a critical accounting estimate in their 2004 annual reports.

There are three key lessons here:• Getinthehabitofstudyingthecriticalaccountingestimates

inthemanagementdiscussionandanalysissectionsofannualreports(and10-Ksor20-Fs,whichareexpandedversionsofannualreportsfiledwiththeSEC)toidentifywheretheaccountingmightbesuspectbecauseitrequiresconsiderablejudgment,whichprovidesopportunitiesforhonesterrorsormanipulation.

• Estimatingtheallowanceforbaddebtisfrequentlylistedasacriticalaccountingestimateandtheuncertaintyassociatedwiththeseestimatesdependsdirectlyonthecompany’sexposuretocreditrisk.

• Themoreyouunderstandtheunderlyingcreditrisk,thebetterpreparedyouwillbetoassessthereliabilityoftheallowanceforbaddebtsandbaddebtexpense(discussedlaterinthischapter).

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Companies can take several steps to manage credit risk including:

• Screeningcustomerscarefullybeforeextendingcredit.

• Settingcreditlimits,preventingsalespersonsfromsellingcustomersmore goods and services on account once their outstanding receivables hit pre specified limits.

• Monitoringoutstandingreceivablesandrefusingtoselladditionalproducts to customers who do not pay their current balances in a reasonable amount of time.

• Outsourcingcustomerfinancingtothirdparties,whoassumetherelated credit risk.

• Selling receivables to banks and other financial institutions, which is called factoring.

• Sellingreceivablestospecial purpose entities (SPE) — legal entities created for a single purpose — buying receivables with cash raised by issuing mostly debt securities. The receivables are said to be securitized because the SPE’s investors have debt and equity security claims on only one asset — the SPE’s receivables.

To assess the costs and benefits of taking these actions, insiders and outsiders must understand the accounting issues discussed in this chapter.

Customer Preference Risk and Demand RiskHave you ever found yourself conflicted when trying to decide whether to purchase a big-ticket item such as a television, computer, automobile, or house? On the upside, you are beginning to get emotionally attached to the product, believing it has the potential to make a big difference in the quality of your life. On the downside, you are not sure you can afford it and even if you can, you are not sure it is the best way to spend your money or assume debt. Maybe you can get a better deal on the product elsewhere, find a close substitute from a competitor at a lower price, or find a completely different use for your money that gives you more satisfaction, including investing it because you are concerned about the economy or otherwise want to ensure you can consume more in the future.

Your uncertainty about this product versus other alternatives for the same or less money reflects your preference risk — uncertainty about your preference for a product or service. From the perspective of the person trying to sell you the product and more generally the supply chain he or she represents, the way you resolve this uncertainty has an upside — you buy the product — and a downside — you take your business elsewhere.

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From the seller’s perspective, your preference risk combined with other customers’ preference risk increases demand risk — uncertainty about the quantity of products that can be sold at various prices.

For the most part, we will not be concerned about subtle distinctions between demand risk (that directly affects sellers but only affects buyers indirectly through prices) and customer preference risk (that directly affects both customers and sellers) and will use the terms interchangeably to mean the risk customers will prefer another alternative to a company’s products, or buy its products and return them at a later date for a refund.

Customer preference (demand) risk either encompasses or is affected by several other risks companies can manage to varying degrees. Some of these risks, such as downturns in the economy, commodity price increases, and increasing competition, are largely beyond companies’ control. They can take actions to mitigate their consequences; but they can not control them at the source.

Regardlessofwhethercompaniesrespondproactivelyorreactively,theirsuccessdependslargelyontheirabilitytomanagerisksbetterthantheircompetitors.

In the long-term companies can devise strategies to mitigate customer preference risk including, among other things, designing innovative products and/or cutting costs and passing some of the savings along to customers. Companies also frequently take shorter-term actions, which is the focus herein, including offering customers:

• Generousreturnpolicies,allowingcustomerstopurchaseproductsthey are uncertain about, knowing they can return them at a later date if the products fail to meet their expectations, they find better substitutes, or they find themselves strapped for cash.

• Comprehensivewarrantiestoalleviatecustomers’concernsaboutdefects and product quality.

• Priceprotection,rebates,andvolumediscountstomitigatecustomers’concerns about finding lower prices elsewhere.

• Customerloyaltyprogramssuchasfrequentflyerprogramstoencourage repeat business.

• Belowmarketinterestratesandattractivepaymenttermstoaddresscustomers’ concerns about financing.

• Competitivepricesforalloftheabovefeatures.

Another way companies manage customer preference risk is advertising. By advertising companies can provide information about products, which

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reduces customers’ concerns as to whether the products will meet their needs. Advertising can also provide emotional comfort. Let’s face it, ads frequently tell us very little about products but still strengthen our emotional bond to them.

Companies must understand and manage customer preference risk to achieve sales growth —a key driver of shareholder value. However, establishing return policies, credit terms, warranty policies, and taking other actions to stimulate sales growth entails taking on costs and risks that can affect the other two key determinants of shareholder value — return on equity and the cost of capital — favorably or adversely depending on how companies forecast and manage these costs and risks and implement related policies.

For example, if a company were to offer lifetime warranties and return privileges for products only expected to last a few years, it would stimulate considerable sales growth in the short term, but ultimately it would likely go out of business. By contrast, if a company were to set return periods too short, restocking fees too high, or offer exchanges rather than refunds, it would run the risk customers would take their business to competitors offering more generous terms.

Companiesoftenshiftriskfromcustomerstothemselvestolowercustomerpreferencerisk.Forexample,thisriskisgenerallyloweredwhencompaniesofferreturnpoliciessuperiortotheircompetitors.Customersfeelmorecomfortablepurchasingproductsknowingtheycanreturnthemforrefunds.However,companiesarethenstuckwiththeriskreturnedproductswillbecomeobsoleteorotherwisebecomeimpairedandbearcoststoprocess,hold,andresalereturnedproducts.

Similarly, warranties shift customer preference risks associated with product quality from customers to sellers and price protection shifts the risk prices will decline after purchases from customers to sellers (or the risk customers will find lower prices elsewhere).

In other situations where companies take actions to mitigate customer preference risk such as offering coupons, sales rebates, or reward points, risk is not shifted from customers to sellers, but sellers still incur risks. For example, companies run the risk of offering costly rebates to customers who would have purchased the products without rebates or offering more generous rebates than needed to attract sales. Similarly, offering generous credit terms to customers to alleviate financing concerns can be risky because sellers assume not only credit risk, but also interest rate risk, and in some cases, foreign currency risk.

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Many of the actions companies take to manage customer preference risk affect revenue recognition. For example, companies must estimate product returns and warranty costs when they make related sales. When these estimates are not reliable because a company does not have enough historical experience to establish reliable benchmarks, they can not recognize revenue on these sales when products are delivered.

Thus, in assessing a company’s performance, outsiders need to not only understand the financial-statement consequence of actions taken to manage customer preference risks, outsiders should also consider the extent to which the benefits from these actions more than compensate for the costs and risks. To this end, outsiders rely greatly on numbers reported in financial statement and footnotes. However, many of these numbers are based on estimates affected by the underlying risks and can require considerable judgment when these risks are severe.

aCCounting impliCation of RisksThe remainder of this chapter focuses primarily on record keeping and reporting associated with events and circumstances greatly influenced by credit risk, customer preference risk, and companies’ efforts to manage these risks. We will briefly discuss a few accounting implications of these risks to help you recognize the similarities in the measurements and entries in the subsequent sections.

Credit risks and customer preference risks definitely have important income statement consequences. However, the measurement focus is primarily on balance sheets and, in particular, on ensuring the end-of-period balances in allowances are adequate to cover future costs associated with these risks or efforts to mange them.

For example, the GAAP measurement goal associated with bad debts is to ensure the ending balance in the allowance for bad debts represents management’s best estimate of future bad debts associated with the outstanding receivables on the balance-sheet date or, equivalently, net accounts receivable is management’s best estimate of the expected future collections.

Tothisend,companiestypicallyrecordanadjustingentryattheendofthereportingperiodensuringtheallowancehastherightbalance.Thus,theamountrecordedinthisentryisdeterminedbythetargetendingbalance:theaccountantfirstestimatestheendingbalanceandthendetermineshowmuchmustberecordedtoensurethisbalance.Thisbalance-sheetmeasurementapproachcontrastswiththeaccountingwehavestudiedthusfar,whereendingbalancessimplytotaledentriesanddidnotinfluencetheamountsrecorded.

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Like bad debts, the measurement goal for warranties is to ensure the balance sheet records a warranty liability, also called a warranty allowance or warranty reserve, that is management’s best estimate of the future warranty claims associated with products still under warranty sold in the current and prior periods. Also similar to bad debts, an adjusting entry is recorded at the end of the period to ensure this balance.

Similarly, the accounting for sales returns, price protection, rebates, loyalty programs, and other sales incentives generally centers on getting the appropriate balances in allowances that are either contra assets (like the allowance for bad debts) or liabilities (like the warranty allowance).

Another common concept of the accounting in this chapter is the adjusting entries ensuring the correct balance sheet numbers also affect income. For example, the adjusting entry to ensure the correct ending balance for the allowance for bad debts also increases bad debt expense.

Asyoustudythesubsequentsectionspayparticularattentiontowhichincomestatementlineitemsareaffectedbytheseentries.Someincreasecontrarevenuesandthusreducenetrevenueswhileothersincreaseexpenses.

You do not need to understand much about credit risk and customer preference risk to understand the entries herein, their financial-statement consequences, and the underlying events and circumstances they aim to measure. However, you do need to calibrate the extent to which these risks are present to assess how reliably the numbers in these entries measure what they are intended to measure.

Several factors affect the reliability of reported numbers, but three are particularly important: the extent to which the underlying events and circumstances are risky, the extent to which there are reliable measurement benchmarks — market prices, historical measures of comparable activity, or other companies’ measures of comparable activity — and the extent to which managers are motivated to report honestly.

Generally, the riskier the activity being estimated (such as future bad debts, product returns, or warranty claims) and the less reliable the available benchmarks, the greater the possibility of measurement errors for all managers and the more opportunities there are for dishonest managers to manipulate measures.

Historically, the measures we will be studying in this chapter have frequently been associated with earnings manipulation, with numerous managers facing the SEC’s wrath for under reporting allowances to boost income or recognizing revenue when there was too much uncertainty about future returns or collections.

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The measures in this chapter can be particularly suspect since they require the most judgment and are recorded at the end of the period, when managers are feeling particularly pressured to make their performance targets and know how close they are to making them. At this time, if they know they are going to fall short of their targets, they may be tempted to reduce allowances below what they should be to comply with GAAP and thus increase reported income. By contrast, if they know they will otherwise exceed their targets, they may be tempted to build a cushion for the future by increasing allowances above what they should be to comply with GAAP.

Concerned about such manipulations, the SEC issued standards in 1999 and 2001 that tightened the guidelines for revenue recognition and measuring allowances. For example, prior to the 1999 standard, companies could decide when they had enough historical experience to reliably estimate returns, a prerequisite for recognizing revenue at the time of a sale. However, the SEC narrowed the latitude of these judgments:

In general, the [SEC] staff typically expects a start-up company, a company introducing new services, or a company introducing services to a new class of customer to have at least two years of experience to be able to make reasonable and reliable estimates.

Footnote 40, SEC Staff Accounting Bulletin No. 101, December 1999

Similarly, the 2001 standard tightened the guidelines for estimating allowances and, in particular, required companies to establish consistent policies, methodologies, and processes for estimating allowances and to document that they are following them consistently each year.

Notwithstandingthesetighterguidelines,youstillneedtoexercisehealthyskepticismwhenassessingthereliabilityofmostofthenumbersindisclosuresrelatedtotopicsdiscussedinthischapter.Whilecompletingtheseassessmentsisbeyondthescopeofthischapter,youwilllearnhowtoidentifysituationswherethenumbersrequirethemostjudgment—arecriticalaccountingestimates—andtheplaceswhereyoushouldbemostskepticalaboutreliability.

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DEFERRED REVENUEIn the Income Statement Chapter, the deferred revenue examples we considered centered on situations were revenue was deferred until goods were delivered to customers (Starbucks’ value cards and gift cards). Here we are going to extend this discussion to situations where revenues are deferred when delivery occurs.

For example, in some situations, manufacturers who sell products to distributors for resell to consumers must defer revenue recognition until the distributors “sell through” the products to consumers. This happens even though the manufacturers have delivered the products to the distributors and the distributors have accepted them.

Why is revenue deferred at delivery? In the past, there have been several situations where manufacturers who had significant influence over their distributors pressured or otherwise motivated the distributors to purchase considerably more product than they needed to hold as inventory to meet consumer demand. The manufacturers did this so they could meet revenue targets. To curb this aggressive behavior, GAAP now requires manufactures who meet certain criteria to defer revenue until products are sold through by the distributors.

exampleAssumptions

• WXYcompany,anapparelmanufacturer,sellsproductstoDEFcompany, a distributor, who later sells them to customers.

• WXYdefersrevenueuntilDEFsellsthroughproductstoconsumers.DEFinformsWXYwhenthisoccurs.

• OnDecember1,2010,WXYsellsDEFproductsfor$25cash.Thesold merchandise was recorded in inventory at $10 prior to the sale.

• OnJanuary15,2011,DEFnotifiesWXYthatithassoldtheproductsthroughtoconsumersandWXYrecognizesrelatedrevenuesand cost of sales.

• WXYusestheaccountsatthetopofthenextpagefortheentriesrecordedonDecember1,2010andJanuary15,2011.

Entries Delivery Date: December 1, 2010

GAAP is silent regarding the accounting for inventoried costs in these situations. However, the Accounting Research Manager, a widely used GAAP reference that also provides interpretations in places where GAAP

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is silent or imprecise, recommends the approach used in this example (segregating delivered inventory from finished goods and disclosing the amount segregated, either on the balance sheet or in footnotes) and opposes the only other logical alternative — recognizing these inventoried costs in a contra liability to deferred revenue:

In addition, it would generally not be appropriate to offset against deferred revenue any related deferred costs.

Accounting Research Manager, Interpretations and Examples/18

The SEC also demonstrated a preference for this approach when it forced the pharmaceutical company Bristol-Myers Squibb (BMS) to restate its financial statements in 2004.

Consistent with this approach, WXYtransfersinventoriedcoststo“segregated inventories: deferred revenue” when goods are delivered and revenue is deferred.TheargumentinfavorofthisaccountingisWXYisdeemed to still have significant control over the inventory even though it has been delivered to the distributor. Recall, the necessity for deferral arose from situations where manufacturers had considerable influence over distributors.

The following entries are recorded upon delivery on December 1, 2010:

ASSETSC CashFGI FinishedgoodsinventorySIdr Segregatedinventory:deferredrevenues

LIABILITIESDefRev Deferredrevenue

OWNERS' EQUITY

Cgs CostofgoodssoldRev Revenue

WXY CompanyChart of Accounts Excerpt

= Debit Credit

+ C = + DefRev Cash $25

+ +$25 = + +$25 Deferredrevenue $25

Defer revenue upon delivery

Assets Liabilities

= Debit Credit

+ FGI + SIdr = Segregatedinventory:deferredrevenues $10

+ -$10 + +$10 = Finishedgoodsinventory $10

Segregate inventory related to deferred revenue

Assets

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Entries Products Sold Through to Consumers: January 15, 2011

Here are the entries when the goods are sold through to consumers and WXYrecognizesrevenuesandcostofsales:

= Debit Credit

= + DefRev + Rev Deferredrevenue $25

= + -$25 + +$25 Revenue $25

Liabilities Owners' Eq

Recognize previously deferred revenue

= Debit Credit

+ SIdr = - Cgs Costofgoodssold $10

+ -$10 = - +$10 Segregatedinventory:deferredrevenues $10

Recognize previously deferred cost of good sold

Assets Owners' Eq.

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RECEIVABLES In prior chapters, we have seen that receivables are increased when customers are billed and decreased when cash is subsequently collected. These entries typically explain most of the change in gross accounts receivable. These are operating events.

We have also seen receivables generally increases when a company acquires another company and decreases when it disposes of one of its segments or divisions. These are non-operating events.

This section examines record keeping and reporting associated with:

• Discountsforearlypayments

• Interestearnedwhencustomersdonotpaytheirbillsontime

• Baddebts:

Writing off receivables associated with uncollectable bad debts

Reinstating previously written off receivables — recoveries

Establishing or replenishing allowances for estimated bad debts

Most companies record entries for discounts for early payments and interest associated with receivables, so we will quickly cover the related entries. However, with one exception, these entries are usually relatively immaterial compared to other events affecting net accounts receivable. The exception is accruing interest can be very important to companies such as GE, GM, and Ford with extensive financing receivables and to banks and other financial institutions with loans (which are essentially financing receivables).

Most companies also record three entries for bad debts associated with receivables: write-offs, recoveries, and establishing or replenishing allowances. While these entries can also be relatively immaterial for some companies, understanding them and their financial-statement consequences is very important when analyzing companies particularly susceptible to credit risk. This is especially true during the 2007-2012 global credit crisis.

Receivables can also be affected by entries associated with product returns. We will discuss these when we study product returns later in the chapter.

disCounts foR eaRly paymentsCustomers can sometimes receive discounts for paying their bills quickly. For example, if a company permits its customers to pay their bills within

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sixty days to avoid an interest penalty, it might offer a 2% discount to customers who pay within ten days of being billed.

The accounting is straightforward as illustrated by the following example.

ExampleAssumptions

• ABCcompanyofferscustomersadiscountforpayingtheirbillswithin ten days of the billing date.

• OnDecember1,2010,ABCsellsgoodstoDEF,billsDEF$100,and recognizes $100 of revenues.

• OnDecember10,2010,ABCcollects$98fromDEF,havinggivenDEF a $2 discount for early payment.

• Ignore the inventory/cost of sales aspect of the sale on December 1.

Entries

• OnDecember1,2010,ABCrecognizes$100of“gross”revenues,meaning revenues before deducting discounts, rebates, and product returns. The entry is increase (debit) accounts receivable and increase (credit) gross revenues.

• OnDecember10,2010,ABCcollects$98fromthecustomer:$100less the 2% discount. The entry is increase (debit) cash $98, decrease (credit) accounts receivable $100 to reverse the amount recorded on December 1, and increase (debit) a sales discount contra revenue account $2.

The combined income-statement effect of these two entries is $98 of net revenues is reported. Recording the discounts to a separate contra revenue account helps ABC track discounts and thus manage discounts.

inteRest inComeThe entry to accrue interest income earned on accounts receivables when customers do not pay their bills on time is straightforward and described here for completeness:

• Increase(debit)accountsreceivable,orarelatedaccountsuchasinterest receivable, for the interest earned during the reporting period.

• Increase(credit)interestincomeforthesameamount.

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WRiting off Bad deBtsMost companies have policies specifying when they will write off receivables associated with uncollectable bad debts. For example, the Management Discussion and Analysis section of General Electric’s annual report indicates GE writes off receivables past due by either 120 or 180 days, depending on the nature of the receivables:

We write off unsecured closed-end installment loans at 120 days contractually past due and unsecured open-ended revolving loans at 180 days contractually past due. We write down consumer loans secured by collateral other than residential real estate when such loans are 120 days past due. Consumer loans secured by residential real estate (both revolving and closed-end loans) are written down to the fair value of collateral, less costs to sell, no later than when they become 360 days past due. Unsecured consumer loans in bankruptcy are written off within 60 days of notification of filing by the bankruptcy court or within contractual write-off periods, whichever occurs earlier.

Page 68, General Electric’s 2009 Annual Report

Animportantlessonisthereistypicallynojudgmentinvolvedwithwrite-offsonceacompany’spolicyisestablished.

The following example illustrates the write-off entries under two scenarios: when there is no collateral and when there is collateral.

ExampleAssumptions

• OnJanuary31,2011,ABC’sallowancefordoubtfulaccountshasa$25 balance and ABC will not replenish the allowance until February 28, 2011.

ThenextfewassumptionsindicateABCwillwriteoffmorethan$25ofreceivablespriortoreplenishingtheallowance.Thiswillcausetheallowancetohaveanegativebalancepriortobeingreplenished.Animportantlessonhere,andtheonlyreasonweincludedthisassumption,isitisnotunreasonablenorunusualforallowancestohavenegativebalancesduringthereportingperiod.Theadjustingentryreplenishingtheaccount(discussedlater)ensuresapositivebalanceattheendoftheperiod.

Why are we using the allowance to write-off bad debts before we create the allowance?

Perhaps you expect allowances to be created before they are used. This would be a perfectly acceptable alternative to the approach we have taken here.

Had we taken this alternative, we would have introduced three events: create the allowance when the company starts operations; use the allowance during each reporting period, starting with the first; replenish the allowance at the end of each period to ensure it covers expected future write-offs.

We skip the first event here – creating the allowance.

The reason we took this approach is most of the companies you will be studying have been in business for years. As a result, their allowances have positive balances at the start of each period, having been replenished at the end of the previous period, and each period they use the allowances before replenishing them.

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• OnFebruary1,2011,ABCwritesoffa$10receivableowedbyXYZ.There is no collateral associated with this receivable.

• OnFebruary3,2011,ABCwritesoffa$100DEFreceivable.

The collateral is products ABC previously sold to DEF.

ABC fully expects to repossess the collateral without incurring significant costs and to reinstate it to finished goods inventories.

ABC values the collateral at $70 when it writes off the receivable on February 3, 2011. This is the replacement cost of comparable products ABC holds in inventory at that time: what it would cost to replace them. (This means no gain or loss is recognized when the collateral is recovered).

• OnFebruary15,2011,DEFturnsoverthecollateralassociatedwiththe February 3, 2011 write-off to ABC.

The replacement cost of comparable products in inventory is still $70.

ABC reinstates the collateral to finished goods inventory at this $70 replacement cost.

• ABCusestheaccountsbelowforrelatedentries.

Required

(a) Recordthewrite-offoftheXYZreceivableonFebruary1,2011.

(b) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entry.

(c) Record the write-off of the DEF receivable on February 3, 2011.

(d) Record the receipt of collateral associated with the DEF write-off on February 15, 2011.

(e) Identify the combined effect of the entries in parts (c) and (d) on ABC’s balance sheet, income statement, and cash-flow statement.

(f ) The allowance for bad debts is associated with credit risk. How do write-off entries relate to credit risk?

ASSETSAR Accountsreceivable(gross)AllDA AllowancefordoubtfulaccountsFGI Finishedgoodsinventories

ABC CompanyChart of Accounts Excerpt

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Solution

Part (a) — Write-offs Entries, No Collateral

• OnFebruary1,2011,ABCwillrecordthefollowingentrytowrite-offtheXYZreceivable:

Part (b) — Write-offs Entries Effects, No Collateral

Balance Sheet

• Thereisa$0neteffectonaccountsreceivable,netofallowancefordoubtful accounts:

Gross accounts receivable decreases by $10, indicating ABC can nolongerexpecttocollect$10fromXYZ.

The allowance for bad debts decreases by $10, signifying $10 of theallowancewasusedtowriteofftheXYZreceivable.Recordingwrite-offsdecreasesgrossaccountsreceivableandtheallowanceforbaddebts,butitdoesnotchangenetaccountsreceivableandhasnovisibleeffectonthebalancesheet.Still,banksandcompaniessuchasGE,GM,andFordwithextensivefinancingreceivablestypicallyreportwrite-offsintheirfootnotesandallcompaniesregisteredwiththeSECmustreporttheminScheduleII(asdiscussedlaterinthechapter).

Income Statement

• Thereisnoeffect.

Statement of Cash Flows

• Thereisnoincomeeffectandnocasheffect,sonoadjustmentsarerequired.

• Thereisa$0neteffectontheaccountsreceivableadjustment.Youmightbethinkingthisentryisnotveryimportantbecauseithasnoneteffectonanyofthefinancialstatements.Thisistrue,buttheentrycanhaveaveryimportantindirecteffect:Totheextentreceivableswere

= Debit Credit

+ AR - AllDA = Allowancefordoubtfulaccounts $10

+ -$10 - -$10 = Accountsreceivable(gross) $10

Write off XYZ receivable (no collateral)

Assets

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writtenoffduringthecurrentperiodthatwerenotanticipatedwhentheallowancewasreplenishedattheendofthelastreportingperiod,themoretheallowancewillneedtobereplenishedattheendofthecurrentperiodandtherelatedadjustingentrydecreasesnetincome(asweshallseeshortly).

Part (c) — Write-offs Entries, with Collateral

• OnFebruary3,2011,ABCwillrecordthefollowingentrytowrite-off the DEF receivable: $30 = $100 - $70 value of the collateral.

Thus, ABC continues to recognize a $70 receivable, signifying the value of the collateral it expects to receive from DEF in the near future.

Part (d) — Receipt of Collateral Entries

• OnFebruary15,2011,ABCwillrecordthefollowingentrywhenitreceives collateral associated with the DEF write-off:

Part (e) — Effects of Write-offs with Collateral Received

Balance Sheet

• Thecombinedeffectoftheentriesinparts(c)and(d)isa$70decrease in Accounts receivable, net of allowance for doubtful accounts:

Gross accounts receivable decreases by $100 ($30 + $70).

The allowance for bad debts decreases by $30. Whenthereiscollateral,theallowancecanbesetlowerbecausethevalueofthecollateralreducesthedownsideofwrite-offs.

Inventory increases by $70, the value of the collateral returned to inventory.

= Debit Credit

+ AR - AllDA = Allowancefordoubtfulaccounts $30

+ -$30 - -$30 = Accountsreceivable(gross) $30

Write off DEF receivable (with collateral)

Assets

= Debit Credit

+ AR + FGI = Finishedgoodsinventories $70

+ -$70 + +$70 = Accountsreceivable(gross) $70

Write off DEF receivable (with collateral)

Assets

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Income Statement

• Thereisnoeffect.


• Combined,theentriesinparts(c)and(d)donoteffectnetincomeor cash from operations and thus the adjustments must net to $0.

• Thereisa+$70neteffectontheaccountsreceivableadjustment:

Recording the write-off has a $0 effect on net accounts receivable and thus does not alter the adjustment.

Reinstating the collateral to inventory decreases accounts receivable $70, which is associated with a positive adjustment.

• Thereisa-$70neteffectontheinventoriesadjustment,whichisassociated with the $70 increase in inventories.

Part (f) — Connection to Credit Risk

All risks, including credit, are forward looking, centering on the possibility something could go wrong. Write-offs are realizations of credit risk. Something did go wrong: customers didn’t keep their promises.

Theimportantaccountingissueiswhethertheserealizationswereanticipatedonthebalancesheet.Theendingbalanceintheallowancealwaysreflectstheconsequencesofcurrent-periodwrite-offs.Thecriticalissuethatinsidersandoutsidersmustassessiswhetherthecompanyalsoanticipatesfuturelosses:towhatextentdoestheallowancereflectcreditrisk.

ReCoveRing WRite-offsOccasionally, previously written off accounts receivable are reinstated (recovered) either because customers or other debtors pay their bills to maintain their credit standing or renegotiate the outstanding balance.

Recoveries are recorded by reversing all or part of the prior write-off:

• Increase(debit)grossaccountsreceivablefortheamountthecustomer will owe going forward.

• Increase(credit)theallowanceforbaddebtsforthesameamount.

Replenishing the alloWanCeAt the end of each accounting period, prior to creating financial statements, companies record adjusting entries to replenish the allowance for bad debts. The GAAP goal is to ensure that the allowance’s ending balance reflects management’s best estimate of the expected future write-offs (net of recoveries) associated with the outstanding gross receivables at the balance sheet date.

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The following adjusting entry to replenish the allowance will be illustrated in the example that follows:

• Increase(credit)theallowancefordoubtfulaccountsfortheamountneeded to ensure the target ending balance of expected future write-offs (net of recoveries).

• Increase(debit)inbaddebtsexpense(alsocalledtheprovisionforbaddebts by companies following US GAAP) for the same amount.

Anticipating this financial-statement consequence, companies have been known to abandon the GAAP goal of reporting the number that reflects their best estimate of the future write-offs in favor of manipulating income through the expense associated with the entry. The SEC has taken several steps to try to curb such opportunistic behavior, but there is still plenty of room for dishonest managers to play games.

ExampleAssumptions

• ABCstartsfiscal2011with$100ofgrossaccountsreceivableanda$5 allowance for bad debts, or $95 of net accounts receivable. Thus, assuming ABC was following GAAP, ABC’s management expected it would write off $5 of its $100 of outstanding receivables at the end of fiscal 2010.

• Duringfiscal2011,ABC:

Billed customers $60 when it sold goods and services

Collected $75 from customers related to previous sales on account

Wrote off $7 of accounts receivable.

• ABC’screditdepartmentexpectstocollect$71oftheoutstandingreceivables at the end of 2011.

• ABCusestheaccountsbelowforrelatedentry.

ASSETSAllDA Allowancefordoubtfulaccounts

Owners' Equity (temporary)Bdexp Baddebtexpense

ABC CompanyChart of Accounts Excerpt

Provisions Under IFRS versus US GAAP Under IFRS, a provision is a liability of uncertain timing or amount1, such as a provision for warranty.

In contrast, in the U.S. a provision typically refers to an expense, such as provision for taxes or the provision for doubtful accounts.

Thus, provision refers to a balance at a point in time under IFRS; but to a change over a period in the U.S. Beware of this significant difference: ‘provision’ must be interpreted in context.

1 IAS 37 ¶10.

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ABC’s credit department expects $71 of the $78 gross accounts receivable ending balance to be collected in the future, which means they expect $7 (=$78 - $71) of these receivables will be written off in the future (which happens to be the actual write-offs for fiscal 2011).

Prior to recording the expense, the allowance balance is -$2 (as indicated above). The allowance must be increased by $9 to take it from -$2 to the +$7 target ending balance. As a result, the allowance and bad debt expense is increased by $9.

Part (b) — Bad Debts Expense Entry

Here is the adjusting entry ABC records at the end of fiscal 2011 to recognize the bad debt expense and ensure the allowance for doubtful accounts is at the target balance:

Required

(a) Determine the bad debts expense to be recorded at the end of 2011.

(b) Record the 2011 bad debts expense.

(c) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (b) entry.

(d) How does recording the bad debts expense relate to credit risk?Solution

Part (a) — Determining the bad debt expense

The first step towards determining the expense is to derive the trial balances for gross accounts receivable and the allowance for bad debts immediately prior to recording the expense:

GrossAccounts

Receivable

Allowancefor Doubtful

Accounts

NetAccounts

Receivable

Beginningbalance $100 $5 $95

Salesonaccount $60 $60

Collections ($75) ($75)

Write-offs ($7) ($7)

Trialbalance $78 ($2) $80

= Debit Credit

- AllDA = - Bdexp Baddebtexpense $9

- +$9 = - +$9 Allowancefordoubtfulaccounts $9

Replenish the allowance for doubtful accounts

Assets Owners' Eq.

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Part (c) — Effects of Bad Debts Expense

Balance Sheet

• Theexpenseincreasestheallowancefordoubtfulaccountsandthus decreases accounts receivable net of the allowance, reducing the future benefits associated with this asset — expected future collections.

• Theexpensedecreasesincomeandthusdecreasesretainedearnings.

Income Statement

• Mostcompaniesdonotreportbaddebtsexpenseseparatelyontheirincome statements. Instead, it is typically included in an operating expense such as SG&A.


• Recordingtheexpensedecreasesnetincomeby$9butdoesnotaffectcash from operations. Thus, a +$9 adjustment is needed to reconcile net income to net cash provided by operations.

• Somecompaniesdisclosesthisadjustmentseparatelyasbaddebtsorprovision for bad debts (US GAAP companies).

Banksandothercompanieswithlargereceivablesgenerallyreportaseparatereconciliationadjustmentforbaddebtexpensebutmostcompanieswithrelativelysmallreceivablesbalancesdonotdiscloseaseparateadjustment.Instead,theexpenseadjustmentisincludedintheaccountsreceivableadjustment.

Byconventiontheneteffectsofalloperatingentriesaffectingworkingcapitalaccounts,suchasaccountsreceivable,areincludedintheadjustments.Asaresult,wetypicallycaninterprettheaccountsreceivableadjustmentastheneteffectsoftheoperatingentriesaffectingaccountsreceivable,ormorepreciselyasthenegativeoftheseeffects.

Whenaseparateadjustmentisprovidedforthebaddebtsexpense,itmustbecombinedwiththeaccountsreceivableadjustmenttodeterminetheneteffectsofoperatingentriesonaccountsreceivable.

Part (d) — Connection to Credit Risk

In contrast to write-offs net of recoveries, which reflects realizations of credit risk, recording bad debts expense reflects three aspects of credit risk:

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(1) Measurement error: More or less realizations of risk during the current period — write-offs net of recoveries — than was anticipated in the allowance at the start of the period.

(2) Revisions to the allowance associated with the arrival of new information during the period about receivables outstanding at the start of the period. For example, suppose part of ABC’s $5 allowance at the start of 2011 had pertained to non-current receivables not due until 2012. If the credit quality of these receivables deteriorated during 2011 because of previously unforeseen circumstances, the allowance would need to be increased to reflect the increased credit risk.

(3) Management’s estimate at the end of the period of the expected future write-offs (net of recoveries) associated with new receivables added during the period.

Note, the first aspect of credit risk looks back at unanticipated risk realizations and the second and third look forward to expected future losses.

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analyzing Bad deBts This section discusses where you can search for information that will help you assess bad debts and related credit risk, ways you can use it to assess a company’s credit risk associated with receivables, and calibrate the relative importance of this risk in assessing a company’s overall financial position.

This discussion and the exercises at the end of the section will help you begin to assess companies’ exposure to credit risk associated with receivables. However, you will still have a good deal to learn to become an expert.

Searching for Bad Debt InformationBefore you start creating ratios and comparing them across companies and time, it is important to analyze a company’s exposure to credit risk qualitatively.

For example, knowing Boeing sells a good deal of airplanes to airlines and many of these customers were in dire financial condition at the end of 2005, we would start an analysis of Boeing’s credit risk knowing qualitatively it was likely severe.

More generally, the first step in analyzing the credit risk associated with a company’s receivables is to understand its business and the general health of its customers. If you are not already knowledgeable about a company and its customers, you can usually gain a pretty good general understanding from the Business and Risks sections of companies’ 10-Ks filings to the SEC (Sections I and IA, respectively).

Another qualitative assessment you should make early on is the extent to which the company’s receivables are concentrated in a few customers. Companies with concentrated receivables discuss the extent of this concentration in footnotes. For example, the Credit Risk section of the Significant Group Concentration of Risks footnote (Note 22) of Boeing’s 2005 annual report states:

Of the $15,252 in Accounts receivable and Customer financing included in the Consolidated Statements of Financial Position as of December 31, 2005, $9,711 related to commercial aircraft customers ($221 of Accounts receivable and $9,490 of Customer financing) and $2,797 related to the U.S. Government. Of the $9,490 of aircraft customer financing $8,917 related to customers we believe have less than investment grade credit. Air Tran Airways, United, and AMR Corporation were associated with 18%, 11% and 12%, respectively, of our aircraft financing portfolio. Financing for aircraft is collateralized by security in the

28



related asset, and historically we have not experienced a problem in accessing such collateral.

Page 77, Boeing’s 2005 Annual Report

This quote also suggests another path you could follow at this point: analyze (at least qualitatively) customers’ financial statements and footnotes, especially those under financial duress.

Customer concentration is not the only type of concentration you should assess up front. Moreover, relatively small amounts associated with retained interests in receivables transferred to special purpose entities (SPEs) are highly concentrated sources of credit risk. You should qualitatively gauge the extent to which this type of concentration is likely to be problematic early in your analysis.

Once you have completed a qualitative assessment of a company’s bad debts and credit risk, you should search for the numbers in bad debts entries. As we shall see, these can be useful for creating ratios reflecting credit risk that can be compared across companies and time.

When can you locate the numbers we recorded in an earlier section for bad debts entries? The short answer is we can generally locate or reliably estimate write-offs, recoveries, and bad debt expense when they are important and, in particular, when companies include bad debts estimation as a critical accounting estimate in their management discussion and analysis section of their annual reports (or 10-K SEC filings). By contrast, you can typically not estimate these items reliably for companies with relatively small receivables balances. Between these extremes, you may or may not locate these numbers.

The best place to start a search for this information for a company that is registered with the SEC is Schedule II in 10-Ks, “Valuation and Qualifying Accounts.” The SEC requires companies to include Schedule II when the related numbers are material.

For example, the drug store chain Walgreens, the 32nd largest U.S. company by sales in fiscal 2010, includes estimating doubtful accounts as a critical accounting policy in its 2010 annual report (page 15). To determine if Walgreens includes Schedule II in its 10-K, we downloaded its fiscal 2010 10-K from the investor relations section of its web site.

Searching for “Schedule II” in this file, we soon find the table on the next page.

Interpreting Disclosed NumbersKnowing the entries we recorded earlier, we are tempted to conclude the $111 million “Additions Charged to costs and expenses” for 2010 is the bad debts expense.

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However, when we study product returns later in the chapter, you are going to learn some companies combine their allowances for returns and bad debts. This is appropriate when products are typically returned before customers pay their bills. By contrast, when customers tend to purchase products with third party credit cards or cash, the returns allowance is classified as a liability, rather than as a contra asset. Unfortunately, often it is impossible to determine how companies classify their product returns allowances.

The adjusting entry to replenish the allowance for product returns differs from the one to replenish the allowance for bad debts. The entries are similar in they both increase an allowance (and perhaps the same allowance), but the offsetting accounts differ (as discussed in detail later in this chapter).

Thus, based solely on the table, all we can reasonably conclude is the $111 million additions charged to costs and expenses could very well be explained by two adjusting entries (there could be other entries but they will usually have a much smaller impact on the allowance):

(1) Recording bad debts expense and/or

(2) Recording product returns contra revenue.

For Walgreens, we can likely eliminate the hypothesis the returns contra revenue explains much, if any, of the $111 million because the company’s 2010 10-K states:

Customer returns are immaterial. , Walgreens’ 2010 Annual Report

WALGREEN CO. AND SUBSIDIARIES

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

FOR THE YEARS ENDED AUGUST 31, 2010, 2009 AND 2008

(Dollars in Millions)

Classification

Balance at Beginning of

Period

Additions Charged to Costs and

Expenses DeductionsBalance at End

of Period

Allowances deducted from receivables for doubtful accounts -

Year Ended August 31, 2010 $ 110 $ 111 $ (117) $ 104



15

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Thus, we are pretty confident the entry below is a reasonable estimate of the combined entries Walgreens recorded during fiscal 2010 to replenish its allowance for doubtful accounts.

= Debit Credit

- AllDA = - Bdexp Baddebtexpense $111

- +$111 = - +$111 Allowancefordoubtfulaccounts $111

Summary of Walgreen's fiscal 2010 entries to replenish the allowance for doubtful accounts

Assets Owners' Eq.

Similarly, we are also confident the $117 million reported as “Deductions” is a good estimate of Walgreens’ write-offs net of recoveries.

Measuring and Calibrating Credit RiskThe importance of credit risk and related bad debts information for assessing a company’s overall performance and financial position can vary greatly from one company to another and can vary significantly over time for the same company.

Assuming for now the allowance for bad debts is a reasonably reliable estimate of future bad debts, one way to measure credit risk is to express the allowance as a percent of gross accounts receivable at each balance sheet date. This measure reflects credit risk concerns going forward. Similarly, we can measure credit risk realizations, which can be a good indicator of future realizations, by expressing write-offs as a percent of the average gross receivables balances during the reporting period.

These measures can then be compared to those of comparable companies, to the same company over time, or to changes in economy wide or industry wide measures tending to correlate with credit risk. To illustrate how to locate information in these ratios and their limitations, we will derive Walgreens’ allowance to gross receivables ratios at the ends of fiscal 2009 and 2010.

We could derive Walgreens’ gross receivables by adding the allowance balances in the earlier table to the net receivables on the balance sheet. Alternatively, we can get this information directly from the table reported in Walgreens’ Supplementary Financial Information footnote.

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We see the allowance decreased slightly from 4.22% of gross receivables at the end of fiscal 2009 (4.22% = $110/2606) to 4.07% at the end of fiscal 2010. These percentages are nearly twice those Ford typically report and other auto manufacturers, suggesting a few hypotheses an analyst might examine:

(1) Walgreens’ receivables are riskier than Ford’s receivables.

(2) Walgreens’ receivables’ risk is more concentrated because it retains more credit risk associated with securitizations than Ford.

(3) Ford either unintentionally or intentionally understate their allowances.

(4) Walgreens either intentionally or unintentionally overstate its allowance.

The first hypothesis likely explains most of the difference between Walgreens and automobile manufacturers. We would expect Ford’s receivables to be less risky than Walgreens’ because they are collateralized while Walgreens’ are not collateralized.

Page 38, Walgreens’ 2010 Annual Report

Page 38 2010 Walgreens Annual Report

Notes to Consolidated Financial Statements (continued)

Amounts recognized in accumulated other comprehensive (income) loss (In millions) :

2010 2009

Prior service credit $ (131) $ (141)Net actuarial loss 188 104

Amounts expected to be recognized as components of net periodic costs for fiscal year 2011 (In millions) :

2011

Prior service credit $ (10)Net actuarial loss 14

The measurement date used to determine postretirement benefits is August 31.

The discount rate assumption used to compute the postretirement benefit obli-gation at year-end was 4.95% for 2010 and 6.15% for 2009. The discount rate assumption used to determine net periodic benefit cost was 6.15%, 7.50% and 6.50% for fiscal years ending 2010, 2009 and 2008, respectively.

Future benefit costs were estimated assuming medical costs would increase at a 7.50% annual rate, gradually decreasing to 5.25% over the next nine years and then remaining at a 5.25% annual growth rate thereafter. A one percentage point change in the assumed medical cost trend rate would have the following effects (In millions) :

1% Increase 1% Decrease

Effect on service and interest cost $ (3) $ 2Effect on postretirement obligation (22) 15

Estimated future benefit payments and federal subsidy (In millions) :

Estimated Estimated Future Benefit Federal Payments Subsidy

2011 $ 13 $ 12012 14 12013 15 22014 17 22015 19 2

2016—2020 136 18

The expected benefit to be paid net of the estimated federal subsidy during fiscal year 2011 is $12 million.

14. Supplementary Financial Information

Non-cash transactions in fiscal 2010 include a $95 million increase in the retiree medical benefit liability, $29 million in dividends declared and $44 million in accrued liabilities related to the purchase of property and equipment. Non-cash transactions in fiscal 2009 include $25 million in dividends declared and $20 million in accrued liabilities related to the purchase of property and equipment.

Included in the Consolidated Balance Sheets captions are the following assets and liabilities (In millions) :

2010 2009

Accounts receivable — Accounts receivable $ 2,554 $ 2,606 Allowance for doubtful accounts (104) (110)

$ 2,450 $ 2,496

Other non-current assets — Intangible assets, net (see Note 5) $ 1,114 $ 697 Other 168 133

$ 1,282 $ 830

Accrued expenses and other liabilities — Accrued salaries $ 781 $ 687 Taxes other than income taxes 419 408 Insurance 233 164 Profit sharing 197 192 Other 1,133 955

$ 2,763 $ 2,406

Other non-current liabilities — Postretirement health care benefits $ 430 $ 317 Accrued rent 384 319 Insurance 330 330 Other 591 430

$ 1,735 $ 1,396

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WARRANTIESCompanies providing warranties promise customers their products are free from defects and work as intended. Companies’ warranty policies state what types of problems are covered under warranty, the time period, and what remedies the company will provide and pay for, such as repairs or replacement of defective products.

If you have purchased electronic equipment, home appliances, or big ticket items such as a car, you likely already know there are two types of warranties: standard and extended. Standard warranties come with the product and are typically short-term like one year, and extended warranties are optional and sold separately, usually when products are purchased and can cover many years.

Warranties are similar to bad debts in they are a risky future cost companies incur to mitigate customer preference risk and increase current sales. However, while credit risk centers on problems with customers, warranty risk centers on problems with products.

Warranty risk is typically larger for extended warranties because they cover longer periods. Also, extended warranty costs can be riskier because the further out in the future the warranty claims occur, the more uncertainty there is about the costs of parts and labor to honor them.

Both types of warranties affect revenue recognition, but their effects differ significantly. For standard warranties, the revenue recognition issue is similar to the one arising with bad debts: revenue associated with sale of a product with a standard warranty can be recognized when warranty claims can be forecasted reliably and the four criteria for revenue recognition have been met. Also similar to bad debts, a warranty allowance is maintained to cover the cost of expected claims. However, as we shall see in the next section, the entries differ.

Importantly, there are not separate revenue disclosures for standard warranties under GAAP. That is, the revenue associated with the sale of the product implicitly reflects revenue associated with the standard warranty. The logic here is that the customer bought a bundle for one price, which included the product and its warranty. This contrasts with extended warranties, which are purchased and thus priced separately from the related products.

To summarize, there are three significant differences between extended and standard warranties that explain differences in the related accounting:

1. Extended warranties are riskier and, in particular, forecasting the costs of future warranty claims reliably is more difficult.

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2. Extended warranty prices can generally be determined more reliably.

3. The services associated with extended warranties are delivered further in the future from the dates products are sold.

Because of these differences, revenue recognition is deferred at the time customers purchase extended warranties and subsequently recognized ratably during the extended warranty period as service is delivered. Also in contrast to standard warranties, allowances for extended warranty costs are not accrued.

Thus, accounting for extended warranties is conceptually the same as accounting for Starbucks Value Cards. Recall, revenue is deferred when customers purchase value cards and subsequently recognized as customers use the cards to purchase coffee, along with the cost to deliver the coffee.

standaRd WaRRantiesAccounting for standard warranties and bad debts are similar in that an allowance is used up during the reporting period and replenished at the end of the period with an adjusting entry ensuring the ending balance will cover expected future costs.

Also, similar to bad debts, estimating the allowance for warranties can require considerable judgment: over 10% of the Fortune-100 companies and 6% of the Fortune 900-950 listed warranty allowance estimation as a critical accounting estimate in their 2004 annual reports. As with all critical accounting estimates, this provides opportunities for honest errors or manipulation.

Similarities aside, accounting for standard warranties and bad debts differ in two ways:

• Theadjustingentryreplenishingtheallowanceimpactstheincomestatement differently, increasing cost of sales for standard warranties and selling, general, and administrative expenses for bad debts provisions.

• Onthebalancesheet,theallowanceisaliabilityforextendedwarranties and a contra asset (to gross accounts receivable) for bad debts.

Here is an overview of the entries associated with standard warranties, which are illustrated in the following example:

• Usingtheallowanceduringtheperiodwhenwarrantyclaimsaremet:decrease (debit) the allowance for the total cost incurred for parts and labor, decrease (credit) inventories for parts costs, and increase

34



(credit) accrued liabilities or decrease (credit) cash for labor costs (and possibly other costs).

• Replenishingtheallowanceattheendofreportingperiods:increase(credit) the allowance and increase (debit) cost of sales.

ExampleAssumptions

• ABCprovidesastandardwarrantywithitsproductsandmaintainsanallowancewitha$1,000balanceonJanuary1,2013.

• During2013,ABCincurspartsandlaborcostsof$400and$900,respectively, to meet warranty claims.

• OnDecember31,2013,ABCestimatesitwillcost$1,100tomeetfuture claims associated with products under standard warranty at that time.

• ABC’sfinancial-statementshavethesamelineitemsasCisco’sfiscal2012 statements.

• ABCusestheaccountsbelowforrelatedentries.

ASSETSFGI Finishedgoodsinventory

LIABILITIES

AcrWag AccruedwagesWarAll Warrantyallowance

OWNERS' EQUITY

CGS Costofgoodssold

ABC's Accounts for Standard Warranties

Required

(a) Record the costs associated with 2013 warranty claims.

(b) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entries.

(c) Determine the adjustment required at the end of 2013 to ensure the allowance will cover expected future warranty claims.

(d) Record the adjusting entry at the end of 2013 to ensure the allowance will cover the expected future warranty claims.

(e) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (d) entries.

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or

+ FGI = + AcrWag + WarAll+ - $400 = + + $900 + - $1,300

Debit CreditWarAll $1,300

FGI $400AcrWag $900

Part (b) — Meeting Warranty Claims EffectsBalance Sheet

• Inventoriesdecreasesby$400,reflectingtheuseofparts.

• Accruedcompensation(currentliability)increasesby$900,reflectingthe obligation to employees associated with labor costs.

• Othercurrentliabilitiesdecreasesby$1,300.Ciscoindicatesthislineitem includes its warranty allowance (page 45 of its fiscal 2012 10-K). This decrease indicates ABC’s warranty obligations have partly been met by settling claims.

Income Statement

• Noeffect


• Theentrydoesnotaffectnetincomeorcashfromoperations,thusthe adjustments must net to $0:

$400 increase in Inventories adjustment.

$900 increase in Accrued compensation adjustment.

$1,300 decrease in Other accrued liabilities adjustment.

Part (c) — Determining Allowance AdjustmentThe table below explains how the $1,400 adjustment is determined. First, a ($300) trial balance is determined to assess the allowance prior to the entry. A $1,400 adjustment is needed to ensure the allowance has the $1,100 target ending balance:

SolutionPart (a) — Meeting Warranty Claims EntryHere is the entry to record the warranty claims during 2013:

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WarrantyAllowance

Beginning balance $1,000

Used during year to cover warranty claims ($1,300)

Trial balance before replenishing allowance ($300)

Target ending balance needed to cover future claims $1,100

Adjustment needed to get from trial balance to target balance $1,400

Part (d) — Replenishing the AllowanceHere is the adjusting entry recorded at the end of 2013 to replenish the allowance:

= + WarAll - CGS= + + $1,400 - + $1,400

orDebit Credit

CGS $1,400WarAll $1,400

Part (e) — Replenishing Allowance EffectsBalance Sheet

• Othercurrentliabilitiesincreasesby$1,400,reflectinganincreaseinABC’s obligation to meet customers’ future warranty claims.

• Retainedearningsdecreases(pretax)bythe$1,400recognizedincostof sales, indicating the owners’ equity decreases in anticipation of future warranty costs.

Income Statement

• Costofsalesincreasesby$1,400.Thus,thehigherthewarrantyprovision, the lower the company’s gross margin. The warranty provision is not necessarily consistent with the matching principle. Rather, it can be affected by the size of the allowance at the beginning of the period, the cost of current and prior period warranty claims, and expected future warranty claims.


• Netincomedecreasesby$1,400butNetcashprovidedbyoperatingactivities is not affected by the entry.

• TheOtherliabilitiesreconciliationadjustmentincreasesby$1,400toreconcile the -$1,400 income effect to the $0 cash effect.

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extended WaRRantiesAccounting for extended warranties involves three entries similar to entries we covered extensively earlier in the chapter:

• Deferrevenuewhenextendedwarrantiesaresold:increase(debit)accounts receivable or cash and increase (credit) a deferred revenue liability.

• Recognizerevenueratablyduringtheextendedwarrantyperiod:increase (credit) service revenue and decrease (debit) deferred revenues.

• Recognizecoststomeetwarrantyclaimsastheyareincurredduringthe extended warranty period: increase (debit) cost of sales, decrease (credit) inventories for parts costs, and increase (credit) accrued wages for labor costs (and possibly other costs).

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PRODUCT RETURNSintRoduCtionProduct returns (also called sales returns) are a risky future cost companies incur to reduce customer preference risk and increase sales. Similar to bad debts, revenue recognition on product sales must be deferred at the time of sale if returns can’t be estimated reliably, and when returns can be estimated reliably, revenue is recognized and an allowance must be maintained.

What Do I See?Nordstrom’s Schedule II disclosures for sales returns and doubtful accounts below are quite similar:

• Increases in the allowances decrease income. For example, the $251 increase in the allowance for doubtful accounts during the year ended January30,2010was“chargedtocostsandexpenses”(e.g.,baddebtexpense). Similarly, the $1,030 increase in the allowance for sales returns during the same period was “charged to cost and expenses” and thus decreased income.

• Decreasesintheallowancesoccurwhenpreviouslyanticipatedadverse effects are realized. For example, the $199 of “deductions” to theallowancefordoubtfulaccountsduringtheyearendedJanuary30, 2010 reflects receivable write-offs, net of recoveries, and the $1,024 of “deductions” to the allowance for sales returns reflects customers returning products.

Nordstrom’s 2010 10-K, page 64

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A closer inspection of Nordstrom’s Schedule II hints at big differences between accounting for bad debts and product returns. Footnote C, which pertains to product returns, states “Deductions consist of actual returns offset by the value of the merchandise returned and the sales commissions reversed.”

In this section your going to learn this means every number reported in product return allowances can have up to three components related to three income-statement line items. In particular, the $1,024 charged to cost and expenses understates the decrease to gross revenues associated with product returns by the related cost of sales and sales commissions.

Later in this section, you will learn how to estimate the decrease in gross revenues associated with product returns, given assumptions about cost of sales and sales commission expense as percentages of sales. You will also learn how this information can benefit investors.

It is not unusual for the revenues associated with product returns to be 20-30% of gross revenues for retailers like Nordstrom that sell relatively high priced fashionable merchandise. Fashion conscious customers often have high levels of preference risk when they purchase merchandise that gets resolved after they have a few days to determine whether to keep or return items. A significant increase in product returns can signal customer dissatisfaction with current products and thus decreased future sales.

You’re also going to learn that neither US GAAP nor IFRS specify how the ending balances of product returns allowances should be presented on balance sheets, which has resulted in companies using alternative approaches. However, both IFRS and US GAAP require companies to report product returns allowances at each balance sheet date, when these allowances are material, meaning they can affect users’ decisions.

Nordstrom’s Schedule II previews another difference between allowances for doubtful accounts and product returns. On average over the three years, the deduction to the doubtful accounts allowance is 1.6 times larger than the beginning balances and deduction to the sales returns allowances is 17.2 times larger than the beginning balances. In this section, you will learn the reason the flows in and out for deductions to the allowance for product returns tend to be much larger than the reported balances.

What Happens When Products are Returned?Depending on the business, up to three things can happen when products are returned. These are related to the components of the numbers reported in Nordstrom’s Schedule II, for example, and to the inputs to product return entries. They are also related to what happened at an earlier date when the returned products were originally sold.

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For this reason, we begin an example with a review of what happened when PQR Company sold products to customers during the first quarter of 2012. PQR is a fictitious company we will be revisiting throughout this section.

During the first quarter of 2012, PQR recognized $4,200 of revenues when it sold goods on account. At the same time, PQR recognized $1,260 cost of sales associated with inventoried costs of the sold goods and $420 of sales commission expense. Throughout this section, to simplify the discussion, we assume PQR’s cost of sales is 30% of revenues and its sales commission expense is 10% of revenues.

PQR’s policy regarding sales commissions states that the sales staff is not entitled to commissions if customers return products within 30 days of a sales. This corresponds to the period customers can return products - the product return period.

Consistent with this policy, PQR accrues sales commission at the time of the sale and either cancels this obligation when customers return products or pays the obligation at the end of the return period.

PQR recorded the following entries during the first quarter of 2012 to recognize revenues and related direct costs.

PQR's gross revenues for quarter ending March 31, 2012= Debit Credit

+ ARG = + Grev Accountsreceivable,gross $4,200

+ +$4,200 = + +$4,200 Grossrevenue $4,200

Own.Eq.Assets

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PQR's gross cost of sales for quarter ending March 31, 2012= Debit Credit

+ FGI = - CGS Costofgoodssold $1,260

+ -$1,260 = - +$1,260 Finishedgoodsinventories $1,260

Assets Own.Eq.

PQR's gross sales commissions for quarter ending March 31, 2012= Debit Credit= + ASCg - SCexp Salescommissionexpense $420

= + +$420 - +$420 Accruedsalescommission,gross $420

Liabilities Own.Eq.

To the extent customers subsequently return related products during the return period, these entries will overstate revenues, cost of sales, and sales commission expense. To understand the reason all three are overstated, consider what happens when customers returns products.

What do customers get when they return products? We assume PQR’s customers pay for products after the 30-day return period ends. Thus, customers who return products still have outstanding receivables, which are forgiven in exchange for the returned products. More generally, customers who have already paid for products when they return them, receive cash refunds or credits towards future purchases (depending on the company’s policy).

The amount of consideration customers receive when they return products is the same as the revenue the company recognized when the customers previously purchased them. For this reason, we refer to it as the revenue component of product returns. All product returns have this component.

What does the company get when products are returned? Company’s get up to three things, two of which PQR gets.

First, PQR gets back the product, which it can reinstate to inventory. Thus, inventories increase. More generally, the amount of inventory reinstated corresponds to the cost of sales recognized when the products were originally sold, perhaps decreased for impairments subsequent to the sales.

We refer this as the cost of sales component of product returns related to inventoried costs. Product returns have this component when returned products can be reinstated to inventories. It is not present when companies sell perishable products that can’t be resold, such as newspapers or pharmaceutical products returned beyond their expiration date. As we shall see later when we examine company disclosures, there can also be a cost of sales component related to royalties, however PQR doesn’t pay royalties.

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The second thing PQR gets when products are returned is release from its obligation to pay the sales staff previously accrued sales commissions. Thus, the accrued sales commissions liability is decreased. The amount of liability de-recognized is the same as the amount of sales commission expense previously recognized when the returned products were originally sold. We refer to this as the sales commission expense component of product returns. This component is only present if sales commission obligations are cancelled when products are returned.

alloWanCe foR pRoduCt RetuRnsIn this section, we will record the entries behind the numbers in Schedule II and related footnotes and study their financial-statement effects.

Accounting for product returns would be easy if products were always returned in the same reporting periods they were sold. Generally, this is not be true. As illustrated below, some products returned to PQR inJanuary2012,whichisinthefirstquarterof2012,weresoldtocustomers in December 2011, which is in the prior quarter. Remember, customers have 30 days to return products. Similarly, some products sold during March, were returned in April, which is in the next quarter.

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Beginning Returns Allowance BalancesIn this section, you’re going to learn the reason Nordstrom’s Schedule II balances, for example, are so small relative to the inflows and outflows for deductions to the allowance for product returns.

The balances anticipate future product returns associated with prior sales and are measured at the net cost the company expects to incur: the difference between the consideration the company expects to give customers and what it expects to get back from customers. This is the revenue component less the cost of sales and sales commission components of the product returns.

For example, if a customer returns a product for which $100 revenues were recognized at the time of the sale along with $30 of cost of sales and $10 of commission, the company incurs $60 of net costs: $100 of cost associated with forgiving the customer’s receivables less $30 of benefits associated with reinstating the returned products to inventory and $10 of benefits associated with de-recognizing the accrued sales commission.

The figure below illustrates balances for PQR’s three components and their net amount on December 31, 2011 (and thus the balances at the start of the first quarter, 2012). As indicated in the right-most column, Schedule II reports net amounts only. Because the return period is 30 days, these balances only pertain to the product returns expected to occur inJanuaryassociatedwithsalesmadepriortoDecember31.

This figure suggests the reason the beginning balances of product returns allowances are so small relative to their inflows and outflows. PQR’s

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beginningallowanceonlyreflectsanticipatedJanuaryreturnsduringthe30-day return period associated with December sales. It doesn’t include all first quarter returns associated with all first quarter sales.

More generally, everything else equal, the beginning balance will be smaller (relative to the inflows and outflows) when the return period is shorter and will be very small when most customers return products within a few days of purchases, which is often the case in retail.

Later we will see that some companies recognize the three components in separate balance sheet line items while others net them in a single line item. Regardless, they need to know the three components at each balance sheet date to account for the returns allowance.

To summarize, here is how you should interpret PQR’s product returns’ components’ balances and Schedule II balance at the start of the first quarter: (See bottom row of the figure at the bottom of the prior page.)

• The$30revenuecomponentpertainstocustomerreceivablesPQRrecorded when it recognized revenue in December that it expects to forgiveinJanuarywhencustomersreturnproductspurchasedpriorto December 31, 2011.

• The$9costofsalescomponentpertainstoinventoriedcostsPQRrecognized in cost of sales in December that it expects to reinstate toinventoryinJanuarywhencustomersreturnproductspurchasedprior to December 31, 2011.

• The$3salescommissionexpensecomponentpertainstotheaccruedliability PQR recorded when it recognized sales commission expense inDecemberthatitexpectstocancelinJanuarywhencustomersreturn products purchased prior to December 31, 2011.

• The$18reportedinthenetcolumnrepresentstheanticipatednetcost of the expected future returns. PQR expects to forgive $30 of receivables, reinstate $9 of inventory and cancel $2 of obligations.

Similar to bad debts allowances balances, product returns allowance balances are forecasts of future adverse events, namely product returns. Justasaccountantsrelyoninputsfromthecreditdepartmenttoforecastbad debts, they rely on inputs from sales and marketing departments when forecasting product returns. However, because the forecasts associated with product return balances tend to be over much shorter time horizons than those for bad debts, measurement errors are generally less problematic.

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Using Returns AllowanceThe figure below illustrates how the three components are affected when products are returned during the first quarter of 2012. Similar to using up the bad debts allowance when receivables are written off, the product returns allowance components are used up when products are returned.

Because the component balances at the start of the quarter only anticipate productsreturnedinJanuaryassociatedwithDecembersales,thebalances become negative at some point during the quarter and must be replenished at the end of the quarter.

Replenishing Returns AllowanceThe figure at the top of the next page illustrates the three-step process PQR follows to replenish the allowances, which is similar to the process for the bad debts allowance:

(1) Create trial balances for the three components at the end of the period, prior to replenishing the allowance: ($129), ($39), and ($13) in our example.

(2) Determine target ending balances that reflect expected product returns associated with sales made before end of period: PQR expects $45 of returned products associated with $14 cost of sales and $5 commissions.

(3) Determine how much must be added to the components’ trial balances in adjustment entries to ensure the target balances: $174, $53, and $18.

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BalanCe sheet pResentation and entRiesIFRS and US GAAP both require companies to recognize product returns allowances but neither specifies whether the three components should be reported separately or may be netted on the balance sheet. Later in this section we will see real-company examples of both. To prepare for these disclosures, we will record PQR’s entries using both approaches.

Allowance Components Reported SeparatelyWhen the components are presented separately they can be either assets, contra assets, liabilities, or contra liabilities:

• Revenue component: Strictly speaking the revenue component at the balance sheet date is always a stand ready obligation: the company is obligated to stand ready to forgive receivables, pay refunds, or provide credits for future purchases when customers return products during the return period that were purchased before the balance sheet date.

Stand ready obligations are liabilities so strictly speaking the revenue component is always a liability. And it is reported as a liability when

47



a company mostly gives cash refunds to customers when products are returned, either because the products were purchased with cash or third-party credit cards or, to a lesser extent, because customers tend to return products after they pay off receivables.

However, the revenue component is typically reported as a contra asset to accounts receivable when companies expect to mostly forgive receivables when products are returned. This is an example of a more general concept called netting assets and liabilities.

Generally, standard setters don’t permit companies to net assets and liabilities because doing so shrinks the balance sheet and reduces financial leverage. Instead, it mandates reporting assets and liabilities at gross amounts. The exception is when the assets and liabilities involve the same counterparties and are settled on the same dates, which is true when the revenue component obligation is settled by forgiving receivables.

• Cost of sales component: When reported separately (rather than netted with the other components) this component is an asset, and more precisely, a conditional asset. The company expects to receive a future benefit (the returned product it can resell), conditional on the customer returning the product during the return period that was purchased prior to the balance sheet date. This asset is recognized in an inventory account, but similar to the inventories associated with deferred revenues, the cost of sales component should be segregated from finished goods inventory either on the balance sheet or in the footnotes.

• Sales commission expense component: When reported separately this component is a contra liability to the accrued sales commission liability. This is another example of netting an asset and liability. Strictly speaking the sales commission expense component is a conditional asset: the expected future benefit is the company won’t be required to pay the accrued liability, conditional on the product being returned. However, it is recognized as a contra liability to the accrued liability because it involves the same counter parties and is settled at the same time.

Using the allowanceDuring the period, PQR records an entry each time products are returned. These are summarized on then next page, with the three components recorded separately so you can comprehend them easier. We have also included the allowance table developed earlier so you can see how the recorded numbers relate to the earlier discussion.

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Consistent with the earlier discussion, when products are returned: the revenue component of the allowance is used to forgive receivables, the cost of sales component is used to reinstate finished goods inventory, and the sales commission expense component is used to cancel the accrued sales commission liability.

PQR's product returns for quarter ending March 31, 2012: revenue component= Debit Credit

+ ARG - Allprr = Allowanceforproductreturns:revenuecomponent $159

+ -$159 - -$159 = Accountsreceivable,gross $159

Assets

PQR's product returns for quarter ending March 31, 2012: cost of sales component= Debit Credit

+ FGI + Allprc = Finishedgoodsinventories $48

+ +$48 + -$48 = Allowanceforproductreturns:costofsalescomponent $48

Assets

PQR's product returns for quarter ending March 31, 2012: sales commission component= Debit Credit= + ASCg - Allprs Accruedsalescommission,gross $16

= + -$16 - -$16 Allowanceforproductreturns:salescommissioncomponent $16

Liabilities

PQR'S Allowance for Product Returns

Related to revenues

Related to cost of sales

Related to sales

commissions

Beginningbalance(January1,2012) $30 $9 $3 $18

Deductions ($159) ($48) ($16) ($95)

Chargedtoincome $174 $53 $18 $103

Endingbalance(March31,2012) $45 $14 $5 $26

Product Returns Allowance ComponentsNet amounts reported in Schedule II

Replenishing the allowanceAt the end of the period, PQR records an adjusting entry to replenish the allowance. Once again we will record the replenishments of the three components separately to facilitate interpretation, starting with the revenue component entry.

As indicated in the next entry, when PQR replenishes the product returns allowance at the end of the first quarter, it recognizes $174 of contra

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revenue, which is deducted from the $4,200 of gross revenues recorded earlier. This $174 adjustment includes:

• $129(=$159-$30)thatdoestwothings:■ Adjusts net revenues for products that were sold and returned

during the first quarter. ■ Adjusts net revenues for forecast error, by subtracting the

amounttheactualreceivablesforgiveninJanuaryassociatedwithDecember sales exceeds the $30 of forgiven receivables forecasted forJanuaryasofDecember31.Thisexcessisnegativewhentheactual forgiven receivables are less than the forecast.

• $45,whichadjustsnetrevenuesforreceivablesexpected(onMarch31) to be forgiven in April when products associated with March sales are returned.

Replenishing PQR's product returns allowance on March 31, 2012: revenue component= Debit Credit

- Allprr = - PRCnR Productreturnscontrarevenue $174

- +$174 = - +$174 Allowanceforproductreturns:revenuecomponent $174

Assets Own.Eq.


Related to revenues


Related to sales

commissions


Deductions ($159) ($48) ($16) ($95)




The entry to replenish the cost of sales component of the returns allowance is on the next page. We could have increased a contra account to cost of sales $53 rather than decrease cost of sales directly. The effect would have been the same: $53 is deducted from the $1,260 of “gross” cost of sales recognized at the time of the sale (recorded earlier).

This $53 adjustment includes:

• $39(=$48-$9)thatdoestwothings:■ Adjusts cost of sales for products that were sold and returned

during the first quarter. ■ Adjusts cost of sales for forecast error, by subtracting the amount

ofactualinventoriesreinstatedinJanuaryassociatedwith

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December sales exceeds the $9 of reinstated inventories forecasted forJanuaryonDecember31.Thisexcesswillbenegativewhentheactual returns are less than the forecast.

• $14,whichadjustscostofsalesforinventoriesexpected(onMarch31) to be reinstated in April when products associated with March sales are returned.

There is a similar interpretation for the $18 replenishment to the sales commission expense, which is also recorded below.

Replenishing PQR's product returns allowance on March 31, 2012: cost of sales component= Debit Credit

+ Allprc = - CGS Allowanceforproductreturns:costofsalescomponent $53

+ +$53 = - -$53 Costofgoodssold $53

Assets Own.Eq.

Replenishing PQR's product returns allowance on March 31, 2012: sales commission component= Debit Credit= - Allprs - SCexp Allowanceforproductreturns:salescommissioncomponent $18

= - +$18 - -$18 Salescommissionexpense $18

Liabilities Own.Eq.


Related to revenues


Related to sales

commissions


Deductions ($159) ($48) ($16) ($95)




Allowance Components Netted When the components of the product return allowance are netted, the result is recognized in a single balance sheet line item that is a liability if customers mostly receive cash when products are returned or a contra asset to gross accounts receivable if receivables tend to be forgiven.

Companies that net the components on the balance sheet could use the same accounts and entries they would have used if they had presented the components separately on the balance sheet. That is the same way we just recorded them for PQR in the previous section. They would then net the components’ balances when creating balance sheets.

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Alternatively, they could use a single products returns allowance account and record the entries (for using and replenishing the allowance) as indicated below. Here, we have assumed the allowance is a contra asset to gross receivables. The debits and credits are the same when the allowance is a liability, but the balance sheet effects differ. We could also have used three entries to record the usage and three more for the replenishment, as we did earlier, for each allowance component.

PQR's product returns for quarter ending March 31, 2012: components netted in single allowance account (liability)= Debit Credit

+ ARG + FGI = + ASCg + AllPR Finishedgoodsinventories $48

+ -$159 + +$48 = + -$16 + -$95 Accruedsalescommission,gross $16

Allowanceforproductreturns:componentsnetted $95

Accountsreceivable,gross $159

LiabilitiesAssets

Replenishing PQR's product returns allowance on March 31, 2012: components netted in single allowance account= Debit Credit= + AllPR - PRCnR - CGS - SCexp Productreturnscontrarevenue $174

= + +$103 - +$174 - -$53 - -$18 Allowanceforproductreturns:componentsnetted $103Costofgoodssold $53Salescommissionexpense $18

Liabilities Owners'Equity


Related to revenues


Related to sales

commissions


Deductions ($159) ($48) ($16) ($95)




Financial Statement EffectsThe table on the next page compares the balance-sheet and income-statement effects of the alternative ways to account for product returns discussed thus far. There are a couple of key observations:

• Theincomestatementeffectsarethesameforallalternatives.

• EachalternativeisalsoconsistentwithUSGAAPandIFRS,whichrequirescompaniestodecreaserevenuesandcostofsaleswhencreatingorreplenishingthereturnsallowance.

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• Neitherstandardsettingbodydiscussestheimplicationsofsalescommissionsfortheproductreturnsallowance.However,asweshallseelaterwhenweexaminecompanydisclosures,somecompaniesadjustproductreturnallowancesforsalescommissions.

• Thebalance-sheeteffectsoftheentriesdifferforthealternativesduetobusinessdifferencesandnettingversusreportingthecomponentsseparately.

• Businessdifferencessuchaspayingcashrefundswhenproductsarereturnedratherthanforgivingreceivablesmeanstherevenuecomponentisrecordedasaliabilityratherthanacontraasset.

• Withineachofthesebusinesscontexts(refundsorforgivingreceivables),thebalance-sheeteffectsoftheindividualentriesdiffersignificantlywhenthecomponentsarenettedversusnotnetted.However,thereisverylittledifferenceintheneteffectsofthetwoentries(usingandreplenishingtheallowance)fornettingversusnotnetting,andthusinreportedendingbalances.

Financial Statement Consequenes of Alternative Ways to Record Product Return Entries

Cash NetReceivables Inventories Net effect

on assets

Accruedsales

commission

Productreturns

allowance

Net effect on liabilities

Revenues,net

Cost of sales

Salescommission

expense

Net effect on owners'

equity

($159) ($159) ($159) ($159) $0

$53 $53 ($18) $174 $156 ($174) ($53) ($18) ($103)

($159) $0 $53 ($106) ($18) $15 ($3) ($174) ($53) ($18) ($103)

$0 $0 $0

($174) $53 ($121) ($18) ($18) ($174) ($53) ($18) ($103)

$0 ($174) $53 ($121) ($18) $0 ($18) ($174) ($53) ($18) ($103)

($159) $48 ($111) ($16) ($95) ($111) $0

$0 $103 $103 ($174) ($53) ($18) ($103)

($159) $0 $48 ($111) ($16) $8 ($8) ($174) ($53) ($18) ($103)

($64) $48 ($16) ($16) ($16) $0

($103) ($103) $0 ($174) ($53) ($18) ($103)

$0 ($167) $48 ($119) ($16) $0 ($16) ($174) ($53) ($18) ($103)

Usingtheallowancewhenproductsarereturned

Replenishingallowanceattheendofquarter

Net effect of two entries

Reporting components separately on BS with revenue component a contra asset (receivables forgiven)

Replenishingallowanceatendofquarter


Usingtheallowancewhenproductsreturned

Netting components on BS with allowance a liability(cash refund)




Netting components on BS with allowance a contraasset (receivables forgiven)



Reporting components separately on BSwith revenue component a liability (cash refund)


Balance Sheet

Assets LiabilitiesIncome statement

The above table illustrates the financial statement consequences of the alternatives permitted by IFRS and US GAAP: the income statement effects are the same and when the balance sheet effects differ significantly, the differences largely reflect business differences.

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Allowance By-PassedFor the earlier alternatives, product returns allowances and their three components decreased (were used up) when products were returned. Strangely enough, for the “by-pass” alternative studied next, the product returns allowance is not affected when products are returned.

Is the by-pass alternative consistent with IFRS and US GAAP? Yes. In fact, the accounts, balance sheets, and income statements are exactly the same as they are for the alternatives studied earlier (for the same netting and revenue-component-balance-sheet classification choices). However, the Schedule II and footnote disclosures, while consistent with GAAP, differ greatly from the earlier alternatives. As a result, outsiders don’t observe critical information.

The first table below reports the measures we will be recording for the by-pass alternative. The second table, which is the one we used for the four earlier alternatives, is provided for comparison.

PQR'S Product Returns Allowance: By-Passed When Products are Returned

Related to revenues


Related to sales

commissions


ProductsreturnedduringquarterendingMarch31,2012 $0 $0 $0 $0

TrialbalanceonMarch31,2012 $30 $9 $3 $18

Adjustmentneededtoensuretargetbalance $15 $5 $2 $8

TargetbalanceonMarch31,2012 $45 $14 $5 $26

Product Returns Allowance Components Netallowanceamounts

reported in Schedule II

PQR'S Product Returns Allowance: Used When Products are Returned

Related to revenues


Related to sales

commissions


ProductsreturnedduringquarterendingMarch31,2012 ($159) ($48) ($16) ($95)

TrialbalanceonMarch31,2012 ($129) ($39) ($13) ($77)

Adjustmentneededtoensuretargetbalance $174 $53 $18 $103



Only one entry affects the allowance for the by-pass alternative: replenishing the allowance. Also, because the allowance components are by-passed when products are returned, rather than used up, the amount needed to replenish the allowance is considerably smaller for the by-pass

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approach. This means two entries are needed to ensure that the income effects for the by-pass approach match those for the other approaches. These are shown below for the case where the three components are netted and the allowance is a contra asset.

• Inthefirstentrybelow,productreturnsarerecordeddirectlytoincome as they occur during the period (rather than to the allowance or the three allowance components). For example, when $48 of inventories are reinstated to finished goods inventories, cost of sales decreases by $48.

• Inthesecondentrybelow,theallowanceis“truedup”$8attheendof the first quarter, March 31, to ensure the ending balance reflects the $26 net cost of the returns expected in April that relate to March sales. This matches the $26 allowance balance for the earlier case when the allowances were netted.

By-pass approach: Record product returns directly to income accounts during period= Debit Credit

+ ARG + FGI = + ASCg - PRCnR - CGS - SCexp Finishedgoodsinventories $48+ -$159 + +$48 = + -$16 - +$159 - -$48 - -$16 Accruedsalescommission,gross $16

Productreturnscontrarevenue $159Accountsreceivable,gross $159Costofgoodssold $48Salescommissionexpense $16

Liabilities Owners'EquityAssets

By-pass approach: 'True-up' the allowance at the end of the period= Debit Credit= + AllPR - PRCnR - CGS - SCexp Productreturnscontrarevenue $15= + +$8 - +$15 - -$5 - -$2 Allowanceforproductreturns:componentsnetted $8

Costofgoodssold $5Salescommissionexpense $2

Liabilities Owners'Equity

Allowance not RecognizedThe final alternative for accounting for product returns may be the one used most frequently in practice: management concludes that if the company were to maintain an allowance, it would be too immaterial to affect users’ decisions. This doesn’t mean the returns are necessarily immaterial. For example, the allowance could be very small relative to the returns if most products were returned shortly after the sales date, which is a common situation. When an allowance is not recognized, product returns are recorded directly to income: the entry is the same as the first one above. The second entry above is not recorded because the allowance is too immaterial to recognize.

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outsideRs’ ChallengeGenerally, at most, outsiders only observe the net numbers reported in Schedule II or a similar footnote. For PQR, this is the last column in the the table we have been referencing:

Outsiders’ challenge is to determine or estimate the components behind the disclosed numbers. When there are three components behind the reported numbers, typically outsiders must make two assumptions for this estimation:

(1) Outsiders must assume or estimate the average ratio of cost of sales to sales for the product returns. This is 30% for PQR. Usually the comparable ratio for cost of sales and net revenues reported on the income statement is a good estimate of the product returns ratio. Again this would be 30% for PQR.

(2) Outsiders must estimate the average ratio of sales commission expense to sales for the product returns, 10% for PQR. Generally, companies don’t disclose this information in their reports so outsiders are left to test the sensitivity of their analysis to a range of estimates. We will assume the outsider has perfect insight below and uses 10%.

To estimate the components behind PQR’s Schedule II beginning balance using these assumptions in the following equation:$18 = revenue component - cost of sales component - sales commission expense component = revenue component - 0.30 * revenue component - 0.10 revenue component = 0.60 revenue component

Thus, solving the equation, the revenue component estimate is $30, which is the actual component, as expected given our assumptions. Once the outsider estimates the revenue component, the other components can be estimated from the assumptions. For example, the cost of sales component estimate will be 30% of the revenue component estimate, or $9. The same equation can be used to estimate the components behind the other Schedule II numbers, except $18 will be replaced by the other Schedule II numbers.

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Company disClosuResIn this section, we are going to illustrate a few of the ways companies disclose product returns information.

While we will see that product return disclosures are generally sparse or nonexistent, we begin with a company that has particularly comprehensivedisclosures,publisherJohnWileyandSons,Inc.TheSales Return Reserves section of the Summary of Significant Accounting Policies footnote below details the way Wiley measures product returns allowances at the balance sheet date - estimates future product returns.

The table in the excerpt shows three components of the allowance are reported separately on the balance sheet. As indicated by the naming convention below, two of these components are recognized in cost of sales:

• Therevenuecomponentisacontraassettogrossreceivables.

• Thecostofsales:inventoriedcostcomponentisincludedininventory.

• Thecostofsales:royaltycostcomponentisacontraliabilitytoaccounts and royalties payable. (It is signed the same as inventories in the table below, indicating it decreases liabilities.)

As indicated in the text above the table, the three components explain the allowances’ $48.9 million balance at the end of fiscal 2011:

$48.908 = $65.663 - $9.485 - $7.270

John Wiley and Sons, Inc, 2011 10-K, Pages 57-58

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Wiley’s Schedule II below reports the inflows and outflows that explain the balance sheet changes in the net allowance. In contrast to Nordstrom, where the deductions were approximately 17 times as large as the beginning balances, the Wiley deductions are closer to twice the beginning balances of the product return allowances.

This is what we would expect given our earlier discussion and the differences in the companies’ businesses. Nordtrom’s customers return clothing and other merchandise generally shortly after the purchase dates. By contrast, Wiley’s customers, and in particular bookstores, are offered relatively long return periods to entice them to display Wiley’s books and other publications. In this way, Wiley shares the longer-term risk the bookstores can’t sell the books to their customers.

John Wiley and Sons, Inc, 2011 10-K, page 82

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From our earlier discussions, we know the $96,841 fiscal 2011 charge to cost and expenses nets three components: one decreases revenue and the other two decrease cost of sales.

We can estimate these components for fiscal 2011 by assuming the 0.31 (= $539,043 / $1,742,551) ratio of cost of sales to revenues reported on the income statement below is a reasonable estimate of the same ratio for the expected returns. To this end, we solve the following equation for the revenue component:

$96,841 = revenue component - cost of sales component

= revenue component - 0.31 * revenue component

= 0.69 revenue component

Thus, the revenue component estimate is $140,349 (= $96,841 / 0.69) and the cost component estimate is $43,508 (= $140,349 - $96,841).

Now we can estimate gross revenues (or more precisely revenues before deducting product returns): $1,882,900 (=$1,742,551+ $140,349). This means revenues related to sales returns is estimated to be 7.5% of gross revenues. Remember, this estimate is no better than our assumptions.

John Wiley Sons, 2011 10-K, page 53

We can go one step further. Assuming a 15% average royalty rate, we estimate the royalty portion of the $43,508 cost of sales component to be $21,052 (=0.15 * $140,349) and the inventoried cost portion to be $22,456 (= $43,508 - $21,052). We can now estimate an entry that summarizes the entries Wiley recorded during fiscal 2011 to replenish the allowance:

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Estimate of Wiley's Fiscal 2011 Entry to Replenish the Returns AllowanceDebit Credit

Productreturnscontrarevenues $140,349Allowanceforproductreturns:costofsales-inventoriedcostcomponent $22,456Allowanceforproductreturns:costofsales-royaltycostcomponent $21,052

Allowanceforproductreturns:revenuecomponent $140,349Costofgoodssold $43,508

Earlier we said companies can recognize the allowance components in separate balance sheet line items, which is what Wiley started doing in fiscal 2011. As indicated below in the Reclassifications section of the Summary of Significant Accounting Policies, prior to 2011 Wiley netted the allowance components into a contra asset to gross accounts receivable.

John Wiley Sons, 2011 10-K, page 56

Next we turn to a competitor of Wiley, especially in textbooks, The McGraw-Hill Company, Inc. In contrast to Wiley, McGraw-Hill reports its product returns allowance in a single balance sheet line item, a contra asset to accounts receivable. We know this because the $242 allowance for doubtful accounts and sales returns reported on the balance sheet excerpt below matches the total for these two allowances at this date in Schedule II (at the top of the next page).

The McGraw-Hill Company, 2011 10-K, Page 43

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The McGraw-Hill Company, 2011 10-K, page 76

The structure of McGraw-Hill’s 2011 Schedule II is similar to Wiley’s and in particular there is enough information to estimate the revenue component of the allowance following the same procedure we used for Wiley.

This was not possible in 2009: no deductions are shown in McGraw-Hill’s Schedule II below, suggesting it used the “by-pass”method prior to 2010. This seems to be a reasonable conclusion because the SEC requires companies to report the “activity” in the accounts reported in Schedule II, suggesting there was no deductions recorded.

The McGraw-Hill Company, 2009 10-K, page 15

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As discussed earlier, when retailers like Nordstrom’s customers return products, they tend to do so within a few days of the purchase dates. As a result the allowance inflows and outflows are much larger than the balances. In fact, the balances are almost immaterial. By contrast, the inflows and outflows can be very material. Thus, using the by-pass method could deprive retailers’ investors of important information.

Using this method is likely less problematic for McGraw-Hill: the magnitude of the allowance balances disclosed in fiscal 2011 are relatively close to the magnitude of the inflows and outflows.

This brings us to Macy’s, a prominent retailer that reported $1.3 billion of net income on $26.4 billion of net revenues in fiscal 2011. Macy’s doesn’t report a Schedule II or related footnote in its fiscal 2011 10-K and the only numerical information about sales returns is in note 8 at the top of the next page:

• A$76millionallowanceforfuturesalesreturnsliabilityisreportedatthe end of fiscal 2011 (third item from the bottom of the table). The balance at the start of the year was $9 million less, which is precisely the amount charged to fiscal 2011 income (see the note below the table). This suggests Macy’s uses the by-pass method.

• IfMacy’susestheby-passmethod,itcanreasonablyarguethatitsdisclosures comply with US GAAP and SEC Schedule II guidelines. Companies must report Schedule II when the allowance balances and activity are material. A $9 million adjustment is immaterial for Macy’s, which reported $1.3 billion of net income for fiscal 2011.

An open issue is how relevant the flows in an out of the allowance would have been to Macy’s investors if the company had not used the by-pass method. Recall that Nordstrom reported more than $1 billion of flows on an allowance balance similar to Macy’s ($70 versus $76). These are the net effects of the three components, so from the earlier discussion we know the revenues decreases can be significantly larger.

This highlights a shortcoming in the SEC Schedule II guidelines, and more generally in related IFRS and US GAAP guidance. The standards permit is a great deal of disparity in sales returns disclosures that can challenge outsiders’ analyses.

As seen throughout this section, there is similar diversity in the underlying entries and balance sheet presentations, which largely explains the length of this section. Hopefully you are now prepared to deal with this diversity.

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Macy’s 2011 10-K, page F-20

TAKE-AWAYSIn this section, we are going to develop a schematic that highlights the key concepts associated with the customer-related allowances discussed in this chapter (bad debts, warranties, and product returns) and more generally with other allowances.

Anticipating LossesArguably the most important concept related to allowances is they are created or replenished when companies anticipate in the current period that an adverse event will happen in the future that will result in outflows of cash (or other assets) or otherwise de-recognition of previously recognized assets. For bad debt allowances, companies anticipate customers will fail to meet their obligations (the adverse future event), which will result in write-offs (de-recognition of receivables). For warranty allowances, companies anticipate customers will require warranty repairs (the adverse future event), which will result in outflows of cash and repair parts.

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Because the anticipated future outflows, or de-recognition of assets, are contingent on future adverse events occurring, they are called contingent losses. In this chapter, we studied contingent losses and allowances associated with customers. However, the concept extends to other areas and, in particular to contingent losses associated with pending legal disputes.

Informing Stakeholders of Anticipated LossesManagement has a responsibility to inform stakeholders of anticipated losses once its probable they will occur. They do this by recognizing an asset impairment ( or a contra asset, such as the bad debts allowance) or a liability associated with future asset outflows (such as warranty allowance). These result in a decrease in owners’ equity and, in particular, net income. For example, bad debt expense for receivables impairments, cost of sales for warranty obligations and two or more income items for product returns. Thus, management is telling owners the book value of their claims have decreased because anticipating adverse events has triggered impairing an asset or recognizing a liability.

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Use the Allowance When Adverse Events OccurWhen previously anticipated adverse events occur in future periods, use the allowance to recognize the asset outflow or asset de-recognition. For example, use the bad debt allowance to write off receivables or the warranty allowance to pay for repairs. Here is the completed schematic:

revenue and customers-related balance sheet concepts · risks and risk sharing 4 ... (receivables,...

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