5. GAAP Reporting—Graphic Apparel Corporation
This chapter is composed of an email to a client. In this scenario “The Accounting Firm” is reaching out to their client Nicki in response to some questions about proper reporting methods. To serve as a realistic interaction between client and firm, this chapter is in email format.
The first issue that came up during our analysis was in the area of revenue recognition. It is to my understanding that the custom shirt branch of your business is relatively new, yet thriving. While this is great for GAC, it is important to note that you cannot recognize the revenue from custom orders, or any orders, until your customers have received your product. This follows the assumption that revenue should be recognized in the period which it is earned. Furthermore, because you have already received partial payment, you must record this as unearned revenue until the shirts are actually sent to the customer. For information on how to handle this situation as far as bookkeeping goes, see the attachments.
The next minor fix that needs to take place deals with the accounting for your new customers. According to the information you provided us, it seems that some of your new customers are likely to default on their payments. Because you can reasonably estimate this “bad debt,” GAAP say that you must account for it by creating an “Allowance for Doubtful Accounts” account. This account is a contra asset with a credit balance that essentially reduces your Accounts Receivable by the amount that you reasonably estimate will not be collected. For instance, if your AR balance is at $10,000 and you estimate that you will not collect $500 worth of your receivables, then you would record your Net Accounts Receivable as $9,500—where Gross AR is a debit balance of $10,000 and Allowance for Doubtful Accounts has a credit balance of $500. This provides more accurate information to the bank about the net realizable value of your receivables.
Another area to focus our attention is the recording of sales returns.
According to your recent surveys, it seems that nearly $15,000 of your graphic tees are still out at retail stores, yet most of the stores no longer have your shirts on display. Though it seems likely that most will be returned, you have not had a situation like this in the past, and therefore, you cannot reasonably estimate the amount of sales returns you will have. Therefore, you need to reduce the sales revenue from these shirts and put them back on your books as inventory. This way, you are not understating your inventory by not including shirts that could easily be returned. Of course, you must remember that you would not increase your inventory by the $15,000 selling price of these shirts. Rather, you would record them at the lower of cost or market. Again, see the attachments for more details on how to handle this change.
The final problem we need to address is the water damage that your plain t- shirts incurred during the month of May. Although it was very creative of you to work the damage into your design, according to GAAP standards, these shirts are damaged and must be impaired to bring them back to their net realizable value.
Now, sadly this will involve you recording a loss on your income statement, as the value of your inventory has decreased. However, if you continue to get normal selling price for these shirts then this inventory impairment will not impact your net income. We just want to implement this change so GAC is not overstating its inventory and thus overstating its current ratio.
This brings us to the final topic: the impact on your relationship with the bank. As we have discussed above, there are quite a few changes that need to be
made in order for your books to be reported correctly according the GAAP standard.
Of course, these changes are going to have some effect on your balance sheet, namely on your current assets and liabilities. The attachments will give you the exact numbers, but these changes will ultimately reduce your current ratio enough that you will have to reach out to equity investors in order to get your ratios back up to the bank’s minimum requirement. To be safe, you should reach for about
$10,000 in equity funding, and then your current ratio will be back to an acceptable level.
If gathering that much capital is an issue, you could expedite the production of your custom shirts, send those off, and update your unearned revenue to sales revenue. This would reduce your current liabilities (unearned revenue) and increase your current assets (Accounts receivable) enough to bring your current ratio back to 1.01, an appropriate level.
I hope our solutions were helpful, and please feel free to contact us via email or phone if you have any questions.
Respectfully, Cole McCall, CPA Assurance Partner The Accounting Firm
Attachment 1: Journal Entries
Solution 1
Required journal entry:
Sales Revenue 10,000 Unearned Revenue 7,500 Accounts Receivable 2,500
*To reduce sales revenue from unfulfilled custom order, establish unearned revenue corresponding to cash received, and to reduce accounts receivable from sales not yet made.
Solution 2
Required journal entry:
Bad Debt Expense 3,000
Allowance for Doubtful Accounts 3,000
*To bring accounts receivable to net realizable value by accounting for accounts that are likely to default.
Solution 3
Required journal entries:
Sales Revenue 15,000
Accounts Receivable 15,000
*To reduce sales and accounts receivable by amount in which returns are expected but unknown.
Inventory 7,800
Cost of Goods Sold 7,800
*To increase inventory and reduce cost of goods sold by cost amount of unknown but expected sales returns in entry above. 7800 = 15,000*(1-.48), where .48 = profit margin.
Solution 4
Require journal entries:
Loss on inventory damage 5,100
Inventory 5,100
*To impair inventory to net realizable value, where 5,100 = .5*10,200, the reported amount of plain shirts and ink at cost. This number is chosen based on the fact that half of the inventory was damaged and no circumstances lead us to believe otherwise that damaged shirts are held in other inventories.