Learning Objectives

1
Learning Objectives

• After studying this chapter, you should be able
  to
• Recognize revenue items at the proper time on the
  income statement.
• Account for cash and credit sales.
• Record sales returns and allowances, sales
  discounts, and bank credit card sales.
• Manage cash and explain its importance to the
  company.

2
Learning Objectives

• After studying this chapter, you should be able
  to
• Estimate and interpret uncollectible accounts and
  receivable balances.
• Assess the level of accounts receivable.
• Develop and explain internal control procedures.

3
Recognition of Sales Revenue

• The timing of revenue recognition is critical to
  the measurement of net income.
• Revenue is part of the calculation of net income.
• Net income Revenue - Expenses
• Measurement of revenue sometimes determines when
  a company recognizes certain expenses because of
  the matching principle.
• Expenses must be recognized in the same period as
  the revenues that create the expenses.

4
Recognition of Sales Revenue

• Some users of financial information
  want revenues to be recorded as soon
  as possible.
• Others want to be sure that a company
  will actually receive payment before
  revenues are recorded.
• Accountants must carefully assess when revenue
  should be recognized.

5
Recognition of Sales Revenue

• Recognition of revenue requires a two-pronged
  test
• The revenue is earned.
• Goods or services must be delivered to the
  customers.
• The revenue is realized.
• Cash or other assets must be received.

6
Recognition of Sales Revenue

• What happens if revenue on one sale is earned
  over a long period of time, for example, on a
  long-term contract?
• Generally, the revenue from a long-term contract
  should be recognized as the work on that contract
  is performed.
• For example, if one-fourth of the work is
  completed in the first year, one-fourth of the
  revenue should be recognized.

7
Merchandise Returnsand Allowances

• What happens when sales are recognized at the
  point of sale and a customer returns the goods
  that were sold?
• Sales returns - products returned to the seller
  by the purchaser for various reasons
• These are purchase returns from the customers
  perspective.

8
Merchandise Returnsand Allowances

• Sometimes, instead of returning merchandise, the
  customer demands a reduction, (a sales allowance)
  in the selling price.
• Sales allowance - reduction of the original
  selling price, which is the price previously
  agreed upon by both parties
• These are purchase allowances from the customers
  perspective.

9
Merchandise Returnsand Allowances

• Usually, a contra account called Sales Returns
  and Allowances is used to accumulate both sales
  returns and sales allowances.
• By using a contra account, the amount of gross
  sales is readily available, which allows managers
  to monitor the level of returns and allowances
  for various reasons.
• Using the contra account avoids changing the
  original sales entry for the amounts returned.

10
Merchandise Returnsand Allowances

• Journal entries for returns and allowances
• To record the sale
• Accounts receivable 900,000
• Sales revenue 900,000
• To record the returns and allowances
• Sales returns and allowances 80,000
• Accounts receivable 80,000

11
Merchandise Returnsand Allowances

• Gross sales - total sales revenue before
  deducting sales returns and allowances, if any
• Net sales - total sales revenue reduced by sales
  returns and allowances
• Income statement presentation
• Gross sales 900,000
• Less Sales returns and allowances 80,000
• Net sales 820,000

12
Credit Sales andAccounts Receivable

• Accounts receivable - amounts owed to a company
  by customers as a result of delivering goods or
  services and extending credit in the ordinary
  course of business
• Also known as trade receivables or simply
  receivables
• The main benefit of granting credit
  is a boost in sales and
  profits that would
  otherwise be lost if credit
  were not extended.

13
Uncollectible Accounts

• Uncollectible accounts (bad debts) - receivables
  determined to be uncollectible because debtors
  are unable or unwilling to pay their debts
• Uncollectible accounts are a major cost of
  granting credit to customers.
• Accountants call this cost bad debts expense.
• Extent of nonpayment can vary greatly with size
  of companies and industries and depend on the
  credit risk that managers are willing to accept.

14
Measurement ofUncollectible Accounts

• Two basic ways to record uncollectibles
• Specific write-off method - wait to see which
  receivables will not be paid and write them off
  at that time
• Allowance method - make estimates
  of the portion of accounts receivable
  that will not be collected

15
Specific Write-off Method

• Disadvantage
• It fails to apply the matching principle
  (expenses must be recorded in the same period
  as the related revenues) if the receivable is
  written off in a period other than when the
  receivable is recorded.
• Advantages
• It follows the cost-benefit concept because it is
  simple and extremely inexpensive to use.
• If amounts of bad debts are small (immaterial),
  no great error in measurement of income occurs.

16
Allowance Method

• The allowance method estimates the amount of
  uncollectible accounts to be matched to the
  related revenue.
• It allows accountants to recognize bad debts
  during the proper period, before specific
  uncollectible accounts are identified
  in a subsequent period.

17
Allowance Method

• The allowance method has two basic elements
• An estimate of the amounts that will ultimately
  be uncollectible
• A contra account, Allowance for Uncollectible
  Accounts, which contains the estimate and is
  deducted from Accounts Receivable
• The allowance method is based on historical
  experience and the assumption that the current
  year is similar to prior years.

18
Allowance Method

• Presentation of Accounts Receivable under the
  allowance method
• Accounts receivable 40,000
• Less Allowance for uncollectible accounts
  2,000
• Net accounts receivable 38,000
• 
  

19
Applying the Allowance Method Using a Percentage
of Sales

• Percentage of sales method - an approach to
  estimating bad debts expense and uncollectible
  accounts based on historical relations between
  credit sales and uncollectibles
• Bad debts are assumed to be some percentage of
  sales.

20
Applying the Allowance Method Using a Percentage
of Sales

• Echo Company has 150,000 in credit sales.
  Historically, 2 of credit sales are determined
  to be uncollectible. During the year, Echo
  Company determines that 2,000 of receivables
  will not be collected. What are the entries to
  record the sales, establish the Allowance
  account, and write off the uncollectible accounts?

21
Applying the Allowance Method Using a Percentage
of Sales

• The entry to record the sales
• Accounts receivable 150,000
• Sales 150,000
• The entry to record the estimate for bad debts
• Bad debts expense 3,000
• Allowance for uncollectible accounts
  3,000
• The entry to record actual uncollectible
  accounts
• Allowance for uncollectible accounts 2,000
• Accounts receivable 2,000

22
Applying the Allowance Method Using a Percentage
of Accounts Receivable

• Percentage of accounts receivable method - an
  approach to estimating bad debts expense and
  uncollectible accounts at year end using the
  historical relations of
  uncollectibles to accounts
  receivable

23
Applying the Allowance Method Using a Percentage
of Accounts Receivable

• The Allowance for Uncollectible accounts is used
  to estimate the approximate amount of bad debts
  included in the ending Accounts Receivable.
• Additions to Allowance for Uncollectible Accounts
  are calculated to achieve a desired ending
  balance in the Allowance account.
• An adjusting journal entry is made to adjust the
  balance in the Allowance account to the desired
  balance at the end of the year.

24
Applying the Allowance Method Using a Percentage
of Accounts Receivable

• Calculating the allowance under the percentage of
  receivables method
• Divide average bad debts by average ending
  balance of Accounts Receivable to calculate the
  historical average uncollectible percentage.
• Apply the percentage from step 1 to the ending
  Accounts Receivable balance to determine the
  desired ending balance in the Allowance account
  at the end of the year.
• Prepare an adjusting entry to adjust the
  Allowance account to the amount determined in
  step 2.

25
Applying the Allowance Method Using the Aging of
Accounts Receivable

• Aging of accounts receivable method - an analysis
  that considers the composition of year-end
  accounts receivable based on the ages of the
  debts.
• The more time elapses after the sale, the less
  likely collection of the receivable becomes.
• The aging gives a desired balance in the
  Allowance account just as the percentage of
  accounts receivable method does however, the
  amount desired in the Allowance account will
  probably be somewhat different.

26
Applying the Allowance Method Using the Aging of
Accounts Receivable

• Accounts receivable aging schedule
• 1-30 days 31-90 days Over 90 days Total
• Accounts
• receivable 70,000 30,000 2,000
• Percentage 1 2
  90
• 700 600 1,800 3,100
• 
  
  
• 3,100 is the desired amount in the Allowance
  account. A journal entry will be made to adjust
  the Allowance account to that amount.

27
Bad Debt Recoveries

• Sometimes accounts will be collected after they
  have been written off.
• When this happens, the write-off should be
  reversed and the collection handled as a normal
  receipt on account.