Reporting and Interpreting Sales Revenue, Receivables, and Cash

Chapter 6

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives
Apply the revenue principle to determine the accepted time to record sales revenue for typical retailers, wholesalers, manufacturers, and service companies.

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Accounting for Sales Revenue

The revenue principle requires that revenues be recorded when earned:

Goods or services have been delivered.

Amount of customer payments known.

Collection is reasonably assured.

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Learning Objectives
Analyze the impact of credit card sales, sales discounts, and sales returns on the amounts reported as net sales.

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Reporting Net Sales

Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor these transactions.

Sales revenue Less: Credit card discounts Sales discounts Sales returns and allowances Net sales

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Credit Card Sales

Companies accept credit cards for several reasons: 1. To increase sales. 2. To avoid providing credit directly to customers.

3. To avoid losses due to bad checks.

4. To avoid losses due to fraudulent credit card sales.

5. To receive payment quicker.

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Credit Card Sales

When credit card sales are made, the company must pay the credit card company a fee for the service it provides.

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Sales on Account

When companies allow customers to purchase merchandise on an open account, the customer promises to pay the company in the future for the purchase.

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Sales Discounts

2/10, n/30
Read as: Two ten, net thirty
When customers purchase on open account, they may be offered a sales discount to encourage early payment.

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Sales Discounts

2/10, n/30
Discount Percentage # of Days in Discount Period Otherwise, the Full Amount Is Due Maximum Days in Credit Period

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To Take or Not Take the Discount

With discount terms of 2/10,n/30, a customer saves $2 on a $100 purchase by paying on the 10th day instead of the 30th day.
Interest Rate for 20 Days =
Interest Rate for 20 Days =

Amount Saved Amount Paid

$2 $98 = 2.04%

Annual Interest Rate =

365 Days 2.04% = 37.23% 20 Days

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Sales Returns and Allowances

Debited for damaged merchandise. Debited for returned merchandise. Contra revenue account.

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Learning Objectives

Analyze and interpret the gross profit percentage.

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Gross Profit Percentage

Gross Profit Percentage = Gross Profit Net Sales

In 2003, Deckers reported gross profit of $51,345,000 on sales of $121,055,000. All other things equal, a higher gross profit results in higher net income.

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Gross Profit Percentage

Gross Profit Percentage Gross Profit Percentage = Gross Profit Net Sales $51,345,000 $121,055,000 = 42.4%

All other things equal, a higher gross profit results in higher net income.

2003 Gross Profit Comparisons Deckers Skechers U.S.A. Timberland 42.4% 38.0% 46.5%

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Measuring and Reporting Receivables

Accounts Receivable
Trade receivables are amounts owed to the business for credit sales of goods, or services. Nontrade receivables are amounts owed to the business for other than business transactions.

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Measuring and Reporting Receivables Notes Receivable

$1,200 Term Goleta, CA January 5, 2006 Payee

Sixty days
Principal the order of Payable at

after date I promise to pay to

Deckers Outdoor Corporation Interest Rate First Goleta National Bank 12%

One thousand two hundred --------------------------------- Dollars Maker per annum

Value received with interest at No. 10242 Due March 6, 2007

Ivan Goodson

Goodson Sporting Goods

Due Date

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Learning Objectives
Estimate, report, and evaluate the effects of uncollectible accounts receivable (bad debts) on financial statements.

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Accounting for Bad Debts

Bad debts result from credit customers who will not pay the business the amount they owe, regardless of collection efforts.

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Accounting for Bad Debts

Bad Debt Expense

Matching Principle

Record in same accounting period.

Sales Revenue

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Accounting for Bad Debts

Most businesses record an estimate of the bad debt expense by an adjusting entry at the end of the accounting period.

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Recording Bad Debt Expense Estimates

Deckers estimated bad debt expense for 2003 to be $504,000. Prepare the adjusting entry.

GENERAL JOURNAL
Date Dec. 31 Description Debit Credit

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Recording Bad Debt Expense Estimates

Deckers estimated bad debt expense for 2003 to be $504,000. Prepare the adjusting entry.
Bad Debt Expense is normally classified as a GENERAL JOURNAL and is closed at year-end. Date selling expense Description Debit
Dec. 31 Bad Debt Expense Allowance for Doubtful Accounts 504,000 504,000

Credit

Contra asset account

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Allowance for Doubtful Accounts

Balance Sheet Disclosure

Accounts receivable Less: Allowance for doubtful accounts Net realizable value of accounts receivable

Amount the business expects to collect.

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Writing Off Uncollectible Accounts

When it is clear that a specific customers account receivable will be uncollectible, the amount should be removed from the Accounts Receivable account and charged to the Allowance for Doubtful Accounts.

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Writing Off Uncollectible Accounts

Deckers total write-offs for 2003 were $876,000. Prepare a summary journal entry for these write-offs.

GENERAL JOURNAL
Date Description Debit Credit

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Writing Off Uncollectible Accounts

Deckers total write-offs for 2003 were $876,000. Prepare a summary journal entry for these write-offs.

GENERAL JOURNAL
Date Description Allowance for Doubtful Accounts Accounts Receivable Debit 876,000 876,000 Credit

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Writing Off Uncollectible Accounts

Assume that before the write-off, Deckers Accounts Receivable balance was $11,000,000 and the Allowance for Doubtful Accounts balance was $1,000,000. Lets see what effect the total write-offs of $876,000 had on these accounts.

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Writing Off Uncollectible Accounts

Before WriteOff Accounts receivable $ 11,000,000 Less: Allow. for doubtful accts. 1,000,000 Net realizable value $ 10,000,000

After WriteOff $ 10,124,000 124,000 $ 10,000,000

Notice that the total write-offs of $876,000 did not change the net realizable value nor did it affect any income statement accounts.

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Methods for Estimating Bad Debts

Percentage of credit sales or Aging of accounts receivable

????

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Percentage of Credit Sales

Bad debt percentage is based on actual uncollectible accounts from prior years credit sales.

Focus is on determining the amount to record on the income statement as Bad Debt Expense.

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Percentage of Credit Sales

Net credit sales % Bad debt loss rate Amount of journal entry

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Percentage of Credit Sales

In 2006, Kids Clothes had credit sales of $600,000. Past experience indicates that bad debts are one percent of sales. What is the estimate of bad debts expense for 2006? $600,000 .01 = $6,000

Now, prepare the adjusting entry.

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Percentage of Credit Sales

GENERAL JOURNAL
Date Description Allowance for Doubtful Accounts Debit Credit 6,000 6,000 Dec. 31 Bad Debt Expense

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Now lets discuss another method that is used to account for uncollectible accounts.

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Aging of Accounts Receivable

Focus is on determining the desired balance in the Allowance for Doubtful Accounts on the balance sheet.

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Aging Schedule

Each customers account is aged by breaking down the balance by showing the age (in number of days) of each part of the balance.
An aging of accounts receivable for Kids Clothes in 2006 might look like this . . .

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Aging Schedule
Days Past Due Not Yet Due $ 1,200 Total A/R 61-90 Over 90 Balance $ 235 1,500 $ 200 $ 500 750 $ 1,540 $ 1,240 325 $10,660

Customer Aaron, R. Baxter, T. Clark, J. Zak, R. Total

1-30 $ 235 300

31-60

$ $ 3,500 $ 2,550

50

325 $ 1,830

Based on past experience, the business estimates the percentage of uncollectible accounts in each time category.

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Aging Schedule
Days Past Due Not Yet Due $ 1,200 Total A/R 61-90 Over 90 Balance $ 235 1,500 $ 200 $ 500 750 $ 1,540 0.25 $ 1,240 0.40 325 $10,660

Customer Aaron, R. Baxter, T. Clark, J. Zak, R. Total % Uncollectible

1-30 $ 235 300

31-60

$ $ 3,500 0.01 $ 2,550 0.04

50

325 $ 1,830 0.10

These percentages are then multiplied by the appropriate column totals.

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Aging Schedule
Days Past Due Total The column totals are then added to Not Yet A/R arrive the total estimate of 90 Balance Customer Due at 1-30 31-60 61-90 Over Aaron, R. $ 235 uncollectible accounts of $1,201. $ 235 Baxter, T. $ 1,200 300 1,500 Clark, J. $ 50 $ 200 $ 500 750 Zak, R. Total % Uncollectible Estimated Uncoll. Amount $ 3,500 0.01 $ 35 $ 2,550 0.04 $ 102 325 $ 1,830 0.10 $ 183 $ 1,540 0.25 $ 385 $ 1,240 0.40 $ 496 325 $10,660

$ 1,201

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Aging of Accounts Receivable

Days Past Due Record the Dec. 31, 2006, adjusting entry assuming that the Allowance for Doubtful Total Not Yet A/R AccountsDue currently a $50 61-90 creditOver balance. Customer 1-30 has 31-60 90 Balance Aaron, R. Baxter, T. Clark, J. Zak, R. Total % Uncollectible Estimated Uncoll. Amount $ 1,200 $ 235 300 $ $ 3,500 0.01 $ 35 $ 2,550 0.04 $ 102 50 $ 200 $ 1,540 0.25 $ 385 $ 500 $ 1,240 0.40 $ 496 325 $ 1,830 0.10 $ 183 $ 235 1,500 750

325 $10,660

$ 1,201

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Aging of Accounts Receivable

GENERAL JOURNAL
Date Description Allowance for Doubtful Accounts Post. Ref. Debit 1,151 1,151 Credit

Dec. 31 Bad Debt Expense

1,201 Desired Balance After posting, the Allowance 50 Credit Balance account would $ 1,151 Adjusting Entry

look like this . . .

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Aging of Accounts Receivable

Allowance for Doubtful Accounts
50 Balance at 12/31/2006 before adj. 2006 adjustment Balance at 12/31/2006 after adj.

Notice that the balance after adjustment is equal to the estimate of $1,201 based on the aging analysis performed earlier.

1,151 1,201

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Aging of Accounts Receivable

Accounts Receivable % Estimated Uncollectible Desired Balance in Allowance Account - Allowance Account Credit Balance Amount of Journal Entry Accounts Receivable % Estimated Uncollectible Desired Balance in Allowance Account + Allowance Account Debit Balance Amount of Journal Entry

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Learning Objectives
Analyze and interpret the accounts receivable turnover ratio and the effects of accounts receivable on cash flows.

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Receivables Turnover
Receivables Turnover = Net Sales Average Net Trade Receivables

Deckers reported 2003 net sales of $121,055,000. December 31, 2002, receivables were $18,745,000 and December 31, 2003, receivables were $20,851,000.

This ratio measures how many times average receivables are recorded and collected for the year.

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Receivables Turnover
Receivables Turnover = Net Sales Average Net Trade Receivables

Receivables $121,055,000 = 6.1 = Turnover ($18,745,000 + $20,851,000) 2 This ratio measures how many times average receivables are recorded and collected for the year.
2003 Receivables Turnover Comparisons Deckers 6.1 Skechers 8.5 Timberland 10.4

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Focus on Cash Flows

Add Decrease in Accounts Receivable Sales Revenue Cash Collected from Customers

Subtract Increase in Accounts Receivable

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Learning Objectives

Report, control, and safeguard cash.

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Cash and Cash Equivalents

Checks Money Orders

Cash and Cash Equivalents

Certificates of Deposit T-Bills Bank Drafts

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Internal Control of Cash

Internal control refers to policies and procedures that are designed to:
Properly account for assets. Safeguard assets. Ensure the accuracy of financial records.

Cash is the asset most susceptible to theft and fraud.

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Internal Control of Cash

Custody

Separation of Duties

Recording

Authorization

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Internal Control of Cash

Bank Reconciliations
Daily Deposits Purchase Approval

Cash Controls
Prenumbered Checks

Payment Approval

Check Signatures

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Bank Reconciliation

Explains the difference between cash reported on bank statement and cash balance on companys books.

Provides information for reconciling journal entries.

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Bank Reconciliation

Balance per Bank

Balance per Book

+ Deposits by Bank (credit memos) - Service Charge - NSF Checks Book Errors = Correct Balance

+ Deposits in Transit

- Outstanding Checks

Bank Errors = Correct Balance

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Bank Reconciliation

All reconciling + Deposits in Transit items on the book side - Outstanding Checks require an adjusting entry Bank Errors to the cash account.
Balance per Bank = Adjusted Balance

Balance per Book

+ Deposits by Bank (credit memos) - Service Charge - NSF Checks Book Errors = Correct Balance

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Bank Reconciliation
Prepare a July 31 bank reconciliation statement and the resulting journal entries for the Simmons Company. The July 31 bank statement indicated a cash balance of $9,610, while the cash ledger account on that date shows a balance of $7,430. Additional information necessary for the reconciliation is shown on the next page.

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Bank Reconciliation

Outstanding checks totaled $2,417. A $500 check mailed to the bank for deposit had not reached the bank at the statement date. The bank returned a customers NSF check for $225 received as payment of an account receivable. The bank statement showed $30 interest earned on the bank balance for the month of July. Check 781 for supplies cleared the bank for $268 but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously credited to our account by the bank.

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Bank Reconciliation
Ending bank balance, July 31 Additions: Deposit in transit Deductions: Bank error $ 486 Outstanding checks 2,417 Correct cash balance $ 9,610 500

2,903 $ 7,207

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Bank Reconciliation
Ending bank balance, July 31 Additions: Deposit in transit Deductions: Bank error $ 486 Outstanding checks 2,417 Correct cash balance Ending book balance, July 31 Additions: Interest Deductions: Recording error $ NSF check Correct cash balance $ 9,610 500

2,903 $ 7,207 $ 7,430 30

28 225

253 $ 7,207

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Bank Reconciliation

GENERAL JOURNAL
Date Jul 31 Cash Interest Revenue 31 Supplies Inventory Accounts Receivable Cash 28 225 253 Description Post. Ref. Debit 30 30 Credit

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Chapter Supplement A
Recording Discounts and Returns

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Credit Card Sales

On January 2, a Deckers factory stores credit card sales were $3,000. The credit card company charges a 3% service fee. Prepare the Deckers journal entry.

GENERAL JOURNAL
Date Jan. 2 Description Debit Credit

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Credit Card Sales

On January 2, a Deckers factory stores credit card sales were $3,000. The credit card company charges a 3% service fee. Prepare the Deckers journal entry.
Credit Card Discounts are reported as a contra-revenue account.

GENERAL JOURNAL
Date Description Credit Card Discounts Sales Revenue $3,000 3% = $90 Credit Card Fee Debit 2,910 90 3,000 Credit Jan. 2 Accounts Receivable

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Sales Discounts
On January 6, Deckers sold $1,000 of merchandise on credit with terms of 2/10, n/30. Prepare the Deckers journal entry.

GENERAL JOURNAL
Date Jan. 6 Description Debit Credit

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Sales Discounts
On January 6, Deckers sold $1,000 of merchandise on credit with terms of 2/10, n/30. Prepare the Deckers journal entry.

GENERAL JOURNAL
Date Jan. Description Sales Revenue Debit 1,000 1,000 Credit 6 Accounts Receivable

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Sales Discounts
On January 14, Deckers receives the appropriate payment from the customer for the January 6 sale. Prepare the Deckers journal entry.

GENERAL JOURNAL
Date Jan. 14 Description Debit Credit

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Sales Discounts
On January 14, Deckers receives the appropriate payment from the customer for the January 6 sale. Prepare the Deckers journal entry.
$1,000 2% = $20 sales discount

$1,000 - $20 = $980 cash receipt GENERAL JOURNAL

Date Jan. 14 Cash Sales Discounts Accounts Receivable Description Debit 980 20 1,000 Credit

Contra-revenue account

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Sales Discounts
If the customer remits the appropriate amount on January 20 instead of January 14, what entry would Deckers make?

GENERAL JOURNAL
Date Jan. 20 Description Debit Credit

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Sales Discounts
If the customer remits the appropriate amount on January 20 instead of January 14, what entry would Deckers make?
Since the customer paid outside of the discount period, a sales discount is not granted.

GENERAL JOURNAL
Date Jan. 20 Cash Accounts Receivable Description Debit 1,000 1,000 Credit

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Sales Returns and Allowances

On July 8, before paying, a customer returns $500 of sandals originally purchased on account from Deckers. The sandals originally cost Deckers $300. Prepare the Deckers journal entry.
GENERAL JOURNAL
Date Description Debit Credit

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Sales Returns and Allowances

On July 8, before paying, a customer returns $500 of sandals originally purchased on account from Deckers. The sandals originally cost Deckers $300. Prepare the Deckers journal entry.
GENERAL JOURNAL
Date
July

Description
Accounts Receivable

Debit
500

Credit
500

8 Sales Returns and Allowances

July

8 Merchandise Inventory Cost of Goods Sold

300 300

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Chapter Supplement B
Applying the Revenue Principle in Special Circumstances

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Delayed Revenue Recognition: Installment Method Generally, revenue is recognized when: An exchange has taken place. The earnings process is nearly complete. Collection is probable.

Uncertain collectibles result in delaying revenue recognition until cash is collected.

Installment method: revenue is recognized as cash is collected, often over several accounting periods.

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Revenue Recognition Before the Earnings Process is Complete: Long-Term Construction Contracts
Completed Contract Method Revenue and expenses are recognized in the year the contract is completed. Construction-in progress years show no revenue or expenses. Percentage-ofCompletion Method Revenue and expenses recognized each year as work is accomplished. Revenues each year are based on the ratio of costs incurred to total costs.

Lets look at an example of the percentage-of-completion method.

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Revenue Recognition Before the Earnings Process is Complete: Long-Term Construction Contracts
Acme Construction is constructing a building for Jones Foods over a three-year period for a total price of $50,000,000. Acme reported the following progress in year one:
Year 1 40,000,000 10,000,000 Year 2 Year 3

Estimated total cost Cost incurred in year one

How much revenue and expense should be recognized on the project in year one using the percentage of completion method?

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Revenue Recognition Before the Earnings Process is Complete: Long-Term Construction Contracts
Acme Construction is constructing a building for Jones Foods over a three-year period for a total price of $50,000,000. Acme reported the following progress in year one:
Year 1 40,000,000 10,000,000 Year 2 Year 3

Estimated total cost Cost incurred in year one

Percent complete = Percent complete =

Total costs incurred to date Estimate of total project cost

$10,000,000 = 25% $40,000,000

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Revenue Recognition Before the Earnings Process is Complete: Long-Term Construction Contracts
Acme Construction is constructing a building for Jones Foods over a three-year period for a total price of $50,000,000. Acme reported the following progress in year one:
Year 1 40,000,000 10,000,000 Year 2 Year 3

Estimated total cost Cost incurred in year one

Construction revenue (25% of $50,000,000) Construction expense Construction income

$ $

12,500,000 10,000,000 2,500,000

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End of Chapter 6