Chapter 5

1. Chapter 5 Accounting for Sales

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. Recognition of Sales Revenue • Most revenues are recognized at the point of sale (when goods are sold and cash changes hands). • At this point, both recognition tests are met. • Sometimes the tests are not always met at the same time. This results in unearned revenue. • Cash is received, but nothing is given in exchange.

8. 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.

9. Measurement of Sales Revenue • Revenue is measured in terms of the cash equivalent value of the asset received. • Journal entries to record sales: Cash xxxx Sales revenue xxxx OR Accounts receivable xxxx Sales revenue xxxx

10. 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 customer’s perspective.

11. 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 customer’s perspective.

12. 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.

13. 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

14. 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 ====================

15. Merchandise Returnsand Allowances • Discounts on sales also affect the amount reported as sales. • Two major types of discounts: • Trade discounts • Cash discounts

16. Merchandise Returnsand Allowances • Trade discounts - reductions to the gross selling price for a particular class of customers to arrive at the actual selling price (invoice price) • Trade discounts are generally price concessions or purchase incentives. • The gross sales revenue recognized from a trade discount is the price received after deducting the discount.

17. Merchandise Returnsand Allowances • Cash discounts - reductions of invoice prices awarded for prompt payment of the invoice • Encourage prompt payment and reduce manufacturer’s or seller’s need for cash • Reduces the risk of bad debts (nonpayment) • Purchasers should always take purchase discounts if possible.

18. Recording Charge Card Transactions • Cash discounts also occur when retailers accept charge cards. • Retailers accept charge cards for three reasons: • To attract credit customers who would otherwise shop elsewhere • To get cash immediately rather than wait for customers to pay • To avoid the cost of keeping track of many customer accounts

19. Recording Charge Card Transactions • Retailers deposit the charge slips in the bank (just like cash), but this costs money (usually from 1% to 3% of gross sales). • This cost must be included in the calculation of net sales. EXAMPLE: $10,000 of sales where the charge card company charges 3% Cash 9,700 Cash discounts for bank cards 300 Sales 10,000

20. Accounting forNet Sales Revenue • Cash discounts and sales returns and allowances are recorded as deductions from gross sales. Gross sales $20,000 Deduct: Sales returns and allowances $200 Cash discounts on sales 550 750 Net sales $19,250 ==================

21. Accounting forNet Sales Revenue • The income statement allows different systems for accounting for net sales. • The preceding example shows sales, sales returns and allowances, and cash discounts in separate accounts. • Net sales can be shown in one account where all sales returns and allowances and cash discounts directly decrease the sales account.

22. Cash • Many companies combine cash and cash equivalents on their balance sheets. • Cash equivalents - highly liquid short-term investments that can easily and quickly be converted into cash • Cash encompasses all items that are accepted for deposit by a bank. • Paper money, coins, money orders, and checks

23. Compensating Balances • Compensating balances - required minimum cash balances on deposit when money is borrowed from banks • The size of the compensating balance usually depends on the amount borrowed. • Annual reports must disclose the state of any significant compensating balances. • Without such a disclosure, readers might think that a company has more cash available than it really does.

24. Management of Cash • Managers spend much time managing cash for several reasons. • Although cash balances may be small at any one time, the flow of cash can be enormous. • Because cash is the most liquid asset, it is enticing to thieves and embezzlers. • Adequate cash is essential to the smooth functioning of operations. • Cash itself does not earn income. It is important not to hold excess cash; it should be invested.

25. Management of Cash • To reconcile a bank statement means to verify that the bank balance for cash is consistent with the accounting records. • The accounting balance and the bank balance are rarely the same. • Deposits and checks are recorded in the books when made or written. • Banks may receive the deposits or process the checks days later.

26. Management of Cash • Internal control procedures to safeguard cash: • The individuals who receive cash do not also disburse cash. • The individuals who handle cash cannot access accounting records. • Cash receipts are immediately recorded and deposited and are not used directly to make payments. • Disbursements are made by serially numbered checks, only with proper authorization by someone other than the person writing the check. • Bank accounts are reconciled monthly.

27. 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.

28. 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.

29. 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

30. Specific Write-off Method • The specific write-off method assumes that all sales are fully collectible until proved otherwise. • This method is used by companies that rarely experience bad debts. • When an account is identified as uncollectible, that account is removed from the books and an expense is recorded. Bad debts expense xxxx Accounts receivable xxxx

31. 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.

32. 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.

33. 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.

34. 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 ====================

35. 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.

36. 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?

37. 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

38. 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

39. 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.

40. 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.

41. 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.

42. Applying the Allowance Method Using the Aging of Accounts Receivable Accounts receivable aging schedule: 1-30 days31-90 daysOver 90 daysTotal 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.

43. 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.

44. Assessing the Level ofAccounts Receivable • Management should monitor the ability of the company to control accounts receivable. • They often use accounts receivable turnover for measuring that ability.

45. Assessing the Level ofAccounts Receivable • Accounts receivable turnover indicates how rapidly collections of accounts receivable occur. • The ratio tells how many times, on average, accounts receivable “turn over” during the year. • Higher turnovers indicate that receivables are collected quickly. • Lower turnovers indicate that receivables are collected more slowly.

46. Assessing the Level ofAccounts Receivable • Days to accounts receivable (average collection period) - an indication of how long it takes to collect money after a sale is made

47. Overview of Internal Control • The purpose of internal control is the creation of a system of checks and balances that assures that all actions occurring within a company are in accord with organizational objectives and have the general approval of top management. • At one level, internal control seeks to tie daily decisions to corporate strategy. • At another level, internal control refers to the protection of firm assets from theft or loss.

48. Overview of Internal Control • Types of controls: • Administrative controls - all methods and procedures that facilitate management planning and control of operations • Accounting controls - the methods and procedures for authorizing transactions, safeguarding assets, and ensuring the accuracy of the financial records

49. Overview of Internal Control • Internal accounting controls should provide reasonable assurance concerning: • Authorization - Transactions are executed in accordance with management’s general or specific intentions. • Recording - All authorized transactions are recorded in the correct amounts, periods, and accounts. No fictitious transactions are recorded. • Safeguarding - Precautions and procedures appropriately restrict access to assets.

50. Overview of Internal Control • Internal accounting controls should provide reasonable assurance concerning: • Reconciliation - Records are compared with other independently kept records and physical counts. • Such comparisons help ensure that other control objectives are attained. • Valuation - Recorded amounts are periodically reviewed for impairment of values and necessary write-downs.