Selling a Product or a Service

1. C H A P T E R 6 Selling a Product or a Service

2. Learning Objective 1 Understand the three basic types of business activities: operating, investing, and financing.

3. Always associated with the primary activities of the business. Major Activities of a Business Operating Activities: • Selling products or services. • Buying inventory for resale. • Incurring and paying for necessary expenses.

4. Their occurrence is much less frequent than operating activities. • The amounts involved are usually quite large. Major Activities of a Business • Investing Activities: • Purchasing assets for use in the business: • Property, plant, and equipment. • Investments in stocks and bonds.

5. Major Activities of a Business • Financing Activities: • Raising money to finance a business: • by borrowing from creditors (debt financing). • by selling stock or ownership interest (equity financing).

6. What Are the Major Activities of a Business? • Operating Activities • Selling products or services. • Buying inventory for resale. • Incurring and paying for necessary expenses. • Investing Activities • Purchasing assets for use in the business: • property, plant, and equipment. • investments in stocks and bonds. • Financing Activities • Raising money to finance a business: • by borrowing from creditors (debt financing). • by selling stock or ownership interest (equity financing).

7. Learning Objective 2 Use the two revenue recognition criteria to decide when the revenue from a sale or service should be recorded in the accounting records.

8. Revenue Recognition When: the work has been substantially completed (the company has done something) And: cash, or a valid promise of future payment, has been received (the company has received something in return)

9. Recognition Concerns As a practical matter, how do most companies handle recognition? • record sales when goods are shipped to customers. • recognize credit sales as revenues before cash is collected. • recognize revenues from services when the service is performed, not necessarily when cash is received.

10. Jan 1 Cash. . . . . . . . . . . . . . . . . . . . 4,000 Accounts Receivable. . . . . . 5,000 Sales Revenue . . . . . . . . . 9,000 Sold 20 top hats for cash and 25 top hats for credit. Example: Revenue Recognition On January 1, Formal Apparel sold 20 top hats for cash and another 25 for credit. Each hat sold for $200. How should the $9,000 of revenue be recorded?

11. When the inventory is sold on account: Jan. 10 Accounts Receivable. . . . . . . . . . 2,000 Sales Revenue. . . . . . . . . . . . . 2,000 Sold equipment to Edison on account. When the collection takes place: Feb. 1 Cash . . . . . . . . . . . . . . . . . . . . . . . 2,000 Accounts Receivable . . . . . . . 2,000 Payment from Edison for equip. sold. Example: Credit Sale and Collection On January 10, Mountain Mining sold Edison Excavation $2,000 of equipment on account. Mountain Mining received payment on February 1. What entries are made?

12. Learning Objective 3 Properly account for the collection of cash and describe the business controls necessary to safeguard cash.

13. Discuss the Complications withRevenue Recognition Sales Discounts Offered as incentives for buyers to make prompt payments. Sales Returns and Allowances Merchandise is returned because the customer did not want it or because it was defective. Uncollectible Accounts Occur when a company is unable to collect on receivables.

14. What Do These Sales Discount Terms Mean? Two percent discount if paid within 10 days, net amount due in 30 days. 2/10, n/30 1/10, n/30 2/10, EOM 1/10, EOM One percent discount if paid within 10 days, net amount due in 30 days. Two percent discount if paid within 10 days, balance due by end of the month. One percent discount if paid within 10 days, balance due by end of the month.

15. If paid within the discount period: Jan. 10 Collected cash within discount period for $1,000 credit sale. If not paid within the discount period: Feb. 15 Cash. . . . . . . . . . . . . . . . . . . . . . . . 1,000 Accounts Receivable. . . . . . . . 1,000 Collected cash on account receivable. Example: Credit Sale and Collection Tidy Paint Supplies sold $1,000 of equipment on account on January 3. The terms of the sales agreement are 2/10, n/30. What are the collection entries if paid on January 10 or on February 15?

16. What Are Contra-Revenue Accounts? • A contra account is offset or deducted from another account. • Sales Discounts is a contra-revenue account. • Sales Discounts is deducted from sales revenue on the income statement. • Sales Discounts is included with other revenue accounts in the general ledger, but it has a debit balance (where revenue accounts normally have a credit balance).

17. Gross Sales • Sales Discounts • Returns and Allowances • Net Sales How Are Sales Returns and Allowances Reported? A contra account deducted from sales revenue on the income statement.

18. Sales entry: Jan. 10 Accounts Receivable (or Cash). . . 2,500 Sales Revenue . . . . . . . . . . . . . . 2,500 Sold equipment on account (for cash). Sales return entry: Jan. 17 Sales Returns and Allowances . . . 250 Accounts Receivable (or Cash). 250 Previously sold equipment was returned. Example: Sales Return On January 10, Handy Man Hardware sold $2,500 of equipment during its annual sale. One week later, $250 of equipment was returned. What are the entries?

19. Review the Control of Cash. • Separate handling of cash from recording of cash. • Deposit all cash receipts daily. • Make all expenditures with pre-numbered checks (except petty cash). • Design budget procedures for monitoring balances and estimating future cash needs. • Keep only minimum balances in no-interest accounts, with other cash in high-yielding investments.

20. Learning Objective 4 Record the losses resulting from credit customers who do not pay their bills.

21. What Are Receivables? • A company’s claims for money, goods, or services. • An account receivable is a current asset representing money due for services performed or merchandise sold on credit. • When an account receivable becomes uncollectible, a bad debt expense is incurred.

22. Credit sale: Jan. 10 Accounts Receivable . . . . . . . . . . 1,000 Sales Revenue . . . . . . . . . . . . . 1,000 Sold equipment on account. Collection--2/10, n/30: Jan. 30 Cash. . . . . . . . . . . . . . . . . . . . . . . . 1,000 Accounts Receivable. . . . . . . . 1,000 Payment received n/30. Example: Accounts Receivable On January 10, Carson Cameras sold $1,000 of equipment on account. The terms of the agreement are 2/10, n/30. Payment was received on January 30. What are the entries?

23. Discuss Uncollectible Accounts. • Occur when customers do not pay for items or services purchased on credit. • When an account receivable becomes uncollectible, a firm incurs a bad debt loss. • Recognized as a cost of doing business, so classified as a selling expense. • Two ways to account for these losses: • the direct write-off method. • the allowance method.

24. 11/1/02 Bad Debt Expense. . . . . . . . . . . . . . 4,000 Accounts Receivable . . . . . . . . . 4,000 To write off an uncollectible account for purchases made on 8/1/01. The Direct Write-Off Method • Method is objective because bad debt expense is written off at the time it proves to be uncollectible. • However, the method violates the matching principle that says: • All costs and expenses in generating revenues must be identified with those revenues period by period.

25. 8/1/02 Bad Debt Expense. . . . . . . . . . . . . . 4,000 Allowance for Bad Debts . . . . . . 4,000 To adjust the Allowance account to the desired balance. The Allowance Method • A firm uses its experience or industry averages to estimate the amount of receivables that will be uncollectible. • Allowance for Bad Debts is a contra-asset account that is offset against Accounts Receivable on the balance sheet. • As actual losses are recognized, Allowance for Bad Debts is reduced.

26. Reverse Write-off: Aug. 1 Accounts Receivable . . . . . . . . . . 4,000 Allowance for Bad Debts . . . . . 4,000 To reinstate a written-off receivable. Eliminate Receivable: Aug. 1 Cash. . . . . . . . . . . . . . . . . . . . . . . . 4,000 Accounts Receivable. . . . . . . . 4,000 Payment for written-off receivable. Reversing Written-off Receivables What are the entries if the credit customer eventually pays? Companies must have good control over both cash collection procedures and accounting for accounts receivable; otherwise such payments could be pocketed by an employee who receives cash without the company’s knowledge.

27. Estimating Uncollectible Accounts Receivable What are the three methods? • As a percentage of credit sales • As a percentage of total receivables • Aging accounts receivable

28. Amount of uncollectibles = a straight percentage of the current year’s credit sales. Based on experience of prior years, modified for changes expected in current year. Any existing balance in Allowance for Bad Debts is not considered in the adjusting entry to record bad debt expense. As a Percentage of Credit Sales

29. Amount of uncollectibles = a percentage of total receivables balance at period’s end. Focus is on estimating total bad debts existing at the end of the period. The ending balance in Allowance for Bad Debts is the amount of total receivables estimated to be uncollectible. As a Percentage of Total Receivables

30. AS A PERCENTAGE OF CREDIT SALES Amount of uncollectibles = a straight percentage of the current year’s credit sales. Based on experience of prior years, modified for changes expected in current year. Any existing balance in Allowance for Bad Debts is not considered in the adjusting entry to record bad debt expense. AS A PERCENTAGE OF TOTAL RECEIVABLES Amount of uncollectibles = a percentage of total receivables balance at period’s end. Focus is on estimating total bad debts existing at period’s end. The ending balance in Allowance for Bad Debts is the amount of total receivables estimated to be uncollectible. Estimating Uncollectible Accounts Receivable

31. AS A PERCENTAGE OF CREDIT SALES AS A PERCENTAGE OF TOTAL RECEIVABLES Estimating Uncollectible Accounts Receivable In practice, a company should consider both techniques to ensure that each yields roughly consistent results.

32. 12/31/01 Bad Debt Expense. . . . . . . . . . . . . . 2,701 Allowance for Bad Debts . . . . . . 2,701 To adjust the Allowance account to desired balance. Uncollectible Accounts Allowance Norm’s Tools had credit sales of $100,000. The current accounts receivable balance is $30,510. The allowance for bad debts balance is $350. Historically, 10 percent of the accounts receivable ending balance is not collected. What is the adjusting entry? Bad Debt Expense Allowance for Bad Debts 350 Bal. Exp. 2,701 2,701 Exp. End. Bal. 2,701 3,051 End. Bal.

33. A more refined and accurate method of estimating the appropriate ending balance in the Allowance for Bad Debts. Requires a company to base its calculations on how long its receivables have been outstanding. Each receivable is categorized according to age, such as Current 1-30 days past due 31-60 days past due, etc. The total amount in each classification is multiplied by an appropriate uncollectible percentage (determined by experience). Aging Accounts Receivable

34. Uncollectible Accounts Expense Copy That had credit sales during the year of $200,000. Using the aging method and the data on the aging receivables worksheet, determine the journal entry needed. The beginning balance for Allowance for Bad Debts is $150. Aging Receivables Worksheet Percentage Estimated to be AgeBalanceUncollectible Amount Current. . . . . . . . . . $10,000 1.5% $ 150 1-30 days. . . . . . . . 4,000 4.0 160 31-90 days. . . . . . . 2,100 20.0 420 Over 90 days. . . . . 1,000 40.0 400 $17,100 $1,130

35. 12/31/01 Bad Debt Expense. . . . . . . . . . . . . . 980 Allowance for Bad Debts . . . . . . 980 To adjust the Allowance account to desired balance. Uncollectible Accounts Expense Copy That had credit sales during the year of $200,000. Using the aging method and the data on the aging receivables worksheet, determine the journal entry needed. The beginning balance for Allowance for Bad Debts is $150. Bad Debt Expense Allowance for Bad Debts 150 Bal. Exp. 980 980 Exp. End. Bal. 980 1,130 End. Bal.

36. Learning Objective 5 Evaluate a company’s management of its receivables by computing and analyzing appropriate financial ratios.

37. Sales Revenue Accounts Receivable Turnover = Average Accounts Receivable Assessing Managementof Receivables • Determines the number of times during a year a company is “turning over” or collecting its receivables. • Measure of how many times old receivables are collected and replaced by new receivables.

38. Assessing Managementof Receivables 365 days Accounts Receivable Turnover Average Collection Period = • Converts accounts receivable turnover into the number of days it takes to collect receivables. • Proper receivables management involves balancing the desire to extend credit in order to increase sales with the need to collect cash quickly to pay the company’s bills.

39. Example: Managementof Receivables Adjust It Square had net credit sales of $150,000 during 2001. The accounts receivables increased $5,000 to $40,000 during the same time. Calculate the accounts receivable turnover ratio and the average collection period. Accounts Receivable Turnover: Sales Revenue = $150,000 = 4.0 Average Accounts Receivable $ 37,500 Average Collection Period: 365 = 365 = 91.25 Accounts Receivable Turnover4.0

40. Learning Objective 6 Match revenues and expenses by estimating and recording future warranty and service costs associated with a sale.

41. Customer Service Costs • When a customer service call is offered free with the sale, the company must estimate how many customers will request this service. • The service cost is then estimated and recognized in the same period as the sale. (Supplies and labor required to honor this service agreement are recorded when service is provided.) • The accountant would not try to go back and “fix” this estimate if it proves to be inexact; the accountant merely monitors the estimates and actual service costs and adjusts future estimates accordingly.

42. Warranty Costs • Estimates for warranty costs are made and recorded at the time of sale. • At the end of the period, the company will show an existing liability for warranty costs it expects to make in future years.

43. 2000 Expanded MaterialLearning Objective 7 Reconcile a checking account.

44. Bank Statement The Big Bank Bank Statement January 30, 2001 Cash Balance, January 1, 2001 + Deposits – Checks processed Cash Balance, January 30, 2001 2000

45. Time period differences • Deposits in transit • Outstanding checks • Bank debits: • monthly service charges • NSF checks • bank transfers • Bank credits: • interest paid by bank on balance • Accounting errors Differences Between Bank Statement and Cash Account

46. Expanded MaterialLearning Objective 8 Understand how receivables can be used by a company to get cash immediately.

47. Selling or “Factoring” Accounts Receivable • Receivables are sold to factoring companies for cash. • The factoring companies charge a percentage of the receivables as a service cost. • Factoring allows companies to receive cash now, instead of waiting to collect on the receivables. • Can be sold with or without recourse.

48. Notes Receivable Formal contracts signed when a customer buys merchandise or services on credit. A claim against someone with an unconditional promise to pay an amount on or before a specified future date. Classified as a current or long-term asset, depending on due date.

49. Notes Receivable Maker The person (entity) who signs the note and assumes responsibility. Payee The person (entity) to whom payment will be made. Principal The face amount of the note. Interest Rate A percentage of the principal the maker is charged to borrow money. Interest The cost of borrowing money. Maturity Value Principal plus interest.

50. Computing Interest Principal (amount) Interest Rate (%) Time (years) x x = Interest On January 1, The Key Company signed a 90-day, $5,000 note payable to The Lock Company in settlement of existing accounts payable. The interest rate is 14 percent. Calculate the interest cost. $5,000 x 0.14 x 90/365 = $172.60