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Accounting for Sales

Accounting for Sales. Lecture 13 (CHAPTER 6). Learning Objectives (LO). 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

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Accounting for Sales

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  1. Accounting for Sales Lecture 13 (CHAPTER 6)

  2. Learning Objectives (LO) 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 • Compute and interpret sales returns and allowances, sales discounts, and bank credit card sales • Manage cash and explain its importance to the company • Estimate and interpret uncollectible accounts receivable balances

  3. Learning Objectives (LO) After studying this chapter, you should be able to • Assess the level of accounts receivable • Explain internal control procedures

  4. LO 1 – Revenue Recognition • Revenue results from the sale of goods/services to a customer and should be recognized when • It is earned - Goods or services have been delivered • It is realized – title has transferred and cash has been received • Or is realizable – if another asset other than cash (e.g. Accounts Receivable) is received and is virtually assured of being converted into cash • Most companies recognize revenue at the point of sale but there are unique circumstances

  5. LO 1 – Revenue Recognition • Cash is received before goods or services have been delivered Cash 1,000 Unearned (deferred) Revenue (liability) 1000 • A portion (50%) is completed but not delivered (percent of completion method) Unearned Revenue 500 Sales Revenue500

  6. LO 1 – Revenue Recognition • Revenue is recorded at the cash-equivalent value of what is received. For example • A sale occurs that has a sticker price of $100 • To entice the buyer, a $5 discount is offered and accepted; the customer charges the purchase Accounts Receivable 95 Sales Discounts * 5 (Contra revenue account) Revenue * 100 * Net sales revenue would be reported at $95 (100 – 5) but two accounts would be used to capture the event

  7. LO 2 – Cash and Credit Sales Revenue • A $100 cash and $100 credit sale Cash 100 Accounts Receivable 100 Sales Revenue 200 • Credit sales increase revenues (and thus expenses) • Credit sales also lead to 1) costs of managing credit and collections and 2) uncollectable accounts • If net revenue > the related expenses, credit sales are good for the business (see Later) • Costs and benefits should be periodically assessed

  8. LO 3 – Sales Returns/Allowances, Trade and Cash Discounts, Credit Card Fees • Income Statement Gross Sales $1,400 LessSales Returns ($100) Sales Allowances ($10) Trade Discounts ($10) Cash Discounts ($2) Credit Card Fees ($3) $125 Net Sales $1,275 • Reports to shareholders typically omit details and show only net revenues (Maybe details are in footnotes) Contra Revenue (Debit Balance) Accounts

  9. LO 3 – Sales Returns • Sales Returns - when a customer returns previously purchased merchandise to the seller (“purchase returns” used by buyers) Cost of Goods Sold 60 Inventory 60 Accounts Receivable 100 Sales Revenue 100 Inventory 60 Purchase Returns/Allowances 60 Contra COGS Sales Returns 100 Accounts Receivable 100 The purchase

  10. LO 3 – Sales Allowances • Sales Allowance is a reduction of the original selling price Cost of Goods Sold 60 Inventory 60 Accounts Receivable 100 Sales Revenue 100 • Purchaser notes lower price ($90) at another store and asks for a $10 price reduction which is given Sales Allowances 10 Accounts Receivable 10

  11. LO 3 – Trade Discounts • Trade discounts - a reduction to the gross selling price for a particular class of customers or for differing order sizes (offered to remain competitive/retain customers) • Customer buys 10 at $10 a piece and gets 10% off • (Example hereafter omit costs of goods sold entries) Accounts Receivable 90 Trade Discounts 10 Sales Revenue 100

  12. LO 3 – Cash Discounts • Cash Discounts – an encouragement to the retailer to quickly pay the wholesaler • Usage varies by company and industry • n/30 - Full billed price (net price) due in 30 days • 15 E.O.M. – Due 15 days after end of the month • “2/10/n30” • 2% off invoice price • If paid within 10 days of invoice date • Net amount due in 30 days after invoice date

  13. LO 3 – Cash Discounts • Cash Discounts (“2/10/n30”) - gross method • Sale Accounts Receivable 100 Sales Revenue 100 • Customer pays • Within 10 days Cash 98 Cash Discounts Taken 2 Accounts Receivable 100 • After 10 days Cash 100 Accounts Receivable 100

  14. LO 3 – Cash Discounts • Cash Discounts (“2/10/n30”) - net method • Sale Accounts Receivable 98 Revenue 98 • Customer pays • Within 10 days Cash 98 Accounts Receivable 98 • After 10 days Cash 100 Accounts Receivable 98 Cash Discounts Lost * 2 * Adjunct account to Revenue or part of Other Income

  15. LO 3 – Charge Cards • Why should retailers offer credit? • Attract customers (who would shop elsewhere or forego a purchase, i.e. boost sales and profit) • Remain competitive with stores in same industry • Should the retailer grant credit themselves? • Must bear costs of • Administering credit card program • Uncollectable accounts (bad debts) • Reward is higher income due to increased sales and/or interest charges

  16. LO 3 – Charge Cards • Or use international credit cards (Visa, MasterCard, etc.) • Reward is • Get cash immediately after the sale • Card company bears the risk of unpaid accounts • Relieve merchant of cost of a credit department • Cost is 1-4% of sales revenue, depending on volume Accounts Receivable (Cash) 97 Discounts for Credit Cards (@3%) 3 Sales Revenue 100

  17. LO 4 - Cash • Usually report cash and cash equivalents on the balance sheets as a single amount • Cash – money, money orders, checks • Cash equivalents - highly liquid short-term investments that can easily and quickly be converted into cash (< 90 days until maturity) • Time deposits • Commercial paper • 90-day Treasury bills • Proceeds from national credit cards (See LO 3)

  18. LO 4 - Cash • Compensating balances - required minimum cash balances on deposit in a bank to compensate for one or more services or loans • Compensating balances increase the effective interest rate that the borrower pays • No compensating balance - $100,000 x 8% annual interest rate = $8,000 interest expense • 10% compensating balance ($10,000) • $8,000 / ($100,000 – $10,000) = 8.9% interest • Must disclose significant compensating balances

  19. LO 4 - Cash • Cash management is important and therefore justifies strong internal controls • Must hold adequate cash to run the business • Cash loses purchasing power during inflationary times justifying holding little excess cash) • While cash balances may seem large, cash in- and out-flows during the year are much larger • Cash, being the most liquid asset is enticing to thieves and embezzlers • Cash earns little to no return (generally the least productive of all the assets)

  20. LO 4 - Cash • The major internal control procedures set up to safeguard cash include: • Separate persons receive and disburse cash • Separate persons handle cash and accessing accounting records • Record and deposit cash receipts immediately • Make disbursements using serially numbered checks, and require proper authorization by someone other than the person writing the check • Reconcile bank accounts monthly by someone who does not write the checks

  21. L O 5 - Uncollectible Accounts • Direct (specific write-off) method • Assume all receivables are collectable, i.e., do nothing at year end to modify income or receivables • When it becomes apparent a receivable ($200) will not be collected (unable or unwilling), write it off Bad Debts Expense 200 Accounts Receivable 200 • If sales revenue was recorded last year and write-off occurred this year, poor “matching” • Says nothing about the remaining credit revenue and receivables – will some of them become bad debts?

  22. L O 5 - Uncollectible Accounts • Allowance method – Common elements • Adjusting entry at year-end (*Contra Receivable) Bad Debts Expense 4000 Allowance for Doubtful Accounts * 4000 • Balance Sheet Accounts Receivable $250,000 Less: Allowance for Doubtful Accounts * ($4,000) Net Accounts Receivable $246,000 • Write off a $200 account this or next year Allowance for Doubtful Accounts * 200 Accounts Receivable 200

  23. L O 5 - Uncollectible Accounts • Allowance method – By estimating the amount of uncollectable accounts at year end Net income and receivables are reduced to reflect potential uncollectable accounts/lower net income • Good matching – expense in same year as revenue • Involves estimating the amounts since do not know specifically which accounts will become uncollectable in the future, thus conducive to manipulation, AKA: “window dressing.”

  24. L O 5 - Uncollectible Accounts Allowance – Percent of Sales (2%) approach • Always estimates Bad Debts Expense – AUA derived • No ending balance in AUA before adjusting entry Allowance for Uncollectable Accounts (AUA) Bad Debt Expense (BDE) Accounts Receivable Cash Revenue 600 1000 400 600 0 20 1000 20 $1,000 credit sales Balance sheet $ 600 in cash collections $ 2% x $1000 credit sales = $20 Accounts Receivable $400 Less Allowance for Uncollectable $20 Bad Debts Expense 20 Net Realizable Value $380 Allowance for Uncollectable Accounts 20

  25. L O 5 - Uncollectible Accounts Allowance – Percent of Sales (2%) approach • Always estimates Bad Debts Expense – AUA derived • Ending balance in AUA before adjusting entry Allowance for Uncollectable Accounts (AUA) Bad Debt Expense (BDE) Accounts Receivable Cash Revenue 600 1000 400 600 3 20 23 1000 20 $1,000 credit sales Balance sheet $ 600 in cash collections $ 2% x $1000 credit sales = $20 Accounts Receivable $400 Less Allowance for Uncollectable $23 Bad Debts Expense 20 Net Realizable Value $377 Allowance for Uncollectable Accounts 20

  26. L O 5 - Uncollectible Accounts Allowance – Percent of Receivables approach • Always estimates end-balance in AUA - BDE derived • No ending balance in AUA before adjusting entry Allowance for Uncollectable Accounts (AUA) Bad Debt Expense (BDE) Accounts Receivable Cash Revenue 600 1000 400 600 0 12 12 1000 12 $1,000 credit sales Balance sheet $ 600 in cash collections $ 3%% x $400 ending receivables = $12 Accounts Receivable $400 Less Allowance for Uncollectable $12 Bad Debts Expense 12 Net Realizable Value $388 Allowance for Uncollectable Accounts 12

  27. L O 5 - Uncollectible Accounts Allowance – Percent of Receivables approach • Always estimates end balance in AUA - BDE derived • Ending balance in AUA before adjusting entry Allowance for Uncollectable Accounts (AUA) Bad Debt Expense (BDE) Accounts Receivable Cash Revenue 600 1000 400 600 2 14 12 1000 14 $1,000 credit sales Balance sheet $ 600 in cash collections $ 3%% x $400 ending receivables = $12 Accounts Receivable $400 Less Allowance for Uncollectable $12 Bad Debts Expense 14 Net Realizable Value $388 Allowance for Uncollectable Accounts 14

  28. L O 5 - Uncollectible Accounts • Allowance • A/R = Accounts Receivable • AUA = Allowance for Uncollectable Accounts • AUA has $12 balance at end last year/begin this year • This year wrote off $12, $15, or $6 of accounts • AUA ends (before adjustments) with ?? balance Same More Less A/R AUA A/R AUA A/R AUA 12 12 12 0 15 12 15 3 6 12 6 6

  29. L O 5 - Uncollectible Accounts • Allowance – Percent of Receivables approach • Could also use an aging of receivables method to estimate uncollectable receivables

  30. L O 5 - Uncollectible Accounts • Either Allowance Method - Write-off followed by payment in full • Customer has $2 balance in his account (A/R) • $2 account is written off c. Customer pays off account in full c1. Reinstate the account as it was before write-off c2. Apply the cash payment to the reinstated account Accounts Receivable Allowance Uncollectables Cash 2 a 2 2 2 2 2 2 b c1 c2

  31. LO 6 - Assessing Accounts Receivable • Cash sales produce cash instantly • Credit sales generally cause sales to increase but they also delay cash receipts. • Major credit cards • Just a few days before credit card company transfers cash to the company • Some treat these receivables as cash equivalents • Company credit cards – using last year’s data • How long did it take to collect receivables • Is that length of time acceptable?

  32. LO 6 - Assessing Accounts Receivable • Accounts Receivable Turnover Ratio Credit Sales $1,000,000 = 8.81 Average Receivables $115,000 + $112,000 2 • On average, receivables were created then collected 8.81 timesin the past year • Higher turnovers indicate that a company collects its receivables faster • Lower turnover indicates slower collection

  33. LO 6 - Assessing Accounts Receivable • Number of days to collect Accounts Receivable 365 days per year 365 = 41.4 days Receivables Turnover Ratio 8.81 • On average, last year receivables were collected 41.4 days after being created • Higher # days puts more pressure on firm to find alternative cash sources while awaiting collection • Lower # days – less pressure • Varies by company and industries

  34. LO 7 - Internal Control • Internal control - a system of checks and balances that ensure company actions are proper and approved by management • Administrative controlsspell out responsibilities for • Reporting • Budgeting • Performance evaluation • Granting credit to customers • Protecting assets • Etc.

  35. LO 7 - Internal Control • Accounting controls • protects company assets and ensures that management maintains accurate financial records.

  36. LO 7 - Internal Control • Internal controls - Accounting controls • Transactions are what management intended • Recording authorized transactions accurately • Safeguarding assets - prevent unauthorized access • Reconciling records to other records or observations • Valuation - amounts are reviewed for impairment and write-downs • Operational efficiency - least amount of waste, errors, fraud

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