The Revenue/ Receivables/Cash Cycle

1. The Revenue/ Receivables/Cash Cycle

2. Learning Objectives • Explain the normal operating cycle of a business. • Prepare journal entries to record sales revenue, including the accounting for bad debts and warranties for service or replacement. • Analyze accounts receivable to measure how efficiently a firm is using this operating asset.

3. Learning Objectives • Discuss the composition, management, and control of cash, including the use of a bank reconciliation. • Recognize appropriate disclosures for presenting sales and receivables in the financial statements.

4. Learning Objectives EXPANDED MATERIAL: • Explain how receivables may be used as a source of cash through secured borrowing or sale. • Describe proper accounting and valuation of notes receivable. • Understand the impact of uncollectible accounts on the statement of cash flows. • Use a petty cash fund.

5. Revenue/Receivables/Cash Time Line RETURNS PROVIDE continuing service STRUGGLE with nonpaying customers DELIVER a product or service COLLECT cash (includes discounts) ACCEPT returned products

6. The Operating Cycle of a Business Cash Accounts Receivable Inventory

7. Credit Sale and Collection Assume that John purchased $1,000 of equipment on account. What entries are made? Assume that John purchased $1,000 of equipment on account. What entries are made? When the inventory is sold on account: Accounts Receivable................ 1,000 Sales.................................. 1,000 Sold equipment to John on account. Assume that John purchased $1,000 of equipment on account. What entries are made? When the inventory is sold on account: Accounts Receivable................ 1,000 Sales.................................. 1,000 Sold equipment to John on account. When the collection takes place: Cash.......................................... 1,000 Accounts Receivable......... 1,000 Payment from John for equipment purchased.

8. Receivables Receivables are all claims against other entities. They are usually settled in cash. • Trade receivables: Receivables arising from normal operating activities. • Nontrade receivables: All receivables arising from activities other than normal operations.

9. Sales Discounts--Gross Method Assume $1,000 of equipment is sold on account. The terms of the agreement are 2/10, n/30. What are the collection entries? If paid within the discount period: Cash............................................ 980 Sales Discounts........................... 20 Accounts Receivable.......... 1,000 If not paid within the discount period: Cash........................................… 1,000 Accounts Receivable......... 1,000

10. Sales Returns and Allowances Felton Company sold $1,000 of merchandise. When delivered, it was determined that the wrong color had been sent. The customer agrees to keep the merchandise for a reduction in price of $100. What are the journal entries? Sales entry: Accounts Receivable (Cash)....… 1,000 Sales..................................…. 1,000 Sales allowance entry: Sales Returns and Allowances..… 100 Accounts Receivable (Cash).. 100

11. Sales Returns and Allowances Felton Company sold $1,000 of merchandise. One week later, when it was delivered, $100 in merchandise (cost, $60) was the wrong color. With Felton’s approval, it was returned. What are the journal entries? Sales entry: Accounts Receivable (Cash)....… 1,000 Sales..................................…. 1,000 Sales return entry: Sales Returns and Allowances..… 100 Accounts Receivable (Cash).. 100 Inventory………………………… 60 Cost of Goods Sold…………. 60

12. Sales Discounts and Sales Returns and Allowances Income Statement Sales.............................................… $1,000 Less: Sales Discounts...................... $ 20 Sales Returns and Allowances 100 (120) Net Sales.......................................... $ 880

13. Bad Debts • Occur when customers do not pay for items or services purchased on credit. • Bad debts are uncollectible accounts receivable. • Bad Debt Expense is reported as a selling or general and administrative expense. • Accounts receivable are reported on the balance sheet at their net realizable value.

14. Accounting for Uncollectible Receivables (Direct Method) Write Off: Bad Debts Expense……………. 400 Accounts Receivable………. 400 To write off an uncollectible account. This entry is made when the account has been determined uncollectible. Since this determination was made after the period in which the sale takes place, the matching principle is violated. This method is not accepted under GAAP.

15. Accounting for Uncollectible Receivables (Allowance Method) In this method, an estimate of the total uncollectible accounts is made at the end of the period, and an expense is recognized. Bad Debts Expense………………….. 2,000 Allowance for Doubtful Accounts.. 2,000 To record estimated uncollectible accounts. GAAP requires use of the “Allowance Method” for determining bad debts expense.

16. Accounting for Uncollectible Receivables (Allowance Method) When the account is then determined to be uncollectible, the write-off entry is: Allowance for Doubtful Accounts……... 400 Accounts Receivable……………… 400 To write off an uncollectible account.

17. Accounting for Uncollectible Receivables (Allowance Method) 2) The actual write-off entry does not reduce net receivables, as shown below: Accts. Receivable $100,000 Accts. Receivable $99,600 Less Allowance for Less Allowance for Doubtful Accounts 2,000 Doubtful Accounts 1,600 Net Receivables $ 98,000 Net Receivables $98,000 (1) The Allowance for Doubtful Accounts is a contra asset account which is subtracted from Accounts Receivable on the balance sheet.

18. Estimating the Allowance for Uncollectible Accounts • Percentage of credit sales. • Percentage of accounts receivable. • Aging receivables.

19. Percentage of Credit Sales Example: Doubtful Accounts Expense The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350 (Cr.). Historically, 3 percent of the credit sales are not collected. What is the entry to record estimated bad debts?

20. Percentage of Credit Sales Example: Doubtful Accounts Expense The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350 (Cr.). Historically, 3 percent of the credit sales are not collected. Bad Debt Expense…………………… 3,000 Allowance for Doubtful Accounts .. 3,000 To record estimated uncollectible accounts for the year.

21. Percentage of Credit Sales Example: Doubtful Accounts Expense Allowance for Doubtful Accounts Balance 350 Adjusting 3,000 Dec. 31, Bal. 3,350

22. Percentage of Accounts Receivable ($30,500 x .05) - $350 Example: Doubtful Accounts Expense The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350. Historically, 5 percent of accounts receivable are not collectible. Bad Debt Expense…………………….. 1,175 Allowance for Doubtful Accounts…. 1,175 To record estimated uncollectible accounts for the year. What is the entry to record estimated bad debts?

23. Percentage of Accounts Receivable Allowance for Doubtful Accounts Balance 350 Adjusting 1,175 Dec. 31, Bal. 1,525

24. Percentage of Accounts Receivable Allowance for Doubtful Accounts What if the allowance account had a debit balance of $300? Adjusting 1,875 Dec. 31, Bal. 1,525 Balance 350

25. Aging Receivables The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350. The firm ages the accounts to determine the expected uncollectibles. Remember, because receivables are involved, the amount derived from aging provides the desired balance of the allowance account.

26. Aging Receivables Percentage Estimated to be AgeBalanceUncollectible Amount Current.............. $21,000 1.5 $ 315 1-30 days.......... 5,000 4.0 200 31-90 days........ 2,800 20.0 560 Over 90 days..... 1,700 40.0 680 $30,500 $1,755

27. Aging Receivables Allowance for Doubtful Accounts Balance 350 Adjusting 1,405 Dec. 31, Bal. 1,755

28. Accounting for Warranties Edna’s Appliances sells washers and dryers with a one-year warranty. Past experience indicates that 15% of the appliances sold will need repairs before the warranty expires. The average repair cost is $80. In 2001, 500 washers and dryers were sold. Actual repair costs for the year totaled $3,400.

29. Accounting for Warranties To record estimated warranty expense: Estimated Liability Under Warranties….. 3,400 Cash…………………………………. 3,400 To record cost of actual repairs in 2001. To record estimated warranty expense: Warranty Expense……………………….. 4,000 Estimated Liability Under Warranties.. 4,000 To record estimated warranty expense based on units sold (500 x $80).

30. Assessing Management of Receivables Average Collection Period: The average number of days that elapse between the time that a sale is made and the time that cash is collected. It is calculated by dividing the average receivables by the average daily sales. The amount for average daily sales is determined by dividing net sales by 365.

31. Assessing Management of Receivables The Wheeler Company had net sales of $150,000 during 2002. Accounts receivable increased $35,000 to $40,000 during the same time. Calculate the average collection period. Average Collection Period: Average Accounts Receivable $37,500 Average Daily Sales ($150,000/365) Average collection period = 91.25 days

32. Composition of Cash • Undeposited coins and currency (change funds) • Demand deposits • Petty cash funds • Cashiers’ checks • Personal checks

33. Composition of Cash Many companies report investments in very short-term, interest-earning securities as cash equivalents in the balance sheet.

34. Composition of Cash A credit balance in the cash account is known as a cash overdraft and should be reported as a current liability.

35. Control of Cash • Specifically assigned responsibilities for handling cash receipts. • Separation of handling and recording receipts. • Daily deposit of all cash received. • Voucher system to control cash payments • Internal audits at irregular intervals. • Double record of cash (bank and book) with reconciliation performed by someone outside the accounting function.

36. Bank Reconciliation A comparison of the bank balance with the book’s balance by means of a summary is a bank reconciliation.

37. Bank Reconciliation Common causes of differences: • Deposits in transit. • Outstanding checks. • Bank debits for items such as service charges and NSF checks. • Bank credits for items such as the bank collecting a note for the depositor. • Accounting errors.

38. Lori’s Florist Bank Reconciliation March 31, 2002 Balance per bank.... $4,135 Additions to bank balance: Deposits in transit.... 500 Total................... $4,635 Deductions from bank balance: Outstanding checks: 191....... $251 192....... 125 195....... 75 451 Adj. bank balance $4,184 Balance per books.............. $3,950 Additions to bank balance: Direct deposit...................… 450 Interest.............................… 71 Total............................… $4,471 Deductions from book balance: Service charge...........… $ 7 NSF check.................… 100 Error in recording check 180 287 Adj. book balance $4,184

39. Bank Reconciliation All adjustments made to the Balance per Books need to be recorded: ADDITIONS: Cash……………………………………. 521 Accounts Receivable………………. 450 Interest Revenue…………………… 71 DEDUCTIONS: Accounts Receivable (NSF)…………… 100 Miscellaneous General Expense (SC)…. 7 Recording Error, Underwritten check*... 180 Cash……………………………….. 287 * Debited to original account.

40. Accounts Receivable as aSource of Cash • As a sale (either with or without recourse). • As a secured borrowing.

41. Accounts Receivable as aSource of Cash SFAS 125 specified conditions that must be met if a transfer of receivables is to be accounted for as a sale: • The transferred assets have been isolated from the transferor and its creditors cannot access the assets. • The transferee has the right to pledge or exchange the transferred assets. • The transferor does not maintain effective control over the assets through an agreement to repurchase them before their maturity.

42. Factoring Accounts Receivable Cash from Factoring Accounts Receivable Payment of Accounts Receivable Sale of Accounts Receivable Goods and Services Provided Customers Company Accounts Receivable Established Factor

43. Accounting for Factoring Accounts Receivable • Close sold receivables. • Close accompanying Allowance for Bad Debts. • Expense any factoring charges. • Establish a receivable for any sales price withheld by the factor. • Debit Cash for net proceeds of the sale. • Recognize a gain or loss from factoring.

44. Example: FactoringAccounts Receivable Assume: Factored Receivables $10,000 Allowance for Bad Debts $300 Factor Withholding 5% Sales Price $8,500 Journalize this transaction.

45. Example: FactoringAccounts Receivable Cash………………………………. 8,075 Receivable from Factor…………... 425 Allowance for Bad Debts………… 300 Loss from Factoring Receivables... 1,200 Accounts Receivable…………. 10,000 Computations: Cash: $8,500 - 425 = $8,075 Factor Receivable: $8,500 x 5% = $425 Factoring Loss: ($10,000 - 300) - $8,500 = $1,200

46. Sale of Receivableswith Recourse Sale of receivables with recourse is different from factoring, since factoring is normally sold on a nonrecourse basis.

47. Sale of Receivableswith Recourse Cash Received $8,500 Estimated Value of Recourse Obligation 500 Net Proceeds $8,000 Book Value of the Receivables $9,700 Net Proceeds to be Received 8,000 Loss on Sale of Receivables $1,700 Continuing the previous example, assume that the receivables were sold with recourse and it is estimated that the recourse obligation has a fair value of $500.

48. Sale of Receivableswith Recourse The entry to record the sale: Cash………………………………. 8,075 Receivable from Factor…………... 425 Allowance for Bad Debts………… 300 Loss on Sale of Receivables……... 1,700 Accounts Receivable………... 10,000 Recourse Obligation………… 500

49. Secured Borrowing • Assignment of Accounts Receivable • There are no special accounting problems involved. • Simply record the loan. • Specific Assignment: • Specified accounts receivable pledged. • Accounts receivable reclassified on balance sheet. • Notes disclosure of loan provisions required.

50. Notes Receivable A promissory note is an unconditional written promise to pay a certain sum of money at a specified time.