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Chapter 9 Revenue Cycle: Sales, Receivables, and Cash Financial Statement Items Covered in this Chapter Revenue Recognition Revenue Recognition Deliver a product or service Collect cash Struggle with non-paying customers Provide continuing service

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Chapter 9 l.jpg

Chapter 9

Revenue Cycle:Sales, Receivables,and Cash


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Financial Statement ItemsCovered in this Chapter

Financial Accounting, 7e Stice/Stice, 2006 © Thomson



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Revenue Recognition

Deliver

a product or service

Collect

cash

Struggle

with non-paying customers

Provide

continuing service

The business issues surrounding revenue recognition

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Revenue Recognition Criteria

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Revenue Recognition Criteriaand Exceptions

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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How Revenue Is Recognized

Revenue is recognized by an increase to Cash or Accounts Receivable and an increase to a revenue account

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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How Revenue Is Recognized

Example: Transaction 11 from the Veda Landscape Solution scenario:

Performed landscaping consulting services for several large clients. Billed these clients $200,000 for these services.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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How Revenue Is Recognized

No revenue is recognized when $160,000 of the account is collected

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Pressure to Recognize Revenue

There is a tendency for companies to want to recognize revenue prematurely because of

  • Initial public offerings

  • Profit goals

  • Executive bonuses tied to income

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Application of the Revenue Recognition Criteria

When the work associated with a sale extends over a significant time period, or when cash collectibility is in doubt, the accountant must use professional judgment in determining the proper time to record the sale

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Selling on Credit

and Collecting Cash


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Granting Credit

Granting credit makes sense if

the cash collected from customers

exceeds the cost of goods sold plus other incremental costs

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Costs of Granting Credit

  • Bad debts

  • Bookkeeping costs

    • Credit approval system

    • Billing and collection system

  • Carrying costs

    • The opportunity cost of not making a return on the cash that is tied up in the form of accounts receivable

    • The cost of securing cash from other sources

  • Credit card sales

    • Card issuer fees for billing and collections

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Credit Policies

Credit period: determines when the cash will be collected

  • n/30, read “net thirty,” means that payment is due within 30 days from the date of the invoice

    Sales discounts: cash reductions offered to credit customers who pay their bills early

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Credit Policies

2/10, n/30

  • 2% discount if the receivable is paid within 10 days of the invoice date

  • the full invoice price is due within 30 days

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Credit Policies

Sales discounts allowed to customers are subtracted from the Sales account and reported as Net Sales on the income statement

Gross Salesrecorded internally

Less: Sales discounts takenrecorded internally

Net Salespublicly reported

Financial Accounting, 7e Stice/Stice, 2006 © Thomson



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Credit Customers Who Don’t Pay

  • Bad debt expense is a natural consequence of selling merchandise on credit

  • The matching concept requires that bad debts be estimated and reported in the same year that the sales occur

  • This estimation method is known as the allowance method

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Allowance Method

Two estimation procedures

  • Percentage of sales method

  • Aging method

    Under either method an increase to Bad Debts Expense is recorded, along with a corresponding increase to Allowance for Bad Debts (a contra account to Accounts Receivable)

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Percentage of Sales Method

An estimate of bad debts expense is made by multiplying a percentage (based on past experience) times credit sales

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Percentage of Sales Method

If Sales are $200,000 and historically 3% of credit sales have become uncollectible, the following year-end entry would be made:

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Percentage of Sales Method

  • The Allowance for Bad Debts account is reported on the balance sheet as a subtraction from Accounts Receivable

  • The percentage of sales method is an income statement approach which relies on historical or industry data to estimate Bad Debts Expense

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Financial Statement Impact

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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The Aging Method

  • The aging method involves dividing the Accounts Receivable balance into different age categories to estimate the amount of those accounts which will ultimately become uncollectible

  • This balance sheet approach seeks to estimate an appropriate year-end balance for the Allowance for Bad Debts account

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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The Aging Method

The chances that an account will ultimately be uncollectible increase as the account gets older

Assume the following aging analysis for Accounts Receivable:

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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The Aging Method

Assigning percentages to each age category yields the following results:

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Write-offs of Bad Debt

  • The write-off entry is merely a confirmation of what has already been estimated and recorded

  • The write-off has no impact on the reported amount of net Accounts Receivable or Bad Debts Expense

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Write-offs of Bad Debt

Customer has declared bankruptcy; receivable balance of $3,200 is written off:

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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The Allowance for Bad DebtsT-Account

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Accounting forWarranties


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Like bad debts expense, warranty expense must be estimated and recognized in the same period in which the revenue is recognized

The accountant must estimate the expense before all of the facts are in.

Warranties

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Warranties

The year-end entry to record Veda Landscape’s estimated Shrub Warranty Expense from planting 50 shrubs is

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Warranties

The entry to record actual costs of replacing shrubs under warranty is

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Cash Management:Controls and Factoring


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Cash

  • Cash includes coins, currency, money orders, checks, and cash in bank accounts that can be used to satisfy the company’s obligations

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Cash Controls

  • Cash must be carefully safeguarded because it is easily stolen

  • Separation of duties

    • The custody of cash should be separated from the recording of cash

  • Cash receipts

    • Deposited daily in bank accounts

  • Cash expenditures

    • Made with pre-numbered checks

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Cash Management

Two methods of obtaining cash from receivables without waiting for collection from customers:

  • Assignment

  • Factoring

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Assignment of Receivables

  • Specific receivables are used as collateral for a loan

  • Disclosure in the financial statement notes is required

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Factoring Receivables

  • Factoring involves one company selling some of its receivables to another company (the factor) who charges a fee for the service

  • Receivables are usually sold “without recourse”

    • The factor assumes all the risk of collecting the receivables

Financial Accounting, 7e Stice/Stice, 2006 © Thomson



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Foreign Currencies

A foreign currency transaction occurs when a a U.S. firm makes a sale to a foreign firm that is denominated in a foreign currency

An exchange rate gain or loss occurs if the exchange rate changes between the time of the sale and when the receivable is collected

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Foreign Currency Transactions

The exchange rate is the rate at which one currency can be exchanged for another (foreign currency exchanged for the U.S. dollar)

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Foreign Currency Transaction Example

American Company sold £200,000 of goods on April 2 to a British customer. Payment in British pounds is due July 10. The following exchange rates apply:

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Foreign Currency Transaction Example

On April 2 the American Company records the sale of $320,000 (£200,000 × $1.60)

On June 30 the company records an exchange loss of $8,000 [£200,000 × ($1.60 - $1.56)]. The loss is reported on the quarterly income statement.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Foreign Currency Transaction Example

On July 10 the company receives payment from its British customer, recording a gain of $2,000 due to the increase in the exchange rate.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Financial Statement Impact

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Evaluating Credit Policy

Budgeting Cash Receipts


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Quantity of Receivables

  • The efficient use of accounts receivable can be evaluated by using two ratios:

    • Accounts receivable turnover

    • Average collection period

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Quantity of Receivables

The accounts receivable turnover determines how many times during the year a company is collecting its average receivable balance

Sales

Accounts Receivable Turnover

=

Average Accounts Receivable

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Quantity of Receivables

The accounts receivable turnover can be converted into the average collection period

The lower the average collection period, the more favorable the ratio

365

Average Collection Period

=

Accounts Receivable Turnover

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Quantity of Receivables

Proper receivables management

  • balancing

    • the desire to extend credit in order to increase sales

    • the need to collect the cash quickly in order to pay off company debt

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Quality of Receivables

  • The relationship between the bad debt allowance and total receivables should be stable from year to year

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Quality of Receivables

  • A change in the ratio may indicate a change in

    • The type of credit customers a business is attracting, or

    • The economic circumstances of existing customers

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Budgeting Cash Receipts

  • A cash budget is an important tool in helping management plan its cash needs

  • Estimating cash and credit sales, as well as estimating the pattern of collection of accounts receivable, are key to the cash receipts budgeting process

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Cash Budgeting Example

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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20% cash

80% credit

January

$20,000

+ $24,000

February

$40,000

March

$14,400

January Sales $100,000

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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Third QuarterCash Receipts Budget

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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In Summary ...

  • Revenue is recognized only after providing a good or service and after receiving a valid promise to pay (two exceptions).

  • Bad debt expense is matched with associated revenue by using the allowance method, either with the percentage of sales and the aging method.

  • Warranty expense is matched with associated revenue

  • Cash controls and management tools

  • Foreign currency transactions can cause foreign currency gains and losses.

  • The quality and quantity of receivables can be evaluated using ratios and relationships.

Financial Accounting, 7e Stice/Stice, 2006 © Thomson


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