Chapter 5 Accounting for Sales
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.
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.
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.
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.
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.
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.
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.
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
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.
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.
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.
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
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 ====================
Merchandise Returnsand Allowances • Discounts on sales also affect the amount reported as sales. • Two major types of discounts: • Trade discounts • Cash discounts
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.
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.
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
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
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 ==================
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.
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
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.
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.
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.
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.
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.
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.
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
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
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.
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.
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.
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 ====================
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.
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?
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
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
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.
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.
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.
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.
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.
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.
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.
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
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.
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
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.
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.