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Chapter 6 Selling a product or a service 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

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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)


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Revenue Recognition

  • Recognize revenues when

  • the work has been substantially completed

  • cash and/or valid promise of future payment has been received handle recognition?

  • record sales revenue when goods are shipped to customers and services are provided

  • recognize credit sales as revenues before cash is collected


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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 equipment 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?


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Other issues - Revenue Recognition

  • Sales Discounts (contra revenue account)

  • Offered as incentives for buyers to make prompt payments.

  • Sales Returns and Allowances (contra revenue account)

  • Merchandise is returned because the customer did not want it or because it was defective.

  • Income statement presentation of sales discounts, returns and allowances


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Terminology

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


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If paid within the discount period:

Jan. 10 Cash. . . . . . . . . . . . . . . . . . . . . . . . 980 Sales Discounts . . . . . . . . . . . . . . 20 Accounts Receivable. . . . . . . . 1,000 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?


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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?


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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


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Accounts 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

  • Uncollectible Accounts (contra asset account)

  • Occur when a company is unable to collect on receivables

  • When an account receivable becomes uncollectible, a bad debt expense is incurred

  • 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


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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.


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At the end of every period, record

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

  • When an account is identified as being uncollectible (it may in the year following the one in which the sale was recorded and a bad debt expense was recorded), a write off of that account is made with the following journal entry

    • Allowance for bad debts

    • Accounts receivable


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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


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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 the allowance account 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 the allowance account is the amount of total receivables estimated to be uncollectible.

Estimating Uncollectible Accounts Receivable


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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.


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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


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Uncollectible Accounts Expense appropriate ending balance in the Allowance for Bad Debts

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


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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.


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Warranty Costs . 980 Allowance for Bad Debts . . . . . . 980

  • Estimates for warranty costs are made and recorded at the time of sale

  • Customer service expense

  • Estimated liability for service

  • At the end of the period, the company will show an existing liability for warranty costs it expects to make in future years

  • As the company provides warranty work, it will reduce the liability for service


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Bank Reconciliation . 980 Allowance for Bad Debts . . . . . . 980

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

Examples

Differences Between Bank Statement and Cash Account


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Selling or “Factoring” Accounts Receivable . 980 Allowance for Bad Debts . . . . . . 980

  • 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


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Notes Receivable . 980 Allowance for Bad Debts . . . . . . 980

  • Formal contracts signed when a customer buys merchandise or services on credit.

  • Classified as a current or long-term asset, depending on due date.

  • 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

  • Journal entries - examples