Chapter 6

1. ©Kimberly Lyons Selling Goods and Services Chapter 6

2. Revenue should be recognized (recorded) when earned, and realized or realizable (collectible) Revenue is earned when an exchange has taken place, and the company has provided goods or services that entitle them to collect ©Kimberly Lyons Revenue Recognition Principle

3. Usually, a company will collect its receivables and convert them to cash • Issues that result in reduced cash collections include: • Sales Discounts • Sales Returns and Allowances • Uncollectible Accounts (bad debts) ©Kimberly Lyons Cash Collection of Receivables

4. Discounts are offered to customers to encourage timely payment • Example: Simco Inc. sells goods to Balto for $1,000 on September 27th, with credit terms 2/10, net/30 • The credit terms allow Balto a 2% discount on payments made within 10 days, the remainder (net) is due within 30 days • Simco records the initial sale: 9/27 Accounts Receivable 1,000 Sales Revenue 1,000 ©Kimberly Lyons Sales Discounts

5. Balto pays the bill on October 5th and Simco records the following 10/5 Cash 980 Sales Discounts 20 Accounts Receivable 1,000 • Sales Discounts is a “contra revenue” account • Contra = opposite • This account has a debit balance and will reduce sales revenue indirectly in the income statement ©Kimberly Lyons Sales DiscountsContinued

6. Occasionally customers return goods or are allowed a reduced price allowance for defective products • Example: Simco Inc. sells goods to Patton Inc. for $1,000 on September 25th with credit terms 2/10, net/30. Patton returns half of the goods on September 30th and pays for the remainder on October 15th (outside of the discount period) • Simco records the following: 9/25 Accounts Receivable 1,000 Sales Revenue 1,000 9/30 Sales Returns & Allow. 500 Accounts Receivable 500 10/15 Cash 500 Accounts Receivable 500 ©Kimberly Lyons Sales Returns and Allowances

7. ©Kimberly Lyons Sales Returns and AllowancesContinued • Sales returns and allowances are also a contra revenue account • They have a debit balance and reduce sales revenue indirectly in the income statement • When both of Simco’s transactions are complete, accounts receivable is zero, and total cash collected of $1,480 equals net sales which is the net “inflow” from the transaction

8. There are two methods of accounting for uncollectible accounts • Direct write-off method • Allowance method • Direct write-off method: when accounts are known to be uncollectible they are written off immediately Bad Debt Expense XXX Accounts Receivable XXX ©Kimberly Lyons Uncollectible Accounts and Bad Debt Expense

9. The direct write-off method often results in the recording of sales revenue in one period and bad debt expense in another No matching of related revenues and expenses Not GAAP Used for tax purposes instead ©Kimberly Lyons Direct Write-off Method Continued

10. Achieves matching by recording bad debt expense in the same period related sales revenue is recorded (GAAP) Estimates are used to record uncollectibles before they happen An allowance account is credited instead of accounts receivable, since specific uncollectible receivables are not yet known When actual write-offs occur at a later date, they are debited against the existing credit in the allowance account ©Kimberly Lyons Allowance Method

11. Example: Piper Inc. estimates uncollectible accounts receivable of $1,300. This estimate is recorded at December 31st as part of the year-end adjustment process: 12/31 Bad Debt Expense 1,300 Allowance for Uncollectibles 1,300 • When actual bad debts become known (in a later period) piper writes them off with: 5/13 Allowance for Uncollectibles 1,250 Accounts Receivable 1,250 ©Kimberly Lyons Allowance Method Continued

12. Allowance for uncollectibles is a contra accounts receivable account It has a credit balance that will net against and reduce receivables in the balance sheet Net receivables is also referred to as net realizable value of receivables A more conservative value of assets ©Kimberly Lyons Allowance for Uncollectibles

13. Example: Piper Inc. estimates uncollectibles of 1% of credit sales. Credit sales for the period are $150,000: 150,000 x .01 = $1,500 12/31 Bad Debt Expense 1,500 Allowance for Uncollectibles 1,500 ©Kimberly Lyons Making Estimates% of Credit Sales

14. When estimates are made as a % of credit sales, the adjustment will be recorded without considering any existing balance in the allowance account Allowance Write-offs 1,250 1,300 Beginning 1,500 Adjustment 1,550 End ©Kimberly Lyons Making Estimates% of Credit SalesContinued

15. Example: Piper Inc. estimates uncollectibles of 5% of outstanding accounts receivable. Accounts receivable at 12/31 are $28,400. Piper started the year with a credit balance in the allowance account of $1,300, against which $1,250 was written off. The balance in the allowance account before adjustment is $50 (credit). Estimate of uncollectibles = (28,400 x .05) = $1,420 year-end adjustment = $1,420 – 50 = $1,370 12/31 Bad Debt Expense 1,370 Allowance for Uncollectibles 1,370 ©Kimberly Lyons Making Estimates% of Accounts Receivable

16. When estimates are made as a % of accounts receivable, the adjustment must take the existing allowance balance into consideration The estimate will become the new balance in the allowance account and will go to the balance sheet to net with accounts receivable Allowance Write-offs 1,250 1,300 Beginning 1,370 Adjustment 1,420 Estimate ©Kimberly Lyons Making Estimates% of Accounts ReceivableContinued

17. ©Kimberly Lyons Balance Sheet Presentation

18. When making estimates of uncollectibles as a % of sales, ignore the existing balance in the allowance account and record the estimate as bad debt expense When making estimates of uncollectibles as a % of accounts receivable, adjust the allowance account so that the estimate will become its ending balance ©Kimberly Lyons Making Estimates Review

19. Selling products with attached warranties gives rise to related expenses These expenses should be matched with related revenues at the time of sale Use of estimates allows recoding warranty expense with the related liability without having to wait for future returns ©Kimberly Lyons Product Warranties

20. Tilton Inc. Sells goods that are under warranty • The company sells 2,000 units for $25 each and expects 2% to be returned for replacement at a cost of $17 each • At the time of sale Tilton must record the warranty expense: (DR) Accts rec. 50,000 (CR) Sales revenue 50,000 (DR) Cost of goods sold 34,000 (CR) Inventory 34,000 (DR)Warranty expense 680 (CR) Warranty liability 680 (2,000 x .02 x $17 = $680) ©Kimberly Lyons Warranty example

21. Suppose 10 units are returned in the future and Tilton replaces the units at cost: (DR) Warranty liability 170 (CR) Inventory 170 (10 units x $17 = $170) ©Kimberly Lyons Warranty example

22. The recorded warranty expense is matched with the related revenue at the time of sale The warranty liability remains in the balance sheet (carries over to the next period or later) until it is honored ©Kimberly Lyons Product Warranties

23. State the revenue recognition principle Calculate and record sales discounts and sales returns and allowances Calculate net sales Record bad debts with the direct write-off method of accounting for uncollectibles Calculate and record bad debt expense using the allowance method and a % of credit sales Calculate and record bad debt expense using the allowance method and a % of accounts receivable ©Kimberly Lyons Review for Exam

24. Which method of accounting for bad debts is GAAP? Why? Calculate net receivables, or net realizable value of receivables Account for warranties ©Kimberly Lyons Review for ExamContinued