Chapter 9 Revenue Cycle: Sales, Receivables, and Cash

2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Statement Items Covered in this Chapter Balance Sheet Income Statement Statement of Cash Flows Current Assets Cash Accounts Rec Allow for BD Current Liabil Warranty Liabil Sales Expenses Bad Debt Exp Warranty Exp Operating Cash from customers

Revenue Recognition

4 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Revenue Recognition The business issues surrounding revenue recognition Deliver a product or service Collect cash Struggle with non-paying customers Provide continuing service

5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Revenue Recognition Criteria

6 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Revenue Recognition Criteria and Exceptions

7 Financial Accounting, 7e Stice/Stice, 2006 © Thomson How Revenue Is Recognized Revenue is recognized by an increase to Cash or Accounts Receivable and an increase to a revenue account

8 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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. How Revenue Is Recognized

9 Financial Accounting, 7e Stice/Stice, 2006 © Thomson No revenue is recognized when $160,000 of the account is collected How Revenue Is Recognized

10 Financial Accounting, 7e Stice/Stice, 2006 © Thomson There is a tendency for companies to want to recognize revenue prematurely because of –Initial public offerings –Profit goals –Executive bonuses tied to income Pressure to Recognize Revenue

11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Application of the Revenue Recognition Criteria

Selling on Credit and Collecting Cash

13 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Granting Credit Granting credit makes sense if the cash collected from customers exceeds the cost of goods sold plus other incremental costs

14 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Costs of Granting Credit

15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Credit Policies

16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Credit Policies

17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Sales discounts allowed to customers are subtracted from the Sales account and reported as Net Sales on the income statement Gross Sales recorded internally Less: Sales discounts taken recorded internally Net Sales publicly reported Credit Policies

Accounting for Credit Customers Who Don’t Pay

19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Credit Customers Who Don’t Pay

20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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) Allowance Method

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Percentage of Sales Method An estimate of bad debts expense is made by multiplying a percentage (based on past experience) times credit sales

22 Financial Accounting, 7e Stice/Stice, 2006 © Thomson If Sales are $200,000 and historically 3% of credit sales have become uncollectible, the following year- end entry would be made: Percentage of Sales Method

23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Percentage of Sales Method

24 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Statement Impact Balance SheetIncome Statement Statement of Cash Flows Accts Rec$40,000 Allow for BD (6,000) Net A/R34,000 Consulting Rev$200,000 Bad Debt Exp6,000 Cash from customers $160,000

25 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 The Aging Method

26 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The chances that an account will ultimately be uncollectible increase as the account gets older Assume the following aging analysis for Accounts Receivable: The Aging Method

27 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Assigning percentages to each age category yields the following results: The Aging Method

28 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Write-offs of Bad Debt

29 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Write-offs of Bad Debt Customer has declared bankruptcy; receivable balance of $3,200 is written off:

30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The Allowance for Bad Debts T-Account Allowance for Bad Debts —write-offs Beginning Balance + new Bad Debt estimates Ending Balance

Accounting for Warranties

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

33 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The year-end entry to record Veda Landscape’s estimated Shrub Warranty Expense from planting 50 shrubs is Warranties

34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The entry to record actual costs of replacing shrubs under warranty is Warranties

Cash Management: Controls and Factoring

36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Cash Cash includes coins, currency, money orders, checks, and cash in bank accounts that can be used to satisfy the company’s obligations

37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Cash Controls

38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Two methods of obtaining cash from receivables without waiting for collection from customers: –Assignment –Factoring Cash Management

39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Assignment of Receivables Specific receivables are used as collateral for a loan Disclosure in the financial statement notes is required

40 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Factoring Receivables

Foreign Currencies

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

43 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The exchange rate is the rate at which one currency can be exchanged for another (foreign currency exchanged for the U.S. dollar) Foreign Currency Transactions

44 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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: Foreign Currency Transaction Example

45 Financial Accounting, 7e Stice/Stice, 2006 © Thomson On April 2 the American Company records the sale of $320,000 (£200,000 × $1.60) Foreign Currency Transaction Example On June 30 the company records an exchange loss of $8,000 [£200,000 × ($ $1.56)]. The loss is reported on the quarterly income statement.

46 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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. Foreign Currency Transaction Example

47 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Statement Impact Balance SheetIncome Statement Statement of Cash Flows Second Quarter Acct Rec$312,000Sales$320,000 FC Exch Loss(8,000) Cash from Customers$0 Third Quarter Cash$314,000 Acct Rec$0 Sales$0 FC Exch Gain2,000 Cash from Customers$314,000

Evaluating Credit Policy Budgeting Cash Receipts

49 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Quantity of Receivables The efficient use of accounts receivable can be evaluated by using two ratios: –Accounts receivable turnover –Average collection period

50 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The accounts receivable turnover determines how many times during the year a company is collecting its average receivable balance Accounts Receivable Turnover = Sales Average Accounts Receivable Quantity of Receivables

51 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The accounts receivable turnover can be converted into the average collection period The lower the average collection period, the more favorable the ratio Average Collection Period = Accounts Receivable Turnover 365 Quantity of Receivables

52 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Quantity of Receivables

53 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The relationship between the bad debt allowance and total receivables should be stable from year to year Quality of Receivables

54 Financial Accounting, 7e Stice/Stice, 2006 © Thomson 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 Quality of Receivables

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

56 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Cash Budgeting Example

57 Financial Accounting, 7e Stice/Stice, 2006 © Thomson January Sales $100,000 20% cash80% credit January $20,000 +$24,000 February $40,000 March $14,400

58 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Third Quarter Cash Receipts Budget

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