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 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.

Merchandise Returns and 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 Returns and 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 Returns and 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 Returns and Allowances Journal entries for returns and allowances: To record the sale: Accounts receivable900,000 Sales revenue900,000 To record the returns and allowances: Sales returns and allowances 80,000 Accounts receivable 80,000

Merchandise Returns and 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 ====================

Credit Sales and Accounts 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 of Uncollectible 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 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 receivable150,000 Sales150,000 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 days Total 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.