1. The Revenue/ Receivable/Cash Cycle
chapter 7
The Revenue/ Receivable/Cash Cycle
An electronic presentation
by Douglas Cloud
Pepperdine University

2. Learning Objectives
1. Explain the normal operating cycle of a business.
2. Prepare journal entries to record sales revenue, including the accounting for bad debts and warranties for service or replacement.
3. Analyze accounts receivable to measure how efficiently a firm is using this operating asset.
Continued

3. Learning Objectives
4. Discuss the composition, management, and control of cash, including the use of a bank reconciliation.
5. Recognize appropriate disclosures for presenting sales and receivables in the financial statements.
Continued

4. Learning Objectives
EXPANDED LEARNING OBEJCTIVES:
6. Explain how receivables may be used as a source of cash through secured borrowing or sale.
7. Describe proper accounting and valuation of notes receivable
8. Understand the impact of uncollectible accounts on the statement of cash flows.

5. Revenue/Receivables/Cash Timeline
DELIVER a product or service
COLLECT cash (includes discounts)
RETURNS
ACCEPT returned products
STRUGGLE
with nonpaying customers
PROVIDE
continuing services

6. The Operating Cycle of a Business
Cash
Inventory
Accounts
Receivables 2

7. The Operating Cycle of a Business
Assume that Acme Manufacturing sold merchandise to Harper Company on account.
When the inventory is sold on account:
Accounts Receivable 1,000
Sales ,000
Sold merchandise to Harper
Company on account.
When the collection takes place:
Cash 1,000
Accounts Receivable ,000
Payment received on account.

8. The Operating Cycle of a Business
Receivables are all claims against other entities. They are usually settled in cash.
Trade receivables: Receivables arising from normal operating activities.
Notes receivable: Trade receivables evidenced by a formal written promise to pay.
Nontrade receivables: All receivables arising from activities other than normal operations. 7

9. The Operating Cycle of a Business
Nontrade receivables arise from a variety of transactions, such as—
(1) The sale of securities or property other than inventory
(2) Deposits to guarantee contract performance or expense payments
(3) Claims for rebates and tax refunds
(4) Dividends and interest receivable

10. Accounting for Sales Revenues
A trade discount may vary by customer, depending on the volume of business or size or order.

11. Accounting for Sales Revenues
A cash (sales) discount is offered to customers to encourage prompt payment of bills.

12. Accounting for Sales Revenues
Gross Method
Assume on March 15, $1,000 of merchandise is sold on account. The terms of the agreement are 2/10, n/30. The firm uses the gross method for record sales on account.
Entry on date of sale:
Accounts Receivable ,000
Sales ,000

13. Accounting for Sales Revenues
Gross Method
If paid within the discount period:
Cash
Sales Discounts
Accounts Receivable ,000
If not paid within the discount period:
Cash ,000
Accounts Receivable ,000 17 8

14. Accounting for Sales Revenues
Net Method
This time, assume that all sales on account are recording using the net method. Again, the terms of the agreement are 2/10, n/30.
At the point of sale (March 15):
Accounts Receivable 980
Sales 980

15. Accounting for Sales Revenues
Net Method
If paid within the discount period:
Cash 980
Accounts Receivable
If not paid within the discount period:
Cash 1,000
Sales Discounts Not Taken 20 Accounts Receivable

16. Sales Returns and Allowances
Red sweaters costing $600 are sold for $1,000. When delivered, it was determined that the sweaters should have been green. The customer agrees to keep the merchandise for a $200 reduction in price.
Sales entry:
Accounts Receivable 1,000
Sales 1,000
Cost of Goods Sold
Inventory
Sales allowance entry:
Sales Returns and Allowances
Accounts Receivable

17. Sales Returns and Allowances
Suppose that instead of the allowance, the customer elects to return the sweaters.
Sales return entries:
Sales Returns and Allowances ,000
Accounts Receivable 1,000
Inventory 600
Cost of Goods Sold 600

18. Sales Discounts and Sales Returns and Allowances
Income Statement
Sales $15,000
Less: Sales discounts $250
Sales returns and allowances (650) Net sales $14,350 24 11

19. Accounting for Bad Debts
Occur when customers do not pay for items or services purchased on credit.
Bad debts are uncollectible accounts receivable.
Bad Debt Expense is reported as a selling or general and administrative expense.
Accounts receivable are reported on the balance sheet at their net realizable value. 25 13

20. Accounting for Uncollectible Receivables (Direct Method)
Write Off:
Bad Debts Expense
Accounts Receivable
To write off an
uncollectible account.
Since this determination was made after the period in which the sale takes place, the matching principle is violated. This method is not accepted under GAAP.
This entry is made when the account has been determined uncollectible. The direct write-off method is used by small businesses because of its simplicity. 32 14

21. Accounting for Uncollectible Receivables (Allowance Method)
In this method, an estimate of the total uncollectible accounts is made at the end of the period, and an expense is recognized.
Bad Debts Expense ,000
Allowance for Bad Debts ,000
To record estimated
uncollectible accounts.
GAAP requires the use of the allowance method. 33 16

22. Accounting for Uncollectible Receivables (Allowance Method)
When the account is then determined to be uncollectible, the write-off entry is:
Allowance for Bad Debts Accounts Receivable To write off an uncollectible
account.
Note: Bad Debt Expense is not debited. 34 17

23. Accounting for Uncollectible Receivables (Allowance Method)
What happens if the written off receivable is later collected? Assume that the customer from Slide 22 pays the $400 written-off debt a month after the write-off.
Accounts Receivable Allowance for Bad Debts To reverse the entry made to
write off the account.
Note: Before the payment entry, the debt must be restored.

24. Accounting for Uncollectible Receivables (Allowance Method)
What happens if the written off receivable is later collected? Assume that the customer from Slide 22 pays the $400 written-off debt a month after the write-off.
Cash Accounts Receivable To record collection of the
account.

25. Accounting for Uncollectible Receivables (Allowance Method)
(1) Allowance for Doubtful Accounts is a contra-asset account which is subtracted from Accounts Receivable on the balance sheet.
2) The actual write-off entry for $400 does not reduce net receivables, as shown below:
Accts. Receivable $100, Accts. Receivable $99,600
Less Allowance for Less Allowance for
Doubtful Accounts , Doubtful Accounts ,600
Net Receivables $ 98,000 Net Receivables $98,000 36 18

26. Estimating the Allowance for Uncollectible Accounts
Percentage of credit sales
Percentage of accounts receivable
Aging receivables 40 20

27. Percentage of Credit Sales
Example: Doubtful Accounts Expense
The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350. Historically, 2 percent of the credit sales are not collected.
What is the entry to record estimated bad debts? 41 21

28. Percentage of Credit Sales
Example: Doubtful Accounts Expense
The ABC company had credit sales of $100,000. The current accounts receivable balance is $30,500. The allowance for doubtful accounts balance is $350. Historically, 2 percent of the credit sales are not collected.
Bad Debt Expense ,000
Allowance for Doubtful Accounts ,000
To record estimated uncollectible
accounts for the year.

29. Percentage of Credit Sales
Allowance for Doubtful Accounts
Balance 350
Adjusting 2,000
Dec. 31, Bal. 2,350

30. Percentage of Accounts Receivable
Example: Doubtful Accounts Expense
The XYZ company had credit sales of $693,000. The current accounts receivable balance is $50,000. The allowance account balance is $600. Historically, 3 percent of accounts receivable are not collectible.
What is the required adjusting entry to record estimated bad debts?

31. Percentage of Accounts Receivable
Bad Debt Expense
Allowance for Doubtful Accounts
To record estimated uncollectible
accounts for the year.
($50,000 x .03) – $600

32. Percentage of Accounts Receivable
Allowance for Doubtful Accounts
Balance 600
Adjusting
Dec. 31, Bal. 1,500
That’s the desired ending balance.

33. Percentage of Accounts Receivable
What if the allowance account had a debit balance of $350?
Allowance for Doubtful Accounts
I see! The ending balance must be “forced” to be the calculated amount.
Adjusting 1,850
Dec. 31, Bal. 1,500
Balance 350

34. Aging Receivables
The ABC company had credit sales of $100,000. The current accounts receivable balance is $47,550. The allowance for doubtful accounts balance is $620. The firm ages the accounts to determine the expected uncollectibles.
Remember, because receivables are involved, the amount derived from aging provides the desired balance of the allowance account. 44 24

35. Aging Receivables Uncollectible Estimated Accounts Amount of
Classification Experience Uncollectible
(in days) Balance Percentage Accounts
Not yet due $40, % $ 800
1-30 past due 3,
31-60 past due 1,
61-90 past due
past due
past due
+365 past due 1, ,120
$47,550 $2,870 45 25

36. Aging Receivables Required balance $2,870 Current balance (620)
Bad Debt Expense ,250
Allowance for Doubtful Accounts ,250
To record estimated uncollectible
accounts for the year.
Required balance $2,870
Current balance (620)
Adjusting entry $2,250

37. Allowance for Doubtful Accounts
Aging Receivables
Allowance for Doubtful Accounts
Balance 620
Adjusting 2,250
Dec. 31, Bal. 2,870

38. Accounting for Warranties
MJW Video & Sound sells compact stereo systems with a two-year warranty. Past experience indicates that 10% of all systems will need repairs in the first year and 20% will need repairs in the second year. The average repair cost is $50 per system.

39. Accounting for Warranties
The number of systems sold in 2004 and 2005 was 5,000 and 6,000, respectively. Actual repair costs were $12,500 in 2004 and $55,000 in 2005.

40. Accounting for Warranties
To record estimated warranty expense:
2004
Warranty Expense ,000
Estimated Liability Under Warranties ,000
To record estimated warranty
expense based on systems sold.
(5,000 x 0.30) x $50

41. Accounting for Warranties
To record the actual cost of doing repairs:
2004
Estimated Liability Under Warranties 12, Cash ,500
To record cost of actual repair
work in 2004.

42. Accounting for Warranties
To record estimated warranty expense:
2005
Warranty Expense ,000
Estimated Liability Under Warranties ,000
To record estimated warranty
expense based on systems sold.
(6000 x 0.30) x $50

43. Monitoring Accounts Receivable
Average Collection Period: The average number of days that lapse between the time that a sale is made and the time that cash is collected. It is calculated by dividing the average daily sales by the average receivables outstanding. 48 29

44. Monitoring Accounts Receivable
WS Corporation had average receivables of $354,250 and average daily sales of $1,650,000. The average collection period can be calculated as follows:
Average Collection Period:
Average receivable $354,250
Average daily sales ($1,650,000/365) =
Average collection period = 78 days 51 30

45. Monitoring Accounts Receivable
Accounts receivable turnover is determined by dividing net sales by the average trade accounts receivable outstanding during the year. For WS Corporation, the 2005 turnover is:
Accounts Receivable Turnover:
Net sales $1,650,000
Average net receivables $ =
Receivables turnover for year = 4.7 times

46. Cash Management and Control
What items are classified as “cash”?
Undeposited Coins and currency (change funds)
Demand deposits
Petty cash funds
Cashier’s checks
Personal checks

47. Composition of Cash
Many companies report investments in very short-term, interest-earning securities as cash equivalents in the balance sheet.

48. Composition of Cash
A credit balance in the cash account is known as a cash overdraft and should be reported as a current liability.

49. Management and Control of Cash
1) Specifically assigned responsibilities for handling cash receipts
2) Separation of handling and recording receipts
3) Daily deposits of all cash received
4) Voucher system to control cash payments
5) Internal audits at irregular intervals
6) Double record of cash—bank and books, with reconciliation performed by someone outside the accounting function 33

50. Bank Reconciliation
A comparison of the bank balance with the book’s balance by means of a summary is a bank reconciliation.

51. Bank Reconciliation Common causes of differences: Deposits in transit.
Outstanding checks.
Bank debits for items such as service charges and NSF checks.
Bank credits for items such as the bank collecting a note for the depositor.
Accounting errors. 37 34

52. Svendsen, Inc. Bank Reconciliation November 30, 2005
Balance per bank $2,979.72
Additions to bank
balance:
Deposits in transit
Error by bank
Total $3,650.72
Deductions from bank
Outstanding checks:
Listed individually (703.83)
Corrected bank bal. $2,946.89
Balance per books $2,952.49
Additions to bank
balance:
Interest earned …
Error by depositor …
Total $3,068.99
Deductions from book
Service charge $ ( 3.16 )
NSF check ( )
Corrected book bal $2,946.89 41 35

53. Bank Reconciliation
All adjustments made to the Balance per Books need to be recorded:
Cash
Interest Revenue
To record interest earned.
Cash
Advertising Expense
To record correction for check in
payment of advertising recorded
as $64 instead of the actual amount,
$46.
Continued 44 36

54. Bank Reconciliation
Accounts Receivable
Miscellaneous General Expense 3.16
Cash
To record customer’s
uncollectible check and bank
charges for November.
Note: When the item is a plus under “Balance per books,” Cash is debited. When it is a minus, Cash is credited.

55. Presentation of Sales and Receivables in the Financial Statements
Receivables qualifying as current items may be grouped for presentation on the balance sheet in the following classes:
1) Notes receivable—trade debtors
2) Accounts receivable—trade debtors
3) Other receivables

56. Accounts Receivable as a Source of Cash
As a sale (either with or without recourse.
As a secured borrowing. 37

57. Accounts Receivable as a Source of Cash
SFAS 140 specified conditions that must be met if a transfer of receivables is to be accounted for as a sale:
1. The transferred assets have been isolated from the transferor and its creditors cannot access the assets.
2. The transferee has the right to pledge or exchange the transferred assets.
3. The transferor does not maintain effective control over the assets through either (a) an agreement to repurchase them before their maturity or (b) the ability to cause the transferee to return specific assets.

58. Factoring Accounts Receivable
Payment of Accounts Receivable
Cash from Factoring Accounts Receivable
Factor
Sale of Accounts Receivable
Goods and Services Provided
Customers
Company
Accounts Receivable Established 39

59. Accounting for Factoring Accounts Receivable
Close sold receivables
Close accompanying Allowance for Bad Debts
Expense any factoring charges
Establish a receivable for any sales price withheld by the factor
Debit Cash for net proceeds of the sale
Recognize a gain or loss from factoring 43

60. Example: Factoring Accounts Receivable
Assume:
Factored Receivables $10,000
Allowance for Bad Debts 300
Factor Withholding %
Sales Price $ 8,500
Let’s journalize this transaction 44

61. Example: Factoring Accounts Receivable
Cash 8,075
Receivable from Factor
Allowance for Bad Debts
Loss from Factoring Receivables 1,200
Accounts Receivable 10,000
Computations
Cash: $8,500 – 425 = $8,075
Factor Receivable: $8,500 x 5% = $425
Factoring Loss: ($10,000 – 300) – $8,500 = $1,200 45

62. Sale of Receivables with Recourse
Sale of receivables with recourse is different from factoring, since factoring is normally sold on a nonrecourse basis.

63. Sale of Receivables with Recourse
When receivables are sold with recourse, a purchaser of receivables retains the right to collect from the seller when the seller’s customers fail to make payments when due.

64. Sale of Receivables with Recourse
A firm raises funds by selling $5,000 of its receivables for $4,300. The receivables have a net realizable value of $4,700. The receivables are sold with recourse and the seller estimates (as required by SFAS No. 140) that the recourse obligation has a fair value of $250. Assume in this illustration that the factor does not withhold a percentage of the purchase price.

65. Sale of Receivables with Recourse
Cash received $4,300
Estimated value of recourse obligation (250)
Net proceeds $4,050
Book value of the receivables $4,700
Net proceeds to be received (4,050)
Loss on sale of receivables $ 650

66. Sale of Receivables with Recourse
The entry to record the sale:
Cash 4,300
Allowance for Bad Debts 300
Loss on Sale of Receivables 650
Accounts Receivable 5,000
Recourse Obligation 250

67. Secured Borrowing Assignment of Accounts Receivable
There are no special accounting problems involved.
Simply record the loan.
Specific Assignment:
Specified accounts receivable pledged.
Accounts receivable reclassified on balance sheet.
Footnote disclosure of loan provisions required. 38

68. Notes Receivable
A promissory note is an unconditional written promise to pay a certain sum of money at a specified time.

69. Notes Receivable Initially recorded at present value. Two types:
Interest-bearing: Interest rate is stated on the note.
Noninterest-bearing: Interest is implied in the face amount of the note. 48

70. Example: Notes Receivable
Assume:
Note Receivable $1,000
Interest Rate %
Time to Maturity years
Journalize this note as:
1. An interest-bearing note.
2. A noninterest-bearing note. 49

71. Example: Notes Receivable
Interest-Bearing Note:
Notes Receivable 1,000
Sales 1,000
Noninterest-Bearing Note:
Notes Receivable 1,210
Sales ,000
Discount on Notes Receivable 210
(PV of 10% for
2 years = $1,210)

72. Discounting Notes Receivables
Discount Rate: The interest rate charged by the financial institution for buying a note receivable.
Discount Period: The time between the date a note is sold to a financial institution and its maturity date. 71 51

73. Formulas for Discounting Notes
Interest = Face amount x Interest rate x Interest period
Maturity value = Face amount + Interest
Discount = Maturity value x Discount period x Discount rate
Proceeds = Maturity value - Discount 72 52

74. chapter 7
The End