1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 5: Sales and Receivables Cornerstones of Financial & Managerial Accounting, 2e

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Timing of Revenue Recognition ► While cash-basis accounting recognizes revenue in the period payment is received (as on your tax return), accrual-basis accounting recognizes revenue when it is ► (1) realized or realizable, which means that non-cash resources (such as inventory) have been exchanged for cash or near cash (accounts receivable) and ► (2) earned, which means the earnings process is substantially complete. 1

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Amount of Revenue Recognized ► The appropriate amount of revenue to recognize is generally the cash received or the cash equivalent of the receivable. ► Three changes to sales revenues include: discounts, returns, and allowances. 2

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Discounts ► To encourage prompt payment, businesses may offer a sales discount. ► This discount is a reduction of the normal selling price and is attractive to both the seller and the buyer. ► For the buyer, it is a reduction to the cost of the goods and services. ► For the seller, the cash is more quickly available and collection costs are reduced. 2

5. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Returns and Allowances ► Occasionally, a customer will return goods as unsatisfactory. ► Sometimes a customer may agree to keep goods with minor defects if the seller is willing to make an ‘‘allowance’’ by reducing the selling price. ► When goods or services arrive late, or in some other way are rendered less valuable, a customer may be induced to accept the goods/services if a price reduction, called a sales allowance is offered by the seller. ► In these cases, a contra-revenue account called sales returns and allowances is used to record the price reduction. ► Merchandise or goods returned by the customer to the seller are sales returns and are also recorded in the sales returns and allowances account. 2

6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Receivables ► Receivables are typically categorized along three different dimensions: ► Accounts Receivable or Notes Receivable: A ‘‘note’’ is a legal document given by a borrower to a lender stating the timing of repayment and the amount (principal and/or interest) to be repaid. Accounts receivable, on the other hand, do not have a formal note. ► Current or Noncurrent Receivables: Although in practice both accounts and notes receivable are typically classified as current, accounts receivable are typically due in 30 to 60 days and do not have interest while notes receivable have interest and typically are due in anywhere from 3 to 12 months. ► Trade or Nontrade Receivables: Trade receivables are due from customers purchasing inventory in the ordinary course of business while nontrade receivables arise from transactions not involving inventory. 3

7. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Bad Debts ► GAAP requires accounts receivable to be shown at their ‘‘net realizable value,’’ which is the amount of cash the company expects to collect. ► When customers do not pay their accounts receivable, bad debts result (also called uncollectible accounts). ► There are two methods to record bad debt expense: ► the direct write off method ► the allowance method 4

8. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Direct Write-Off Method ► The direct write-off method waits until an account is deemed uncollectible before reducing accounts receivable and recording the bad debt expense. ► Since accounts are often determined to be uncollectible in accounting periods subsequent to the sale period, the direct write-off method is inconsistent with the matching concept. ► Therefore, this method can be used only if bad debts are immaterial under GAAP. 4

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allowance Method ► In the allowance method, bad debt expense is recorded in the period of sale, which allows it to be properly matched with revenues according to the matching concept. ► The result is that bad debt expense is recognized before the actual default. ► An account is established to ‘‘store’’ the estimate of potentially uncollectible accounts is known as the Allowance for Doubtful Accounts. ► When a specific account is ultimately determined to be uncollectible under the allowance method, it is written off by a debit to the allowance account and a credit to accounts receivable. ► Under the allowance procedure, two methods commonly used to estimate bad debt expense are the percentage of credit sales method and the aging method. 4

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Percentage of Credit Sales Method ► The simpler of the two methods for determining bad debt expense is the percentage of credit sales method. ► Using past experience, a company estimates the percentage of the current period’s credit sales that will eventually become uncollectible. ► This percentage is multiplied by the total credit sales for the period to calculate the estimated bad debt expense for the period: Total Credit Sales x Percentage of Credit Sales Estimated to Default = Estimated Bad Debt Expense 4

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Aging Method ► Under the aging method, bad debt expense is estimated by determining the collectability of the accounts receivable rather than by taking a percentage of total credit sales. ► At the end of each accounting period, the individual accounts receivable are categorized by age. ► Then an estimate is made of the amount expected to default in each age category based on past experience and expectations about how the future may differ from the past. ► Since the objective of the aging method is to estimate the ending balance in the allowance for doubtful accounts, any existing balance in the allowance account must be considered when determining the amount of the adjusting entry. 4

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Factoring Receivables ► An increasingly common practice is to factor, or sell, receivables. ► When receivables are factored, the seller receives an immediate cash payment reduced by the factor’s fees. ► The factor, the buyer of the receivables, acquires the right to collect the receivables and the risk of uncollectibility. ► In a typical factoring arrangement, the sellers of the receivables have no continuing responsibility for their collection. ► Securitization occurs when large businesses and financial institutions frequently package factored receivables as financial instruments or securities and sell them to investors. 5

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Credit Cards ► Bank credit cards, such as Visa and MasterCard, are really just a special form of factoring. ► The issuer of the credit card (i.e., the bank) pays the seller the amount of each sale less a service charge (on the date of purchase) and then collects the full amount of the sale from the buyer (at some later date). ► The advantages of this arrangement are: ► Sellers receive the money immediately. ► Sellers avoid bad debts because as long as the credit card verification procedures are followed, the credit card company absorbs the cost of customers who do not pay. ► Recordkeeping costs lessen because employees are not needed to manage these accounts. ► Sellers believe that by accepting credit cards, their sales will increase. 5

14. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Debit Cards ► A debit card authorizes a bank to make an immediate electronic withdrawal (debit) from the holder’s bank account. ► The debit card is used like a credit card except that a bank electronically reduces (debits) the holder’s bank account and increases (credits) the merchant’s bank account for the amount of a sale made on a debit card. ► Debit cards are disadvantageous to the card holder since transactions cannot be rescinded by stopping payment. ► Debit cards are advantageous to banks and merchants through reduced transaction-processing costs. 5

15. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Notes Receivable ► Notes receivable are receivables that generally specify an interest rate and a maturity date at which any interest and principal must be repaid. ► The amount lent is the principal. ► The excess of the total amount of money collected over the amount lent is called interest. 6

16. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Calculating Interest ► Interest can be considered compensation paid to the lender for giving up the use of resources for the period of a note (the time value of money). ► The interest rate specified in the note is an annual rate. Therefore, when calculating interest, you must consider the duration of the note using the following formula: 6

17. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Internal Control for Sales ► For sales revenues, internal controls typically involve the following documents and procedures: ► Accounting for a sale begins with the receipt of a purchase order or some similar document from a customer. The order document is necessary for the buyer to be obligated to accept and pay for the ordered goods. ► Shipping and billing documents are prepared based on the order document. Billing documents are usually called invoices. ► A sale and its associated receivable are recorded only when the order, shipping, and billing documents are all present. 7

18. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Sales ► Because sales revenue is such a key component of a company’s success, analysts are interested in a large number of ratios that incorporate sales. ► Many of these profitability ratios attempt to measure the return the company is earning on sales. ► There are three common profitability ratios: ► Gross Profit Margin = Gross Profit ÷ Net Sales ► Operating Margin = Operating Income ÷ Net Sales ► Net Profit Margin = Net Income ÷ Net Sales ► Analysts also like to look at the operating margin and net profit margin percentages to see how much is left from a sales dollar after paying for the product and all its operations. 8

19. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Receivables ► Analysts are also concerned with asset management. Asset management refers to how efficiently a company is using the resources at its disposal. ► One of the most widely-used asset management ratios is accounts receivable turnover: ► Accounts Receivable Turnover = Net Sales ÷ Average Net Accounts Receivable ► This ratio provides a measure of how many times average trade receivables are collected during the period. ► Changes in this ratio over time are also very important. ► For example, a significant reduction in receivables turnover may indicate that management is extending credit to customers who are not paying. 8