Accounting for Sales 4/10/2012. Learning Objectives (LO) Learning Objectives (LO) LO 1 Revenue Recognition. LO 1 Revenue Recognition

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1 4/10/0 Accounting for Sales CHAPTER Learning Objectives (LO) After studying this chapter, you should be able to 1. Recognize revenue items at the proper time on the income statement. Account for cash and credit sales 3. Compute and interpret sales returns and allowances, sales discounts, and bank credit card sales 4. Manage cash and explain its importance to the company 5. Estimate and interpret uncollectible accounts receivable balances of 41 Learning Objectives (LO) LO 1 Revenue Recognition After studying this chapter, you should be able to. Assess the level of accounts receivable 7. Develop and explain internal control procedures 8. Prepare a bank reconciliation Revenue results from the sale of goods/services to a customer and should be recognized when It is earned - Goods or services have been delivered It is realized title has transferred and cash has been received Or is realizable if another asset other than cash (e.g. Receivable) is received and is virtually assured of being converted into cash Most companies recognize revenue at the point of sale but there are unique circumstances 3of 41 4of 41 LO 1 Revenue Recognition LO 1 Revenue Recognition is received before goods or services have been delivered 1,000 Unearned (deferred) Revenue (liability) A portion (50%) is completed but not delivered (percent of completion method) Expenditures 500 (50% of expected total) 500 Unearned Revenue 500 Sales Revenue 500 Revenue is recorded at the cash-equivalent value of what is received. For example A sale occurs that has a sticker price of $100 To entice the buyer, a $5 discount is offered and accepted; the customer charges the purchase Receivable 95 Sales Discounts * 5 (Contra revenue account) Revenue * 100 * Net sales revenue would be reported at $95 (100 5) but two accounts would be used to capture the event 5of 41 of 41 1

2 4/10/0 LO and Credit Sales Revenue A $100 cash and $100 credit sale 100 Sales Revenue 00 Credit sales increase revenues (and thus expenses) Credit sales also lead to 1) costs of managing credit and collections and ) uncollectable accounts If net revenue > the related expenses, credit sales are good for the business (see LO 5) Costs and benefits should be periodically assessed LO 3 Sales Returns/Allowances, Trade and Discounts, Credit Card Fees Income Statement Gross Sales $1, Less Sales Returns ($100) Sales Allowances ($10) Contra Revenue (Debit Balance) Trade Discounts ($10) Discounts ($) Credit Card Fees ($3) $5 Net Sales $1,75 Reports to shareholders typically omit details and show only net revenues (Maybe details are in footnotes) 7of 41 8of 41 LO 3 Sales Returns LO 3 Sales Allowances Sales Returns - when a customer returns previously purchased merchandise to the seller ( purchase returns used by buyers) Cost of Goods Sold 0 Inventory 0 Inventory 0 Purchase Returns/Allowances 0 Sales Returns 100 The purchase Contra COGS Sales Allowance is a reduction of the original selling price Cost of Goods Sold 0 Inventory 0 Purchaser notes lower price ($90) at another store and asks for a $10 price reduction which is given Sales Allowances 10 Receivable 10 9of of 41 LO 3 Trade Discounts LO 3 Discounts Trade discounts - a reduction to the gross selling price for a particular class of customers or for differing order sizes (offered to remain competitive/retain customers) Customer buys 10 at $10 a piece and gets 10% off (Example hereafter omit costs of goods sold entries) Receivable 90 Trade Discounts 10 Discounts an encouragement to the retailer to quickly pay the wholesaler Usage varies by company and industry n/30 - Full billed price (net price) due in 30 days 15 E.O.M. Due 15 days after end of the month /10/n30 % off invoice price If paid within 10 days of invoice date Net amount due in 30 days after invoice date 11 of 41 of 41

3 4/10/0 LO 3 Discounts Discounts ( /10/n30 ) - gross method Sale Customer pays Within 10 days 98 Discounts Taken After 10 days 100 LO 3 Discounts Discounts ( /10/n30 ) - net method Sale Receivable 98 Revenue 98 Customer pays Within 10 days 98 Receivable 98 After 10 days 100 Receivable 98 Discounts Lost * * Adjunct account to Revenue or part of Other Income 13 of of 41 LO 3 Discounts LO 3 Charge Cards Should cash discounts (/10/n30) be taken? Choices Get % reduction if pay within 10 days Get to use your own funds for 0 days at a % interest cost (what you sacrificed by not taking it) 30/0 days = 18 0-day periods in a year 18 x % each period = 3% annual interest rate If can/must borrow at < 3% annual interest - take the discount > 3% annual interest - forego discount Why should retailers offer credit? Attract customers (who would shop elsewhere or forego a purchase, i.e. boost sales and profit) Remain competitive with stores in same industry Should the retailer grant credit themselves? Must bear costs of Administering credit card program Uncollectable accounts (bad debts) Reward is higher income due to increased sales and/or interest charges 15 of 41 1 of 41 LO 3 Charge Cards LO 4 - Or use international credit cards (Visa, MasterCard, etc.) Reward is Get cash immediately after the sale Card company bears the risk of unpaid accounts Relieve merchant of cost of a credit department Cost is 1-4% of sales revenue, depending on volume Receivable () 97 Discounts for Credit Cards (@3%) 3 Usually report cash and cash equivalents on the balance sheets as a single amount money, money orders, checks equivalents - highly liquid short-term term investments that can easily and quickly be converted into cash (< 90 days until maturity) Time deposits Commercial paper 90-day Treasury bills Proceeds from national credit cards (See LO 3) 17 of of 41 3

4 4/10/0 LO 4 - Compensating balances - required minimum cash balances on deposit in a bank to compensate for one or more services or loans Compensating balances increase the effective interest rate that the borrower pays No compensating balance - $100,000 x 8% annual interest rate = $8,000 interest expense 10% compensating balance ($10,000) $8,000 / ($100,000 $10,000) = 8.9% interest Must disclose significant compensating balances LO 4 - management is important and therefore justifies strong internal controls Must hold adequate cash to run the business loses purchasing power during inflationary times justifying holding little excess cash) While cash balances may seem large, cash in- and out-flows during the year are much larger, being the most liquid asset is enticing to thieves and embezzlers earns little to no return (generally the least productive of all the assets) 19 of 41 0 of 41 LO 4 - The major internal control procedures set up to safeguard cash include: Separate persons receive and disburse cash Separate persons handle cash and accessing accounting records Record and deposit cash receipts immediately Make disbursements using serially numbered checks, and require proper authorization by someone other than the person writing the check Reconcile bank accounts monthly by someone who does not write the checks Direct (specific write-off) method Assume all receivables are collectable, i.e., do nothing at year end to modify income or receivables When it becomes apparent a receivable ($00) will not be collected (unable or unwilling), write it off s 00 Receivable 00 If sales revenue was recorded last year and write-off occurred this year, poor matching Says nothing about the remaining credit revenue and receivables will some of them become bad debts? 1 of 41 of 41 Allowance method Common elements Adjusting entry at year-end (* Contra Receivable) s 0 Doubtful * 0 Balance Sheet Receivable $50,000 Less: Doubtful * ($4,000) Net Receivable $4,000 Write off a $00 account this or next year Doubtful * 00 Receivable 00 Allowance method By estimating the amount of uncollectable accounts at year end Net income and receivables are reduced to reflect potential uncollectable accounts/lower net income Good matching expense in same year as revenue Involves estimating the amounts since do not know specifically which accounts will become uncollectable in the future, thus conducive to manipulation, AKA: window dressing. 3 of 41 4 of 41 4

5 4/10/0 Allowance Percent of Sales (%) approach Always estimates s AUA derived No ending balance in AUA before adjusting entry Receivable Uncollectable (AUA) 0 0 Revenue (BDE) $ in cash collections $ % x $ credit sales = $0 Receivable $ Less Uncollectable $0 s 0 Net Realizable Value $380 Uncollectable 0 0 Allowance Percent of Sales (%) approach Always estimates s AUA derived Ending balance in AUA before adjusting entry Uncollectable Receivable (AUA) Revenue (BDE) $ in cash collections $ % x $ credit sales = $0 Receivable $ Less Uncollectable $3 s 0 Net Realizable Value $377 Uncollectable 0 5 of 41 of 41 Allowance Percent of Receivables approach Always estimates end-balance in AUA - BDE derived No ending balance in AUA before adjusting entry Uncollectable Receivable (AUA) Revenue (BDE) 0 $ in cash collections $ 3%% x $ ending receivables = $ Receivable $ Less Uncollectable $ s Net Realizable Value $388 Uncollectable Allowance Percent of Receivables approach Always estimates end balance in AUA - BDE derived Ending balance in AUA before adjusting entry Uncollectable Receivable (AUA) Revenue (BDE) $ in cash collections $ 3%% x $ ending receivables = $ Receivable $ Less Uncollectable $ s 14 Net Realizable Value $388 Uncollectable 14 7 of 41 8 of 41 Allowance A/R = Receivable AUA = Uncollectable AUA has $ balance at end last year/begin this year This year wrote off $, $15, or $ of accounts AUA ends (before adjustments) with?? balance Same More Less A/R AUA A/R AUA A/R AUA Allowance Percent of Receivables approach Could also use an aging of receivables method to estimate uncollectable receivables 9 of of 41 5

6 4/10/0 Either Allowance Method - Write-off followed by payment in full a b c1 c a. Customer has $ balance in his account (A/R) b. $ account is written off c. Customer pays off account in full c1. Reinstate the account as it was before write-off c. Apply the cash payment to the reinstated account Allowance Receivable Uncollectables LO - Assessing Receivable sales produce cash instantly Credit sales generally cause sales to increase but they also delay cash receipts. Major credit cards Just a few days before credit card company transfers cash to the company Some treat these receivables as cash equivalents Company credit cards using last year s data How long did it take to collect receivables Is that length of time acceptable? 31 of 41 3 of 41 LO - Assessing Receivable Receivable Turnover Ratio Credit Sales $1,000,000 = 8.81 Average Receivables $115,000 + $1,000 On average, receivables were created then collected 8.81 times in the past year Higher turnovers indicate that a company collects its receivables faster Lower turnover indicates slower collection LO - Assessing Receivable Number of days to collect Receivable 35 days per year 35 = 41.4 days Receivables Turnover Ratio 8.81 On average, last year receivables were collected 41.4 days after being created Higher # days puts more pressure on firm to find alternative cash sources while awaiting collection Lower # days less pressure Varies by company and industries 33 of of 41 Internal control - a system of checks and balances that ensure company actions are proper and approved by management Administrative controls spell out responsibilities for Reporting Budgeting Performance evaluation Granting credit to customers Protecting assets Etc. Accounting controls protects company assets and ensures that management maintains accurate financial records. 35 of 41 3 of 41

7 4/10/0 Internal controls - Accounting controls Transactions are what management intended Recording authorized transactions accurately Safeguarding g assets - prevent unauthorized access Reconciling records to other records or observations Valuation - amounts are reviewed for impairment and write-downs Operational efficiency - least amount of waste, errors, fraud Good internal control systems have these things in common: Reliable personnel with clear responsibilities Separation of duties makes it harder to collude Adequate documentation ti (source documents) Proper authorization for normal/abnormal transactions Well-documented policies and procedures Physical safeguards over items of value Vacations and rotation of duties Independent review of all systems Cost-benefit considerations should apply 37 of of 41 LO 8 Bank Reconciliation SEC requires publically traded companies to have an Audit Committee Purpose is to explain why the bank statement differs from the account owner s records Composed of independent members Responsible for companies financial affairs Sarbanes-Oxley Act 00 - Requires management to Assess and report on its internal controls Requires independent auditors to review management s assessment and offer their assessment of that effort 39 of of 41 LO 8 Bank Reconciliation Complete Depositor Bank statement Beginning Balance 11,000 11,000 11,000 Deposit 4,000 4,000 4,000 Deposit,000,000,000 Deposit 7,000 7,000 Check (,000) (,000) (,000) Check (3,000) (3,000) (3,000) Check (5,000) (5,000) (5,000) Check (10,000) (10,000) Fee (0) (0) Ending Balance 7,980 8,000 10,980 Adjustment (0) 7,000 Adjustment (10,000) Final Balance 7,980 7, of 41 7