chapter 7 The Revenue ReceivableCash Cycle An electronic

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

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 2

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

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. 4

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

The Operating Cycle of a Business Cash Inventory Accounts Receivables 6

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

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. 8

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

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

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

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 Sales 1, 000

Accounting for Sales Revenues Gross Method If paid within the discount period: Cash Sales Discounts Accounts Receivable If not paid within the discount period: Cash Accounts Receivable 980 20 1, 000

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

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

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 600 Inventory 600 Sales allowance entry: Sales Returns and Allowances Accounts Receivable 200

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

Sales Discounts and Sales Returns and Allowances Income Statement Sales $15, 000 Less: Sales discounts $250 Sales returns and allowances 400 Net sales (650) $14, 350 18

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

Accounting for Uncollectible Receivables (Direct Method) Write Off: Bad Debts Expense Accounts Receivable To write off an uncollectible account. 400 Since This this entry determination is made whenwas themade account afterhas the been period determined in which uncollectible. the sale takes place, The direct the matching write-offprinciple method isisused violated. by small This method businesses is not because accepted of its under simplicity. GAAP.

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 Allowance for Bad Debts To record estimated uncollectible accounts. 2, 000 GAAP requires the use of the allowance method. 2, 000

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. 400 Note: Bad Debt Expense is not debited.

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. 400 Note: Before the payment entry, the debt must be restored.

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. 400

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 Less Allowance for Doubtful Accounts Net Receivables $100, 000 2, 000 $ 98, 000 Accts. Receivable Less Allowance for Doubtful Accounts Net Receivables $99, 600 1, 600 $98, 000

Estimating the Allowance for Uncollectible Accounts § Percentage of credit sales § Percentage of accounts receivable § Aging receivables 26

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?

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 2, 000 Allowance for Doubtful Accounts To record estimated uncollectible accounts for the year. 2, 000

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

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?

Percentage of Accounts Receivable Bad Debt Expense 900 Allowance for Doubtful Accounts 900 To record estimated uncollectible accounts for the year. ($50, 000 x. 03) – $600

Percentage of Accounts Receivable Allowance for Doubtful Accounts That’s the desired ending balance. Balance Adjusting Dec. 31, Bal. 600 900 1, 500

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

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.

35 Aging Receivables Classification (in days) Not yet due 1 -30 past due 31 -60 past due 61 -90 past due 91 -180 past due 181 -365 past due +365 past due Uncollectible Estimated Accounts Amount of Experience Uncollectible Balance Percentage Accounts $40, 000 3, 000 1, 200 650 500 800 1, 400 $47, 550 2% 5 10 20 30 50 $ 800 150 120 130 150 400 1, 120 $2, 870

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

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

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.

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.

Accounting for Warranties To record estimated warranty expense: 2004 Warranty Expense 75, 000 Estimated Liability Under Warranties 75, 000 To record estimated warranty expense based on systems sold. (5, 000 x 0. 30) x $50

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

Accounting for Warranties To record estimated warranty expense: 2005 Warranty Expense 90, 000 Estimated Liability Under Warranties 90, 000 To record estimated warranty expense based on systems sold. (6000 x 0. 30) x $50

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. 43

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 Average daily sales $354, 250 = ($1, 650, 000/365) Average collection period = 78 days 44

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 = Average net receivables $1, 650, 000 $354. 250 Receivables turnover for year = 4. 7 times

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

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

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

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 49

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

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

Svendsen, Inc. Bank Reconciliation November 30, 2005 Balance per bank. . $2, 979. 72 Balance per books. . . $2, 952. 49 Additions to bank balance: Deposits in transit. . 658. 50 Interest earned. . . . …. 98. 50 Error by bank 12. 50 Error by depositor. . …. 18. 00 Total. . . . . $3, 650. 72 Total. . . . $3, 068. 99 Deductions from bank balance: Outstanding checks: Listed individually (703. 83) Corrected bank bal. $2, 946. 89 Deductions from book balance: Service charge. . . NSF check. . . . . Corrected book bal. $ ( 3. 16 ) (118. 94 ) $2, 946. 89

Bank Reconciliation All adjustments made to the Balance per Books need to be recorded: Cash 98. 50 Interest Revenue 98. 50 To record interest earned. Cash 18. 00 Advertising Expense 18. 00 To record correction for check in payment of advertising recorded as $64 instead of the actual amount, $46. Continued

Bank Reconciliation Accounts Receivable Miscellaneous General Expense Cash To record customer’s uncollectible check and bank charges for November. 118. 94 3. 16 122. 10 Note: When the item is a plus under “Balance per books, ” Cash is debited. When it is a minus, Cash is credited.

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

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

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. 57

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

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 59

Example: Factoring Accounts Receivable Assume: Factored Receivables $10, 000 Allowance for Bad Debts 300 Factor Withholding 5 % Sales Price $ 8, 500 Let’s journalize this transaction 60

Example: Factoring Accounts Receivable Cash 8, 075 Receivable from Factor 425 Allowance for Bad Debts 300 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 61

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

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.

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.

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

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

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. 67

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

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. 69

Example: Notes Receivable Assume: Note Receivable Interest Rate Time to Maturity $1, 000 10% 2 years Journalize this note as: 1. An interest-bearing note. 2. A noninterest-bearing note. 70

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

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. 72

Formulas for Discounting Notes Interest = 73 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

chapter 7 The End