Chapter 9 Revenue Cycle Sales Receivables and Cash
Chapter 9 Revenue Cycle: Sales, Receivables, and Cash Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 1
Financial Statement Items Covered in this Chapter Balance Sheet Current Assets Cash Accounts Rec Allow for BD Current Liabil Warranty Liabil Income Statement Sales Statement of Cash Flows Operating Cash from customers Expenses Bad Debt Exp Warranty Exp Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 2
Revenue Recognition Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 3
Revenue Recognition The business issues surrounding revenue recognition Deliver a product or service Diamond Chapter 8 Collect Struggle Provide cash with non-paying customers continuing service 4
Revenue Recognition Criteria Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 5
Revenue Recognition Criteria and Exceptions Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 6
How Revenue Is Recognized Revenue is recognized by an increase to Cash or Accounts Receivable and an increase to a revenue account Diamond Chapter 8 7
How Revenue Is Recognized Example: Transaction 11 from the Veda Landscape Solution scenario: Performed landscaping consulting services for several large clients. Billed these clients $200, 000 for these services. Diamond Chapter 8 8
How Revenue Is Recognized No revenue is recognized when $160, 000 of the account is collected Diamond Chapter 8 9
Pressure to Recognize Revenue There is a tendency for companies to want to recognize revenue prematurely because of – Initial public offerings – Profit goals – Executive bonuses tied to income Diamond Chapter 8 10
Application of the Revenue Recognition Criteria When the work associated with a sale extends over a significant time period, or when cash collectibility is in doubt, the accountant must use professional judgment in determining the proper time to record the sale Diamond Chapter 8 11
Selling on Credit and Collecting Cash Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 12
Granting Credit Granting credit makes sense if the cash collected from customers exceeds the cost of goods sold plus other incremental costs Diamond Chapter 8 13
Costs of Granting Credit • Bad debts • Bookkeeping costs – Credit approval system – Billing and collection system • Carrying costs – The opportunity cost of not making a return on the cash that is tied up in the form of accounts receivable – The cost of securing cash from other sources • Credit card sales – Card issuer fees for billing and collections Diamond Chapter 8 14
Credit Policies Credit period: determines when the cash will be collected – n/30, read “net thirty, ” means that payment is due within 30 days from the date of the invoice Sales discounts: cash reductions offered to credit customers who pay their bills early Diamond Chapter 8 15
Credit Policies 2/10, n/30 – 2% discount if the receivable is paid within 10 days of the invoice date – the full invoice price is due within 30 days Diamond Chapter 8 16
Credit Policies Sales discounts allowed to customers are subtracted from the Sales account and reported as Net Sales on the income statement Gross Sales Less: Sales discounts taken Net Sales Diamond Chapter 8 recorded internally publicly reported 17
Accounting for Credit Customers Who Don’t Pay Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 18
Credit Customers Who Don’t Pay • Bad debt expense is a natural consequence of selling merchandise on credit • The matching concept requires that bad debts be estimated and reported in the same year that the sales occur • This estimation method is known as the allowance method Diamond Chapter 8 19
Allowance Method Two estimation procedures – Percentage of sales method – Aging method Under either method an increase to Bad Debts Expense is recorded, along with a corresponding increase to Allowance for Bad Debts (a contra account to Accounts Receivable) Diamond Chapter 8 20
Percentage of Sales Method An estimate of bad debts expense is made by multiplying a percentage (based on past experience) times credit sales Diamond Chapter 8 21
Percentage of Sales Method If Sales are $200, 000 and historically 3% of credit sales have become uncollectible, the following yearend entry would be made: Diamond Chapter 8 22
Percentage of Sales Method • The Allowance for Bad Debts account is reported on the balance sheet as a subtraction from Accounts Receivable • The percentage of sales method is an income statement approach which relies on historical or industry data to estimate Bad Debts Expense Diamond Chapter 8 23
Financial Statement Impact Balance Sheet Accts Rec Allow for BD Net A/R Statement of Cash Income Statement Flows $40, 000 Consulting Rev $200, 000 (6, 000) Bad Debt Exp 6, 000 34, 000 Financial Accounting, 7 e Stice/Stice, 2006 © Thomson Cash from customers $160, 000 24
The Aging Method • The aging method involves dividing the Accounts Receivable balance into different age categories to estimate the amount of those accounts which will ultimately become uncollectible • This balance sheet approach seeks to estimate an appropriate year-end balance for the Allowance for Bad Debts account Diamond Chapter 8 25
The Aging Method The chances that an account will ultimately be uncollectible increase as the account gets older Assume the following aging analysis for Accounts Receivable: Diamond Chapter 8 26
The Aging Method Assigning percentages to each age category yields the following results: Diamond Chapter 8 27
Write-offs of Bad Debt • The write-off entry is merely a confirmation of what has already been estimated and recorded • The write-off has no impact on the reported amount of net Accounts Receivable or Bad Debts Expense Diamond Chapter 8 28
Write-offs of Bad Debt Customer has declared bankruptcy; receivable balance of $3, 200 is written off: Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 29
The Allowance for Bad Debts T-Account Allowance for Bad Debts Beginning Balance + new Bad Debt estimates —write-offs Ending Balance Diamond Chapter 8 30
Accounting for Warranties Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 31
Warranties Like bad debts expense, warranty expense must be estimated and recognized in the same period in which the revenue is recognized Diamond Chapter 8 The accountant must estimate the expense before all of the facts are in. 32
Warranties The year-end entry to record Veda Landscape’s estimated Shrub Warranty Expense from planting 50 shrubs is Diamond Chapter 8 33
Warranties The entry to record actual costs of replacing shrubs under warranty is Diamond Chapter 8 34
Cash Management: Controls and Factoring Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 35
Cash • Cash includes coins, currency, money orders, checks, and cash in bank accounts that can be used to satisfy the company’s obligations Diamond Chapter 8 36
Cash Controls • Cash must be carefully safeguarded because it is easily stolen • Separation of duties – The custody of cash should be separated from the recording of cash • Cash receipts – Deposited daily in bank accounts • Cash expenditures – Made with pre-numbered checks Diamond Chapter 8 37
Cash Management Two methods of obtaining cash from receivables without waiting for collection from customers: – Assignment – Factoring Diamond Chapter 8 38
Assignment of Receivables • Specific receivables are used as collateral for a loan • Disclosure in the financial statement notes is required Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 39
Factoring Receivables • Factoring involves one company selling some of its receivables to another company (the factor) who charges a fee for the service • Receivables are usually sold “without recourse” – The factor assumes all the risk of collecting the receivables Diamond Chapter 8 40
Foreign Currencies Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 41
Foreign Currencies A foreign currency transaction occurs when a a U. S. firm makes a sale to a foreign firm that is denominated in a foreign currency Diamond Chapter 8 An exchange rate gain or loss occurs if the exchange rate changes between the time of the sale and when the receivable is collected 42
Foreign Currency Transactions The exchange rate is the rate at which one currency can be exchanged for another (foreign currency exchanged for the U. S. dollar) Diamond Chapter 8 43
Foreign Currency Transaction Example American Company sold £ 200, 000 of goods on April 2 to a British customer. Payment in British pounds is due July 10. The following exchange rates apply: Diamond Chapter 8 44
Foreign Currency Transaction Example On April 2 the American Company records the sale of $320, 000 (£ 200, 000 × $1. 60) On June 30 the company records an exchange loss of $8, 000 [£ 200, 000 × ($1. 60 - $1. 56)]. The loss is reported on the quarterly income statement. Diamond Chapter 8 45
Foreign Currency Transaction Example On July 10 the company receives payment from its British customer, recording a gain of $2, 000 due to the increase in the exchange rate. Diamond Chapter 8 46
Financial Statement Impact Balance Sheet Statement of Cash Income Statement Flows Second Quarter Acct Rec $312, 000 Sales FC Exch Loss $320, 000 Cash from (8, 000) Customers $0 Third Quarter Cash Acct Rec $314, 000 Sales $0 FC Exch Gain Financial Accounting, 7 e Stice/Stice, 2006 © Thomson $0 2, 000 Cash from Customers $314, 000 47
Evaluating Credit Policy Budgeting Cash Receipts Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 48
Quantity of Receivables • The efficient use of accounts receivable can be evaluated by using two ratios: – Accounts receivable turnover – Average collection period Diamond Chapter 8 49
Quantity of Receivables The accounts receivable turnover determines how many times during the year a company is collecting its average receivable balance Accounts Receivable = Turnover Diamond Chapter 8 Sales Average Accounts Receivable 50
Quantity of Receivables The accounts receivable turnover can be converted into the average collection period The lower the average collection period, the more favorable the ratio Average Collection = Period Diamond Chapter 8 365 Accounts Receivable Turnover 51
Quantity of Receivables Proper receivables management – balancing • the desire to extend credit in order to increase sales • the need to collect the cash quickly in order to pay off company debt Diamond Chapter 8 52
Quality of Receivables • The relationship between the bad debt allowance and total receivables should be stable from year to year Diamond Chapter 8 53
Quality of Receivables • A change in the ratio may indicate a change in – The type of credit customers a business is attracting, or – The economic circumstances of existing customers Diamond Chapter 8 54
Budgeting Cash Receipts • A cash budget is an important tool in helping management plan its cash needs • Estimating cash and credit sales, as well as estimating the pattern of collection of accounts receivable, are key to the cash receipts budgeting process Diamond Chapter 8 55
Cash Budgeting Example Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 56
January Sales $100, 000 20% cash February January + 80% credit $20, 000 $24, 000 Financial Accounting, 7 e Stice/Stice, 2006 © Thomson $40, 000 March $14, 400 57
Third Quarter Cash Receipts Budget Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 58
In Summary. . . • Revenue is recognized only after providing a good or service and after receiving a valid promise to pay (two exceptions). • Bad debt expense is matched with associated revenue by using the allowance method, either with the percentage of sales and the aging method. • Warranty expense is matched with associated revenue • Cash controls and management tools • Foreign currency transactions can cause foreign currency gains and losses. • The quality and quantity of receivables can be evaluated using ratios and relationships. Financial Accounting, 7 e Stice/Stice, 2006 © Thomson 59
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