accounting-for-sales.pdf

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2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2 of 48

Learning Objectives

After studying this chapter, you should be able to1. Recognize revenue items at the proper time on the

income statement

2. Account for cash and credit sales3. Compute and interpret sales returns andallowances, sales discounts, and bank credit cardsales

4. Manage cash and explain its importance to thecompany

5. Estimate and interpret uncollectible accountsreceivable balances


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Learning Objectives

After studying this chapter, you should be able to6. Assess the level of accounts receivable7. Develop and explain internal control procedures


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Measurement of Sales Revenue

A $100 cash sale is recorded as:

A $100 credit sale is recorded as:

Cash 100

Sales Revenue 100

Accounts receivable 100Sales revenue 100


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Merchandise Returns and Allowances

Gross sales are the initial revenues or asset inflowsbased on the initial sales price

Gross sales are decreased by the amount of the returnsand allowances to calculate the net sales

A sales return occurs when a customer returnspreviously purchased merchandise

A sales allowance is a reduction of the original sellingprice

A contra account ( Sales Returns and Allowances )combines both returns and allowances in a singleaccount


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Suppose The Disney Store has $900,000 ofgross sales on credit and $80,000 of salesreturns and allowances

The journal entries are:

Accounts receivable 900,000Sales 900,000

Sales returns and allowances 80,000 Accounts receivable 80,000




The income statement would show:

Gross sales $900,000Deduct: Sales returns and allowances 80,000Net sales $820,000



Cash and Trade Discounts

Trade discounts offer one or more reductionsto the gross selling price for a particular class ofcustomers

The gross sales revenue recognized from atrade discount sale is the price received afterdeducting the discount

Companies set trade discount terms to becompetitive in industries where such discountsare common or to encourage certain customerbehavior



Cash and Trade Discounts

Cash discounts are rewards for prompt payment

Credit Terms Meaning

n/30 The full billed price (net price) is due on the thirtieth dayafter the invoice date

1/5, n/30 A 1% discount can be taken for payment within 5 daysof the invoice date: otherwise the full billed price is duein 30 days

15 E.O.M. The full price is due within 15 days after the end-of the-monthof sale (an invoice dated December 20 is due January 15)



Recording ChargeCard Transactions

There are three major reasons that retailersaccept credit cards: To attract credit customers who would otherwise shop

elsewhere To get cash immediately instead of waiting for

customers to pay in due course To avoid the cost of tracking, billing and collecting

customers accounts Card companies service charges are typically

from 1% to 4% of gross sales



Recording ChargeCard Transactions

Suppose VISA charges a company a straight 3%of sales for its credit card services

Credit sales of $10,000 will result in cash of only$9,700 [$10,000 (0.03 x $10,000)]

The journal entry is:

Cash 9,700Cash discounts for bank cards 300

Sales 10,000



Accounting for Net Sales Revenue

A detailed income statement might containmultiple elements as follows:

Reports to shareholders typically omit detailsand show only net revenues

Gross sales $ 1000Deduct:

Sales returns and allowances $ 270Cash discounts on sales 20 290

Net sales $ 710



Cash

Many companies combine cash and cashequivalents on their balance sheets

Cash equivalents are highly liquid short-term

investments that can easily and quickly beconverted into cash. Examples include: Time deposits Commercial paper

90-day Treasury bills Cash includes paper money and coins; money

orders; and checks



Compensating Balances

Compensating balances are required minimumbalances on deposit in a bank to compensate forproviding loans

Compensating balances increase the effectiveinterest rate that the borrower pays

Annual reports must disclose any significant

compensating balances



Management of Cash

Cash management is important because Although the cash balance may be small at any one

time, the flow of cash can be enormous

Cash is the most liquid asset, and it is enticing tothieves and embezzlers

Adequate cash is essential to the smooth functioningof operations

Businesses should not hold excess cash becausecash itself does not earn income



Management of Cash

The major internal control procedures set up tosafeguard cash include the following: Have different individuals receive cash than those

who disburse cash Have different individuals handle cash than those who

access accounting records Record and deposit cash receipts immediately Make disbursements using serially numbered checks,

and require proper authorization by someone otherthan the person writing the check

Reconcile bank accounts monthly



Credit Sales and Accounts Receivable

Most sales are on credit, which create AccountsReceivable

Credit sales create a new set of problems formeasuring revenue and managing thecompanys assets

Credit sales generate potential uncollectible

accounts



Uncollectible Accounts

Granting credit entails both costs and benefits: The main benefit is the boost in sales and profit that a

company generates when it extends credit

The most significant cost is uncollectible accounts orbad debts receivables that some credit customersare either unable or unwilling to pay

The cost of granting credit that arises from

uncollectible accounts is called bad debts expense



Measurement ofUncollectible Accounts

Uncollectible accounts require specialaccounting procedures

There are two basic ways to recorduncollectibles: The specific write-off method The allowance method



Specific Write-Off Method

The specific write-off method assumes that allsales are fully collectible until proved otherwise

When a company identifies a specific customeraccount as uncollectible, it reduces the AccountsReceivable

The journal entry for the write-off of a specific

Account Receivable of $40,000 is:Bad debts expense 40,000

Accounts receivable 40,000



Specific Write-Off Method

The specific write-off method fails to apply thematching principle of accrual accounting

Matching requires recognition of the bad debtsexpense at the same time as the relatedrevenue



Allowance Method

The allowance method has two basic elements: An estimate of the amounts that will ultimately be

uncollectible and

A contra account, which contains the estimateduncollectible amount that is deducted from the total

Accounts Receivable



Allowance Method

The contra account is called allowance foruncollectible accounts

The contra account recognizes bad debts ingeneral during the proper period beforeuncollectible accounts from specific individualsare identified in the following period



Allowance Method

Suppose Compuport Knows from experience that it will not collect about

2% of sales

Has sales in 20X1 of $100,000 Estimates that 2% x $100,000 or $2,000 of the 20X1

sales will be uncollectible Does not know on December 31, 20X1, which

customers will fail to pay their accounts Compuport can still acknowledge the $2,000

worth of bad debts in 20X1


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Allowance Method

The journal entries are:

20X1 Sales : Accounts receivable 100,000

Sales 100,000

20X1 Allowances :

Bad debts expense 2,000 Allowance for uncollectible accounts 2,000


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Allowance Method

The journal entry for the write-off of twocustomer accounts in 20X2 is:

20X2 Write-offs : Allowance for uncollectible accounts 2,000

Accounts receivable, Jones 1,400 Accounts receivable, Monterro 600


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Applying the Allowance MethodUsing a Percentage of Sales

Expressing the amount of bad debts as apercentage of total sales is known as thepercentage of sales method

This approach directly calculates the bad debtsexpense that appears on the income statement

The previous example illustrates this approach


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Applying the Allowance Method Using aPercentage of Accounts Receivable

The percentage of accounts receivable methodestimates uncollectible accounts based on thehistorical relationship between uncollectibles to

year-end gross accounts receivable not sales Additions to the allowance account are

calculated to achieve a target ending balance


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Consider the historical experience in thefollowing table:

AccountsReceivable Bad Debts Deemed At End Uncollectible andOf Year Written Off

20X1 $100,000 $ 3,50020X2 80,000 2,45020X3 90,000 2,55020X4 110000 4,10020X5 120,000 5,60020X6 112,000 2,200

Six-year total $612,000 $20,400

Average (divide by 6) $102,000 $ 3,400

Average percentage not collected = $3,400 / $102,000 = 3.33%


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Assume the accounts receivable balance is$115,000 at the end of 20X7

The average percentage of accounts receivablenot collected is applied to the 20X7 endingbalance ($115,000 x 3.33%)

The adjusting journal entry is:

Bad debts expense 3,130 Allowance for bad debts 3,130


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Applying the Allowance Method Usingthe Aging of Accounts Receivable

The aging of accounts receivable methoddirectly incorporates the customers paymenthistories

As more time elapses after the sale, collectionbecomes less likely

The $115,000 balance in Accounts Receivable

on December 31, 20X7, might be aged asshown on the next slide


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Bad Debt Recoveries

When bad debt recoveries occur, the write-offis reversed and the collection is handled as anormal receipt on account

The following October journal entries reverse theFebruary write-off of an individual accountreceivable

Feb. 20X2 Allowance for uncollectible accounts 600 Accounts receivable 600

Oct. 20X2 Accounts receivable 600 Allowance for uncollectible accounts 600

Cash 600 Accounts receivable 600


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Assessing the Level ofAccounts Receivable

One measure of the ability to control receivablesis the accounts receivable turnover

Higher turnovers indicate that a companycollects its receivables quickly

Lower turnovers indicate slower collection

Accounts receivable turnover = Credit Sales / Average accounts receivable


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Suppose credit sales for Compuport in 20X8were $1 million and beginning and endingaccounts receivable were $115,000 and

$112,000, respectively

Accounts receivable turnover = $1,000,000 / 0.5 ($115,000 + $112,000) = 8.81


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The days to collect accounts receivable, oraverage collection period, is calculated bydividing 365 by the accounts receivable turnover

There is significant variability in accountsreceivable turnover levels among industries

Days to collect accounts receivable = 365 / Accounts receivable turnover= 365 days / 8.81= 41.4 days


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Overview of Internal Control

Internal control is a system of checks andbalances that protects company assets andensures that management maintains accurate

financial records. Internal control refers to both administrative

controls and accounting controls


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Administrative controls include methods andprocedures that facilitate management planningand control of operations. Examples include:

Budgeting procedures Reports on performance Procedures for granting credit to customers


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Accounting controls include the methods andprocedures for authorizing transactions,safeguarding assets, and ensuring the accuracy

of the financial records Accounting controls should provide reasonable

assurance concerning

Authorization transactions are created inaccordance with managements intentions Recording transactions are authorized and

accurately recorded


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Accounting controls should provide reasonableassurance concerning Safeguarding restrictions on access to assets are

appropriate Reconciliation records are verified with other

independently kept records or confirmed by physicalcounts

Valuation recorded amounts are periodically

reviewed for impairment of values and necessarywrite-downs Operational Efficiency errors and fraud are

prevented while promoting efficient actions


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The Accounting System

The accounting system handles many repetitivetransactions, which fall primarily into fourcategories:

Cash disbursements Cash receipts Purchase of goods and services, including employee

payroll

Sales or other rendering of goods and services


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The Accounting System

Well-designed and well-run accounting systemsare positive contributions to organizations andthe economy

For example, integrated inventory controls andordering systems allow a computer to interactautomatically with suppliers to generate ordersand reduce delivery times


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Checklist of Internal Control

The following is a checklist of internal controlsthat a manager might use to create or evaluatespecific procedures for cash, purchases, sales,and payroll Reliable personnel with clear responsibilities Separation of duties

The person with custody of assets should not haveaccess to the records of those assets

The same individual should not authorizepayments and also sign the check in payment ofthe bill


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Proper authorization Credit limits to customers Approval of overtime

Approval of large expenditures for capital assets Adequate documents Companies use source documents to support the

immediate, complete, and tamper-proof recording

of data


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Proper procedures Well designed routines permit specialization of

effort, division of duties, and automatic checks oneach step in the routine

Physical safeguards Using safes, locks, guards, guard dogs, and

special lighting Limiting access to sensitive areas

Vacations and rotation of duties Rotating employees and requiring them to takevacations


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Managements Responsibility

Management bears the primary responsibility fora companys financial statements

The audit committee oversees the Internal accounting controls Financial statements Financial affairs of the corporation

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