Download Assessing the Level of Accounts Receivable

Accounting
for Sales
CHAPTER
6
Learning Objectives
After studying this chapter, you should be able to
•
•
•
•
•
Recognize revenue items at the proper time on the income
statement
Account for cash and credit sales
Compute and interpret sales returns and allowances, sales
discounts, and bank credit card sales
Manage cash and explain its importance to the company
Estimate and interpret uncollectible accounts receivable balances
Learning Objectives
After studying this chapter, you should be able to
•
•
•
•
•
•
Develop and explain internal control procedures
Recognition of Sales Revenue
Revenue recognition requires a two-pronged test:
–
–
•
Assess the level of accounts receivable
Goods or services must be delivered to the customers ( the revenue
must be earned)
Cash or an asset virtually assured of being converted into cash must
be received (the revenue must be realized)
Most companies recognize revenue at the point of sale
Measurement of Sales Revenue
A $100 cash sale is recorded as:
A $100 credit sale is recorded as:
Merchandise Returns and Allowances
Gross sales are the initial revenues or asset inflows based on the initial sales
price
•
•
•
•
Gross sales are decreased by the amount of the returns and allowances to
calculate the net sales
A sales return occurs when a customer returns previously purchased
merchandise
A sales allowance is a reduction of the original selling price
A contra account (Sales Returns and Allowances) combines both returns
and allowances in a single account
Merchandise Returns and Allowances
•
•
•
•
•
•
•
•
Suppose The Disney Store has $900,000 of gross sales on credit and
$80,000 of sales returns and allowances
The journal entries are:
Merchandise Returns and Allowances
The income statement would show:
Cash and Trade Discounts
Trade discounts offer one or more reductions to the gross selling price for a
particular class of customers
The gross sales revenue recognized from a trade discount sale is the price
received after deducting the discount
Companies set trade discount terms to be competitive in industries where
such discounts are common or to encourage certain customer behavior
Cash and Trade Discounts
Cash discounts are rewards for prompt payment
Recording Charge
Card Transactions
There are three major reasons that retailers accept 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 Charge
Card 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:
Accounting for Net Sales Revenue
•
•
•
•
•
•
•
A detailed income statement might contain multiple elements as follows:
Reports to shareholders typically omit details and show only net revenues
Cash
Many companies combine cash and cash equivalents on their balance
sheets
Cash equivalents are highly liquid short-term investments that can easily
and quickly be converted 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 minimum balances on deposit in a
bank to compensate for providing loans
Compensating balances increase the effective interest rate that the borrower
pays
•
•
Annual reports must disclose any significant compensating balances
Management of Cash
Cash management is important because
–
–
–
–
•
–
–
–
•
Cash is the most liquid asset, and it is enticing to thieves and
embezzlers
Adequate cash is essential to the smooth functioning of operations
Businesses should not hold excess cash because cash itself does not
earn income
Management of Cash
The major internal control procedures set up to safeguard cash include the
following:
–
–
•
•
Although the cash balance may be small at any one time, the flow of
cash can be enormous
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 other than the person writing the
check
Reconcile bank accounts monthly
Credit Sales and Accounts Receivable
Most sales are on credit, which create Accounts Receivable
Credit sales create a new set of problems for measuring revenue and
managing the company’s 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 or bad
debts—receivables that some credit customers are either unable or
unwilling to pay
The cost of granting credit that arises from uncollectible accounts is
called bad debts expense
Measurement of
Uncollectible Accounts
Uncollectible accounts require special accounting procedures
There are two basic ways to record uncollectibles:
–
–
The specific write-off method
The allowance method
Specific Write-Off Method
The specific write-off method assumes that all sales are fully collectible
until proved otherwise
When a company identifies a specific customer account as uncollectible, it
reduces the Accounts Receivable
The journal entry for the write-off of a specific Account Receivable of
$40,000 is:
Specific Write-Off Method
The specific write-off method fails to apply the matching principle of accrual
accounting
Matching requires recognition of the bad debts expense at the same time as
the related revenue
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 estimated uncollectible amount
that is deducted from the total Accounts Receivable
Allowance Method
•
The contra account is called allowance for uncollectible accounts
•
•
The contra account recognizes bad debts in general during the proper period
before uncollectible accounts from specific individuals are 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
Allowance Method
•
•
•
•
•
The journal entries are:
Allowance Method
The journal entry for the write-off of two customer accounts in 20X2 is:
Applying the Allowance Method
Using a Percentage of Sales
Expressing the amount of bad debts as a percentage of total sales is known
as the percentage of sales method
This approach directly calculates the bad debts expense that appears on the
income statement
The previous example illustrates this approach
Applying the Allowance Method Using a Percentage of Accounts Receivable
•
•
The percentage of accounts receivable method estimates uncollectible
accounts based on the historical relationship between uncollectibles to
year-end gross accounts receivable—not sales
Additions to the allowance account are calculated to achieve a target ending
balance
Applying the Allowance Method Using a Percentage of Accounts Receivable
•Applying
Consider the historical experience in the following table:
the Allowance Method Using a Percentage of Accounts Receivable
•
•
Assume the accounts receivable balance is $115,000 at the end of 20X7
The average percentage of accounts receivable not collected is applied to
the 20X7 ending balance ($115,000 x 3.33%)
•Applying
The adjusting journal entry is:
the Allowance Method Using the Aging of Accounts Receivable
•
•
•
The aging of accounts receivable method directly incorporates the
customers’ payment histories
As more time elapses after the sale, collection becomes less likely
The $115,000 balance in Accounts Receivable on December 31, 20X7,
might be aged as shown on the next slide
Applying the Allowance Method Using the Aging of Accounts Receivable
Bad Debt Recoveries
•
•
•
•
•
•
When bad debt recoveries occur, the write-off is reversed and the
collection is handled as a normal receipt on account
The following October journal entries reverse the February write-off of an
individual account receivable
Assessing the Level of
Accounts Receivable
One measure of the ability to control receivables is the accounts receivable
turnover
Higher turnovers indicate that a company collects its receivables quickly
Lower turnovers indicate slower collection
Assessing the Level of
Accounts Receivable
Suppose credit sales for Compuport in 20X8 were $1 million and beginning
and ending accounts receivable were $115,000 and $112,000, respectively
Assessing the Level of
Accounts Receivable
•
•
•
•
•
The days to collect accounts receivable, or average collection period, is
calculated by dividing 365 by the accounts receivable turnover
There is significant variability in accounts receivable turnover levels among
industries
Overview of Internal Control
Internal control is a system of checks and balances that protects company
assets and ensures that management maintains accurate financial records.
Internal control refers to both administrative controls and accounting controls
Overview of Internal Control
Administrative controls include methods and procedures that facilitate
management planning and control of operations. Examples include:
–
–
–
Budgeting procedures
Reports on performance
Procedures for granting credit to customers
Overview of Internal Control
•
•
Accounting controls include the methods and procedures for authorizing
transactions, safeguarding assets, and ensuring the accuracy of the financial
records
Accounting controls should provide reasonable assurance concerning
–
–
Authorization – transactions are created in accordance with
management’s intentions
Recording – transactions are authorized and accurately recorded
Overview of Internal Control
•
Accounting controls should provide reasonable assurance concerning
–
Safeguarding – restrictions on access to assets are appropriate
–
–
–
•
•
•
Valuation – recorded amounts are periodically reviewed for impairment
of values and necessary write-downs
Operational Efficiency – errors and fraud are prevented while
promoting efficient actions
The Accounting System
The accounting system handles many repetitive transactions, which fall
primarily into four categories:
–
–
–
–
•
Reconciliation – records are verified with other independently kept
records or confirmed by physical counts
Cash disbursements
Cash receipts
Purchase of goods and services, including employee payroll
Sales or other rendering of goods and services
The Accounting System
Well-designed and well-run accounting systems are positive contributions to
organizations and the economy
For example, integrated inventory controls and ordering systems allow a
computer to interact automatically with suppliers to generate orders and
reduce delivery times
Checklist of Internal Control
The following is a checklist of internal controls that a manager might use to
create or evaluate specific procedures for cash, purchases, sales, and
payroll
–
–
Reliable personnel with clear responsibilities
Separation of duties
•
•
–
The person with custody of assets should not have access to the
records of those assets
The same individual should not authorize payments and also
sign the check in payment of the bill
Checklist of Internal Control
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
Checklist of Internal Control
–
–
–
Proper procedures
•
Well designed routines permit specialization of effort, division of
duties, and automatic checks on each 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 take vacations
Checklist of Internal Control
–
–
•
•
•
Independent check
•
All phases of the system should undergo periodic review by
independent public accountants and internal auditors
Cost-benefit analysis
•
The cost of a control should not exceed its benefits
The goal of internal control is not total prevention of fraud, but the
achievement of efficient operations and the minimization of temptation
Management’s Responsibility
Management bears the primary responsibility for a company’s financial
statements
The audit committee oversees the
–
–
–
Internal accounting controls
Financial statements
Financial affairs of the corporation