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18th
Edition
Chapter 7
The
Revenue/Receivable/
Cash Cycle
Intermediate
Accounting
James D. Stice
Earl K. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2012 Cengage Learning
7-1
The Operating Cycle of
a Business
•
•
•
The normal operating cycle of a business
involves purchasing inventory (using
either cash or credit), which is then sold,
often on account.
Once the receivable is collected, the
cycle begins again.
The normal operating cycle is the
lifeblood of any business enterprise.
(continued)
7-2
The Operating Cycle of
a Business
•
•
•
The recognition of revenue is generally
related to the recognition of accounts
receivable.
Revenues are generally recorded when the
earning process is complete and a valid
promise of payment (or payment itself) is
received.
A receivable arising from the sale of goods is
generally recognized when the title to the
goods passes to a bona fide buyer.
(continued)
7-3
The Operating Cycle of
a Business
The entry for recognizing revenue and a
receivable from the sale of goods or
services is as follows:
Accounts Receivable
Sales
xx
xx
(continued)
7-4
The Operating Cycle of
a Business
When the amount is collected, Accounts
Receivable is credited and Cash is
debited as follows:
Cash
Accounts Receivable
xx
xx
7-5
Types of Receivables
•
•
Trade receivables, generally most
significant category of receivables, result
from the normal activities of a business.
Trade receivables may be evidenced by a
formal written promise to pay and classified
as notes receivables.
In its broadest sense, the term receivable
is applicable to all claims against others for
money, goods, or services.
7-6
Nontrade Receivables
Nontrade receivables include all other types
of receivables. They 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 payment
3) Claims for rebates and tax refunds
4) Dividends and interest receivable
7-7
Sales Returns and Allowances
Red sweaters costing $600 are sold to a
customer for $1,000. The customer calls and
states that green sweaters were ordered and
should have been shipped. Rather than return
the sweaters, the customer agrees to keep the
sweaters for a reduction in price—an
allowance of $200. The return is recorded as
follows:
Sales Returns and Allowances
Accounts Receivable
(continued)
200
200
7-8
Sales Returns and Allowances
Suppose that instead of an allowance, the
customer elects to return the sweaters. The
return requires two entries.
Sales Returns and Allowances
Accounts Receivable
Inventory
Cost of Goods Sold
1,000
1,000
600
600
The first entry recognizes the return and the
reduction of the customer’s account. The
second entry reports that the sweaters are now
in inventory.
7-9
Accounting for Bad Debts
• Bad debts occur when customers do not pay
•
•
for items or services purchased on credit; thus,
bad debts are uncollectible accounts
receivable.
Bad Debt Expense is reported as a selling or
general and administrative expense.
Accounts Receivable are reported on the
balance sheet at net realizable value; that is,
the expected cash value and not the present
value.
(continued)
7-10
Uncollectible Accounts Receivable—
Direct Write-Off Method
When a receivable proves to be
uncollectible, the direct write-off
method requires the following entry:
Bad Debt Expense
Accounts Receivable
xxx
xxx
(continued)
7-11
Uncollectible Accounts Receivable—
Direct Write-Off Method
• The direct write-off method is often used by
•
small businesses because of its simplicity.
The use of the direct write-off method is
not allowed under GAAP because it does
not provide for the matching of expenses
with current revenues and does not report
receivables at their net realizable value.
7-12
Uncollectible Account
Receivables—Allowance Method
•
Using the allowance method, which is
required by GAAP, the amount of
receivables that are not collectible has to
be estimated.
7-13
Establishing an Allowance
for Bad Debts
• A typical entry to recognize bad debt
expense, normally made as an end-of-theperiod adjustment is as follows:
Bad Debt Expense
xx
Allowance for Bad Debts
To record estimated uncollectible
accounts receivable for the period.
xx
• Bad Debt Expense is reported as a
selling or general and administrative
expense.
(continued)
7-14
Writing off an Uncollectible Accounting
Under the Allowance Method
• When positive evidence is available
concerning the partial or complete
worthlessness of an account, the account is
written off using the following entry:
Allowance for Bad Debts
Accounts Receivable
To record the write-off of an
uncollectible account.
xx
xx
Note: Bad Debt Expense
is not debited.
7-15
Collecting a Written-off Account Under
the Allowance Method
Occasionally, an account that has been
written off is unexpectedly collected.
Assume a $1,500 account previously
written off is collected. Two entries are
required as shown next: the first to reverse
the write-off entry; the second to record
receipt of the cash.
(continued)
7-16
Collecting a Written-off Account Under
the Allowance Method
The first entry is to reverse the write-off entry:
Accounts Receivable
Allowance for Bad Debts
To reverse the entry made to
write off the account.
1,500
1,500
The second entry is to record receipt of the
cash:
Cash
Accounts Receivable
To record collection of the
account.
1,500
1,500
7-17
Allowance for Bad Debts
•
Allowance for Bad Debts is a contra-asset
account that is subtracted from Accounts
Receivable on the balance sheet.
•
The actual write-off entry for $1,500 does not
reduce net receivables, as shown below:
Accts. receivable
Less: Allowance for
bad debts
Net receivables
$300,000
15,000
$285,000
Accts. receivable
Less: Allowance for
bad debts
Net receivables
$298,500
13,500
$285,000
7-18
Estimating Uncollectibles Based
on Percentage of Sales
When basing estimated uncollectibles on
sales for the period, it is preferable to
apply the percentage to credit sales.
However, the percentage is frequently
applied to total sales to avoid having to
maintain separate records for cash and
credit sales.
(continued)
7-19
Estimating Uncollectibles Based
on Percentage of Sales
•
If 2% of sales is considered doubtful in terms of
collection and sales for the period are
$100,000, the charge for Bad Debt Expense
would be 2% of the current period’s sales, or
$2,000.
•
The existing balance in Allowance for Bad
Debts is ignored.
Bad Debt Expense
Allowance for Bad Debts
2,000
2,000
To record estimated bad debt expense
for the period ($100,000  0.02 = $2,000).
(continued)
7-20
Estimating Uncollectibles Based
on A/R Balance
If total accounts receivable for Lamberson Company
are $50,000 and it is estimated that 3% of those
accounts will be uncollectible, the allowance account
needs to have a balance of $1,500 ($50,000  0.03). If
the allowance account already has a $600 credit
balance, the current-period adjusting entry is as
follows:
Bad Debt Expense
Allowance for Bad Debts
900
900
To record estimated bad debt expense
for the period ($1,500 required balance
 $600 current balance = $900
adjustment).
7-21
Aging Receivables
• The most commonly used method for
•
establishing an allowance based on
outstanding receivables involves aging
receivables.
Individual accounts are analyzed to
determine those not yet due and those
past due.
7-22
Aging Receivables
The amount derived from aging, $2,870, is the
desired balance of the allowance account after
the adjusting entry. If Allowance for Bad Debts
already has a credit balance of $620 before
adjustment, the following entry is needed:
Bad Debt Expense
Allowance for Bad Debts
2,250
2,250
To record estimated bad debt expense
for the period ($2,870 required balance
 $620 current balance = $2,250
adjustment)
7-23
Corrections to Allowance
for Bad Debts
• If the allowance provisions are too large or
•
small, a correction in the allowance as well
as a change in the rate or in the method
employed will be needed (if the amount is
material).
The effect of this change in accounting
estimate would be reported in the current
and future periods as an ordinary item on
the income statement, usually as an
addition or subtraction from Bad Debt
Expense.
7-24
Helpful Reminder
•
When bad debts are estimated based on a
percentage of sales, bad debt expense is
computed and the balance of the allowance
account is then determined.
• When you are using the percentage-ofreceivables method, the balance in the
allowance account is computed, and then
the amount of bad debt expense for the
period is determined.
7-25
Warranties for Service or
Replacement
• Many companies agree to provide free
services on units failing to perform
satisfactorily or to replace defective goods.
These agreements are referred to as
warranties.
• When warranties are priced separately from
the product, the revenue for the sale should
be divided between the product and the
warranty service.
(continued)
7-26
Warranties for Service or
Replacement
MJW Video & Sound sells DVD players
with a 2-year warranty. Past experience
indicates that 10% of all systems sold
will need repairs in the first year, and
20% will need repairs in the second
year. The average repair cost is $50 per
system.
(continued)
7-27
Warranties for Service or
Replacement
The number of systems sold in 2012 and
2013 was 5,000 and 6,000, respectively.
Actual repair costs were $12,500 in 2013
and $55,000 in 2014.
(continued)
7-28
Warranties for Service or
Replacement
2012
To record estimated warranty expense:
Warranty Expense
75,000
Estimated Liability for Warranties
To record estimated warranty
expense based on systems sold
(5,000  0.30  $50 = $75,000).
75,000
(continued)
7-29
Warranties for Service or
Replacement
2012
To record the cost of actual repairs in 2012:
Estimated Liability for Warranties
Cash
To record cost of actual repairs
in 2012.
12,500
12,500
(continued)
7-30
Warranties for Service or
Replacement
2013
To record estimated warranty expense:
Warranty Expense
Estimated Liability for Warranties
To record estimated warranty
expense based on systems
sold (6,000  0.30  $50).
90,000
90,000
(continued)
7-31
Warranties for Service or
Replacement
2013
To record cost of actual repairs in 2013:
Estimated Liability under Warranties
55,000
Cash
55,000
To record cost of actual repairs in
2013.
(continued)
7-32
Warranties for Service or
Replacement
Periodically, the warranty liability account
should be analyzed to see whether the
actual repairs approximate the estimate.
2012 sales still under warranty for 6 months:
$50 x [5,000 units x (6/12 x 0.20)]
$ 25,000
2013 sales still under warranty for 18 months:
$50 x [6,000 units x (6/12 x.10) +
6,000 units x (12/12 x .020)]
75,000
Total
$100,000
The $100,000 approximation is
reasonably close to the $97,500
balance in the allowance account.
(continued)
7-33
Warranties for Service or
Replacement
Assume that warranty costs incurred in 2013
were only $35,000. Then the ending balance in
the allowance account of $117,500 would be
considered much higher than the $100,000
estimate. The following adjustment would be
made in 2013.
Estimated Liability under Warranties
Warranty Expense.
To record adjustment for
estimate for warranty repair.
17,500
17,500
7-34
Monitoring Accounts Receivable
• The average collection period is 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
receivables outstanding by the average
daily sales.
(continued)
7-35
Monitoring Accounts Receivable
In 2012, WS Corporation had average
receivables of $354,250 and net sales of
$1,650,000. The average collection period can
be calculated as follows:
Average receivable
$354,250
=
Average daily sales
($1,650,000/365)
Average collection period = 78 days
(continued)
7-36
Monitoring Accounts Receivable
Accounts receivable turnover is determined
by dividing net sales by the average trade
accounts receivable outstanding during the year.
The calculation for 2012 is as follows:
Net sales
$1,650,000
=
Average net receivables
$354,250
Accounts receivable turnover = 4.7 times
7-37
Cash Management and Control
• Revenues and receivables have value
because they will eventually be converted
to cash.
• Cash is important because it provides the
basis for measurement and accounting for
all other items.
• The FASB identified the need to report
information on cash and liquidity as one of
the key objectives of financial reporting.
(continued)
7-38
Composition of Cash
• Coins and currency not yet
•
•
•
•
•
deposited
Funds that can
be withdrawn
Demand deposits
on demand
Petty cash funds
Cashier’s checks
Personal checks
Sometimes
referred to as
Very short-term
cash
interest-earning securities equivalents
(continued)
7-39
Composition of Cash
•
Deposits that are not immediately available
for withdrawal or have other restrictions are
sometimes referred to as time deposits.
•
Time deposits are sometimes separately
classified as temporary investments.
•
Deposits in foreign banks that are subject
to immediate and unrestricted withdrawal
generally qualify as cash.
(continued)
7-40
Composition of Cash
•
Cash balances specifically designated by
management for special purposes should be
reported separately, e.g. a bond sinking
fund.
•
A credit balance in the cash account resulting
from the issuance of checks in excess of the
amount on deposit is known as a cash
overdraft.
7-41
Compensating Balances
•
•
In connection with financing arrangements,
it is common practice for a company to
agree to maintain a minimum or average
balance on deposit with a bank.
These compensating balances are
defined by the SEC as “that portion of any
demand deposit maintained by a
corporation . . . which constitutes support
for borrowing arrangements . . .”
(continued)
7-42
Management and Control of Cash
Basic characteristics of a cash control
system are:
1. Specifically assigned responsibilities for
handling cash receipts
2. Separation of handling and recording
cash receipts
3. Daily deposits of all cash received
4. Voucher system to control cash payments
(continued)
7-43
Management and Control of Cash
5. Internal audits at irregular intervals
6. Double record of cash—bank and books,
with reconciliations performed by someone
outside the accounting function
These controls are more likely to be
found in large companies with many
employees.
7-44
Bank Reconciliation
A comparison of the bank balance
with the book balance is usually made
monthly by means of a summary
known as a bank reconciliation.
Book
balance
Bank
balance
(continued)
7-45
Bank Reconciliation
If, after considering these items, the
bank statement and the book balances
cannot be reconciled, a detailed
analysis of both the bank’s records and
the depositor’s books may be necessary
to determine whether errors or
irregularities exist on the records of
either party.
(continued)
7-46
Preparing a Bank Reconciliation
The following entries would be required on the books
of Svendsen, Inc., as a result of the November 30
reconciliation:
Cash
Interest Revenue
98.50
98.50
To record interest earned during
November.
Cash
Advertising Expense
18.00
18.00
To record correction for check
payment of advertising recorded as
$64 instead of the actual amount,
$46.
(continued)
7-47
Preparing a 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
7-48
Presentation of Receivables in the
Financial Statements
•
•
•
Current receivables may be grouped in the
balance sheet in the following classes:
 Notes receivable—trade debtors
 Accounts receivable—trade debtors
 Other receivables
It is possible to combine trade notes and
accounts receivable into a single amount.
Restrictions on any receivables should be
disclosed.
7-49
Receivables as a
Source of Cash
Receivables may be converted to cash
quickly in one of two ways:
• As a sale (either with or without
recourse)
• As a secured borrowing
(continued)
7-50
Receivables as a
Source of Cash
FASB specified in Topic 860 the conditions
for receivables to be accounted for as a
sale:
1. The transferred assets have been
isolated from the transferor. That is, the
transferor and its creditors cannot
access the assets.
2. The transferee has the right to pledge
or exchange the transferred assets.
(continued)
7-51
Receivables as a
Source of Cash
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.
7-52
Sale of Receivables
Without Recourse
•
•
•
When banks, dealers, and finance companies
purchase receivables from companies, in
many cases, these purchases are done
without recourse.
Without recourse means the purchaser
assumes the risks associated with the
collectibility of the receivables.
A sale of receivables without recourse is
commonly referred to as accounts
receivable factoring, and the buyer is the
factor.
(continued)
7-53
Sale of Receivables
Without Recourse
Recourse is defined by the FASB as “the right
of a transferee of receivables to receive
payment from the transferor of those receivable
for any of the following reasons:
a) failure of the debtors to pay when due,
b) the effects of prepayments, or
c) adjustments resulting from defects in the
eligibility of the transferred receivables.”
(continued)
7-54
Sale of Receivables
Without Recourse
• Assume that $10,000 of receivables are
•
•
factored, that is, sold without recourse, to a
finance company for $8,500.
An allowance for bad debts equal to $300
was previously established for these
accounts.
The finance company withheld 5% of the
purchase price as protection against sales
returns and allowances.
(continued)
7-55
Sale of Receivables
Without Recourse
Cash
8,075
Receivable from Factor
425
Allowance for Bad Debts
300
Loss from Factoring Receivables
1,200
Accounts Receivable
10,000
To record the factoring of receivables.
Computations:
Cash: $8,500 – $425 = $8,075
Factor receivable: $8,500  5% = $425
Factoring loss: ($10,000 – $300) – $8,500 = $1,200
(continued)
7-56
Sale of Receivables
Without Recourse
Assuming there were no returns or
allowances, the final settlement would be
recorded as follows:
Cash
Receivable from Factor
To record the final settlement
associated with previously
factored receivables.
425
425
7-57
Sale of Receivables
With Recourse
Selling receivables with recourse
means that a purchaser (bank or finance
company) advances cash in return for
receivables but retains the right to collect
from the seller if debtors (seller’s
customers) fail to make payments when
due.
(continued)
7-58
Secured Borrowing
•
With an assignment of receivables:
 There are no special accounting problems
involved.
 Simply record the loan.
•
With specific assignment:
 Specified accounts receivable pledged
 Accounts Receivable reclassified on balance
sheet
 Footnote disclosure of loan provisions
required
(continued)
7-59
Secured Borrowing
•
On July 1, 2013, Provo Mercantile Co.
assigns receivables total $300,000 to Salem
Bank as collateral on a $200,000, 12% note.
Provo Mercantile does not notify its account
debtors and will continue to collect the
assigned receivables.
•
Salem assesses a 1% finance charge on
assigned receivables in addition to the interest
on the note.
(continued)
7-60
Derecognition of
Receivables: IAS 39
The purpose of the three conditions in
FASB ASC Section 860-10-40 is to
identify receivable transfers in which
economic ownership of the receivables has
been transferred. IAS 39 contains the
same concept but applied slightly
differently.
(continued)
7-61
Derecognition of
Receivables: IAS 39
IAS 39 contains a 2-step test for
derecognition.
1. Determine whether the receivable transfer
involves a transfer of “substantially all of
the risks and rewards of ownership of the
[receivable].” If so, the transfer is
accounted for as a sale of the receivable.
(continued)
7-62
Derecognition of
Receivables: IAS 39
2. If the receivable transfer does not involve
the transfer of substantially all the risks
and rewards of ownership, determine
whether control of the receivable has been
transferred. If so, account for the
receivable transfer as a sale. If not, the
transfer is treated as a secured loan.
7-63
Notes Receivable
A promissory note is an unconditional
written promise to pay a certain sum of
money at a specified time.
• The note is signed by the maker and is
payable to the order of a specified
payee or bearer.
•
Notes usually involve interest stated at
an annual rate.
•
Most notes are negotiable notes.
7-64
Valuation of Notes Receivable
• Notes receivable are initially recorded at
their present value.
•
•
When a note is exchanged for property,
goods, or services, the present value
equals the current cash selling price of the
items exchanged.
An interest-bearing note is written as a
promise to pay principal (or face amount)
plus interest at a specified rate.
(continued)
7-65
Valuation of Notes Receivable
• A non-interest-bearing note does not
specify an interest rate, but the face amount
includes the interest charge.
•
The present value is the difference between
the face amount and the interest included in
that amount, sometimes called the implicit
(or effective) interest.
7-66
Special Valuation Problems
When a note is exchanged for cash:
• It should be recorded at its face amount
and
• any difference between face and cash
proceeds should be recorded as premium
or discount on the note.
(continued)
7-67
Special Valuation Problems
When a note is exchanged for property,
goods, or services in an arm’s-length
transaction:
• the present value of the note is usually
evidenced by the terms of the note or
supporting documents
• there is a general presumption that the
interest specified by the parties to a
transaction represents fair and adequate
compensation for the use of funds
(continued)
7-68
Special Valuation Problems
Valuation problems arise when one of the
following conditions exists:
• No interest rate is stated
•
The stated rate does not seem reasonable,
given the nature of the transaction and
surrounding circumstances
•
The stated face amount of the note is
significantly different from the current cash
equivalent sales price of similar property,
goods, or service
7-69
Determine the Amount to be
Received from the Bank
1. Determine the maturity value of the note.
Maturity value = Face amount ÷ Interest
Interest = Face amount x Interest rate x
Interest period
Interest period = Date of note to date of
maturity
The maturity value is the amount you will
receive when the note matures.
(continued)
7-70
Determine the Amount to be
Received from the Bank
2. Determine the amount of discount.
Discount = Maturity value x Discount rate x
Discount period
Discount period = Date of discount to date of
maturity
The amount of time you have to wait to get the
money is termed the discount period.
3. Determine the proceeds:
Proceeds = Maturity Value ‒ Discount
7-71
Imputing an Interest Rate
• If there is no current market price for either
the property, goods, or services or the note,
then the present value of the note must be
determined by selecting an appropriate
interest rate and using that rate to discount
future receipts to the present.
• The imputed interest rate is determined at
the date of exchange and is not altered
thereafter.
7-72
Impact of Uncollectible
Accounts on Cash Flows
A decrease in receivables can occur when
the:
• customers pay on account
and
• customers never pay and the account
is written off
7-73
Chapter 7
₵
The End
$
7-74
7-75