The Revenue/ Receivable/Cash Cycle

1. chapter7 The Revenue/Receivable/Cash Cycle An electronic presentation by Douglas Cloud Pepperdine University

2. 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

3. 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

4. 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.

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

6. The Operating Cycle of a Business Inventory Accounts Receivables Cash

7. The Operating Cycle of a Business 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 1,000 Accounts Receivable 1,000 Payment received on account.

8. 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.

9. 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

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

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

12. 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 1,000 Sales 1,000

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

14. 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

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

16. 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 200 Accounts Receivable 200

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

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

19. Accounting for Bad Debts • Occur when customers do not pay for items or services purchased on credit. • 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 their net realizable value.

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

21. 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 2,000 Allowance for Bad Debts 2,000 To record estimated uncollectible accounts. GAAP requires the use of the allowance method.

22. Accounting for Uncollectible Receivables (Allowance Method) When the account is then determined to be uncollectible, the write-off entry is: Allowance for Bad Debts 400 Accounts Receivable 400 To write off an uncollectible account. Note: Bad Debt Expense is not debited.

23. 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 400 Allowance for Bad Debts 400 To reverse the entry made to write off the account. Note: Before the payment entry, the debt must be restored.

24. 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 400 Accounts Receivable 400 To record collection of the account.

25. Accounting for Uncollectible Receivables (Allowance Method) 2) The actual write-off entry for $400 does not reduce net receivables, as shown below: Accts. Receivable $100,000 Accts. Receivable $99,600 Less Allowance for Less Allowance for Doubtful Accounts 2,000 Doubtful Accounts 1,600 Net Receivables $ 98,000 Net Receivables $98,000 (1) Allowance for Doubtful Accounts is a contra-asset account which is subtracted from Accounts Receivable on the balance sheet.

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

27. 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?

28. 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 2,000 To record estimated uncollectible accounts for the year.

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

30. 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?

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

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

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

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

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

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

38. 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.

39. 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.

40. 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

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

42. 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

43. 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.

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

45. 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 $1,650,000 Average net receivables $354.250 = Receivables turnover for year = 4.7 times

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

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

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

49. 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

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