2/10, n/30. Chapter 7 16/10/2012. Read as: Two ten, net thirty. Accounting for Sales Revenue. Credit Card Sales to Consumers

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1 Accounting for Sales Revenue Chapter 7 Reporting and Interpreting Sales Revenue, Receivables and Cash Copyright 2009 McGraw-Hill Ryerson Limited. All rights reserved. The revenue principle requires that revenues be recorded when earned. Goods or services have been transferred/ delivered. The entity retains neither continuing managerial involvement nor effective control over the goods sold. The amount of revenue can be measured reliably. Collection is reasonably assured. The costs in respect of the transaction can be measured reliably. LO 1 Speeding up the Collection Process Credit Card Sales Credit card companies charge a fee credit card discount Offering customers a discount for early payment sales (cash) discountts LO-5 Credit Card Sales to Consumers Dr Cash (+A) Dr Credit Card Discounts (+XR, -R, -SE) Cr Sales Revenue (+R, +SE) NOTE Credit Card Discounts are reported as a contra-revenue account When credit card sales are made, the company must pay the credit card company a fee for the service it provides. 7-3 Extending Credit to Customers LO-1 Speed UP! Sales Discounts to Businesses Bad debt costs Extending credit is likely to increase sales, but not without costs: Increased employee costs to manage receivables Delayed receipt of cash 7-5 Discount Percentage When customers purchase on open account, they may be offered a sales discount to encourage early payment. 2/10, n/30 # of Days in Discount Period Net (Total sales less returns) Read as: Two ten, net thirty Maximum Days in Credit Period 1

2 The Discount - To Take or Not Take With discount terms of 2/10,n/30, a customer saves $2 on a $100 purchase by paying on the 10 th day instead of the 30 th day. Interest Rate for 20 Days = Interest Rate for 20 Days = Annual Interest Rate = 365 Days 20 Days Amount Saved Amount Paid $2 $98 = 2.04% 2.04% = 37.23% Recording Sales (Cash) Discounts Jan. 6 Trade Receivables (+A) 1,000 Sales Revenue (+R,+SE) 1,000 Jan. 14 Cash (+A) 980 Sales Discounts (+XR,-R,-SE) 20 Trade Receivables (-A) 1,000 Make sale on credit (2/10,n/30) First - Record sale as normal Then, if receive cash within the discount period record reduced cash of $980 Otherwise, record collection as normal Sales Returns and Allowances These situations are recorded in a separate account called Sales Returns and Allowances (a contra revenue account). Damaged merchandise. Returned merchandise. Recording Discounts and Returns On Jan 8, before paying, a customer returns $500 of sandals originally purchased on account. Prepare the journal entry. Jan. 8 Sales Returns and Allowances (+XR,-R,-SE) 500 Trade Receivables (-A) 500 Appendix 7B Reporting Net Sales Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor these transactions. Sales revenue Less: Credit card discounts Sales discounts Sales returns and allowances Net sales Accounting for Bad Debts Bad debts result from credit customers who will not pay the amount they owe, regardless of collection efforts. Matching Process Bad Debt Expense Record in same accounting period as Sales Revenue Most businesses record an estimate of the bad debt expense with an adjusting entry at the end of the accounting period. 2

3 Allowance Method What is the problem with recording bad debts when they occur? Timing Solution: Estimate amount of bad debts when the sale is recorded Allowance method involves: 1. Recording an estimated bad debt expense in the period in which the sale took place 2. Removing ( Write off ) specific customer balances in the period in which they are determined to be uncollectible Recording Bad Debt Expense Make estimate (2 methods) Reduce AR through the AFDA Reduce net income through Bad Debt Expense Adjusting entry: Debit Bad Debt Expense (+E, -SE) Credit Allowance for Doubtful Accounts (+XA,-A) (this is a contra asset account) Net Accounts Receivable Net AR vs Gross AR. Just a subtotal- not a separate account. Accounts receivable Less: Allowance for doubtful accounts Net accounts receivable Amount the business expects to collect Write Off Specific Customer Balances Write off when it becomes clear that a particular customer will not pay its balance Debit Allowance for Doubtful Accounts (-XA,+A) Credit Accounts Receivable (-A) The main purpose for writing off an uncollectible account is to clean up the accounting records NOTE this does not change the value of the net receivables (or total assets) 7-16 Recovery of an Uncollectible Account Collection of a previously written off account Recorded in two parts: 1. Reinstate the receivable Debit Accounts Receivable, Credit Allowance for Doubtful Accounts 2. Record the cash collection Debit Cash, Credit Accounts Receivable Methods for Estimating Bad Debts Comparison Aging of trade receivables method (statement of financial position method (B/S)) or Percentage of credit sales method (income statement method (I/S))???? p

4 I/S Method (% Credit Sales Method) Bases bad debt expense on the historical percentage of credit sales that result in bad debts Focus is on determining the amount to record on the income statement as Bad Debt Expense Net Credit Sales % Estimated Uncollectible Amount of Journal Entry Aging of Accounts Receivable Method (B/S) Estimates uncollectible accounts based on the age of each accounts receivable Focus is on determining the desired balance in the Allowance for Doubtful Accounts on the Statement of Financial Position (B/S) Use an aging schedule and apply historical % to each category (<30, 30-60, 61-90) Aging Schedule Days Past Due Total Customer Not Yet Due A/R Over 90 Balance Aaron, R. $ 235 $ 235 Baxter, T. $ 1, ,500 Clark, J. $ 50 $ 200 $ Zak, R Total $ 3,500 $ 2,550 $ 1,830 $ 1,540 $ 1,240 $ 10,660 % Uncollectible Based on past experience, the business estimates the percentage of uncollectible accounts in each time category. These percentages are then multiplied by the appropriate column totals. Aging Schedule Days Past Due Total Customer Not Yet Due A/R Over 90 Balance Aaron, R. $ 235 $ 235 Baxter, T. $ 1, ,500 Clark, J. $ 50 $ 200 $ Zak, R Total $ 3,500 $ 2,550 $ 1,830 $ 1,540 $ 1,240 $ 10,660 % Uncollectible Estimated Uncoll. Amount $ 35 $ 102 $ 183 $ 385 $ 496 $ 1,201 The column totals are then added to arrive at the total estimate of uncollectible accounts of $1,201. Record the Dec. 31, 2010, adjusting entry assuming that the Allowance for Doubtful Accounts currently has a $50 credit balance. Estimating Bad Debts Aging of Receivables Dec. 31 Bad Debt Expense (+E,-SE) 1,151 Allowance for Doubtful Accounts (+XA,-A) 1,151 1,201 Desired Balance - 50 Credit Balance $ 1,151 Adjusting Entry After posting, the Allowance account would look like this... Estimating Bad Debts Aging of Receivables Allowance for Doubtful Accounts (XA) Notice that the balance after adjustment is equal to the estimate of $1,201 based on the aging analysis performed earlier. 50 Balance at 12/31/2010 before adj. 1, adjustment 1,201 Balance at 12/31/2010 after adj. 4

5 Estimating Bad Debts Aging of Receivables Trade Receivables % Estimated Uncollectible Desired Balance in Allowance Account - Allowance Account Credit Balance Amount of Journal Entry Trade Receivables % Estimated Uncollectible Desired Balance in Allowance Account + Allowance Account Debit Balance Amount of Journal Entry Notes Receivable If a customer is having difficulty paying, it s A/R could be transferred to a note receivable Each note typically outlines the: Amount owed (called the principal), Date by which it is to be repaid to the company (called the maturity date ), and Interest rate charged while the note remains unpaid Interest Formula: Interest = Principal Interest Rate Time Record interest when EARNED, dr interest receivable, cr interest revenue LO Receivables Turnover Analysis Determines how many times the process of selling and collecting on account occurs during the period on average LO-6 Average Collection Period Some people find it easier to think in terms of the amount of time (in days) it takes to collect an account receivable LO-6 Receivables Turnover Ratio = Net Credit Sales Revenue Average Net Trade Receivables Days to Collect = 365 Receivables Turnover Ratio The higher the ratio, the faster the collection 7-27 Indicates the average time it takes a customer to pay its accounts Receivables turnover results can vary widely across industries 7-28 The Impact of Estimation Underestimating Bad Debt Expense overstates: Net income Net Receivables on the balance sheet. Net Income can be manipulated, in a practice called income smoothing, by overestimating Bad Debt Expense in periods of strong sales and strong gross margins, and then underestimating Bad Debt Expense in periods of weak sales and weak gross margins. P 7-3 NOMURA EXPORT COMPANY Income Statement Items Income Statement Items Year 1 Year 2 Gross sales revenue $160,000 $232,000 Sales returns and allowances? 18,000 Net sales revenue?? Cost of sales 68%? Gross profit? 30% Operating expenses 18,000? Profit before income taxes? 20,000 Income tax expense?? Income tax rate 20% 20% Profit?? Earnings per share 2.40? Number of outstanding shares 10,000 10,

6 Internal Controls Internal Controls are the processes by which the company s board of directors, management, and other personnel provide reasonable assurance regarding the reliability of the company s financial reporting, the effectiveness and efficiency of its operations, and its compliance with applicable laws and regulations. Controls Over Trade Receivables To guard against the extending credit to nonworthy customers, the following practices can help minimize bad debts: 1. Require approval of customer s credit history by a person independent of the sales and collection functions. 2. Monitor the age of trade receivables periodically and contact customers with overdue payments. 3. Reward both sales and collection personnel for speedy collections so that they work as a team. Internal Control of Cash Internal control refers to policies and procedures designed to: Properly account for assets. Safeguard assets. Ensure the accuracy of financial records. Cash is the asset most susceptible to theft and fraud. Separation of Duties Recording Custody Authorization Internal Control of Cash Daily Deposits Payment Approval Bank Reconciliations Cash Controls Prenumbered Cheques Purchase Approval Cheque Signatures Bank Reconciliation Explains the difference between cash reported on bank statement and cash balance on company s books and provides information for reconciling journal entries. Balance per Bank + Deposits in Transit Outstanding Cheques ± Bank Errors Balance per Book + Deposits by Bank (credit memos) Service Charge NSF Cheques ± Book Errors LO 7 Bank Reconciliation Explains the difference between cash reported on bank statement and cash balance on company s books and provides information for reconciling journal entries. All Balance reconciling per Bank items on the + Deposits in Transit book side - Outstanding require Cheques an adjusting entry ± Bank Errors to the cash account. Balance per Book + Deposits by Bank (credit memos) Service Charge NSF Cheques ± Book Errors LO 7 6