5. To Take or Not Take the Discount, That is the Question 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. $2 $98 = 2.04% Interest Rate for 20 Days = Interest Rate for 20 Days = Amount Saved Amount Paid
6. Sales Returns and Allowances Damaged merchandise. Returned merchandise. These situations are recorded in a separate account called Sales Returns and Allowances.
7.
8. Gross Profit Percentage In 2008, Deckers reported gross profit of $305,318,000 on sales of $689,445,000. Other things equal, higher gross profit results in higher net income. Gross Profit Percentage Gross Profit Net Sales = Gross Profit Percentage $305,318,000 $689,445,000 = = 44.3%
9. Measuring and Reporting Receivables Accounts receivable are created when companies have sales to customers on open accounts. Trade receivables are amounts owed to the business for credit sales of goods, or services. Nontrade receivables are amounts owed to the business for other than business transactions. Notes receivable are written promises from another party to pay with specified terms. Balance Sheet Classifications Current (short term) Noncurrent (long term)
10.
11. Recording Bad Debt Expense Estimates Deckers estimated bad debt expense for 2008 to be $27,567,000. Prepare the adjusting entry. Bad Debt Expense is normally classified as a selling expense and is closed at year-end. Contra asset account
12. Allowance for Doubtful Accounts Balance Sheet Disclosure Amount the business expects to collect.
13.
14. Writing Off Specific Uncollectible Accounts The total write-offs of $25,216,000 did not change the net realizable value nor did it affect any income statement accounts. Assume that before the write-off, Deckers’ Accounts Receivable balance was $144,051,000 and the Allowance for Doubtful Accounts balance was $35,922,000. Let’s see what effect the total write-offs of $25,216,000 had on these accounts.
15. Estimating Bad Debts ─ Percentage of Credit Sales Method Bad debt percentage is based on actual uncollectible accounts from prior years’ credit sales . Focus is on determining the amount to record on the income statement as Bad Debt Expense .
16.
17. Estimating Bad Debts ─ Aging of Accounts Receivable Focus is on determining the desired balance in the Allowance for Doubtful Accounts on the balance sheet. Each customer’s account is aged by breaking down the balance by showing the age (in number of days) of each part of the balance. An aging of accounts receivable for Kid’s Clothes in 2010 might look like this . . .
18. Aging Schedule 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.
19. Aging Schedule Record the Dec. 31, 2010, adjusting entry assuming that the Allowance for Doubtful Accounts currently has a $50 credit balance. The column totals are then added to arrive at the total estimate of uncollectible accounts of $1,201.
20.
21. Estimating Bad Debts ─ Aging of Accounts Receivable 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.
23. Receivables Turnover Deckers reported 2008 net sales of $689,445,000. December 31, 2007, receivables were $72,209,000 and December 31, 2008, receivables were $108,129,000. This ratio measures how many times average receivables are recorded and collected for the year. Net Sales Average Net Trade Receivables Receivables Turnover = $689,445,000 ($72,209,000 + $108,129,000) ÷ 2 Receivables Turnover = = 7.6
24. Average Collection Period Deckers Receivables Turnover was 7.6. This ratio indicates the average time it takes a customer to pay its accounts . 365 Receivables Turnover Average Collection Period = 365 7.6 Average Collection Period = = 48 days
25. Focus on Cash Flows Sales Revenue Cash Collected from Customers
26. Cash and Cash Equivalents Checks Money Orders Bank Drafts Certificates of Deposit T-Bills Cash and Cash Equivalents
27. Internal Control of Cash Cash is the asset most susceptible to theft and fraud. Internal control refers to policies and procedures designed to: Separation of Duties Authorization Recording Custody
28. Internal Control of Cash Daily Deposits Purchase Approval Prenumbered Checks Payment Approval Check Signatures Bank Reconciliations Cash Controls
29. Bank Reconciliation Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Errors = Correct Balance Balance per Book + Deposits by Bank (credit memos) - Service Charge - NSF Checks ± Book Errors = Correct Balance Explains the difference between cash reported on bank statement and cash balance on company’s books and provides information for reconciling journal entries.
30. Bank Reconciliation Balance per Bank + Deposits in Transit - Outstanding Checks ± Bank Errors = Correct Balance Balance per Book + Deposits by Bank (credit memos) - Service Charge - NSF Checks ± Book Errors = Correct Balance All reconciling items on the book side require an adjusting entry to the cash account. Explains the difference between cash reported on bank statement and cash balance on company’s books and provides information for reconciling journal entries.
Chapter 6: Reporting and Interpreting Sales Revenue, Receivables and Cash
The revenue principle requires that revenues be recorded when earned. delivery has occurred or services have been rendered, there is persuasive evidence of an arrangement for customer payment, the price is fixed or determinable, and collection is reasonably assured). Revenues are considered to be earned when the following conditions are met: 1. Goods have been delivered or services have been rendered. 2. There is persuasive evidence of an arrangement for customer payment. 3. The price for the goods or services is known. 4. Collection from the customer is reasonably assured.
Companies accept credit cards for several reasons: To increase sales. To avoid providing credit directly to customers. To avoid losses due to bad checks. To avoid losses due to fraudulent credit card sales. To receive payment quicker. When credit card sales are made, the company must pay the credit card company a fee for services provided by the credit card company. The fee is typically between 2 and 4 percent of the amount charged by the customer using a credit card.
Customers, purchasing on open account, are sometimes offered a sales discount to encourage early payment. The sales discount terms are typically written as this slide shows. This particular discount term would be read as “two ten, net thirty.” The first number represents the discount percentage, 2 percent. The second number represents the discount period, 10 days. The letter “n” stands for the word net, the total sales less any returns. The last number represents the maximum days in the credit period. In this case, if the customer pays within 10 days, then a 2 percent discount may be deducted from the invoice amount. If not, then the net amount is due within 30 days.
With discount terms of 2/10,n/30, a customer saves $2 on a $100 purchase by paying by the 10 th day instead of the 30 th day. If not paid until the thirtieth day, the customer has incurred $2 of interest on a $98 debt for twenty days. The annualized interest rate for the decision to defer payment for 20 days is 37.23 percent. Even if the customer had to borrow money at 12 or 15 percent interest to be able to pay in time to take the discount, the money should be borrowed to avoid paying 37 percent interest.
Customers may return undamaged merchandise for a full refund. This is called a sales return. Customers may also return merchandise that is damaged but usable. In this case the seller may offer the customer a reduction from the original selling price to entice the customer to keep the damaged merchandise. This is called a sales allowance. For either type of situation, the seller records the transaction in a separate account called Sales Returns and Allowances.
Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor these transactions. Credit card discounts, sales discounts, and sales returns and allowances are contra-revenue accounts, deducted from sales revenue in the income statement to arrive at net sales.
The difference between sales revenue and cost of goods sold is called gross profit. The gross profit percentage indicates how much of each sales dollar is left, after deducting the cost of goods sold, to cover expenses and provide a profit. It is calculated as gross profit divided by net sales. Other things being equal, the company with the higher gross profit percentage is able to charge premium prices and produce goods and services at low cost. In 2008, Deckers reported gross profit of $305,318,000 on sales of $689,445,000. Let’s calculate Decker’s gross profit percentage. Deckers’ 2008 gross profit percentage is 44.3 percent, obtained by dividing gross profit of $305,318,000 by net sales of $689,445,000. Notice that Deckers’ 2008 gross profit percentage is higher than one of its competitors and slightly lower than another competitor.
Receivables may be classified in three ways. First, they may be classified as either an Account Receivable or a Note Receivable. An account receivable is created when companies allow customers to purchase merchandise on an open account, the customer promises to pay the company in the future for the purchase. A note receivable is a promise, in writing, that requires another party to pay the company a specified amount, at a specified date, with a stated amount of interest. Receivables may also be classified as either trade receivables or nontrade receivable. Trade receivables are amounts owed to the business for credit sales of goods, or services. Nontrade receivables are amounts owed to the business for other than business transactions. For example, personal loans to employees are nontrade receivables. Also, on a classified balance sheet, receivables must be presented as either current (short-term) or noncurrent (long-term) based on when the cash is expected to be collected.
Businesses extend credit to customers to stimulate sales, but credit sales are not without costs. Some customers may be unwilling or unable to pay off their accounts receivable. Bad debts result from credit customers who will not pay the amount they owe, regardless of collection efforts. Companies must account for the fact that these customers may not be able to pay the amounts they owe. We will focus on the allowance method of accounting for bad debts. The allowance method attempts to match bad debts expense in the period with the related revenue. Since the actual amount of bad debts may not be known with certainty at the end of an accounting period, businesses record an estimate of the bad debt expense with an adjusting entry.
To illustrate the adjusting entry to record the estimate for bad debts, we will look at an example from Deckers Outdoor Corporation. Deckers estimated bad debt expense for 2008 to be $27,567,000. In the adjusting entry, Deckers debits bad debt expense and credits allowance for doubtful accounts for $27,567,000. Bad debt expense is normally classified as a selling expense on the income statement. Allowance for doubtful accounts is a contra asset account that is deducted from accounts receivable on the balance sheet.
Because we do not want to overstate assets, we must show accounts receivable at its net realizable value on the balance sheet. The allowance for doubtful accounts is subtracted from the accounts receivable balance to determine net realizable value. This is the amount of accounts receivable that we actually think we will collect.
Now, let’s see what happens when we determine that a specific customer will not be able to pay the amount owed. When it is clear that a specific customer’s account receivable will be uncollectible, the amount should be removed from accounts receivable and charged to the allowance for doubtful accounts. In 2008 Deckers determined that customers with balances totaling $25,216,000 would not pay. We will make one summary entry for all of these customers. When using the allowance method, we write off the specific uncollectible accounts to allowance for doubtful accounts by debiting allowance for doubtful accounts and crediting accounts receivable for $25,216,000. There is no additional entry to recognize bad debts. We previously recognized bad debts expense when we made the end of period bad debts expense adjusting entry.
Assume that before the write-off entry the balance in accounts receivable was $144,051,000 and that the balance in allowance for doubtful accounts was $35,922,000. After the $25,216,000 write off, the accounts receivable balance is reduced from $144,051,000 to 118,835,000 and the allowance for doubtful accounts balance is reduced from $35,922,000 to $10,706,000. However, note that the net realizable value, the amount Deckers expects to collect, is unchanged at $108,129,000. The total write-offs of $25,216,000 did not change net accounts receivable nor did it affect any income statement accounts.
Using the percentage of credit sales method, a bad debt percentage is based on records of actual uncollectible accounts from prior years’ credit sales. The focus is on determining the amount to record on the income statement as bad debt expense. When using the percentage of credit sales method, the bad debt expense estimate at the end of the period is determined by multiplying current period credit sales by an established bad debt loss rate percentage. The bad debt loss rate percentage is determined based on past history of the company and current economic trends.
Let’s look at an example from a company called Kid’s Clothes. In the current year Kid’s Clothes had credit sales of $600,000. Past experience indicates that bad debts are one percent of sales. Let’s compute the bad debts expense for the year. Bad debts expense of $6,000 is found by multiplying $600,000 times one percent. Now let’s prepare the journal entry to record the bad debts expense estimate. Kid’s Clothes will debit bad debts expense and credit allowance for doubtful accounts for $6,000.
When using the aging of accounts receivable method to arrive at an estimate of bad debt expense, the focus is on determining the desired balance in allowance for doubtful accounts on the balance sheet. First we classify accounts receivable by how long the receivable has been outstanding, or age of the receivable. Second, for each age group we determine the likelihood of the accounts being uncollectible. Third, for each age group we calculate a separate allowance amount. Then, we add up all the allowance amounts and that gives us the desired balance in the allowance for doubtful accounts. The following slide shows us what an aging schedule for Kid’s Clothes might look like.
First we decide on the aging categories for the individual accounts receivable from zero to thirty days from the date of sale to over ninety days from the date of sale. Then we list individual accounts receivable from Kid’s Clothes alphabetically with the dollar amounts in each age category. Then we total the amounts in each age category column. Next, based on past experience, we will estimate the percentage of uncollectible accounts in each time category. For the zero to thirty days age group (not yet due), one percent is expected to be uncollectible. For the thirty to sixty days age group, four percent is expected to be uncollectible, and so on. Notice that the older the age group the higher the uncollectible percentage. After determining the percentages for each age group, we will multiply these percentages by the appropriate column totals.
After we multiply the balance of each age group by its uncollectible percentage, we add the amounts for each age category column to get the total estimated uncollectible amount of $1,201. This is the balance we want in allowance for doubtful accounts. The next step is to record the year-end adjusting entry for bad debts expense. Assume that the allowance for doubtful accounts currently has a $50 dollar credit balance.
Since we want the credit balance in allowance for doubtful accounts to be $1201, and the account currently has a credit balance of $50, we only need to credit this account for $1,151. The adjusting entry requires a debit to bad debt expense and a credit to allowance for doubtful accounts for $1,151. The next slide will show us the allowance for doubtful accounts after posting the adjusting entry.
The beginning balance in the account was $50. This is the amount remaining in the account at the end of the year, after write-offs of specific accounts, but before the year-end bad debts adjusting entry. The adjusting entry for $1,151 brings the account to the desired balance of $1,201, the amount we determined from our aging schedule.
When using the aging of accounts receivable method, a desired balance in the Allowance account is calculated. The amount of the journal entry is impacted by the current balance in the Allowance account. For example if the allowance account has a credit balance, that amount is subtracted to determine the amount of the journal entry. However, if the allowance account has a debit balance, that amount is added to the desired balance to determine the amount of the adjustment for the journal entry. A debit balance in the allowance account results when specific write-offs for the year are larger than the balance provided at the beginning of the year.
The receivables turnover ratio tells us the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable. We calculate receivables turnover by dividing net credit sales by average net receivables. Deckers reported 2008 net sales of $689,445,000. December 31, 2007, receivables were $72,209,000 and December 31, 2008, receivables were $108,129,000. Let’s calculate the receivables turnover ratio. Average net trade receivables is determined by adding the $72,209,000 beginning balance to the $108,129,000 ending balance and dividing the total by two. The result is divided into the net credit sales revenue for the year to obtain a receivables turnover ratio of 7.6 times. Deckers has a higher receivables turnover than Skechers and Deckers ratio is the same as Timberland.
The average collection period indicates the average time it takes a customer to pays it accounts. It is also called the or average days sales in receivable . We calculate the ratio by dividing 365, the number of days in a year, by the receivables turnover ratio. Deckers receivables turnover ratio was 7.6. The average collection period is calculated as 48 days. Since existing differences across industries and between firms in the manner in which customer purchases are financed can cause dramatic differences in the ratio, a particular firm’s ratio should be compared only with its prior years’ figures or with other firms in the same industry following the same financing practices.
When there is a decrease in accounts receivable for the year, cash collections from customers are more than sales revenue. Using the indirect method of preparing the cash flow from operating activities portion of the statement of cash flows, we add the decrease in accounts receivable to reported net income. When there is an increase in accounts receivable for the year, cash collections from customers are less than sales revenue. Using the indirect method of preparing the cash flow from operating activities portion of the statement of cash flows, we subtract an increase in accounts receivable from reported net income.
Cash includes currency, coins, and amounts on deposit in bank accounts, checking accounts, and savings accounts. Cash equivalents are short-term, highly liquid investments that are easily converted into a known amount of cash, are close to maturity, and are not sensitive to interest rate changes. Cash and cash equivalents are usually combined on the balance sheet.
An internal control system is a collection of policies and procedures that safeguards assets, ensures reliable accounting, promotes efficient operations, and urges adherence to company policies and applicable laws and regulations. Specifically, internal controls should assist companies in maintaining adequate accounting information, ensure that all transactions are legitimate and properly authorized, and detect or prevent the unauthorized use of company assets. Of all assets, cash is the most susceptible to theft and fraud. For that reason, effective cash controls are essential. Separation of duties is one internal control practice that companies use to protect cash. The person handling cash should not be responsible for recording cash transactions. All disbursements should be duly authorized.
In addition to separation of duties, internal controls for cash include: Promptly reconciling bank statements. Proper authorization for purchases. Proper authorization for cash payments. Making all payments using prenumbered checks. Allowing only a limited number of persons authorized to sign checks. Requiring daily deposits of cash receipts.
All businesses should prepare a bank reconciliation each month. The bank reconciliation should not be prepared by the same person who handles cash or accounts for cash transactions. A bank reconciliation explains the difference between the cash balance in the general ledger account and the amount shown on the bank statement. A bank reconciliation will identify any errors that need to be corrected by the company or the bank. Why are the balances different on the bank statement and on the cash ledger? Because of timing differences. When we prepare a bank reconciliation, there are two sections. In one section, we reconcile the bank statement balance to the correct balance. In the other section, we reconcile the book balance to the correct balance. The correct balances in both sections should be equal. On the bank’s side, we will start with the balance on the bank statement and adjust it for outstanding checks, deposits in transit, and errors made by the bank. On the book’s side, we will start with the cash balance in the ledger and adjust it for collections made by the bank on our behalf, interest earned, bank service charges, customer checks that were drawn on accounts that were nonsufficient, and errors we made. Examples of collections made by the bank on our behalf are when the bank acts as a collection box for customer payments or when the bank collects a note receivable for us from a customer.
All reconciling items on the book side require an adjusting entry to the cash account. Now, let’s look at an example of a bank reconciliation.
Let’s prepare a bank reconciliation for the Simmons Company. The July 31 bank statement indicated a cash balance of $9,610, while the cash ledger account on that date shows a balance of $7,430. Additional information necessary for the reconciliation is shown on the next page.
Before preparing the reconciliation, we need the following information: Outstanding checks totaled $2,417. A $500 check mailed to the bank for deposit had not reached the bank at the statement date. The bank returned a customer’s nonsufficient funds check for $225 received as payment of an account receivable. The bank statement showed $30 interest earned on the bank balance for the month of July. Check 781 for supplies cleared the bank for $268 but was erroneously recorded in our books as $240. A $486 deposit by Acme Company was erroneously credited to our account by the bank. Before advancing to the next slide, you should decide how each of these items affects the book or bank balance.
We begin the reconciliation process with the bank balance of $9,610. Next, we add the $500 deposit in transit. Now, we have two deductions: the $486 bank error and the $2,417 of outstanding checks. We now have determined that the correct cash balance is $7,207. This is the amount of cash that must be shown on the company’s balance sheet at July 31. We complete the reconciliation by adjusting the balance in our general ledger account. Simmons earned $30 in interest on the checking account during the month of July, so we must add this amount to the book balance. A check was written for $268 but erroneously recorded on our books as $240. We correct this error in the reconciliation by subtracting the difference, $28, from our book balance. Finally, we accepted a check and deposited it in the bank, but the check bounced because the maker did not have sufficient funds to cover the check. To correct this, we subtract the amount of the check, $225, from our general ledger cash balance. Notice that the correct balance on the bank and book sides of the reconciliation are the same. Our goal now is to adjust our book balance to the correct amount of $7,207. To do this we will need to make two adjusting entries. Let’s go to the next screen and begin making the adjustments
To record the interest earned on our checking account, we debit the cash account and credit interest revenue for $30. To correct the bookkeeping error, we will debit supplies inventory for $28. The non-sufficient funds check must be placed in an account receivable account because the person still owes us the $225. We will credit the cash account for the total of two hundred fifty-three dollars. Now, the reconciliation process is complete.
Supplement A: Recording Discounts and Returns Credit card discounts, sales discounts, and sales returns and allowances are contra-revenue accounts, deducted from sales revenue in the income statement to arrive at net sales. Let’s look at some examples to see how we record these contra-revenue accounts. On January 2, credit card sales at a Deckers factory store were $3,000. The credit card company charges a 3% service fee. Prepare the Deckers journal entry. The credit card service fee is 3 percent of $3,000, or $90. We record the credit card sales transaction with a debit to accounts receivable for $2,910, a debit to credit card discounts for $90, and a credit to sales revenue for $3,000. When preparing the income statement, we deduct the debit balance in the contra-revenue account, credit card discounts, from the credit balance in the sales revenue account.
On January 6, Deckers sold $1,000 of merchandise on credit with terms of 2/10, n/30. Let’s prepare the Deckers journal entry. We record the sale with a debit to accounts receivable and a credit to sales revenue for $1,000. In the next example we will assume that the customer paid within the discount period.
On January 14, Deckers receives the appropriate payment from the customer for the January 6 sale. Let’s prepare the Deckers journal entry. The sales discount is 2 percent of $1,000, or $20. We record the cash receipt from the customer with a debit to cash for $980, a debit to sales discounts for $20, and a credit to accounts receivable for $1,000. When preparing the income statement, we deduct the debit balance in the contra-revenue account, sales discounts, from the credit balance in the sales revenue account. Next, let’s assume the customer paid after the ten-day discount period.
If the customer remits the appropriate amount on January 20 instead of January 14, what entry would Deckers make? Since the customer paid outside of the discount period, a sales discount is not granted. The customer forfeits the available $20 discount and remits the entire $1,000. We record the cash receipt from the customer with a debit to cash and a credit to accounts receivable for $1,000.
On July 8, before paying, a customer returns $500 of sandals originally purchased on account from Deckers. The Sales Returns and Allowances account would be debited and Accounts Receivable would be credited. In addition, the related cost of goods sold entry for the 10 pairs of sandals would be reversed.
![Accounting for Sales Revenue ,[object Object],Goods or services have been delivered. Collection is reasonably assured. Price is fixed or determinable. There is persuasive evidence of a customer payment arrangement](data:image/gif;base64,R0lGODlhAQABAIAAAAAAAP///yH5BAEAAAAALAAAAAABAAEAAAIBRAA7)