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Selling Goods and Services May 2010©Kimberly Lyons 1
Revenue should be recognized (recorded) when earned, and realized or realizable (collectible) Revenue is earned when an exchange has taken place, and the company has provided goods or services that entitle them to collect May 2010©Kimberly Lyons 2
Usually, a company will collect its receivables and convert them to cash Issues that result in reduced cash collections include: Sales Discounts Sales Returns and Allowances Uncollectible Accounts (bad debts) May 2010©Kimberly Lyons 3
Discounts are offered to customers to encourage timely payment Example: Simco Inc. sells goods to Balto for $1,000 on September 27 th, with credit terms 2/10, net/30 The credit terms allow Balto a 2% discount on payments made within 10 days, the remainder (net) is due within 30 days Simco records the initial sale: 9/27 Accounts Receivable1,000 Sales Revenue1,000 May 2010©Kimberly Lyons 4
Balto pays the bill on October 5 th and Simco records the following 10/5 Cash980 Sales Discounts 20 Accounts Receivable1,000 Sales Discounts is a contra revenue account Contra = opposite This account has a debit balance and will reduce sales revenue indirectly in the income statement May 2010©Kimberly Lyons 5
Occasionally customers return goods or are allowed a reduced price allowance for defective products Example: Simco Inc. sells goods to Patton Inc. for $1,000 on September 25 th with credit terms 2/10, net/30. Patton returns half of the goods on September 30 th and pays for the remainder on October 15 th (outside of the discount period) Simco records the following: 9/25Accounts Receivable1,000 Sales Revenue1,000 9/30Sales Returns & Allow. 500 Accounts Receivable 500 10/15Cash 500 Accounts Receivable 500 May 2010©Kimberly Lyons 6
Sales returns and allowances are also a contra revenue account They have a debit balance and reduce sales revenue indirectly in the income statement When both of Simcos transactions are complete, accounts receivable is zero, and total cash collected of $1,480 equals net sales which is the net inflow from the transaction Sales Revenue $2,000 Sales discounts (20) Sales returns (500) Net sales $1,480 ©Kimberly Lyons 7 May 2010
There are two methods of accounting for uncollectible accounts Direct write-off method Allowance method Direct write-off method: when accounts are known to be uncollectible they are written off immediately Bad Debt ExpenseXXX Accounts Receivable XXX May 2010©Kimberly Lyons 8
The direct write-off method often results in the recording of sales revenue in one period and bad debt expense in another No matching of related revenues and expenses Not GAAP Used for tax purposes instead May 2010©Kimberly Lyons 9
Achieves matching by recording bad debt expense in the same period related sales revenue is recorded (GAAP) Estimates are used to record uncollectibles before they happen An allowance account is credited instead of accounts receivable, since specific uncollectible receivables are not yet known When actual write-offs occur at a later date, they are debited against the existing credit in the allowance account May 2010©Kimberly Lyons 10
Example: Piper Inc. estimates uncollectible accounts receivable of $1,300. This estimate is recorded at December 31 st as part of the year-end adjustment process: 12/31 Bad Debt Expense1,300 Allowance for Uncollectibles1,300 When actual bad debts become known (in a later period) piper writes them off with: 5/13 Allowance for Uncollectibles 1,250 Accounts Receivable1,250 May 2010©Kimberly Lyons 11
Allowance for uncollectibles is a contra accounts receivable account It has a credit balance that will net against and reduce receivables in the balance sheet Net receivables is also referred to as net realizable value of receivables A more conservative value of assets May 2010©Kimberly Lyons 12
Example: Piper Inc. estimates uncollectibles of 1% of credit sales. Credit sales for the period are $150,000: 150,000 x.01 = $1,500 12/31 Bad Debt Expense1,500 Allowance for Uncollectibles1,500 May 2010©Kimberly Lyons 13
When estimates are made as a % of credit sales, the adjustment will be recorded without considering any existing balance in the allowance account Allowance Write-offs 1,250 1,300Beginning 1,500Adjustment 1,550End May 2010©Kimberly Lyons 14
Example: Piper Inc. estimates uncollectibles of 5% of outstanding accounts receivable. Accounts receivable at 12/31 are $28,400. Piper started the year with a credit balance in the allowance account of $1,300, against which $1,250 was written off. The balance in the allowance account before adjustment is $50 (credit). Estimate of uncollectibles = (28,400 x.05) = $1,420 year-end adjustment = $1,420 – 50 = $1,370 12/31 Bad Debt Expense1,370 Allowance for Uncollectibles1,370 May 2010©Kimberly Lyons 15
When estimates are made as a % of accounts receivable, the adjustment must take the existing allowance balance into consideration The estimate will become the new balance in the allowance account and will go to the balance sheet to net with accounts receivable Allowance Write-offs 1,250 1,300Beginning 1,370Adjustment 1,420Estimate May 2010©Kimberly Lyons 16
Assets: Accounts Receivable $28,400 Less: Allowance (1,420) Net Realizable Value $26,980 ©Kimberly Lyons 17 May 2010
When making estimates of uncollectibles as a % of sales, ignore the existing balance in the allowance account and record the estimate as bad debt expense When making estimates of uncollectibles as a % of accounts receivable, adjust the allowance account so that the estimate will become its ending balance May 2010©Kimberly Lyons 18
Selling products with attached warranties gives rise to related expenses These expenses should be matched with related revenues at the time of sale Use of estimates allows recoding warranty expense with the related liability without having to wait for future returns May 2010©Kimberly Lyons 19
Tilton Inc. Sells goods that are under warranty The company sells 2,000 units for $25 each and expects 2% to be returned for replacement at a cost of $17 each At the time of sale Tilton must record the warranty expense: (DR) Accts rec.50,000 (CR) Sales revenue50,000 (DR) Cost of goods sold34,000 (CR) Inventory34,000 (DR)Warranty expense 680 (CR) Warranty liability 680 (2,000 x.02 x $17 = $680) May 2010©Kimberly Lyons 20
Suppose 10 units are returned in the future and Tilton replaces the units at cost: (DR) Warranty liability170 (CR) Inventory170 (10 units x $17 = $170) May 2010©Kimberly Lyons 21
The recorded warranty expense is matched with the related revenue at the time of sale The warranty liability remains in the balance sheet (carries over to the next period or later) until it is honored May 2010©Kimberly Lyons 22
State the revenue recognition principle Calculate and record sales discounts and sales returns and allowances Calculate net sales Record bad debts with the direct write-off method of accounting for uncollectibles Calculate and record bad debt expense using the allowance method and a % of credit sales Calculate and record bad debt expense using the allowance method and a % of accounts receivable May 2010©Kimberly Lyons 23
Which method of accounting for bad debts is GAAP? Why? Calculate net receivables, or net realizable value of receivables Account for warranties May 2010©Kimberly Lyons 24
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