1. 1 CHAPTER 13 REVENUES AND CASH COLLECTIONS

2. 2 Chapter Overview  Why is managing and reporting liquidity important?  Why might a company offer credit sales, and what management policies should exist for accounts receivable?  How does a company report credit sales and net sales?  How does a company determine the amount of its bad debt expense, and how does it report the related amounts on its financial statements?

3. 3  What is an exchange rate, and how does an exchange gain (loss) arise from a credit sale made to a company in another country?  How does a company account for cash collected prior to a sale?  What are the important characteristics of a note receivable, and how is interest computed?  What are cash equivalents and what items does a company include in its cash and cash equivalents? Chapter Overview

4. 4  Liquidity management refers to a company’s policies and activities that control its liquidity position.  It refers to how a company manages cash, receivables, and current liabilities.  Liquidity management is important to both managers and external users, in understanding how a company is maximizing the use of its limited resources. Liquidity Management

5. 5 Current Assets and Current Liabilities

6. 6  Company policies and activities affect how transactions and events happen (and therefore how account balances are affected), and  Company policies and activities are not carried out in isolation, but rather occur within the larger business and economic environment.  Key to successful liquidity management is the ability to know how changes in accounts affect a company financial statements. Evaluating Account Balances

7. 7  Can you explain how changes in accounts receivable affect the balance sheet, the income statement, and the statement of cash flows? Evaluating Account Balances

8. 8 The Scope of Liquidity Management Exhibit 13-3

9. 9 Accounts Receivable Management Establishing policies and procedures to control and approve creditworthy customers; obtaining letters of credit or export insurance where appropriate. Establishing policies and procedures to ensure revenues are recorded when earned; recording and controlling sales returns and allowances. Sending monthly statements to customers; prompt follow up on outstanding accounts; monitoring balances for slowed collections. Under GAAP, accounts receivable is presented at net realizable value – what the company expects to ultimately collect from customers.

10. 10  If Bayside Candle Company ordered 300 boxes of chocolate from Unlimited Decadence for $1,350 ($4.50 per box, costing Unlimited Decadence $2.50 each), how would this be recorded? Recording Credit Sales and Returns Assets = Liabilities + Stockholders’ Equity +$1,350 (Accounts receivable) -$750 (Inventory) +$1,350 (Sales Revenue) -$750 (+Cost of goods sold) The sales event The inventory event

11. 11  What happens when Bayside is granted a $300 allowance on its sales price because the candy was not packaged as requested?  This is a sales allowance and reduces both the accounts receivable and the sales revenue previously recognized on the sale. Recording Credit Sales and Returns Assets = Liabilities + Stockholders’ Equity -$300 (Accounts receivable) -$300 (Sales Revenue)

12. 12  What happens when Bayside returns 100 boxes of chocolate rather than asking for an allowance?  This is a sales return; it reduces the accounts receivable and the sales revenue previously recognized. In addition, inventory and cost of goods sold must be adjusted to reflect the returned merchandise. Recording Credit Sales and Returns Assets = Liabilities + Stockholders’ Equity -$450 (Accounts receivable) +$250 (Inventory) -$450 (Sales Revenue) +$250 (-Cost of goods sold) Adjust inventory Adjust previous sales

13. 13  GAAP requires that accounts receivable be reported at net realizable value (NRV).  NRV means that an allowance for bad debts must be provided against the receivables to reflect amounts estimated to be uncollectible.  Bad debt expense is the estimated cost, for the accounting period, of the eventual noncollection of accounts receivable. Measuring and Reporting Receivables

14. 14  When accounts receivable is reported on the balance sheet, it is net of an allowance for bad debts.  As the allowance for bad debt increases, the net realizable value of accounts receivable decreases. For this reason, the allowance account is called a contra-account: Measuring and Reporting Receivables Net realizable value of accounts receivable

15. 15 Measuring and Reporting Receivables  The matching principle provides the underlying reason why bad debts are estimated each period, attempting to match the cost of producing revenues with the revenues reported in the period.  Bad debt expense is the estimated cost, for the accounting period, of the eventual noncollection of accounts receivable.

16. 16 Recording Bad Debt Expense  If Unlimited Decadence estimates that its bad debt expense for 2004 is $134,000, how would this be recorded? Bad debt expense and the allowance for bad debts increase for $134,000 Net accounts receivable 1/1/04 = $5,989,000 Net accounts receivable at 12/31/04 = $5,866,000

17. 17  Bad debt expense is estimated every period, but accounts are not actually written off until they are determined uncollectible.  Accounts receivable is reduced for the bad account. Since the allowance for bad debts is the reserve against future uncollectible accounts, bad accounts are written off against it. If an $8,000 account is written off, it has no affect on the net amount of accounts receivable Writing Off Bad Accounts

18. 18  Under GAAP, there are two methods of estimating bad debts during an accounting period and reporting accounts receivable.  The aging method estimates bad debts based on the age of accounts receivable. Since it focuses on the balance sheet, it is often called the “balance sheet approach.”  The percentage of sales method estimates bad debts based on a percentage of net credit sales. Since it focuses on the income statement, it is often called the “income statement approach.” Reporting Accounts Receivable

19. 19 Aging Method: Step 1  The first step in the aging method is to categorize the individual customer accounts receivable into age groups based on the length of time they have been outstanding. When Unlimited Decadence completes its aging schedule, the $6 million in accounts receivable is broken down by time outstanding.

20. 20 Aging Method: Step 2  The second step in the aging method is to estimate the portion of each amount that is not collectible. This is usually done by applying percentages based on past experiences in collecting receivables or industry estimates.

21. 21 Aging Method: Step 3  The third step in the aging method is to total the uncollectible amounts to calculate the required ending balance in the Allowance for Bad Debts account. Unlimited Decadence estimates that $145,000 of its $6 million in accounts receivable will ultimately be uncollectible. This is the required ending balance in the allowance account.

22. 22 Aging Method: Step 4  The last step is to record the bad debt expense for the year, an adjustment which will bring the Allowance for Bad Debts account to the amount calculated on the aging schedule. Bad debt expense and the allowance for bad debts increase for $134,000 Balance before adjustment 12/31/04 Net accounts receivable = $5,989,000 12/31/04 balance after adjustment = $5,866,000

23. 23 Percentage of Sales Method  In the percentage of sales method, Unlimited Decadence simply estimates some portion of its net credit sales as uncollectible, based on prior history or industry data. This amount is added to bad debt expense and to the allowance account for the period

24. 24 Foreign Exchange  As U.S companies expand abroad, they frequently become involved in transactions with customers and suppliers in other countries.  When non-U.S. dollar currency transaction arise, a company must account for the event using exchange rates to convert into their functional currency.  An exchange rate measures the value of one currency in terms of another currency.

25. 25 Foreign Exchange Rates

26. 26 Foreign Exchange Gains/Losses  Exchange gains or loss result from change in the exchange rate between the date that a company records an event and the date of actual collection.  An exchange gain occurs when the exchange rate increases between the date a receivable is recorded and the date of collection.  An exchange loss occurs when the exchange rate decreases between the date a receivable is recorded and the date of collection.

27. 27 Recording Foreign Exchange Events  If Unlimited Decadence sells candy to the Hermann Company, a Germany company, on credit for an agreed price of 300,000 Euros when the exchange rate is $0.92 (1 Euro = $0.92), how would the transaction be recorded?  300,000 Euros X 0.92 = $276,000, the amount of the transaction recorded by Unlimited Decadence. Assets = Liabilities + Stockholders’ Equity +$276,000 (Accounts receivable) +$276,000 (Sales Revenue)

28. 28 Recording Foreign Exchange Events  Hermann Company has the obligation to pay 300,000 Euros regardless of exchange rate differences. What happens when the exchange rate falls to $0.90 on the date of collection by Unlimited Decadence?  300,000 Euros X 0.90 = $270,000, the amount of the cash received by Unlimited Decadence. This results in a $6,000 exchange loss. Assets = Liabilities + Stockholders’ Equity +$270,000 (Cash) -$276,000 (Accounts receivable) -$6,000 (+Exchange loss)

29. 29 Unearned Revenue  In some industries, it is common for a company to collect cash from customers before it delivers the goods or provides services.  For example, magazine publishers require customers to pay for subscriptions in advance, before the magazines are provided.  When a company collects cash before it delivers the goods or services, it gives rise to unearned revenue. This represents a liability to provide goods or services at a later date.

30. 30  Assume Bookworm Publishing receives a check for $3,600 from Aroma Health Stores to purchase 100 annual subscriptions of a new monthly magazine, called Enlightened Life. How is this transaction recorded?  Bookworm has a $3,600 liability to provide future magazine subscriptions. Assets = Liabilities + Stockholders’ Equity +$3,600 (Cash) +3,600 (Unearned Subscription Revenue) Unearned Revenue

31. 31  As the subscriptions are delivered, revenue is earned. Bookworm has satisfied its obligation to provide the future subscription.  On December 1, Bookworm sends out 100 issues of the December issue of Enlightened Life. 1/12 of the obligation has been satisfied ($3,600 x 1/12 = $300). How is this event recorded? +$300 (Subscription Revenue) Assets = Liabilities + Stockholders’ Equity -$300 (Unearned Subscription Revenue) Unearned Revenue

32. 32 Analysis of the Unearned Revenue Account Exhibit 13-6

33. 33  Can you explain how changes in the unearned revenue account affects the balance sheet, the income statement, and the statement of cash flows? Evaluating Account Balances

34. 34 Notes Receivable  Many companies sell goods to customers under more formal, extended credit arrangements.  Customers usually are required to sign a promissory note, making an unconditional promise to pay another party (seller) a certain amount of money in the future.  Because the seller expects to receive cash in the future based on a written commitment, the amount the customer owes is called a note receivable.

35. 35 Illustration of a Promissory Note Exhibit 13-7

36. 36  Recording a note receivable is virtually the same as a sale on account. The only difference is that the Notes Receivable account is increased rather than the Account Receivable account.  If Unlimited Decadence receives a 6-month, 12%, $10,000 note from John Burgen, Inc. on August 1, 2004 for candy purchased on credit, how would this be recorded? Recording Receipt of a Note Receivable Assets = Liabilities + Stockholders’ Equity +$10,000 (Notes receivable) +S10,000 (Sales revenue)

37. 37  The note received by Unlimited Decadence earns 12% interest over the time the note is outstanding, even though the interest is not paid until the note matures.  The total interest on the note is $600, computed as follows: Recording Accrued Interest on a Note Receivable Interest = Principal X Interest X Time Interest = $10,000 X.012 X 6/12 Interest = $600 For each month Unlimited Decadence holds the note, $100 of interest would be earned: $10,000 X.012 X 1/12, or $600/6months

38. 38 How Interest Accrues on a Note Receivable Exhibit 13-8

39. 39  At December 31, 2004, Unlimited Decadence has earned 5 months of interest, the time over which the note has been outstanding.  5/6 of the $600 interest must be recognized as interest revenue, or $500. How is this recorded? Recording Accrued Interest on a Note Receivable Assets = Liabilities + Stockholders’ Equity +$500 (Interest receivable) +$500 (Interest revenue) Interest = $10,000 x.12 x 5/12, or $500

40. 40  On February 1, 2005, the note and the interest are paid by the customer, Burgen Candles.  How is this recorded when the note and some of the interest revenue was recorded in the previous year? Recording Payment on the Note Receivable Assets = Liabilities + Stockholders’ Equity +$10,600 (Cash) -$10,000 (Note receivable) -$500 (Interest receivable) +$100 (Interest revenue) When the note and interest are collected, $100 more of interest revenue must be recognized for the 6 th month the note is outstanding in 2005

41. 41 Cash and Cash Equivalents  Under GAAP, a company is required to report Cash and Cash Equivalents on its balance sheet.  Cash equivalents are investments in short- term, interest-bearing, highly liquid investments that involve so little risk that they are considered to be cash.  Examples include short-term government notes and commercial paper (loans) issued by corporations.

42. 42 Cash and Cash Equivalents Exhibit 13-9