Copyright 2003 Prentice Hall Publishing Company1 Chapter 7 Sales and Collection Cycle

Copyright 2003 Prentice Hall Publishing Company2 Sales And Services Are The Backbone Of Any Business l Sales forecasts are the starting point for making any plans for the business. l New ways of making sales are becoming very important to businesses.

Copyright 2003 Prentice Hall Publishing Company3 Receiving Orders l In person l By mail l By phone l By fax l By computer n Ordering merchandise over the internet is becoming a very significant portion of many businesses.

Copyright 2003 Prentice Hall Publishing Company4 Selecting And Preparing Goods For Delivery l Increasing automation is reducing inventory costs and decreasing delivery time. l Have you benefited from these trends? l How does a business benefit?

Copyright 2003 Prentice Hall Publishing Company5 Receiving Payment For Goods And Services l Cash (includes checks): control is the biggest issue l Credit card sales l Credit: accounts receivable n Bad debts

Copyright 2003 Prentice Hall Publishing Company6 Controlling CASH l Cash has universal appeal and ownership is difficult to prove. l Both cash receipts and cash payments should be recorded immediately when received and made. l Checks should be prenumbered and kept secure.

Copyright 2003 Prentice Hall Publishing Company7 Safeguarding Cash l Separation of duties n Different people receive and disburse the cash. n Procedures for the record keeping of cash receipts and disbursements are separate. n Handling the cash and record keeping are completely separate.

Copyright 2003 Prentice Hall Publishing Company8 Procedures To Have In Place l Both cash receipts and cash payments should be recorded immediately when received and made. l Keep cash under strict physical control, and deposit cash receipts daily. l Have separate approvals for purchases and the payment for those purchases.

Copyright 2003 Prentice Hall Publishing Company9 Procedures l Use pre-numbered checks, and keep a log of electronic transfers. l Payment approval, check signing, and electronic funds transfer should be assigned to different individuals. l Bank accounts and cash balances should be reconciled monthly.

Copyright 2003 Prentice Hall Publishing Company10 Accounting For Cash: Reconciling The Bank Statement l An important part of internal control l Need for calculating a true cash balance l Two “sides” to be reconciled n balance per bank n balance per books l If there are any mistakes or transactions that have not been recorded in the company’s books, the company’s records should be updated.

Copyright 2003 Prentice Hall Publishing Company11 Terminology Bank statement Monthly report prepared by bank that contains details of a company’s deposits, disbursements, and bank charges. Bank reconciliation Report prepared by the company after receiving the bank statement that compares the bank statement with the company’s records to verify the accuracy of both.

Copyright 2003 Prentice Hall Publishing Company12 More Terminology Outstanding check A check written by the company that has been recorded on the company’s records but has not yet cleared the bank Deposit in transit A deposit that the company has made and recorded, but it has not reached the bank’s record keeping system yet.

Copyright 2003 Prentice Hall Publishing Company13 More Terminology NSF check A “bad” check written by a customer that must be deducted from the company’s records. The company recorded the check as a cash receipt (and then deposited it), but the check writer didn’t have the money in his or her account to cover it. The bank will have already deducted it from the company’s balance (in the bank’s records), but the company will have to make an adjustment to their records.

Copyright 2003 Prentice Hall Publishing Company14 More Terminology Credit memo An addition to the company’s balance in the bank’s records for a reason such as the bank having collected a note for the company (from a third party who owed the company). Debit memo A deduction from the company’s balance in the bank’s records for a reason such as a bank service charge.

Copyright 2003 Prentice Hall Publishing Company15 An Example Of A Reconciliation Given the following information: Balance per bank at 4/30$8,750 Balance per books at 4/30 6,900 Outstanding checks at 4/30 1,380 Bank service charge for April 30 Deposit in transit at 4/ Customer’s NSF check 100 (returned with bank statement) Bank collected note receivable 1,000 for company

Copyright 2003 Prentice Hall Publishing Company16 Balance Per Bank Section Of The Reconciliation Balance per bank $8,750 Plus: Deposit in transit 400 Less: Outstanding checks (1,380) Cash Balance at 4/30 $7,770

Copyright 2003 Prentice Hall Publishing Company17 Balance Per Books Section Of The Reconciliation Balance per books$6,900 Plus: Note collected by bank 1,000 Less:NSF check returned (100) Service charge ( 30) Cash balance at 4/30 $7,770

Copyright 2003 Prentice Hall Publishing Company18 There Is One True Cash Balance l Bank balance per statement is reconciled to the TRUE cash balance l Book balance (company’s records) is reconciled to the TRUE cash balance

Copyright 2003 Prentice Hall Publishing Company19 Cash (Bank) Reconciliation Has Two “Independent” Parts ++ deposits in transit outstanding checks -- True cash balance ++ collections for us made by the bank NSF checks (from customers) -- Service charges True cash balance Balance per bank Balance per books

Copyright 2003 Prentice Hall Publishing Company20 l A/R are the expected future cash receipts of a company. They are typically small and are expected to be received within 30 days. l N/R are used when longer credit terms are necessary. The note specifies the maturity date, the rate of interest, and other credit terms. Accounts And Notes Receivable

Copyright 2003 Prentice Hall Publishing Company21 Value Of Receivables l Receivables are reported at their face value less an allowance for accounts which are likely to be uncollectible. l The amount which is actually expected to be collected is called the net realizable value (NRV). l GAAP requires that A/R be reported at NRV.

Copyright 2003 Prentice Hall Publishing Company22 Used only when bad debts are a very small item or when credit sales are insignificant. GAAPNot GAAP Two Methods Allowance MethodDirect Write-Off Method A/R Method Sales Method

Copyright 2003 Prentice Hall Publishing Company23 The Most Common Method Allowance method n Estimate the bad debt expense as an adjustment when it is time to prepare the financial statements. n Record the amount as a reduction in ACCOUNTS RECEIVABLE, even though you don’t know whose accounts will be “bad.”

Copyright 2003 Prentice Hall Publishing Company24 Allowance Method, continued n We will base the estimate on: »Sales, or »Accounts Receivable n This method attempts to match the expense (bad debt) with the revenue (sale) by recording the expense in the same period as the sale even though the company has not specifically identified which accounts will go unpaid.

Copyright 2003 Prentice Hall Publishing Company25 The Other Method Direct Write-Off n No estimates of bad debts are made. n Only when a specific account is known to be uncollectible (customer files bankruptcy, for example) is bad debt expense recorded. n This doesn’t do a very good job of matching the revenue (sale) with the expense (bad debt), because a company often discovers an account is uncollectible in a period subsequent to the one in which the sale was made.

Copyright 2003 Prentice Hall Publishing Company26 l Assume the following selected events occurred at Cell-It. For each event: n Determine how the accounting equation was affected. n Determine the effect on the financial statements. Transaction Analysis

Copyright 2003 Prentice Hall Publishing Company27 1. Provided services to customers for $9,000, on account. Assets = Liab. + Cont. Cap. + Ret. Earnings l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Increases income Increases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company28 2. Collected $6,000 Cash From Account Receivable. 2. Collected $6,000 Cash From Account Receivable. Assets = Liab. + Cont. Cap. + Ret. Earnings (6000) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: no effect on income no effect on equity increases cash flow

Copyright 2003 Prentice Hall Publishing Company29 3. At year-end it was estimated that $200 of accounts receivable will never be collected. Assets = Liab. + Cont. Cap. + Ret. Earnings (200)(200) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Decreases income Decreases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company30 How Do We Report AR On The Balance Sheet? Net Realizable Value of AR = what we expect to collect On the balance sheet: Accounts Receivable$3,000 less allowance for uncollectible accounts (200) Net AR$2,800

Copyright 2003 Prentice Hall Publishing Company31 Here’s What The T-accounts Would Look Like: Accounts Receivable Allowance for U.Accts. 9,000 6,000 3,000 Bad Debt Expense

Copyright 2003 Prentice Hall Publishing Company32 Here’s What The T-accounts Would Look Like: Accounts Receivable Allowance for U.Accts. 9,000 6,000 3,000 Bad Debt Expense 200

Copyright 2003 Prentice Hall Publishing Company33 4. The $50 account receivable of Jane Doe was written-off as uncollectible. Assets = Liab. + Cont. Cap. + Ret. Earnings +50 (50) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: no effect on income no effect on equity no effect on cash flow

Copyright 2003 Prentice Hall Publishing Company34 Here’s What The T-accounts Would Look Like: Accounts Receivable Allowance for U.Accts. 9,000 6,000 3,

Copyright 2003 Prentice Hall Publishing Company35 Effect of Transaction 4 on AR Net Realizable Value Before Event 4After Event 4 AR$3,000AR $2,950 Allow. 200Allow. 150 N.R.V.$2,800N.R.V. $2,800 Net realizable value of accounts receivable did not change as a result of the write-off.

Copyright 2003 Prentice Hall Publishing Company36 An Example l Two years of transactions n Effect on accounting equation n Financial statements

Copyright 2003 Prentice Hall Publishing Company37 1. Provided $5,000 Services On Account. Assets = Liab. + Cont. Cap. + Ret. Earnings A/R+5000 Sales Revenue l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Increases income Increases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company38 2. Collected $4,000 Cash From Accounts Receivable. Assets = Liab. + Cont. Cap. + Ret. Earnings cash (4000) A/R l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: No effect Increases cash flow

Copyright 2003 Prentice Hall Publishing Company39 3. Adjusting Entry Booked To Reflect The Estimate Of 5% Of Ending A/R To Be Uncollectible. Assets = Liab. + C C. + Ret. Earnings (50) Allowance (50) Bad Debt Expense l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Decreases income Decreases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company40 Financial Statements At The End Of Year 19X4: Income Statement For the year 19X4 Sales $5,000 Bad debt expense 50 Net Income$4,950 Statement of Cash Flows For the year 19X4 Cash from operations $4,000 Cash from investing-0- Cash from financing-0- Total change in cash $4,000

Copyright 2003 Prentice Hall Publishing Company41 Assets: Cash $4000 AR 1,000 Allowance (50) Net A/R 950 Total Assets $4,950 $4,950 Liab. + Equity: RE $4,950 Balance Sheet At 12/31/X4

Copyright 2003 Prentice Hall Publishing Company42 1-b. Wrote Off A $40 A/R That Was Determined To Be Uncollectible Assets = Liab. + Cont. Cap. + Ret. Earnings (40) AR +40 Allowance l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: No effect

Copyright 2003 Prentice Hall Publishing Company43 2-b. Provided $6,000 Worth Of Services On Account. Assets = Liab. + Cont. Cap. + Ret. Earnings AR revenue l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Increases incomes Increases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company44 3-b. Collected $4,500 Cash From Accounts Receivable. Assets = Liab. + Cont. Cap. + Ret. Earnings Cash (4500) AR l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: No effect Increases cash flow

Copyright 2003 Prentice Hall Publishing Company45 4-b. Adjusted the accounting records to reflect the expectation that 5% of the ending AR balance would be uncollectible. (Balance is $2460.) Assets = Liab. + Cont. Cap. + Ret. Earnings l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows:

Copyright 2003 Prentice Hall Publishing Company46 Where Do We Stand? We overestimated bad debts by $10--we estimated $50 but we only wrote off $40 in the subsequent year. This year our estimate is 5% of $2460 (BB 1, ,000 credit sales - $4,500 collections -$40 accounts written off)= $123. But since we overestimated last year, we only need to record $113 this year.

Copyright 2003 Prentice Hall Publishing Company47 4.b Adjusted The Accounting Records To Reflect the Expectation That 5% Of The Ending AR Balance Would Be Uncollectible. Assets = Liab. + Cont. Cap. + Ret. Earnings (113) allowance(113) bad for doubtfuldebt expense accounts l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Decreases incomes Decreases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company48 To summarize: l Two methods: n the allowance method n the direct write-off method l Which one involves estimating future uncollectibles?

Copyright 2003 Prentice Hall Publishing Company49 Summary Of The Allowance Method Continued l One way to estimate bad debt expense is to use a percentage of ending A/R (or an aging schedule) l When an actual account is written off as uncollectible, it is credited out of A/R and debited out of the Allowance. THERE IS NO NET EFFECT ON ASSETS and NO EXPENSE at the time of the write-off.

Copyright 2003 Prentice Hall Publishing Company50 Other Accounting Issues Related to Sales: Warranty Costs l Why give warranties? l When should expense be recognized? Warranty We will repair or replace this item...

Copyright 2003 Prentice Hall Publishing Company51 WarrantiesWarranties l How is the warranty obligation met and subsequently removed from the balance sheet? l How do all of the above affect financial statements? l What other issues are similar to warranties?

Copyright 2003 Prentice Hall Publishing Company52 Transaction Analysis l Assume the following selected events occurred at Cell-It. For each event: n Determine how the accounting equation was affected. n Determine the effect on the financial statements. n Record the event in t-accounts.

Copyright 2003 Prentice Hall Publishing Company53 1. Sold Merchandise For $5,000 Cash That Had Originally Cost $4,000. These Goods Were Sold With A Two-year Warranty. Assets = Liab. + Cont. Cap. + Ret. Earnings+5000 (4000) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Increases incomes Increases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company54 2. Estimated That $100 Of Warranty Cost Will Be Incurred Over The Next Two Years On The Goods Sold In Transaction 1. Assets = Liab. + Cont. Cap. + Ret. Earnings +100(100) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Decreases incomes Decreases equity No effect on cash flow

Copyright 2003 Prentice Hall Publishing Company55 3. A Customer Returned Goods Under Warranty For Repair. The Cost Of The Repair Was $30 Cash. Assets = Liab. + Cont. Cap. + Ret. Earnings (30) l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: No effect on income No effect on equity Decreases cash flow