1. of Financial Accounting, 3e CORNERSTONES

2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 5: SALES AND RECEIVABLES Cornerstones of Financial Accounting, 3e

3. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Timing of Revenue Recognition  While cash-basis accounting recognizes revenue in the period payment is received, accrual-basis accounting recognizes revenue when it is  (1) realized or realizable, which means that non-cash resources (such as inventory) have been exchanged for cash or near cash (accounts receivable) and  (2) earned, which means the earnings process is substantially complete. LO-1

4. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Amount of Revenue Recognized  The appropriate amount of revenue to recognize is generally the cash received or the cash equivalent of the receivable.  Three changes to sales revenues include: discounts, returns, and allowances. LO-2

5. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Discounts  To encourage prompt payment, businesses may offer a sales discount.  This discount is a reduction of the normal selling price and is attractive to both the seller and the buyer.  For the buyer, it is a reduction to the cost of the goods and services.  For the seller, the cash is more quickly available and collection costs are reduced. LO-2

6. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Discounts (Cont.)  Sales discounts must be distinguished from both trade and quantity discounts:  A trade discount is a reduction in the selling price granted by the seller to a particular class of customers.  A quantity discount is a reduction in the selling price granted by the seller because selling costs per unit are less when larger quantities are ordered. LO-2

7. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Returns and Allowances  Occasionally, a customer will return goods as unsatisfactory.  When goods or services arrive late, or in some other way are rendered less valuable, a customer may be induced to accept the goods/services if a price reduction, called a sales allowance is offered by the seller. LO-2

8. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Sales Returns and Allowances (cont.)  A contra-revenue account called sales returns and allowances is used to record the price reduction.  Merchandise or goods returned by the customer to the seller are sales returns and are also recorded in the sales returns and allowances account. LO-2

9. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Receivables  Receivables are typically categorized along three different dimensions:  Accounts Receivable or Notes Receivable: A ‘‘note’’ is a legal document given by a borrower to a lender stating the timing of repayment and the amount (principal and/or interest) to be repaid. Accounts receivable, on the other hand, do not have a formal note. LO-3

10. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Receivables (cont.)  Current and Noncurrent Receivables  Both accounts and notes receivable can be classified as current.  Most accounts receivables are due within one year, but notes receivables can be both current and noncurrent.  If the receivable is due beyond one year, it will be classified as noncurrent. LO-3

11. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Bad Debts  GAAP requires accounts receivable to be shown at their ‘‘net realizable value,’’ which is the amount of cash the company expects to collect.  When customers do not pay their accounts receivable, a bad debt expense results (also called uncollectible accounts expense). LO-4

12. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Bad Debts (Cont.)  There are two methods to record bad debt expense:  the direct write off method  the allowance method

13. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Direct Write-Off Method  The direct write-off method waits until an account is deemed uncollectible before reducing accounts receivable and recording the bad debt expense.  Since accounts are often determined to be uncollectible in accounting periods subsequent to the sale period, the direct write-off method is inconsistent with the matching concept.  Therefore, this method can be used only if bad debts are immaterial under GAAP. LO-4

14. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allowance Method  In the allowance method, bad debt expense is recorded in the period of sale, which allows it to be properly matched with revenues according to the matching concept.  The result is that bad debt expense is recognized before the actual default.  The account, Allowance for Doubtful Accounts is established for the estimate of potentially uncollectible accounts. LO-4

15. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allowance Method (cont.)  When a specific account is ultimately determined to be uncollectible, it is written off by a debit to the allowance account and a credit to accounts receivable.  Under the allowance procedure, two methods commonly used to estimate bad debt expense are the percentage of credit sales method and the aging method. LO-4

16. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Percentage of Credit Sales Method  Using past experience, a company estimates the percentage of the current period’s credit sales that will eventually become uncollectible. LO-4

17. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Percentage of Credit Sales Method (cont.)  This percentage is multiplied by the total credit sales for the period to calculate the estimated bad debt expense for the period: Total Credit Sales x Percentage of Credit Sales Estimated to Default = Estimated Bad Debt Expense LO-4

18. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Aging Method  Under the aging method, bad debt expense is estimated by determining the collectability of the accounts receivable rather than by taking a percentage of total credit sales.  At the end of each accounting period, the individual accounts receivable are categorized by age. LO-4

19. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Factoring Receivables  An increasingly common practice is to factor, or sell, receivables.  When receivables are factored, the seller receives an immediate cash payment reduced by the factor’s fees.  The factor, the buyer of the receivables, acquires the right to collect the receivables and the risk of not being able to collect. LO-5

20. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Factoring Receivables (cont.)  In a typical factoring arrangement, the sellers of the receivables have no continuing responsibility for their collection.  Securitization occurs when large businesses and financial institutions frequently package factored receivables as financial instruments or securities and sell them to investors. LO-5

21. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Credit Cards  Bank credit cards, such as Visa and MasterCard, are really just a special form of factoring.  The issuer of the credit card (i.e., the bank) pays the seller the amount of each sale less a service charge (on the date of purchase) and then collects the full amount of the sale from the buyer (at some later date). LO-5

22. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Debit Cards  A debit card authorizes a bank to make an immediate electronic withdrawal (debit) from the holder’s bank account.  The debit card is used like a credit card except that a bank electronically reduces (debits) the holder’s bank account and increases (credits) the merchant’s bank account for the amount of a sale made on a debit card. LO-5

23. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Management: Debit Cards (cont.)  Debit cards are disadvantageous to the card holder since transactions cannot be rescinded by stopping payment.  Debit cards are advantageous to banks and merchants through reduced transaction- processing costs. LO-5

24. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Notes Receivable  Notes receivable are receivables that generally specify an interest rate and a maturity date at which any interest and principal must be repaid.  The amount borrowed is the principal.  The excess of the total amount of money collected over the amount borrowed is called interest. LO-6

25. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Calculating Interest  Interest can be considered compensation paid to the lender for giving up the use of resources for the period of a note (the time value of money).  Interest on a note is calculated as follows: Interest = Principal X Annual Interest Rate X Fraction of One Year LO-6

26. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Internal Control for Sales  For sales revenues, internal controls typically involve the following documents and procedures:  Accounting for a sale begins with the receipt of a purchase order or some similar document from a customer. The order document is necessary for the buyer to be obligated to accept and pay for the ordered goods. LO-7

27. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Internal Control for Sales (cont.)  Shipping and billing documents are prepared based on the order document. Billing documents are usually called invoices.  A sale and its associated receivable are recorded only when the order, shipping, and billing documents are all present. LO-7

28. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Sales  Because sales revenue is such a key component of a company’s success, analysts are interested in a large number of ratios that incorporate sales.  Many of these profitability ratios attempt to measure the return the company is earning on sales. LO-8

29. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Sales (cont.)  There are three common profitability ratios: Gross Profit Margin = Gross Profit ÷ Net Sales Operating Margin = Operating Income ÷ Net Sale Net Profit Margin = Net Income ÷ Net Sales  Analysts also like to look at the operating margin and net profit margin percentages to see how much is left from a sales dollar after paying for the product and all its operations. LO-8

30. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Receivables  Analysts are also concerned with asset management. Asset management refers to how efficiently a company is using the resources at its disposal.  One of the most widely-used asset management ratios is accounts receivable turnover: Accounts Receivable Turnover = Net Sales ÷ Average Net Accounts Receivable LO-8

31. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Receivables (cont.)  This ratio provides a measure of how many times average trade receivables are collected during the period.  Changes in this ratio over time are also very important.  For example, a significant reduction in receivables turnover may indicate that management is extending credit to customers who are not paying. LO-8