Koz

Selling a Productor a ServiceSelling a Productor a Service

C H A P T E R 6

Learning Objective 1

Understand the three basic types of business activities: operating, investing, and financing.

Major Activities of a Business

Operating Activities:Selling products or services.Buying inventory for resale.Incurring and paying for necessary expenses.

Always associated with

the primary activities of the

business.

Always associated with

the primary activities of the

business.


Investing Activities: Purchasing assets for use in the business: Property, plant, and equipment. Investments in stocks and bonds.

• Their occurrence is much less frequent than operating activities.

• The amounts involved are usually quite large.

• Their occurrence is much less frequent than operating activities.

• The amounts involved are usually quite large.

Financing Activities:Financing Activities: Raising money to finance a business:

by borrowing from creditors (debt financing).

by selling stock or ownership interest (equity financing).


What Are the Major Activities of a Business?

Operating Activities• Selling products or services.• Buying inventory for resale.• Incurring and paying for necessary expenses.

Investing Activities• Purchasing assets for use in the business:

• property, plant, and equipment.• investments in stocks and bonds.

Financing Activities• Raising money to finance a business:

• by borrowing from creditors (debt financing).• by selling stock or ownership interest (equity

financing).


Use the two revenue recognition criteria to decide when the revenue from a sale or service should be recorded in the accounting records.

Revenue Recognition

When:the work has been substantially completed (the company has done something)

And:cash, or a valid promise of future payment, has been received (the company has received something in return)

Recognition Concerns

As a practical matter, how do most companies handle recognition?

record sales when goods are shipped to customers.

recognize credit sales as revenues before cash is collected.

recognize revenues from services when the service

is performed, not necessarilywhen cash is received.

On January 1, Formal Apparel sold 20 top hats for cash and another 25 for credit. Each hat sold for $200. How should the $9,000 of revenue be recorded?

Example: Revenue Recognition

Jan 1 Cash. . . . . . . . . . . . . . . . . . . . 4,000

Accounts Receivable. . . . . . 5,000

Sales Revenue . . . . . . . . . 9,000

Sold 20 top hats for cash and 25 top hats for credit.

Example: Credit Sale and Collection

When the inventory is sold on account:

Jan. 10 Accounts Receivable. . . . . . . . . .2,000Sales Revenue. . . . . . . . . . . . . 2,000

Sold equipment to Edison on account.

When the collection takes place:

Feb. 1 Cash . . . . . . . . . . . . . . . . . . . . . . .2,000Accounts Receivable . . . . . . . 2,000

Payment from Edison for equip. sold.

On January 10, Mountain Mining sold Edison Excavation $2,000 of equipment on account. Mountain Mining received payment on February 1. What entries are made?


Properly account for the collection of cash and describe the business controls necessary to safeguard cash.

Discuss the Complications withRevenue Recognition

Sales DiscountsOffered as incentives for buyers to make prompt payments.

Sales Returns and AllowancesMerchandise is returned because the customer did not want it or because it was defective.

Uncollectible AccountsOccur when a company is unable to collect on receivables.

2/10, n/30

1/10, n/30

2/10, EOM

1/10, EOM

What Do These Sales Discount Terms Mean?

Two percent discount if paid within 10 days, net amount due in 30 days.

One percent discount if paid within 10 days, net amount due in 30 days.

Two percent discount if paid within 10 days, balance due by end of the month.One percent discount if paid within 10 days, balance due by end of the month.

Example: Credit Sale and CollectionTidy Paint Supplies sold $1,000 of equipment on account on January 3. The terms of the sales agreement are 2/10, n/30. What are the collection entries if paid on January 10 or on February 15?

If not paid within the discount period:Feb. 15 Cash. . . . . . . . . . . . . . . . . . . . . . . . 1,000

Accounts Receivable. . . . . . . . 1,000Collected cash on account receivable.

If paid within the discount period:Jan. 10

Collected cash within discount period for $1,000 credit sale.

What Are Contra-Revenue Accounts?

A contra account is offset or deducted from another account.

Sales Discounts is a contra-revenue account.

Sales Discounts is deducted from sales revenue on the income statement.

Sales Discounts is included with other revenue accounts in the general ledger, but it has a debit balance (where revenue accounts normally have a credit balance).

How Are Sales Returns and Allowances Reported?

A contra account deducted from sales revenue on the income

statement.

Gross SalesGross Sales– Sales Discounts– Returns and Allowances

Net SalesNet Sales

Example: Sales Return

Sales return entry:

Jan. 17 Sales Returns and Allowances . . . 250Accounts Receivable (or Cash). 250

Previously sold equipment was returned.

On January 10, Handy Man Hardware sold $2,500 of equipment during its annual sale. One week later, $250 of equipment was returned. What are the entries?

Sales entry:

Jan. 10 Accounts Receivable (or Cash). . . 2,500Sales Revenue . . . . . . . . . . . . . . 2,500

Sold equipment on account (for cash).

Review the Control of Cash.

Separate handling of cash from recording of cash.

Deposit all cash receipts daily.

Make all expenditures with pre-numbered checks (except petty cash).

Design budget procedures for monitoring balances and estimating future cash needs.

Keep only minimum balances in no-interest accounts, with other cash in high-yielding investments.


Record the losses resulting from credit customers who do not pay their bills.

What Are Receivables? A company’s claims for

money, goods, or services. An account receivable is a

current asset representing money due for services performed or merchandise sold on credit.

When an account receivable becomes uncollectible, a bad debt expense is incurred.

Credit sale:

Jan. 10 Accounts Receivable . . . . . . . . . . 1,000Sales Revenue . . . . . . . . . . . . . 1,000

Sold equipment on account.

Collection--2/10, n/30:

Jan. 30 Cash. . . . . . . . . . . . . . . . . . . . . . . . 1,000Accounts Receivable. . . . . . . . 1,000

Payment received n/30.

On January 10, Carson Cameras sold $1,000 of equipment on account. The terms of the agreement are 2/10, n/30. Payment was received on January 30. What are the entries?

Example: Accounts Receivable

Discuss Uncollectible Accounts.Occur when customers do not pay for items

or services purchased on credit.When an account receivable becomes

uncollectible, a firm incurs a bad debt loss.Recognized as a cost of doing business, so

classified as a selling expense.Two ways to account for these losses:

the direct write-off method.

the allowance method.

The Direct Write-Off Method11/1/02 Bad Debt Expense. . . . . . . . . . . . . . 4,000

Accounts Receivable . . . . . . . . . 4,000

To write off an uncollectible account for purchases made on 8/1/01.

Method is objective because bad debt expense is written off at the time it proves to be uncollectible.

However, the method violates the matching principle that says:

All costs and expenses in generating revenues must be identified with those revenues period by period.

• A firm uses its experience or industry averages to estimate the amount of receivables that will be uncollectible.

• Allowance for Bad Debts is a contra-asset account that is offset against Accounts Receivable on the balance sheet.

• As actual losses are recognized, Allowance for Bad Debts is reduced.

The Allowance Method8/1/02 Bad Debt Expense. . . . . . . . . . . . . . 4,000

Allowance for Bad Debts . . . . . . 4,000

To adjust the Allowance account to the desired balance.

Reversing Written-off Receivables

Reverse Write-off:

Aug. 1 Accounts Receivable . . . . . . . . . . 4,000Allowance for Bad Debts . . . . . 4,000

To reinstate a written-off receivable.

Eliminate Receivable:

Aug. 1 Cash. . . . . . . . . . . . . . . . . . . . . . . . 4,000Accounts Receivable. . . . . . . . 4,000

Payment for written-off receivable.

What are the entries if the credit customer eventually pays?

Companies must have good control over both cash collection procedures and accounting for accounts receivable; otherwise such payments could be pocketed by an employee who receives cash without the company’s knowledge.

What are the three methods? As a percentage of credit sales As a percentage of total receivables Aging accounts receivable

Estimating Uncollectible Accounts Receivable

Amount of uncollectibles = a straight percentage of the current year’s credit sales.

Based on experience of prior years, modified for changes expected in current year.

Any existing balance in Allowance for Bad Debts is not considered in the adjusting entry to record bad debt expense.

As a Percentage of Credit Sales

o Amount of uncollectibles = a percentage of total receivables balance at period’s end.

o Focus is on estimating total bad debts existing at the end of the period.

o The ending balance in Allowance for Bad Debts is the amount of total receivables estimated to be uncollectible.

As a Percentage of Total Receivables

AS A PERCENTAGE OF CREDIT SALES

Amount of uncollectibles = a straight percentage of the current year’s credit sales.

Based on experience of prior years, modified for changes expected in current year.

Any existing balance in Allowance for Bad Debts is not considered in the adjusting entry to record bad debt expense.

AS A PERCENTAGE OF TOTAL RECEIVABLES

Amount of uncollectibles = a percentage of total receivables balance at period’s end.

Focus is on estimating total bad debts existing at period’s end.

The ending balance in Allowance for Bad Debts is the amount of total receivables estimated to be uncollectible.


AS A PERCENTAGE OF CREDIT SALES

AS A PERCENTAGE OF TOTAL RECEIVABLES


In practice, a company should consider both techniques to ensure

that each yields roughly consistent results.

Bad DebtExpense

Allowance for Bad Debts

Uncollectible Accounts AllowanceNorm’s Tools had credit sales of $100,000. The current accounts receivable balance is $30,510. The allowance for bad debts balance is $350. Historically, 10 percent of the accounts receivable ending balance is not collected. What is the adjusting entry?

12/31/01 Bad Debt Expense. . . . . . . . . . . . . . 2,701Allowance for Bad Debts . . . . . . 2,701

To adjust the Allowance account to desired balance.

350 Bal.Exp. 2,701 2,701 Exp.

End. Bal. 2,701 3,051 End. Bal.

A more refined and accurate method of estimating the appropriate ending balance in the Allowance for Bad Debts.

Requires a company to base its calculations on how long its receivables have been outstanding.

Each receivable is categorized according to age, such as

Current 1-30 days past due 31-60 days past due, etc.

The total amount in each classification is multiplied by an appropriate uncollectible percentage (determined by experience).

Aging Accounts Receivable

Percentage Estimated to be

Age Balance Uncollectible AmountCurrent. . . . . . . . . . $10,000 1.5% $ 1501-30 days. . . . . . . . 4,000 4.0 16031-90 days. . . . . . . 2,100 20.0 420Over 90 days. . . . . 1,000 40.0 400

$17,100 $1,130

Uncollectible Accounts Expense

Aging Receivables Worksheet

Copy That had credit sales during the year of $200,000. Using the aging method and the data on the aging receivables worksheet, determine the journal entry needed. The beginning balance for Allowance for Bad Debts is $150.

Bad DebtExpense

Allowance for Bad Debts

Uncollectible Accounts Expense

150 Bal.Exp. 980 980 Exp.

End. Bal. 980 1,130 End. Bal.

Copy That had credit sales during the year of $200,000. Using the aging method and the data on the aging receivables worksheet, determine the journal entry needed. The beginning balance for Allowance for Bad Debts is $150.

12/31/01 Bad Debt Expense. . . . . . . . . . . . . . 980Allowance for Bad Debts . . . . . . 980

To adjust the Allowance account to desired balance.


Evaluate a company’s management of its receivables by computing and analyzing appropriate financial ratios. %%

Assessing Managementof Receivables

Determines the number of times during a year a company is “turning over” or collecting its receivables.

Measure of how many times old receivables are collected and replaced by new receivables.

Sales Revenue

Average Accounts Receivable

Accounts Receivable Receivable TurnoverTurnover

=

365 days Accounts Receivable Turnover

Assessing Managementof Receivables

Average Average Collection Collection

PeriodPeriod

Converts accounts receivable turnover into the number of days it takes to collect receivables.

Proper receivables management involves balancing the desire to extend credit in order to increase sales with the need to collect cash quickly to pay the company’s bills.

=

Example: ManagementExample: Managementof Receivablesof Receivables

Accounts Receivable Turnover:

Sales Revenue = $150,000 = 4.0

Average Accounts Receivable $ 37,500

Average Collection Period:365 = 365 = 91.25

Accounts Receivable Turnover 4.0

Adjust It Square had net credit sales of $150,000 during 2001. The accounts receivables increased $5,000 to $40,000 during the same time. Calculate the accounts receivable turnover ratio and the average collection period.


Match revenues and expenses by estimating and recording future warranty and service costs associated with a sale.

Customer Service CostsWhen a customer service call is offered free

with the sale, the company must estimate how many customers will request this service.

The service cost is then estimated and recognized in the same period as the sale. (Supplies and labor required to honor this service agreement are recorded when service is provided.)

The accountant would not try to go back and “fix” this estimate if it proves to be inexact; the accountant merely monitors the estimates and actual service costs and adjusts future estimates accordingly.

Warranty Costs

Estimates for warranty costs are made and recorded at the time of sale.

At the end of the period, the company will show an existing liability for warranty costs it expects to make in future years.

Expanded MaterialLearning Objective 7

Reconcile a checking account.

2000

Bank Statement

The Big BankBank StatementJanuary 30, 2001

Cash Balance, January 1, 2001+ Deposits– Checks processedCash Balance, January 30, 2001

2000

Differences Between Bank Statement and Cash Account

Time period differences Deposits in transit Outstanding checks Bank debits:

monthly service chargesNSF checksbank transfers

Bank credits: interest paid by bank on

balance Accounting errors

Expanded MaterialLearning Objective 8

Understand how receivables can be used by a company to get cash immediately.

Selling or “Factoring” Accounts Receivable

Receivables are sold to factoring companies for cash.

The factoring companies charge a percentage of the receivables as a service cost.

Factoring allows companies to receive cash now, instead of waiting to collect on the receivables.

Can be sold with or without recourse.

Notes ReceivableFormal contracts signed when a customer buys merchandise or services on credit.

A claim against someone with an unconditional promise to pay an amount on or before a specified future date.

Classified as a current or long-term asset, depending on due date.

MakerMaker The person (entity) who signs the note and assumes responsibility.

PayeePayee The person (entity) to whom payment will be made.

PrincipalPrincipal The face amount of the note.

Interest RateInterest Rate A percentage of the principal the maker is charged to borrow money.

InterestInterest The cost of borrowing money.

Maturity ValueMaturity Value Principal plus interest.

Notes Receivable

Computing Interest

Principal(amount)

xInterest

Rate (%)x

Time(years)

= Interest

$5,000 x 0.14 x 90/365 = $172.60

On January 1, The Key Company signed a 90-day, $5,000 note payable to The Lock Company in settlement of existing accounts payable. The interest rate is 14 percent. Calculate the interest cost.

Journalizing Notes ReceivableJournalizing Notes Receivable

Sign Note:

Jan. 1 Accounts Payable . . . . . . . . . 5,000.00 Notes Payable . . . . . . . . . . 5,000.00

Pay Note Plus Interest:

Apr. 1 Notes Payable . . . . . . . . . . . . 5,000.00 Interest Expense . . . . . . . . . . 172.60

Cash . . . . . . . . . . . . . . . . . . 5,172.60

Using the previous example, what journal entries are required for The Key Company (the maker)?

What journal entries are required for The Lock Company (the payee)?

Journalizing Notes ReceivableJournalizing Notes Receivable

Accept Note:

Jan. 1 Notes Receivable . . . . . . . . . 5,000.00 Accounts Receivable. . . . 5,000.00

Collect Note Plus Interest:

Apr. 1 Cash. . . . . . . . . . . . . . . . . . . . 5,172.60 Notes Receivable . . . . . . . 5,000.00Interest Revenue. . . . . . . . 172.60

Discount RateThe annual rate charged by the financial institution for buying the note.

DiscountThe actual amount the bank will earn (interest) = Maturity value x Discount rate x Discount period.

Discount Period The length of time for which the note is discounted (how long the bank must wait to receive payment).

$ Discounting = selling a note.

$ For the company selling the note, it’s a way of receiving cash earlier.

$ For the bank, it’s like making a loan.

Discounting Notes Receivable

Example: Discounting a Note

Interest = $1,000 x 0.14 x 3/12 = $ 35.00

Maturity Value = $1,000 + $35 = $ 1,035.00

Discount = $1,035 x 0.16 x 2/12 = $ 27.60

Proceeds = $1,035 - $27.60 = $ 1,007.40

Discounted Note:

Jan. 1 Cash. . . . . . . . . . . . . . . . . . . . 1,007.40 Notes Receivable . . . . . . . 1,000.00Interest Revenue. . . . . . . . 7.40

The original note is a 3-month, $1,000 note at 14% interest. What is the journal entry if the note is discounted after one month at 16 percent?

Koz

Economy & Finance

Transcript of Koz