Stice | Stice | Skousen
Intermediate Accounting,17E
The Revenue/Receivable/
Cash Cycle
PowerPoint presented by: Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2010 Cengage Learning
The Operating Cycle of
a Business
1. Purchase inventory with cash or
credit.
2. Sell the inventory, usually on
account.
3. Collect the receivable.
4. Reinvest cash in the business.
7-2
The Operating Cycle
of a Business
The entry for recognizing revenue
and a receivable from the sale of
goods or services is as follows:
Accounts Receivable
Sales
xx
xx
7-3
The Operating Cycle
of a Business
When the amount is collected,
Accounts Receivable is credited and
Cash is debited as follows:
Cash
Accounts Receivable
xx
xx
7-4
Types of Receivables
• Trade receivables—most significant
category resulting from everyday
credit sales of goods/services to
customers.
• Notes receivables—trade receivables
with a formal written promise to pay.
7-5
Nontrade Receivables
Nontrade receivables include all other
types of receivables. They arise from a
variety of transactions, such as:
1. The sale of securities or property
other than inventory
2. Deposits to guarantee contract
performance or expense payment
3. Claims for rebates and tax refunds
4. Dividends and interest receivable
7-6
Accounting for Sales Revenue
• Discounts—offered at the time of sale or
the time of payment.
• Sales Returns and Allowances—occur
subsequent to the sale and can occur before
or after payment has been made.
• Bad Debts—must be estimated in the
period when credit sales are made or
accounts receivable are outstanding.
• Warranties for Service or Replacement—
long after a sale is made, the warranty
period may still be in place.
7-7
Discounts
• A trade discount reduces the list sales
price to the net sales price charged to the
customer.
• A cash (sales) discount can only be taken
if the customer makes the payment within a
specified time period. There are two
methods to account for this:
 Gross method
 Net method
7-8
Cash Discount—Gross Method
The gross method is illustrated as follows
with credit terms of 2/10, n/30.
7-9
Cash Discount—Net Method
The net method records the sale and the
receivable net of the discount.
7-10
Sales Returns and Allowances
Red sweaters costing $600 are sold to a
customer for $1,000. The customer calls and
states that green sweaters were ordered and
should have been shipped. Rather than return
the sweaters, the customer agrees to keep the
sweaters for a reduction in price—an
allowance of $200. The return is recorded as
follows:
Sales Returns and Allowances
Accounts Receivable
200
200
7-11
Sales Returns and Allowances
Suppose that instead of an allowance, the
customer elects to return the sweaters. The
return requires two entries.
Sales Returns and Allowances
Accounts Receivable
Inventory
Cost of Goods Sold
1,000
1,000
600
600
The first entry recognizes the return and the
reduction of the customer’s account. The
second entry reports that the sweaters are
now in inventory.
7-12
Accounting for Bad Debts
• Occurs when customers do not pay for
items or services purchased on credit.
• Bad debts are uncollectible accounts
receivable.
• Bad Debt Expense is reported as a selling
or general and administrative expense.
• Accounts Receivable are reported on the
balance sheet at net realizable value; that
is, the expected cash value.
7-13
Uncollectible Accounts Receivable—
Direct Write-Off Method
When a receivable proves to be
uncollectible, the direct write-off
method requires the following entry:
Bad Debt Expense
Accounts Receivable
xxx
xxx
7-14
Uncollectible Accounts Receivable—
Direct Write-Off Method
• While it does a poor job of matching
expenses with current revenues, the
direct write-off method is often used
by small businesses.
• The use of the direct write-off
method is not allowed under
generally accepted accounting
principles.
7-15
Uncollectible Receivables
(Allowance Method)
Using the allowance method, the amount
of receivables estimated to be uncollectible
is recorded by the following entry:
Bad Debt Expense
Allowance for Bad Debts
xxx
xxx
Bad Debt Expense is reported as a selling
or general and administrative expense.
7-16
Uncollectible Receivables
(Allowance Method)
When a particular account is
determined to be uncollectible:
Allowance for Bad Debts
Accounts Receivable
xxx
xxx
Note: Bad Debt Expense
is not debited.
7-17
Uncollectible Receivables
(Allowance Method)
Occasionally, an account that has
been written off is unexpectedly
collected. Assume a $1,500 account
previously written off is collected. Two
entries are required as shown next: the
first to reverse the write-off entry; the
second to record receipt of the cash.
7-18
Uncollectible Receivables
(Allowance Method)
The first entry is to reverse the write-off
entry:
Accounts Receivable
Allowance for Bad Debts
1,500
1,500
The second entry is to record receipt of the
cash:
Cash
Accounts Receivable
1,500
1,500
7-19
Uncollectible Receivables
(Allowance Method)
• Allowance for Bad Debts is a contra-asset
account that is subtracted from Accounts
Receivable on the balance sheet.
• The actual write-off entry for $1,500 does
not reduce net receivables, as shown below:
Accts. receivable
Less: Allowance for
bad debts
Net receivables
$300,000
15,000
$285,000
Accts. receivable
Less: Allowance for
bad debts
Net receivables
$298,500
13,500
$285,000
7-20
Percentage of Sales
When basing estimated
uncollectibles on sales for the period,
it is preferable to apply the
percentage to credit sales. However,
the percentage is frequently applied
to total sales to avoid having to
maintain separate records for cash
and credit sales.
7-21
Percentage of Credit Sales
During 2011, a company had credit sales of
$100,000. The current accounts receivable
balance is $30,500. The allowance for bad
debts balance is $350. Historically, 2
percent of the credit sales are not collected.
The following adjusting entry is made at the
end of the fiscal period:
Bad Debt Expense
Allowance for Bad Debts
2,000
2,000
To record estimated bad debt expense for
the period ($100,000  0.02 = $2,000).
7-22
Percentage of Credit Sales
After the adjusting entry is posted,
Allowance for Bad Debts will have a
balance of $2,350.
Allowance for Bad Debts
Balance
Adjusting
Dec. 31, Bal.
350
2,000
2,350
7-23
Percentage of Accounts
Receivable
If total accounts receivable for Lamberson
Company are $50,000 and it is estimated that
3% of those accounts will be uncollectible, the
allowance account needs to have a balance of
$1,500 ($50,000  0.03). If the allowance
account already has a $600 credit balance, the
current-period adjusting entry is as follows:
Bad Debt Expense
Allowance for Bad Debts
900
900
To record estimated bad debt expense for
the period ($1,500 required balance  $600
current balance = $900 adjustment)
7-24
Percentage of Accounts
Receivable
• The ending balance must be forced to
achieve the desired balance.
• For instance, in the previous example if the
allowance account had already had a debit
balance of $200, the adjustment required
would be for $1,700 to bring the allowance
account to the desired ending balance of
$15,00.
Balance
Allowance for Bad Debts
200 Adjusting
Dec. 31, Bal.
1,700
1,500
7-25
Aging Receivables
• The most commonly used method
for establishing an allowance based
on outstanding receivables involves
aging receivables.
• Individual accounts are analyzed to
determining those not yet due and
those past due.
7-26
Corrections to Allowance
for Bad Debts
• If the allowance provisions are too large
or small, a correction in the allowance
as well as a change in the rate or in the
method employed will be needed (if the
amount is material).
• The effect of this change in accounting
estimate would be reported in the
current and future periods as an
ordinary item on the income statement,
usually as an addition or subtraction
from Bad Debt Expense.
7-27
Warranties for Service or
Replacement
Many companies agree to provide
free services on units failing to
perform satisfactorily or to
replace defective goods. These
agreements are referred to as a
warranties.
7-28
Warranties for Service or
Replacement
MJW Video & Sound sells DVD
players with a 2-year warranty. Past
experience indicates that 10% of all
systems sold will need repairs in the
first year, and 20% will need repairs
in the second year. The average
repair cost is $50 per system.
7-29
Warranties for Service or
Replacement
The number of systems sold in 2010
and 2011 was 5,000 and 6,000,
respectively. Actual repair costs were
$12,500 in 2010 and $55,000 in
2011.
7-30
Warranties for Service or
Replacement
2010
To record estimated warranty expense:
Warranty Expense
Estimated Liability for Warranties
75,000
75,000
To record estimated warranty
expense based on systems sold
(5,000  0.30  $50 = $75,000).
7-31
Warranties for Service or
Replacement
2010
To record the cost of actual repairs in
2010:
Estimated Liability for Warranties
Cash
12,500
12,500
To record cost of actual repairs
in 2010.
7-32
Warranties for Service or
Replacement
2011
To record estimated warranty expense:
Warranty Expense
Estimated Liability for Warranties
90,000
90,000
To record estimated warranty
expense based on systems
sold (6,000  0.30  $50).
7-33
Warranties for Service or
Replacement
2011
To record cost of actual repairs in 2011:
Estimated Liability for Warranties
Cash
55,000
55,000
To record cost of actual repairs
in 2011.
7-34
Monitoring Accounts Receivable
• Average collection period is the
average number of days that lapse
between the time that a sale is made
and the time that cash is collected.
• It is calculated by dividing the average
daily sales by the average receivables
outstanding.
7-35
Monitoring Accounts Receivable
In 2010, WS Corporation had average
receivables of $354,250 and net sales of
$1,650,000. The average collection
period can be calculated as follows:
Average receivable
$354,250
=
Average daily sales
($1,650,000/365)
Average collection period = 78 days
7-36
Monitoring Accounts Receivable
7-37
Monitoring Accounts Receivable
Accounts receivable turnover is
determined by dividing net sales by
the average trade accounts receivable
outstanding during the year.
Net sales
$1,650,000
=
Average net receivables $354,250
Accounts receivable turnover = 4.7 days
7-38
Monitoring Accounts Receivable
7-39
Monitoring Accounts Receivable
In some cases, it may be more
useful to report the average
collection period for the receivables
existing at the end of the period.
7-40
7-41
Compensating Balances
• In connection with financing
arrangements, it is common practice for
a company to agree to maintain a
minimum or average balance on deposit
with a bank.
• These compensating balances are
defined by the SEC as “that portion of
any demand deposit maintained by a
corporation . . . which constitutes
support for borrowing arrangements . . .”
7-42
Management and Control of Cash
Basic characteristics of a cash control
system are:
1. Specifically assigned responsibilities for
handling cash receipts
2. Separation of handling and recording cash
receipts
3. Daily deposits of all cash received
4. Voucher system to control cash payments
5. Internal audits at irregular intervals
6. Double record of cash—bank and books,
with reconciliations performed by someone
outside the accounting function
7-43
Bank Reconciliation
A comparison of the bank
balance with the book balance is
usually made monthly by means
of a summary known as a bank
reconciliation.
Bank
balance
Book
balance
7-44
Bank Reconciliation
Common causes for differences between
the two records are:
• Deposit in transit
• Outstanding checks
• Bank debits for items such as service
charges and NSF checks
• Bank credits for items such as the
bank collecting a note for the depositor
• Errors
7-45
Bank Reconciliation
7-46
Bank Reconciliation
The following entries would be required on the
books of Svendsen, Inc., as a result of the
November 30 reconciliation:
Cash
Interest Revenue
98.50
98.50
To record interest earned during
November.
Cash
Advertising Expense
18.00
18.00
To record correction of advertising
recorded as $64 instead of the
actual amount of $46.
(continues)
7-47
Bank Reconciliation
Accounts Receivable
Miscellaneous General Expense
Cash
118.94
3.16
122.10
To record customer’s uncollectible
check and bank charges for November.
7-48
Presentation of Receivables in
the Financial Statements
• Current receivables may be grouped in the
balance sheet in the following classes:
1. Notes receivable—trade debtors
2. Accounts receivable—trade debtors
3. Other receivables
• It is possible to combine trade notes and
accounts receivable into a single amount.
• Restrictions on any receivables should be
disclosed.
7-49
Receivables as a
Source of Cash
Receivables may be converted to
cash:
• As a sale (either with or
without recourse)
• As a secured borrowing
7-50
Receivables as a
Source of Cash
FASB Statement No. 140 specified the
conditions for receivables to be
accounted for as a sale:
1. The transferred assets have been
isolated from the transferor and its
creditors cannot access the assets.
2. The transferee has the right to
pledge or exchange the transferred
assets.
(continues)
7-51
Receivables as a
Source of Cash
3. The transferor does not maintain
effective control over the assets
through either (a) an agreement to
repurchase them before their
maturity or (b) the ability to cause
the transferee to return specific
assets.
7-52
Sale of Receivables
Without Recourse
A sale of receivables without recourse is
commonly referred to as accounts
receivable factoring and involves the
following steps:
1. Close the receivables accounts.
2. Close the accompanying allowance for
bad debts account.
3. Any loss from a factoring charge is
found by comparing the book value of
the receivables to the proceeds.
(continues)
7-53
Sale of Receivables
Without Recourse
4. Establish a receivable for any portion of
sales price withheld until final
settlement.
5. Debit Cash for net proceeds of the sale.
6. Recognize a gain or loss from factoring.
7-54
7-55
Sale of Receivables
With Recourse
Selling receivables with recourse
means that a purchaser (bank or
finance company) advances cash in
return for receivables but retains the
right to collect from the seller if
debtors (seller’s customers) fail to
make payments when due.
7-56
Secured Borrowing
• With an assignment of receivables:
 There are no special accounting problems
involved.
 Simply record the loan.
• With specific assignment:
 Specified accounts receivable pledged
 Accounts Receivable reclassified on balance
sheet
 Footnote disclosure of loan provisions required
7-57
Derecognition of
Receivables: IAS 39
The purpose of the three conditions in
SFAS No. 140 is to identify receivable
transfers in which economic ownership
of the receivables has been
transferred. IAS 39 contains the same
concept but applied slightly differently.
7-58
Derecognition of
Receivables: IAS 39
IAS 39 contains a 2-step test for
derecognition.
1. Determine whether the receivable
transfer involves a transfer of
“substantially all of the risks and
rewards of ownership of the
[receivable].” If so, the transfer is
accounted for as a sale of the
receivable.
(continues)
7-59
Derecognition of
Receivables: IAS 39
2. If the receivable transfer does not
involve the transfer of substantially all
the risks and rewards of ownership,
determine whether control of the
receivable has been transferred. If so,
account for the receivable transfer as a
sale. If not, the transfer is treated as a
secured loan.
7-60
Notes Receivable
A promissory note is an
unconditional written promise to pay a
certain sum of money at a specified
time.
• The note is signed by the maker
and is payable to the order of a
specified payee or bearer.
• Notes usually involve interest
stated at an annual rate.
7-61
Special Valuation Problems
• When a note is exchanged for cash:
• It should be recorded at its face amount.
• Any difference between face and cash
proceeds―record as premium or discount on
the note.
• When a note is exchanged for property,
goods, or services:
• The present value of the note is found in the
terms of the note or supporting documents.
• If there is no current market price for the
property, goods, or services or the note, then
use an imputed interest rate.
7-62
Note Exchanged for
Property Illustration
On July 1, 2011, Timberline
Corporation sells a tract of land
purchased three years ago at a cost
of $250,000. The buyer gives
Timberline a 1-year note with a face
amount of $310,000, bearing interest
at a stated rate of 8%. The market
value of the land is $300,000.
(continues)
7-63
Note Exchanged for
Property Illustration
2011
July 1 Notes Receivable
Discount on Notes Receivable
Land
Gain on Sale of Land
310,000
10,000
250,000
50,000
The unamortized discount balance
would be subtracted from Notes
Receivable on the December 31, 2011,
balance sheet.
7-64
Imputing an Interest Rate
If there is no current market price for
either the property, good, or service or
the note, then the present value of the
note must be determined by selecting
an appropriate interest rate. The
imputed interest rate is determined at
the date of the exchange and not
altered thereafter.
7-65
Imputing an Interest Rate
Horrocks & Associates accepted a
$45,000 note as payment for services.
The note is non-interest-bearing and
comes due in three yearly installments
of $15,000 each, beginning December
31, 2012. Assume there is no market
value for the note and no objective way
to determine the value of the service.
(continues)
7-66
Imputing an Interest Rate
The computation is based on the present
value calculations as follows:
Face amount of note
$45,000
Less present value of note
PV: PMT = $15,000; N = 3; I = 10% 37,303*
Discount on note
$ 7,697
The entry to record the receipt of the note
would be:
7-67
Imputing an Interest Rate
A schedule showing the amortization of
the discount on the note follows.
7-68
Impact of Uncollectible
Accounts on Cash Flows
• A decrease in receivables can occur
when the:
 Customers pay on account
 Customers never pay and the account is
written off
• To find the net cash provided by
operations:
 Adjust for a change in the Accounts
Receivable balance.
 Adjust for changes in the Allowance for
Bad Debts account.
7-69