Learning Objectives
After studying this chapter, you should be
able to:
• Recognize revenue items at the proper time on the
income statement.
• Account for cash and credit sales.
• Record sales returns and allowances, sales
discounts, and bank credit card sales.
• Manage cash and explain its importance to the
company.
Learning Objectives
After studying this chapter, you should be
able to:
• Estimate and interpret uncollectible accounts and
receivable balances.
• Assess the level of accounts receivable.
• Develop and explain internal control procedures.
Recognition of Sales Revenue
• The timing of revenue recognition is critical
to the measurement of net income.
– Revenue is part of the calculation of net
income.
• Net income = Revenue - Expenses
– Measurement of revenue sometimes determines
when a company recognizes certain expenses
because of the matching principle.
• Expenses must be recognized in the same period as
the revenues that create the expenses.
Recognition of Sales Revenue
• Some users of financial information
want revenues to be recorded as soon
as possible.
• Others want to be sure that a company
will actually receive payment before
revenues are recorded.
• Accountants must carefully assess when
revenue should be recognized.
Recognition of Sales Revenue
• Recognition of revenue requires a twopronged test:
– The revenue is earned.
• Goods or services must be delivered to the
customers.
– The revenue is realized.
• Cash or other assets must
be received.
Recognition of Sales Revenue
• What happens if revenue on one “sale” is
earned over a long period of time, for
example, on a long-term contract?
• Generally, the revenue from a long-term
contract should be recognized as the work
on that contract is performed.
– For example, if one-fourth of the work is
completed in the first year, one-fourth of the
revenue should be recognized.
Merchandise Returns
and Allowances
• What happens when sales are recognized at
the point of sale and a customer returns the
goods that were sold?
• Sales returns - products returned to the
seller by the purchaser for various reasons
– These are purchase returns from the customer’s
perspective.
Merchandise Returns
and Allowances
• Sometimes, instead of returning
merchandise, the customer demands a
reduction, (a sales allowance) in the selling
price.
• Sales allowance - reduction of the original
selling price, which is the price previously
agreed upon by both parties
– These are purchase allowances from the
customer’s perspective.
Merchandise Returns
and Allowances
• Usually, a contra account called Sales
Returns and Allowances is used to
accumulate both sales returns and sales
allowances.
– By using a contra account, the amount of gross
sales is readily available, which allows
managers to monitor the level of returns and
allowances for various reasons.
– Using the contra account avoids changing the
original sales entry for the amounts returned.
Merchandise Returns
and Allowances
• Journal entries for returns and allowances:
To record the sale:
Accounts receivable
Sales revenue
900,000
900,000
To record the returns and allowances:
Sales returns and allowances
Accounts receivable
80,000
80,000
Merchandise Returns
and Allowances
• Gross sales - total sales revenue before
deducting sales returns and allowances, if
any
• Net sales - total sales revenue reduced by
sales returns and allowances
• Income statement presentation:
Gross sales
Less: Sales returns and allowances
$900,000
80,000
Credit Sales and
Accounts Receivable
• Accounts receivable - amounts owed to a
company by customers as a result of
delivering goods or services and extending
credit in the ordinary course of business
– Also known as trade receivables or simply
receivables
– The main benefit of granting credit
is a boost in sales and profits that
would otherwise be lost if credit
were not extended.
Uncollectible Accounts
• Uncollectible accounts (bad debts) receivables determined to be uncollectible
because debtors are unable or unwilling to
pay their debts
– Uncollectible accounts are a major cost of
granting credit to customers.
– Accountants call this cost bad debts expense.
– Extent of nonpayment can vary greatly with
size of companies and industries and depend on
the credit risk that managers are willing to
Measurement of
Uncollectible Accounts
• Two basic ways to record uncollectibles:
– Specific write-off method - wait to see which
receivables will not be paid and write them off
at that time
– Allowance method - make estimates
of the portion of accounts receivable
that will not be collected
Specific Write-off Method
• Disadvantage
– It fails to apply the matching principle
(expenses must be recorded in the same period
as the related revenues) if the receivable is
written off in a period other than when the
receivable is recorded.
• Advantages
– It follows the cost-benefit concept because it is
simple and extremely inexpensive to use.
– If amounts of bad debts are small (immaterial),
no great error in measurement of income
Allowance Method
• The allowance method estimates the amount
of uncollectible accounts to be matched to
the related revenue.
– It allows accountants to recognize
bad debts during the proper period,
before specific uncollectible
accounts are identified in a
subsequent period.
Allowance Method
• The allowance method has two basic
elements:
– An estimate of the amounts that will ultimately
be uncollectible
– A contra account, Allowance for Uncollectible
Accounts, which contains the estimate and is
deducted from Accounts Receivable
• The allowance method is based on historical
experience and the assumption that the
Allowance Method
• Presentation of Accounts Receivable under
the allowance method:
Accounts receivable
$40,000
Less: Allowance for uncollectible accounts
2,000
Net accounts receivable
$38,000
====================
Applying the Allowance Method
Using a Percentage of Sales
• Percentage of sales method - an approach to
estimating bad debts expense and
uncollectible accounts based on historical
relations between credit sales and
uncollectibles
– Bad debts are assumed to be some percentage
of sales.
Applying the Allowance Method
Using a Percentage of Sales
Echo Company has $150,000 in credit sales.
Historically, 2% of credit sales are determined to
be uncollectible. During the year, Echo Company
determines that $2,000 of receivables will not be
collected. What are the entries to record the sales,
establish the Allowance account, and write off the
uncollectible accounts?
Applying the Allowance Method
Using a Percentage of Sales
The entry to record the sales:
Accounts receivable
Sales
150,000
150,000
The entry to record the estimate for bad debts:
Bad debts expense
Allowance for uncollectible accounts
3,000
3,000
The entry to record actual uncollectible accounts:
Allowance for uncollectible accounts
Accounts receivable
2,000
2,000
Applying the Allowance Method Using
a Percentage of Accounts Receivable
• Percentage of accounts receivable method an approach to estimating bad debts
expense and uncollectible accounts at year
end using the historical relations of
uncollectibles to accounts
receivable
Applying the Allowance Method Using
a Percentage of Accounts Receivable
• The Allowance for Uncollectible accounts is
used to estimate the approximate amount of
bad debts included in the ending Accounts
Receivable.
– Additions to Allowance for Uncollectible
Accounts are calculated to achieve a desired
ending balance in the Allowance account.
– An adjusting journal entry is made to adjust the
balance in the Allowance account to the desired
balance at the end of the year.
Applying the Allowance Method Using
a Percentage of Accounts Receivable
•
Calculating the allowance under the percentage
of receivables method:
–
–
–
Divide average bad debts by average ending balance
of Accounts Receivable to calculate the historical
average uncollectible percentage.
Apply the percentage from step 1 to the ending
Accounts Receivable balance to determine the
desired ending balance in the Allowance account at
the end of the year.
Prepare an adjusting entry to adjust the Allowance
account to the amount determined in step 2.
Applying the Allowance Method Using
the Aging of Accounts Receivable
• Aging of accounts receivable method - an
analysis that considers the composition of
year-end accounts receivable based on the
ages of the debts.
– The more time elapses after the sale, the less
likely collection of the receivable becomes.
– The aging gives a desired balance in the
Allowance account just as the percentage of
accounts receivable method does; however, the
amount desired in the Allowance account will
probably be somewhat different.
Applying the Allowance Method Using
the Aging of Accounts Receivable
Accounts receivable aging schedule:
Total
Accounts
receivable
Percentage
1-30 days
31-90 days
Over 90 days
$70,000
1%
$ 700
$30,000
2%
$ 600
$2,000
90%
$1,800
$3,100
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$3,100 is the desired amount in the Allowance
account. A journal entry will be made to adjust
Bad Debt Recoveries
• Sometimes accounts will be collected after
they have been written off.
• When this happens, the write-off should be
reversed and the collection handled as a
normal receipt on account.