Chapter 5:
Sales and Receivables
Cornerstones of
Financial and Managerial Accounting, 2e
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Learning Objectives
1.
2.
3.
4.
5.
6.
7.
8.
Explain the criteria for revenue recognition.
Measure net sales revenue.
Describe the principal types of receivables.
Measure and interpret bad debt expense and the allowance
for doubtful accounts.
Describe the cash flow implications of accounts receivable.
Account for notes receivable from inception to maturity.
Describe internal control procedures for merchandise sales.
Analyze profitability and asset management using sales and
receivables.
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1
Timing of Revenue Recognition
►While cash-basis accounting recognizes revenue in
the period payment is received (as on your tax
return), 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.
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1
Criteria Set by the SEC
►The SEC maintains that revenue is realized or
realizable and earned when the following
criteria are met:
►Persuasive evidence of an arrangement exists (e.g., a
contract or other proof of the details of the exchange).
►Delivery has occurred or services have been provided.
►The seller’s price to the buyer is fixed and determinable.
►Collectability is reasonably assured.
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2
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.
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Quiz 2
Snap Quiz
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Quiz 1
Snap Quiz
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
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.
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2
Sales Discounts
(continued)
► Sales invoices use a standard notation to state discount and
credit terms.
► For example, the invoice of a seller who expects payment in 30 days
and offers a 2 percent discount if payment is made within 10 days
would bear the notation 2/10,
30’’).
n/30 (which is read ‘‘2/10, net
► Most companies record the sale and the associated
receivable at the gross (pre-discount) amount of the invoice,
using the ‘‘gross method.”
► When a discount is taken, the amount of the discount is
recorded in a contra-revenue account called sales discounts.
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2
Cornerstone 5-1
Recording Receivables
Using the Gross Method
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2
Cornerstone 5-1
Recording Receivables
Using the Gross Method (continued)
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Quiz 3
Snap Quiz
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2
Sales Discounts
(continued)
► It is also important to monitor changes in how customers use
sales discounts.
► Customers who stop taking sales discounts may be
experiencing cash flow problems and may be potential credit
risks.
► 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.
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2
Sales Returns and Allowances
► Occasionally, a customer will return goods as unsatisfactory.
► Sometimes a customer may agree to keep goods with minor
defects if the seller is willing to make an ‘‘allowance’’ by
reducing the selling price.
► 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.
► In these cases, 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.
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Quiz 5
Snap Quiz
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3
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.
►Current or Noncurrent Receivables: Although in practice both
accounts and notes receivable are typically classified as current,
accounts receivable are typically due in 30 to 60 days and do not
have interest while notes receivable have interest and typically are
due in anywhere from 3 to 12 months.
►Trade or Nontrade Receivables: Trade receivables are due from
customers purchasing inventory in the ordinary course of business
while nontrade receivables arise from transactions not involving
inventory.
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Quiz 4
Snap Quiz
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End of Lesson 1
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4
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, bad debts result (also called uncollectible
accounts).
►There are two methods to record bad debt expense:
►the direct write off method
►the allowance method
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4
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.
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Quiz 7
Snap Quiz
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4
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.
► An account is established to ‘‘store’’ the estimate of
potentially uncollectible accounts is known as the Allowance
for Doubtful Accounts.
► When a specific account is ultimately determined to be
uncollectible under the allowance method, 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.
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Quiz 6
Snap Quiz
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4
Percentage of Credit Sales Method
►The simpler of the two methods for determining bad
debt expense is the 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.
►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
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Quiz 10
Snap Quiz
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4
Cornerstone 5-2
Estimating Bad Debt Expense Using the
Percentage of Credit Sales Method
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4
Cornerstone 5-2
Estimating Bad Debt Expense Using the
Percentage of Credit Sales Method (continued)
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4
Cornerstone 5-2
Estimating Bad Debt Expense Using the
Percentage of Credit Sales Method (continued)
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Quiz 8
Snap Quiz
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4
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.
► Then an estimate is made of the amount expected to default
in each age category based on past experience and
expectations about how the future may differ from the past.
► Since the objective of the aging method is to estimate the
ending balance in the allowance for doubtful accounts, any
existing balance in the allowance account must be considered
when determining the amount of the adjusting entry.
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4
Cornerstone 5-3
Estimating the Allowance for Doubtful
Accounts Using the Aging Method
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4
Cornerstone 5-3
Estimating the Allowance for Doubtful
Accounts Using the Aging Method (continued)
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4
Cornerstone 5-3
Estimating the Allowance for Doubtful
Accounts Using the Aging Method (continued)
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4
Comparison of Percentage of Credit
Sales Method and Aging Method
► When deciding which method to use, it is important to
recognize that the underlying differences between the
percentage of credit sales method and the aging method is
what is being estimated.
► The percentage of credit sales method is primarily concerned
with appropriately estimating bad debt expense on the
income statement.
► The aging method is a balance sheet approach that analyzes
the accounts receivable to estimate its net realizable value.
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Quiz 9
Snap Quiz
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End of Lesson 2
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5
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 uncollectibility.
► 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.
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Quiz 11
Snap Quiz
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5
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).
► The advantages of this arrangement are:
► Sellers receive the money immediately.
► Sellers avoid bad debts because as long as the credit card verification
procedures are followed, the credit card company absorbs the cost of
customers who do not pay.
► Recordkeeping costs lessen because employees are not needed to
manage these accounts.
► Sellers believe that by accepting credit cards, their sales will increase.
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5
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.
► 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.
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6
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 lent is the principal.
► The excess of the total amount of money collected over the
amount lent is called interest.
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6
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).
► The interest rate specified in the note is an annual rate.
Therefore, when calculating interest, you must consider the
duration of the note using the following formula:
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Quiz 12
Snap Quiz
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6
Cornerstone 5-4
Accounting for Notes Receivable
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6
Cornerstone 5-4
Accounting for Notes Receivable (continued)
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Quiz 13
Snap Quiz
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7
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.
►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.
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Quiz 14
Snap Quiz
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7
Internal Controls for
Recording Sales Revenue
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8
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.
► There are three common profitability ratios:
►Gross Profit Margin = Gross Profit ÷ Net Sales
►Operating Margin = Operating Income ÷ Net Sales
►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.
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8
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
► 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.
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8
Cornerstone 5-5
Calculating the Gross Profit Margin,
Operating Margin, Net Profit Margin, and
Accounts Receivable Turnover Ratios
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8
Cornerstone 5-5
Calculating the Gross Profit Margin,
Operating Margin, Net Profit Margin, and
Accounts Receivable Turnover Ratios
(continued)
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Quiz 15
Snap Quiz
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