A Review of the Accounting Cycle

1
chapter 7
The Revenue/ Receivable/Cash Cycle
An electronic presentation by Douglas Cloud
Pepperdine University
2
Learning Objectives

• 1. Explain the normal operating cycle of a
  business.
• 2. Prepare journal entries to record sales
  revenue, including the accounting for bad debts
  and warranties for service or replacement.
• 3. Analyze accounts receivable to measure how
  efficiently a firm is using this operating asset.

Continued
3
Learning Objectives
4. Discuss the composition, management, and
control of cash, including the use of a bank
reconciliation. 5. Recognize appropriate
disclosures for presenting sales and receivables
in the financial statements.
Continued
4
Learning Objectives
EXPANDED LEARNING OBEJCTIVES

• 6. Explain how receivables may be used as a
  source of cash through secured borrowing or sale.
• 7. Describe proper accounting and valuation of
  notes receivable
• 8. Understand the impact of uncollectible
  accounts on the statement of cash flows.

5
Revenue/Receivables/Cash Timeline
6
The Operating Cycle of a Business
Cash
7
The Operating Cycle of a Business
Assume that Acme Manufacturing sold merchandise
to Harper Company on account.
When the inventory is sold on account Accounts
Receivable 1,000 Sales
1,000 Sold merchandise to Harper Company
on account.
When the collection takes place Cash
1,000 Accounts Receivable
1,000 Payment received on account.
8
The Operating Cycle of a Business
Receivables are all claims against other
entities. They are usually settled in cash.

• Trade receivables Receivables arising from
  normal operating activities.
• Notes receivable Trade receivables evidenced by
  a formal written promise to pay.
• Nontrade receivables All receivables arising
  from activities other than normal operations.

9
The Operating Cycle of a Business
Nontrade receivables 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 payments (3) Claims for
rebates and tax refunds (4) Dividends and
interest receivable
10
Accounting for Sales Revenues
A trade discount may vary by customer, depending
on the volume of business or size or order.
11
Accounting for Sales Revenues
A cash (sales) discount is offered to customers
to encourage prompt payment of bills.
12
Accounting for Sales Revenues
Gross Method
Assume on March 15, 1,000 of merchandise is sold
on account. The terms of the agreement are 2/10,
n/30. The firm uses the gross method for record
sales on account.
Entry on date of sale Accounts Receivable
1,000 Sales 1,000
13
Accounting for Sales Revenues
Gross Method
If paid within the discount period Cash

980 Sales Discounts
20 Accounts Receivable 1,000
If not paid within the discount period Cash

1,000 Accounts Receivable
1,000
14
Accounting for Sales Revenues
Net Method
This time, assume that all sales on account are
recording using the net method. Again, the terms
of the agreement are 2/10, n/30.
At the point of sale (March 15) Accounts
Receivable 980 Sales 980
15
Accounting for Sales Revenues
Net Method
If paid within the discount period Cash 980 A
ccounts Receivable 980
If not paid within the discount
period Cash 1,000 Sales Discounts Not
Taken 20 Accounts Receivable 980
16
Sales Returns and Allowances
Red sweaters costing 600 are sold for 1,000.
When delivered, it was determined that the
sweaters should have been green. The customer
agrees to keep the merchandise for a 200
reduction in price.
Sales entry Accounts Receivable 1,000
Sales 1,000 Cost of Goods Sold
600 Inventory 600
Sales allowance entry Sales Returns and
Allowances 200 Accounts Receivable
200
17
Sales Returns and Allowances
Suppose that instead of the allowance, the
customer elects to return the sweaters.
Sales return entries Sales Returns and
Allowances 1,000 Accounts
Receivable 1,000 Inventory 600 Cost of
Goods Sold 600
18
Sales Discounts and Sales Returns and Allowances
Income Statement Sales 15,000 Less Sales
discounts 250 Sales returns and
allowances 400 (650) Net
sales 14,350
19
Accounting for Bad Debts

• Occur 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 their net realizable value.

20
Accounting for Uncollectible Receivables (Direct
Method)
Write Off Bad Debts Expense
400 Accounts Receivable
400 To write off an uncollectible
account.
This entry is made when the account has been
determined uncollectible. The direct write-off
method is used by small businesses because of its
simplicity.
Since this determination was made after the
period in which the sale takes place, the
matching principle is violated. This method is
not accepted under GAAP.
21
Accounting for Uncollectible Receivables
(Allowance Method)
In this method, an estimate of the total
uncollectible accounts is made at the end of the
period, and an expense is recognized. Bad
Debts Expense 2,000 Allowance
for Bad Debts 2,000
To record estimated uncollectible
accounts.
GAAP requires the use of the allowance method.
22
Accounting for Uncollectible Receivables
(Allowance Method)
When the account is then determined to be
uncollectible, the write-off entry is
Allowance for Bad Debts 400
Accounts Receivable 400 To write
off an uncollectible account.
Note Bad Debt Expense is not debited.
23
Accounting for Uncollectible Receivables
(Allowance Method)
What happens if the written off receivable is
later collected? Assume that the customer from
Slide 22 pays the 400 written-off debt a month
after the write-off.
Accounts Receivable 400
Allowance for Bad Debts 400 To
reverse the entry made to write off the account.
Note Before the payment entry, the debt must
be restored.
24
Accounting for Uncollectible Receivables
(Allowance Method)
What happens if the written off receivable is
later collected? Assume that the customer from
Slide 22 pays the 400 written-off debt a month
after the write-off.
Cash 400 Accounts
Receivable 400 To record
collection of the account.
25
Accounting for Uncollectible Receivables
(Allowance Method)
(1) Allowance for Doubtful Accounts is a
contra-asset account which is subtracted from
Accounts Receivable on the balance sheet.
26
Estimating the Allowance for Uncollectible
Accounts

• Percentage of credit sales
• Percentage of accounts receivable
• Aging receivables

27
Percentage of Credit Sales
Example Doubtful Accounts Expense
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350. Historically, 2 percent of the
credit sales are not collected.
What is the entry to record estimated bad debts?
28
Percentage of Credit Sales
Example Doubtful Accounts Expense
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
30,500. The allowance for doubtful accounts
balance is 350. Historically, 2 percent of the
credit sales are not collected.
Bad Debt Expense 2,000 Allowance for
Doubtful Accounts 2,000 To record
estimated uncollectible accounts for the year.
29
Percentage of Credit Sales
Allowance for Doubtful Accounts
Balance 350 Adjusting 2,000 Dec. 31, Bal. 2,350
30
Percentage of Accounts Receivable
Example Doubtful Accounts Expense
The XYZ company had credit sales of 693,000.
The current accounts receivable balance is
50,000. The allowance account balance is 600.
Historically, 3 percent of accounts receivable
are not collectible.
What is the required adjusting entry to record
estimated bad debts?
31
Percentage of Accounts Receivable
Bad Debt Expense 900 Allowance for
Doubtful Accounts 900 To record
estimated uncollectible accounts for the year.
32
Percentage of Accounts Receivable
Allowance for Doubtful Accounts
Balance 600 Adjusting 900 Dec. 31, Bal. 1,500
Thats the desired ending balance.
33
Percentage of Accounts Receivable
What if the allowance account had a debit balance
of 350?
I see! The ending balance must be forced to be
the calculated amount.
Allowance for Doubtful Accounts
Adjusting 1,850 Dec. 31, Bal. 1,500
Balance 350
34
Aging Receivables
The ABC company had credit sales of 100,000.
The current accounts receivable balance is
47,550. The allowance for doubtful accounts
balance is 620. The firm ages the accounts to
determine the expected uncollectibles.
Remember, because receivables are involved, the
amount derived from aging provides the desired
balance of the allowance account.
35
Aging Receivables
Uncollectible Estimated Accounts Amount
of Classification Experience Uncollectible (in
days) Balance Percentage Accounts
Not yet due 40,000 2 800 1-30 past
due 3,000 5 150 31-60 past due 1,200 10 120 61-9
0 past due 650 20 130 91-180 past
due 500 30 150 181-365 past due 800 50 400 365
past due 1,400 1,120 47,550 2,870
36
Aging Receivables
Bad Debt Expense 2,250 Allowance for
Doubtful Accounts 2,250 To record
estimated uncollectible accounts for the year.
Required balance 2,870 Current balance
(620) Adjusting entry 2,250
37
Aging Receivables
Allowance for Doubtful Accounts
Balance 620 Adjusting 2,250 Dec. 31, Bal. 2,870
38
Accounting for Warranties
MJW Video Sound sells compact stereo systems
with a two-year warranty. Past experience
indicates that 10 of all systems will need
repairs in the first year and 20 will need
repairs in the second year. The average repair
cost is 50 per system.
39
Accounting for Warranties
The number of systems sold in 2004 and 2005 was
5,000 and 6,000, respectively. Actual repair
costs were 12,500 in 2004 and 55,000 in 2005.
40
Accounting for Warranties
To record estimated warranty expense
2004
Warranty Expense
75,000 Estimated Liability Under Warranties
75,000 To record estimated warranty
expense based on systems sold.
(5,000 x 0.30) x 50
41
Accounting for Warranties
To record the actual cost of doing repairs
2004
Estimated Liability Under Warranties 12,500
Cash 12,500 To record
cost of actual repair work in 2004.
42
Accounting for Warranties
To record estimated warranty expense
2005
Warranty Expense
90,000 Estimated Liability Under Warranties
90,000 To record estimated warranty
expense based on systems sold.
(6000 x 0.30) x 50
43
Monitoring Accounts Receivable

• Average Collection Period 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.

44
Monitoring Accounts Receivable
WS Corporation had average receivables of
354,250 and average daily sales of 1,650,000.
The average collection period can be calculated
as follows
Average Collection Period Average
receivable 354,250 Average daily
sales (1,650,000/365)

Average collection period 78 days
45
Monitoring Accounts Receivable
Accounts receivable turnover is determined by
dividing net sales by the average trade accounts
receivable outstanding during the year. For WS
Corporation, the 2005 turnover is
Accounts Receivable Turnover Net
sales 1,650,000 Average net receivables
354.250

Receivables turnover for year 4.7 times
46
Cash Management and Control
What items are classified as cash?

• Undeposited Coins and currency (change funds)
• Demand deposits
• Petty cash funds
• Cashiers checks
• Personal checks

47
Composition of Cash
Many companies report investments in very
short-term, interest-earning securities as cash
equivalents in the balance sheet.
48
Composition of Cash
A credit balance in the cash account is known as
a cash overdraft and should be reported as a
current liability.
49
Management and Control of Cash

• 1) Specifically assigned responsibilities for
  handling cash receipts
• 2) Separation of handling and recording 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 cashbank and books, with
  reconciliation performed by someone outside the
  accounting function

50
Bank Reconciliation
A comparison of the bank balance with the books
balance by means of a summary is a bank
reconciliation.
51
Bank Reconciliation
Common causes of differences

• Deposits 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.
• Accounting errors.

52
Svendsen, Inc. Bank Reconciliation November 30,
2005
Balance per books............. 2,952.49
Additions to bank balance Interest
earned................ 98.50 Error by
depositor.......... 18.00
Total............................ 3,068.99
Deductions from book balance Service
charge.............. ( 3.16 ) NSF
check.................... (118.94 ) Corrected
book bal. 2,946.89
Balance per bank.... 2,979.72 Additions to
bank balance Deposits in transit....
658.50 Error by bank 12.50
Total................... 3,650.72
Deductions from bank balance Outstanding
checks Listed individually
(703.83) Corrected bank bal. 2,946.89
53
Bank Reconciliation
All adjustments made to the Balance per Books
need to be recorded Cash 98.50 Interest
Revenue 98.50 To record interest
earned. Cash 18.00 Advertising
Expense 18.00 To record correction for check
in payment of advertising recorded as 64
instead of the actual amount, 46.
Continued
54
Bank Reconciliation
Accounts Receivable 118.94 Miscellaneous General
Expense 3.16 Cash 122.10 To record
customers uncollectible check and
bank charges for November.
Note When the item is a plus under Balance per
books, Cash is debited. When it is a minus,
Cash is credited.
55
Presentation of Sales and Receivables in the
Financial Statements
Receivables qualifying as current items may be
grouped for presentation on the balance sheet in
the following classes
1) Notes receivabletrade debtors 2) Accounts
receivabletrade debtors 3) Other receivables
56
Accounts Receivable as aSource of Cash

• As a sale (either with or without recourse.
• As a secured borrowing.

57
Accounts Receivable as aSource of Cash
SFAS 140 specified conditions that must be met if
a transfer of receivables is 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.
• 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.

58
Factoring Accounts Receivable
Factor
59
Accounting for Factoring Accounts Receivable

• Close sold receivables
• Close accompanying Allowance for Bad Debts
• Expense any factoring charges
• Establish a receivable for any sales price
  withheld by the factor
• Debit Cash for net proceeds of the sale
• Recognize a gain or loss from factoring

60
Example FactoringAccounts Receivable

• Assume
• Factored Receivables 10,000
• Allowance for Bad Debts 300
• Factor Withholding 5
• Sales Price 8,500

Lets journalize this transaction
61
Example FactoringAccounts Receivable

• Cash 8,075
• Receivable from Factor 425
• Allowance for Bad Debts 300
• Loss from Factoring Receivables 1,200
• Accounts Receivable 10,000
• Computations
• Cash 8,500 425 8,075
• Factor Receivable 8,500 x 5 425
• Factoring Loss (10,000 300) 8,500
  1,200

62
Sale of Receivableswith Recourse
Sale of receivables with recourse is different
from factoring, since factoring is normally sold
on a nonrecourse basis.
63
Sale of Receivableswith Recourse
When receivables are sold with recourse, a
purchaser of receivables retains the right to
collect from the seller when the sellers
customers fail to make payments when due.
64
Sale of Receivableswith Recourse
A firm raises funds by selling 5,000 of its
receivables for 4,300. The receivables have a
net realizable value of 4,700. The receivables
are sold with recourse and the seller estimates
(as required by SFAS No. 140) that the recourse
obligation has a fair value of 250. Assume in
this illustration that the factor does not
withhold a percentage of the purchase price.
65
Sale of Receivableswith Recourse
66
Sale of Receivableswith Recourse
The entry to record the sale
Cash 4,300 Allowance for Bad Debts 300 Loss on
Sale of Receivables 650 Accounts
Receivable 5,000 Recourse Obligation 250
67
Secured Borrowing

• Assignment of Accounts Receivable
• There are no special accounting problems
  involved.
• Simply record the loan.
• Specific Assignment
• Specified accounts receivable pledged.
• Accounts receivable reclassified on balance
  sheet.
• Footnote disclosure of loan provisions required.

68
Notes Receivable
A promissory note is an unconditional written
promise to pay a certain sum of money at a
specified time.
69
Notes Receivable

• Initially recorded at present value.
• Two types
• Interest-bearing Interest rate is stated on the
  note.
• Noninterest-bearing Interest is implied in the
  face amount of the note.

70
Example Notes Receivable

• Assume
• Note Receivable 1,000
• Interest Rate 10
• Time to Maturity 2 years
• Journalize this note as
• 1. An interest-bearing note.
• 2. A noninterest-bearing note.

71
Example Notes Receivable
Interest-Bearing Note Notes Receivable 1,000 Sal
es 1,000
Noninterest-Bearing Note Notes Receivable
1,210 Sales 1,000 Discount on Notes
Receivable 210 (PV of 1,000 _at_ 10 for 2
years 1,210)
72
Discounting Notes Receivables

• Discount Rate The interest rate charged by the
  financial institution for buying a note
  receivable.
• Discount Period The time between the date a
  note is sold to a financial institution and its
  maturity date.

73
Formulas for Discounting Notes

• Interest Face amount x Interest rate x
  Interest period
• Maturity value Face amount Interest
• Discount Maturity value x Discount
  period x Discount rate
• Proceeds Maturity value - Discount

74
chapter 7
The End
75
(No Transcript)