Accounting for Sales

1
Chapter 5

Accounting for Sales
2
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.

3
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.

4
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.

5
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.

6
Recognition of Sales Revenue

• Recognition of revenue requires a two-pronged
  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.

7
Recognition of Sales Revenue

• Most revenues are recognized at the point of sale
  (when goods are sold and cash changes hands).
• At this point, both recognition tests are met.
• Sometimes the tests are not always met at the
  same time. This results in unearned revenue.
• Cash is received, but nothing is given in
  exchange.

8
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.

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Measurement of Sales Revenue

• Revenue is measured in terms of the cash
  equivalent value of the asset received.
• Journal entries to record sales
• Cash xxxx
• Sales revenue xxxx
• OR
• Accounts receivable xxxx
• Sales revenue xxxx

10
Merchandise Returnsand 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 customers
  perspective.

11
Merchandise Returnsand 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 customers
  perspective.

12
Merchandise Returnsand 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.

13
Merchandise Returnsand Allowances

• Journal entries for returns and allowances
• To record the sale
• Accounts receivable 900,000
• Sales revenue 900,000
• To record the returns and allowances
• Sales returns and allowances 80,000
• Accounts receivable 80,000

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Merchandise Returnsand 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 900,000
• Less Sales returns and allowances 80,000
• Net sales 820,000

15
Merchandise Returnsand Allowances

• Discounts on sales also affect the amount
  reported as sales.
• Two major types of discounts
• Trade discounts
• Cash discounts

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Merchandise Returnsand Allowances

• Trade discounts - reductions to the gross selling
  price for a particular class of customers to
  arrive at the actual selling price (invoice
  price)
• Trade discounts are generally price concessions
  or purchase incentives.
• The gross sales revenue recognized from a trade
  discount is the price received after deducting
  the discount.

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Merchandise Returnsand Allowances

• Cash discounts - reductions of invoice prices
  awarded for prompt payment of the invoice
• Encourage prompt payment and reduce
  manufacturers or sellers need for cash
• Reduces the risk of bad debts (nonpayment)
• Purchasers should always take purchase discounts
  if possible.

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Recording Charge Card Transactions

• Cash discounts also occur when retailers accept
  charge cards.
• Retailers accept charge cards for three reasons
• To attract credit customers who would otherwise
  shop elsewhere
• To get cash immediately rather than wait for
  customers to pay
• To avoid the cost of keeping track of many
  customer accounts

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Recording Charge Card Transactions

• Retailers deposit the charge slips in the bank
  (just like cash), but this costs money (usually
  from 1 to 3 of gross sales).
• This cost must be included in the calculation of
  net sales.
• EXAMPLE
• 10,000 of sales where the charge card company
  charges 3
• Cash 9,700
• Cash discounts for bank cards 300
• Sales 10,000

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Accounting forNet Sales Revenue

• Cash discounts and sales returns and allowances
  are recorded as deductions from gross sales.
• Gross sales 20,000
• Deduct
• Sales returns and allowances 200
• Cash discounts on sales 550 750
• Net sales 19,250

21
Accounting forNet Sales Revenue

• The income statement allows different systems for
  accounting for net sales.
• The preceding example shows sales, sales returns
  and allowances, and cash discounts in separate
  accounts.
• Net sales can be shown in one account where all
  sales returns and allowances and cash discounts
  directly decrease the sales account.

22
Cash

• Many companies combine cash and cash equivalents
  on their balance sheets.
• Cash equivalents - highly liquid short-term
  investments that can easily and quickly be
  converted into cash
• Cash encompasses all items that
  are accepted for deposit by a bank.
• Paper money, coins, money orders,
  and checks

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Compensating Balances

• Compensating balances - required minimum cash
  balances on deposit when money is borrowed from
  banks
• The size of the compensating balance usually
  depends on the amount borrowed.
• Annual reports must disclose the state of any
  significant compensating balances.
• Without such a disclosure, readers might think
  that a company has more cash available than it
  really does.

24
Management of Cash

• Managers spend much time managing cash for
  several reasons.
• Although cash balances may be small at any one
  time, the flow of cash can be enormous.
• Because cash is the most liquid asset, it is
  enticing to thieves and embezzlers.
• Adequate cash is essential to the smooth
  functioning of operations.
• Cash itself does not earn income. It is
  important not to hold excess cash it should be
  invested.

25
Management of Cash

• To reconcile a bank statement means to verify
  that the bank balance for cash is consistent with
  the accounting records.
• The accounting balance and the bank balance are
  rarely the same.
• Deposits and checks are recorded in the books
  when made or written.
• Banks may receive the deposits or process the
  checks days later.

26
Management of Cash

• Internal control procedures to safeguard cash
• The individuals who receive cash do not also
  disburse cash.
• The individuals who handle cash cannot access
  accounting records.
• Cash receipts are immediately recorded and
  deposited and are not used directly to make
  payments.
• Disbursements are made by serially numbered
  checks, only with proper authorization by someone
  other than the person writing the check.
• Bank accounts are reconciled monthly.

27
Credit Sales andAccounts 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.

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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 accept.

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Measurement ofUncollectible 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

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Specific Write-off Method

• The specific write-off method assumes that all
  sales are fully collectible until proved
  otherwise.
• This method is used by companies that rarely
  experience bad debts.
• When an account is identified as uncollectible,
  that account is removed from the books and an
  expense is recorded.
• Bad debts expense xxxx
• Accounts receivable xxxx

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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 occurs.

32
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.

33
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 current
  year is similar to prior years.

34
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
• 
  

35
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.

36
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?

37
Applying the Allowance Method Using a Percentage
of Sales

• The entry to record the sales
• Accounts receivable 150,000
• Sales 150,000
• The entry to record the estimate for bad debts
• Bad debts expense 3,000
• Allowance for uncollectible accounts
  3,000
• The entry to record actual uncollectible
  accounts
• Allowance for uncollectible accounts 2,000
• Accounts receivable 2,000

38
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

39
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.

40
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.

41
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.

42
Applying the Allowance Method Using the Aging of
Accounts Receivable

• Accounts receivable aging schedule
• 1-30 days 31-90 days Over 90 days Total
• Accounts
• receivable 70,000 30,000 2,000
• Percentage 1 2
  90
• 700 600 1,800 3,100
• 
  
  
• 3,100 is the desired amount in the Allowance
  account. A journal entry will be made to adjust
  the Allowance account to that amount.

43
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.

44
Assessing the Level ofAccounts Receivable

• Management should monitor the ability of the
  company to control accounts receivable.
• They often use accounts receivable turnover for
  measuring that ability.

45
Assessing the Level ofAccounts Receivable

• Accounts receivable turnover indicates how
  rapidly collections of accounts receivable occur.
• The ratio tells how many times, on average,
  accounts receivable turn over during the year.
• Higher turnovers indicate that receivables are
  collected quickly.
• Lower turnovers indicate that receivables are
  collected more slowly.

46
Assessing the Level ofAccounts Receivable

• Days to accounts receivable (average collection
  period) - an indication of how long it takes to
  collect money after a sale is made

47
Overview of Internal Control

• The purpose of internal control is the creation
  of a system of checks and balances that assures
  that all actions occurring within a company are
  in accord with organizational objectives and have
  the general approval of top management.
• At one level, internal control seeks to tie daily
  decisions to corporate strategy.
• At another level, internal control refers to the
  protection of firm assets from theft or loss.

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Overview of Internal Control

• Types of controls
• Administrative controls - all methods and
  procedures that facilitate management planning
  and control of operations
• Accounting controls - the methods and procedures
  for authorizing transactions, safeguarding
  assets, and ensuring the accuracy of the
  financial records

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Overview of Internal Control

• Internal accounting controls should provide
  reasonable assurance concerning
• Authorization - Transactions are executed in
  accordance with managements general or specific
  intentions.
• Recording - All authorized transactions are
  recorded in the correct amounts, periods, and
  accounts. No fictitious transactions are
  recorded.
• Safeguarding - Precautions and procedures
  appropriately restrict access to assets.

50
Overview of Internal Control

• Internal accounting controls should provide
  reasonable assurance concerning
• Reconciliation - Records are compared with other
  independently kept records and physical counts.
• Such comparisons help ensure that other control
  objectives are attained.
• Valuation - Recorded amounts are periodically
  reviewed for impairment of values and necessary
  write-downs.

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Overview of Internal Control

• The first three objectives, authorizing,
  recording, and safeguarding, are related to
  establishing the system of accountability and are
  aimed at the prevention of errors and
  irregularities.
• The fourth and fifth objectives, reconciliation
  and valuation, are aimed at detecting errors and
  irregularities.
• A sixth objective of internal control is to
  promote operating efficiency.

52
The Accounting System

• Accounting system - a set of records, procedures,
  and equipment that routinely deals with the
  events affecting the financial performance and
  position of the entity
• The focus of the accounting system is on
  repetitive, voluminous transactions that fall
  into four categories
• Cash disbursements
• Cash receipts
• Purchase of goods and services, including payroll
• Sales or other rendering of goods and services

53
The Accounting System

• Most accounting systems make use of computers
  and data processing to handle the
  enormous number of
  transactions that occur
  each day.
• Well-designed and well-run accounting systems are
  positive contributions to the organization.

54
Managements Responsibility

• Although outside auditors attest to the financial
  reports of an entity, management bears the
  responsibility for a companys financial
  statements.
• Management reports - explicit statements in
  annual reports of publicly held companies that
  management is responsible for all audited and
  unaudited information in the annual report

55
The Audit Committee

• Audit committee - a committee of the board of
  directors that oversees the internal accounting
  controls, financial statements, and financial
  affairs of the corporation

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The Audit Committee

• The committee provides contact and communication
  among the board, the external auditors, the
  internal auditors, the financial executives, and
  the operating executives.
• The committee is typically composed of members
  from inside the company (managers) and
  outside the company (nonemployees).

57
Checklist of Internal Controls

• Good internal control systems have certain
  features in common. The following checklist
  summarizes the guidance found in much of
  the systems and auditing literature.

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Checklist of Internal Controls

• Reliable Personnel with Clear Responsibilities
• The most important element of successful control
  is personnel.
• Bad personnel can undermine the system, no matter
  how good that system is.
• Assigning responsibility means tracking actions
  as far down in the organization as possible so
  that results can be related to individuals.
• Have sales clerks sign sales slips.
• Have workers sign time cards.
• Many retailers assign each cashier a separate
  money tray.

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Checklist of Internal Controls

• Separation of Duties
• Separation of duties means that responsibility
  for a sequence of related operations should be
  divided among two or more persons.
• This separation of duties makes it hard for one
  person, acting alone, to defraud the company.
• Examples of separation of duties
• One individual should not authorize payment of an
  invoice and also sign the check to pay that
  invoice.
• One individual should not handle cash receipts
  and post receipts to accounts receivable.

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Checklist of Internal Controls

• Proper Authorization
• General authorization - usually found in writing
  - often sets limits on what price to pay, what
  price to receive, what credit limits to grant to
  customers, etc.
• Specific authorization - means that a superior or
  manager must authorize any particular deviations
  from the limits set by general authorizations.
• Examples of proper authorization
• A manager may have to approve overtime.
• A manager may have to approve the return of
  merchandise.

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Checklist of Internal Controls

• Adequate Documents
• Immediate, complete, and tamper-proof recording
  is the aim of adequate documentation, especially
  for handling cash sales.
• It is encouraged by
• Optical scanning of bar-coded data
• Having all source documents prenumbered and
  accounted for
• Using devices such as cash registers
• Designing forms for ease of recording

62
Checklist of Internal Controls

• Proper Procedures
• Most organizations use procedures manuals to
  specify the flow of documents and provide
  instructions to facilitate adequate record
  keeping.
• This basically means doing things by the book.
• Routine and automatic checks
  are often used.

63
Checklist of Internal Controls

• Physical Safeguards
• Losses can be minimized by using safes, locks,
  guards, and limited access.
• Examples of physical safeguards
• Require all visitors to sign a register and
  wear name tags.
• Doors to research areas or computer
  facilities can be opened only
  with
  special keys or by the use of a
  specific code.

64
Checklist of Internal Controls

• Bonding, Vacation, and Rotation of Duties
• Rotating employees and mandatory vacations ensure
  that more than one employee knows how to do each
  job.
• They also discourage employees from engaging in
  fraudulent activities that might be discovered
  when someone else has access to their records.
• Bonding is like buying insurance
  against embezzlement, but it is
  not a
  substitute for prevention of the loss.

65
Checklist of Internal Controls

• Independent Check
• All phases of the system should be subjected to
  periodic review by outsiders, such as independent
  external auditors, and by internal auditors.
• Independent auditors can spot weaknesses that
  management might miss during day-to-day
  operations.
• Internal auditors are company employees who help
  design control systems and assess the degree of
  compliance with the existing systems.

66
Checklist of Internal Controls

• Cost-Benefit Analysis
• Investments in more costly systems must be
  compared with the expected benefits.
• No internal control system is perfect in the
  sense that it can prevent all fraud.
• The goal of designing an internal control system
  is to design a cost-effective tool that will help
  achieve efficient operations and reduce
  temptation.

67
Bank Reconciliations

• Bank reconciliation - the analysis that details
  the items responsible for the difference between
  the cash balance reported in the bank statement
  and the balance of the Cash account in the ledger
• A bank reconciliation is prepared each month by
  the depositor to make sure that all cash receipts
  and disbursements are accounted for by the bank.

68
Bank Reconciliations

• Most bank reconciliations have two sections
• Balance per books
• Adjustments are made for items not entered in the
  books but already entered by the bank.
• Balance per bank
• Adjustments are made for items not entered by the
  bank but already entered in the books.
• After adjustments, each section should end with
  identical adjusted cash balances.

69
Bank Reconciliations

• Basic form of a bank reconciliation
• Balance per books
• Add Amounts collected by the bank on behalf of
  the depositor
• Deduct Bank service charges
• Checks returned for insufficient
  funds from customers
• Adjusted balance per books
• Balance per bank
• Add Deposits not recorded by the bank
• Deduct Outstanding checks
• Adjusted balance per bank

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