Chapter 5- Financial Accounting

Credit Sales

Transfer of goods or services to a customer today while bearing the risk of collecting payment from that customer in the future 

• Sales on account or services on account 

  • increase in accounts receivable and revenue

• Payment terms usually require payment within 30-60 days 

Invoice

A source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale, and the payment terms 

Benefits of Extending Credit

The seller makes it more convenient for buyer to purchase 

• Therefore increase profitability of the company 

Cost of Extending Credit

The delay in collecting cash from customers, some may not want to pay it 

• Reduce the operating efficiency and leads to lower profitability 

 

Nontrade Receivables

Receivables that originate from sources other than customers 

• Include tax refund claims, interest receivable, and loans by the company to other entities, stockholders and employees 

*trade receivables: what are you in the business of doing*

Notes Receivable

When receivables are accompanied by formal credit arrangements made with written debt instruments (notes) 

Interest = Principle x Annual Rate x Time out of Year

Net revenues

total revenues - (discounts, returns and allowances)

Revenue recognition principle

Record revenue in the period in which we provide goods/services to customers (for the amount the company is entitled to receive)

Transactions that can reduce amount of cash a company is entitled to receive 

1. Trade discounts 

2. Sales returns 

3. Sales allowances 

4. Sales discounts 

Trade Discounts

Reduction in the listed price of a good or service 

• Provides incentives to larger customers 

• A way to change prices without publishing a new price list or to disguise real prices from competitors 

Sales Return

Customer returns a product 

• Seller issues a cash refund if original sale was for cash 

• Seller reduces balance of accounts receivable if original sale was on account 

• Debit: sales return

• Credit: accounts receivable

Sales Allowance

Seller reduces the customer's balance owed or provides at least a partial refund because of some deficiency in the company's good or service (MORE LIKELY SERVICES) 

• Customer does NOT return goods 

  • Seller issues a cash refund if original sale was for cash

Debit: Sales Allowances

Credit: accounts receivable

Sales Discount

Reduction in the amount to be received from a credit customer if collection on account occurs within a specified period of time 

• Provides incentive to the customer for quick payment 

  • Used if need for cash quickly 

• 2/10: two ten, customer receives 2% discount if amount is paid in 10 days 

  • The amount of the discount and the time period within which it's available 

• N/30: net thirty, if customer doesn’t take the discount, full payment of any returns or allowances is due in 30 days 

Collection of cash w/ discount:

Debit: Cash and Sales Discount

Credit: Accounts Receivable

Contra Revenue Account

Have a normal DEBIT balance

• An account with a balance that is opposite, or "contra," to that of its related revenue account 

  • We use to keep a record of the total revenue recognized separate from the reduction due to subsequent sales returns 

  • Ex: sales returns, discounts, allowances

The amounts reported for contra revenues in the 2027 income statement include 

1. Actual returns, allowances, and discounts during 2027 

2. Estimates of returned, allowances, and discounts expected to occur in 2028 that relate to transactions in 2027 

Uncollectible accounts

Customers' accounts that no longer are considered collectible 

Allowance Method (GAAP)

Method of reporting accounts receivable for the net amount expected to be collected 

• Required under GAAP 

• Must estimate amount of current accts. receivable that will prove uncollectible in the future and report this to a contra account 

  • Using the allowance method, we account for events that have not yet occurred but are likely to. 

Three Stages in Allowance

1. At end of first year, establish allowance by est future uncollectible 

2. During next year, write off actual bad debts as uncollectible  

   1. (actual writes offs can differ from the previous estimate) 

3. At end of year, est. future uncollectible accounts again 

Bad debt expense and allowance for uncollectible accounts equation

Remaining payment x rate of uncollectible accounts

• Reduces assets and increases expenses

Uncollectible Accounts journal entry

Bad Debt Expense....................................   Debit 

    Allowance for Uncollectible Accounts................ Credit 

Allowance for Uncollectible Accounts

A contra asset account that represents the amount of accounts receivable that is viewed as not going to be collected 

• Indirectly reduces accounts receivable 

• CREDIT BALANCE

Net Accounts Receivable Equation

Total accounts receivable - allowance for uncollectible accounts

Bad Debt Expense

Represents the cost of estimated future bad debts that is reported as an expense in the current year's income statement 

• Provision for uncollectible accounts 

Writing off a customer’s account

Debit: Allowance for Uncollectible Accounts

Credit: Accounts Receivable

• Total assets are unchanged, no effect on balance sheet or income statement

Collecting on Accounts Previously Written Off

• First entry: reverses some of previous entry made to write off account 

  • Debit: Accounts receivable

  • Credit: allowance for uncollectible accounts

• Second entry: records the collection of the account receivable 

  • Debit: cash

  • Credit: accounts receivable

• Collecting cash on an account previously written off has no effect on total assets and net income 

Percentage-of-receivables method 

Method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected 

• Balance sheet method 

• % can be estimated using economic conditions, company history, and industry guidelines 

Aging method

Basing the estimate of future bad debts on the various ages of individual accounts receivable, using a higher percentage for "old" accounts than for "new" accounts 

• The older the account, the less likely it is to be collected 

• More detailed application of the percentage-of-receivables method, also a balance sheet method 

Adjustments for a previous CREDIT balance

Subtract current balance from estimated ending balance for Bad Debt Expense 

• A credit balance before adjustment indicates that the balance of the allowance account at the beginning of the year (or end of last year) may have been too high (overstated) 

Adjustments for a previous DEBIT balance

Add current balance from estimated ending balance for Bad Debt Expense

• A debit balance before adjustment indicates that the balance of the allowance account at the beginning of the year was too low 

The year-end adjusting entry is affected by the extend to which

the previous year's ending balance of Allowance for Uncollectible Accounts differs from the current year's actual amount of uncollectible accounts 

Allowance for Uncollectible Accounts adjustment for previous credit balance

Subtract balance before adjustment from ending balance

• like from 2 to 7

  • bad debt expense = 5

Allowance for Uncollectible Accounts adjustment for previous debit balance

Add balance before adjustment to ending balance

• like from -2 to 7

  • bad debt expense = 9

Subsidiary Ledgers

A group of individual accounts associated with a particular general ledger control account 

Notes Receivable 

Formal credit arrangements evidenced by a written debt instrument, or note 

• Normally arise from loans to other entities, loans to stockholders and employees, and sometimes loans to customers 

• If the time to maturity is longer than one year, the note receivable is a long-term asset 

• ASSETS 

Establishing

• Debit: Notes Receivable

• Credit: Service Revenue?

Collection

• Debit: Cash

• Credit: Notes Receivable (for total amount) and Interest Revenue

Interest Calculation

Interest = Face Value x Annual interest rate x Fraction of the year

Accrued Interest

The length of note and interest rate remain the same, to the total interest remains the same 

• However, interest revenue will be spread over two accounting periods 

Adjusting entry to accrue interest revenue

Debit: Interest Receivable

Credit: Interest Revenue

Payment of note and interest

Debit: Cash

Credit: Notes Receivable, Interest Receivable, Interest Revenue

Receivables Turnover Ratio

Net Credit Sales/ Avg. Accounts Receivable

• average accounts receivable = (beginning + ending accts receiv.)/2

Number of times during a year the average accounts receivable balance is collected

Average Collection Period

365 days/receivables turnover ratio

• number of days the average accounts receivable balance is outstanding