Chapter 6-Financial Accounting
Chapter 6: Reporting and Interpreting Sales Revenue, Receivables, and Cash
Authors
Susan Coomer Galbreath, Ph.D., CPA
Charles W Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2 Learning Objectives
After studying this chapter, you should be able to:
6-1: Analyze the impact of credit card sales, sales discounts, sales returns, and sales of bundled items on the amounts reported as net sales.
6-2: Estimate, report, and evaluate the effects of uncollectible accounts receivable (bad debts) on financial statements.
6-3: Analyze and interpret the receivables turnover ratio and the effects of accounts receivable on cash flows.
6-4: Report, control, and safeguard cash.
6-3 Learning Objective 6-1
6-1: Impact Analysis
Analyze credit card sales, sales discounts, sales returns, and sales of bundled items' impact on reported net sales.
6-4 Accounting for Net Sales Revenue (1 of 2)
Revenue is recognized when the company transfers goods and services to customers.
Recognized in the amount the company expects to receive.
Revenue Recognition Principle: Revenues must be recorded when the company is entitled to them.
6-5 Accounting for Net Sales Revenue (2 of 2)
FOB (Free on Board) Terms:
FOB Destination: Title of goods changes hands on delivery.
FOB Shipping Point: Title changes hands at shipping date.
For sellers, sales revenue is recorded when title and risks transfer to the buyer.
Service companies record revenue when services have been provided.
6-6 Summary of Significant Accounting Policies
Example of Financial Statement Footnote: Discloses the revenue recognition rule (as seen in collections like Skechers U.S.A. Quarterly Report).
6-7 Motivating Sales and Collections
Companies motivate purchases and payments with:
Credit card payment options.
Direct credit and discounts for early payment to business customers.
Return policies under certain conditions.
These methods affect net sales computations.
6-8 Credit Card Sales to Consumers
Retailers Accepting Credit Cards
Reasons for acceptance:
Increase in customer traffic.
Reduction of costs for direct customer credit.
Lower risks from bad checks.
Absorption of losses from fraudulent transactions by credit card companies.
Faster receipt of payments.
Credit Card Discounts: A fee paid to the credit card company (e.g., for sales of $3,000 at a 3% fee:
Sales revenue = $3,000
Less: Credit card discounts = $90
Net Sales = $2,910
6-9 Sales Discounts to Businesses
Open accounts are often used without formal promissory notes, with discounts incentivizing early payments:
Example Discount Terms: “2/10, n/30”
Components Explained:
2/10: 2% discount if paid within 10 days.
n/30: Net amount due in 30 days.
Early payments reduce the need for loans and provide timely cash flow for businesses.
6-10 Cash Discount Benefits
Example: A $100 purchase saving $2 if paid within the discount period (2/10, n/30):
Interest Rate Calculation over 20 Days:
Annual Interest Rate:
rac{365 ext{ Days}}{20 ext{ Days}} imes 2.04 ext{ ext{%}} = 37.23 ext{ ext{%}}
Cash discounts are beneficial compared to a company’s borrowing rate.
6-11 Sales Returns and Allowances
Customers can return unsatisfactory merchandise and receive adjustments:
Sales Revenue Example:
Sales revenue = $2,000
Less: Sales Returns and Allowances = $500
Net Sales = $1,500
Related cost of goods sold is also adjusted downward by the corresponding value of returns.
6-12 Reporting Net Sales
Organizations must record credit card discounts, sales discounts, and returns separately:
Example Reporting:
Sales Revenue = $6,000
Less:
Credit card discounts = $90
Sales discounts = $20
Sales returns and allowances = $500
Net Sales = $5,390
6-14 Volume Discounts/Rebates and Earnings Misstatements
Example:
The SEC found Monsanto misstating revenues by improperly accounting for volume discounts and rebates, overstating gross profits and affecting net sales by recording them wrongly, leading to a misstatement by $44.5 million and $48 million, respectively, over two years.
Revenue recorded must equal the amount the company expects to be entitled to.
6-15 Revenue Recognition for Bundled Goods and Services: A Five Step Process (1 of 3)
Bundles of goods/services in one sales contract are common.
Five-Step Revenue Recognition:
Identify the contract.
Identify performance obligations.
Determine transaction price.
Allocate price to performance obligations.
Recognize revenue when obligations are satisfied.
6-16 Revenue Recognition for Bundled Goods and Services: A Five Step Process (2 of 3)
Example with iPad:
Total Transaction Price = $500:
Hardware with essential software = $450
Future software upgrades = $50
Revenue is recognized based on the step-wise evaluation of fulfilling service obligations over time.
6-17 Revenue Recognition for Bundled Goods and Services: A Five Step Process (3 of 3)
Revenue recognition schedule:
Hardware with software = $450 in Year 1.
Future software upgrades = $10 for each year for 5 years.
6-18 Measuring and Reporting Receivables
Types of Receivables:
Accounts Receivable: Credit sales on open account.
Notes Receivable: Written promise to pay.
Trade Receivables: Normal business credit sales.
Nontrade Receivables: Transactions other than sales.
Classifications:
Current (Short-term) / Noncurrent (Long-term).
6-19 Foreign Currency Receivables
Export sales are often on credit, resulting in foreign currency receivables that must be converted to U.S. dollars using the end-of-period exchange rate.
6-20 Learning Objective 6-2
6-2: Effects of Uncollectible Accounts on Financial Statements
Focus on estimating, reporting, and evaluating uncollectible accounts receivable.
6-21 Accounting for Bad Debts
Bad debts arise from non-paying credit customers and are accounted for in subsidiary accounts.
Expense Recognition Principle: Bad debt expenses are recorded in the same period as related sales via the allowance method which entails:
End-of-period adjusting entry for bad debt expense.
Writing off specific uncollectible accounts.
6-22 Recording Bad Debt Expense Estimates
Example: Skechers's estimated bad debt expense for 2019 = $6,402 (thousands). Adjusting entry recorded.
Contra-asset Account: Allowance for doubtful accounts reduces the overall asset presented on balance sheets.
6-23 Writing Off Specific Uncollectible Accounts
Bad debts, once recognized, are written off with a journal entry. Skechers’s total write-offs for 2019 were $7,912. This does not alter income statement accounts or net book value of accounts receivable.
6-24 Bad Debt Recoveries
Restoring a previously written-off account involves reversing the write-off and recording the cash received.
Example: For a $677 write-off, journal entries are made to reflect recovery.
6-25 Summary of the Accounting Process (1 of 2)
Two-step process for bad debts includes:
Record bad debts adjustment.
Identify and write off actual debts as they become known.
Accounts Affected: Bad Debt Expense, Allowance for Doubtful Accounts, Accounts Receivable, and Net Income.
6-26 Summary of the Accounting Process (2 of 2)
Let’s consider Skechers's balances and adjustments for allowances and write-offs detailing flows and status of accounts receivable throughout the period.
6-28 Exhibit 6.3 Accounts Receivable Valuation Schedule (Form 10-K)
Requirements for publicly traded companies regarding the reporting of bad debt expense and account write-offs if material.
6-29 Estimating Bad Debt Expense
Bad debt expense can be estimated using:
Percentage of total credit sales method.
Aging of accounts receivable method.
The percentage method is simpler, dedicated to earlier assessments, while the aging method provides accuracy through thorough analysis.
6-30 Estimating Bad Debts—Percentage of Credit Sales Method
Calculation formula:
Example: For credit sales of $1,970,000 at a 1.0% loss rate, the bad debt expense = $19,700.
6-31 Estimating Bad Debts—Aging of Accounts Receivable
The aging method assesses uncollectible accounts based on their age.
6-32 Estimating Bad Debts—Comparison of the Two Methods
Key distinctions:
Percentage of credit sales: directly computes bad debt expense.
Aging of Receivables: estimates ending balance, and adjusts based on difference from previous balance.
6-33 Actual Write-offs Compared with Estimates
When estimated uncollectibles differ from actual losses, subsequent adjustments modify bad debt expense estimates, but prior period financial statements remain unchanged.
6-34 Control over Accounts Receivable Practices
Credit history checks, accounts aging, incentivizing speedy collections can help minimize bad debts.
6-35 Learning Objective 6-3
6-3: Analyzing the Receivables Turnover Ratio
Measuring the efficiency of receivables management and its effect on cash flows is emphasized.
6-36 Receivables Turnover Ratio
Measures frequency of trade receivables collection per year.
6-38 Learning Objective 6-4
6-4: Reporting and Safeguarding Cash
6-39 Cash and Cash Equivalents
Definition: Includes checks, money orders, bank drafts, certificates of deposit, Treasury bills, etc.
Investments with maturity of 3 months or less that are easily convertible to cash are considered cash equivalents.
6-40 Cash Management
Effective cash management practices ensure funds' availability and avoid excess cash accumulation.
6-41 Effective Internal Control of Cash
Separation of roles, daily deposits, and monthly reconciliations constitute robust practices for cash controls.
6-42 Ethics and the Need for Internal Control
High standards of behavior and ethics are critical in preventing financial malpractices.
6-44 Need for Reconciliation
Bank reconciliations are necessary for detecting discrepancies between the company’s cash records and bank statements.
6-45 Bank Reconciliation
Objectives include checking cash record accuracy and identifying transactions that need journal entries.
6-49 Chapter Supplement: Recording Discounts and Returns (1 of 3)
Credit card and cash discounts reduce net sales as contra-revenues.
6-50 Chapter Supplement: Recording Discounts and Returns (2 of 3)
Record discounts accurately to reflect true sales reporting.
6-51 Chapter Supplement: Recording Discounts and Returns (3 of 3)
Sales returns and allowances should always be treated as contra-revenue, highlighting their significance in financial reporting.