Accounting
for Sales
© 2010 Pearson Education Inc. Publishing as Prentice Hall
CHAPTER
5
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Learning Objectives (LO)
After studying this chapter, you should be able to
1. Recognize revenue items at the proper time on the
income statement
2. Account for cash and credit sales
3. Compute and interpret sales returns and
allowances, sales discounts, and bank credit card
sales
4. Manage cash and explain its importance to the
company
5. Estimate and interpret uncollectible accounts
receivable balances
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Learning Objectives (LO)
After studying this chapter, you should be able to
6. Assess the level of accounts receivable
7. Develop and explain internal control procedures
8. Prepare a bank reconciliation
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LO 1 – Revenue Recognition
• Revenue results from the sale of goods/services
to a customer and should be recognized when
– It is earned - Goods or services have been delivered
– It is realized – title has transferred and cash has been
received
– Or is realizable – if another asset other than cash
(e.g. Accounts Receivable) is received and is virtually
assured of being converted into cash
• Most companies recognize revenue at the point
of sale but there are unique circumstances
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LO 1 – Revenue Recognition
• Cash is received before goods or services have
been delivered
Cash
Unearned (deferred) Revenue (liability)
1,000
1000
– A portion (50%) is completed but not delivered
(percent of completion method)
Expenditures
500 (50% of expected total)
Cash
500
Unearned Revenue
Sales Revenue
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500
500
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LO 1 – Revenue Recognition
• Revenue is recorded at the cash-equivalent
value of what is received. For example
– A sale occurs that has a sticker price of $100
– To entice the buyer, a $5 discount is offered and
accepted; the customer charges the purchase
Accounts Receivable
Sales Discounts *
Revenue *
95
5
(Contra revenue account)
100
* Net sales revenue would be reported at $95 (100 – 5)
but two accounts would be used to capture the event
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LO 2 – Cash and Credit Sales Revenue
• A $100 cash and $100 credit sale
Cash
Accounts Receivable
Sales Revenue
100
100
200
– Credit sales increase revenues (and thus expenses)
– Credit sales also lead to 1) costs of managing credit
and collections and 2) uncollectable accounts
– If net revenue > the related expenses, credit sales are
good for the business (see LO 5)
– Costs and benefits should be periodically assessed
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LO 3 – Sales Returns/Allowances, Trade
and Cash Discounts, Credit Card Fees
• Income Statement
Gross Sales
Less Sales Returns
($100)
Sales Allowances ($10)
Trade Discounts
($10)
Cash Discounts
($2)
Credit Card Fees
($3)
Net Sales
$1,400
Contra Revenue
(Debit Balance)
Accounts
$125
$1,275
– Reports to shareholders typically omit details and
show only net revenues (Maybe details are in footnotes)
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LO 3 – Sales Returns
• Sales Returns - when a customer returns
previously purchased merchandise to the seller
(“purchase returns” used by buyers)
Cost of Goods Sold
Inventory
Accounts Receivable
Sales Revenue
60
60
100
100
Inventory
60
Purchase Returns/Allowances 60
Sales Returns
100
Accounts Receivable
100
© 2012 Pearson Education
The purchase
Contra COGS
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LO 3 – Sales Allowances
• Sales Allowance is a reduction of the original
selling price
Cost of Goods Sold
Inventory
Accounts Receivable
Sales Revenue
60
60
100
100
– Purchaser notes lower price ($90) at another store
and asks for a $10 price reduction which is given
Sales Allowances
10
Accounts Receivable
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LO 3 – Trade Discounts
• Trade discounts - a reduction to the gross
selling price for a particular class of customers
e.g. for differing order sizes (offered to remain
competitive/retain customers)
– Customer buys 10 at $10 a piece and gets 10% off
– (Example hereafter omit costs of goods sold entries)
Accounts Receivable
Trade Discounts
Sales Revenue
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10
100
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Discounts VS allowance
• Discounts and allowances are reductions to a
basic price of goods or services
• A discount is a reduction in the full price due to
either a sale or a promotion
• An allowance is also a reduction, but generally
(not always) because the goods are faulty or not
fit for purpose.
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LO 3 – Cash Discounts
• Cash Discounts – an encouragement to the
retailer to quickly pay the wholesaler
– Usage varies by company and industry
• n/30 - Full billed price (net price) due in 30 days
• 15 E.O.M. – Due 15 days after end of the month
• “2/10/n30”
• 2% off invoice price
• If paid within 10 days of invoice date
• Net amount due in 30 days after invoice date
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LO 3 – Cash Discounts
• Cash Discounts (“2/10/n30”) - gross method
– Sale
– Customer pays
• Within 10 days
• After 10 days
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Accounts Receivable 100
Sales Revenue
100
Cash
98
Cash Discounts Taken
2
Accounts Receivable 100
Cash
100
Accounts Receivable 100
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LO 3 – Cash Discounts
• Cash Discounts (“2/10/n30”) - net method
– Sale
– Customer pays
• Within 10 days
• After 10 days
Accounts Receivable
Revenue
98
98
Cash
98
Accounts Receivable 98
Cash
100
Accounts Receivable 98
Cash Discounts Lost * 2
* Adjunct account to Revenue or part of Other Income
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LO 3 – Cash Discounts
• Should cash discounts (2/10/n30) be taken?
– Choices
• Get 2 % reduction if pay within 10 days
• Get to use your own funds for 20 days at a 2%
interest cost (what you sacrificed by not taking it)
– 360/20 days = 18 20-day periods in a year
– 18 x 2% each period = 36% annual interest rate
– If can/must borrow at
• < 36% annual interest - take the discount
• > 36% annual interest - forego discount
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LO 3 – Cash Discounts
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LO 3 – Charge Cards
• Why should retailers offer credit?
– Attract customers (who would shop elsewhere or
forego a purchase, i.e. boost sales and profit)
– Remain competitive with stores in same industry
• Should the retailer grant credit themselves?
– Must bear costs of
• Administering credit card program
• Uncollectable accounts (bad debts)
– Reward is higher income due to increased sales
and/or interest charges
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LO 3 – Charge Cards
• Or use international credit cards (Visa,
MasterCard, etc.)
– Reward is
• Get cash immediately after the sale
• Card company bears the risk of unpaid accounts
• Relieve merchant of cost of a credit department
– Cost is 1-4% of sales revenue, depending on volume
Accounts Receivable (Cash)
Discounts for Credit Cards (@3%)
Sales Revenue
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3
100
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LO 4 - Cash
• Usually report cash and cash equivalents on the
balance sheets as a single amount
• Cash – money, money orders, checks
• Cash equivalents - highly liquid short-term
investments that can easily and quickly be
converted into cash (< 90 days until maturity)
–
–
–
–
Time deposits
Commercial paper
90-day Treasury bills
Proceeds from national credit cards (See LO 3)
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LO 4 - Cash
• Compensating balances - required minimum
cash balances on deposit in a bank to
compensate for one or more services or loans
– Compensating balances increase the effective
interest rate that the borrower pays
• No compensating balance - $100,000 x 8% annual
interest rate = $8,000 interest expense
• 10% compensating balance ($10,000)
• $8,000 / ($100,000 – $10,000) = 8.9% interest
• Must disclose significant compensating balances
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LO 4 - Cash
• Cash management is important and therefore
justifies strong internal controls
– Must hold adequate cash to run the business
– Cash loses purchasing power during inflationary
times justifying holding little excess cash)
– While cash balances may seem large, cash in- and
out-flows during the year are much larger
– Cash, being the most liquid asset is enticing to
thieves and embezzlers
– Cash earns little to no return (generally the least
productive of all the assets)
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LO 4 - Cash
• The major internal control procedures set up to
safeguard cash include:
– Separate persons receive and disburse cash
– Separate persons handle cash and accessing
accounting records
– Record and deposit cash receipts immediately
– Make disbursements using serially numbered checks,
and require proper authorization by someone other
than the person writing the check
– Reconcile bank accounts monthly by someone who
does not write the checks
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L O 5 - Uncollectible Accounts
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L O 5 - Uncollectible Accounts
• Direct (specific write-off) method
– Assume all receivables are collectable, i.e., do
nothing at year end to modify income or receivables
– When it becomes apparent a receivable ($200) will
not be collected (unable or unwilling), write it off
Bad Debts Expense
200
Accounts Receivable
200
– If sales revenue was recorded last year and write-off
occurred this year, poor “matching”
– Says nothing about the remaining credit revenue and
receivables – will some of them become bad debts?
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L O 5 - Uncollectible Accounts
• Allowance method – Common elements
– Adjusting entry at year-end (* Contra Receivable)
Bad Debts Expense
Allowance for Doubtful Accounts *
4000
4000
– Balance Sheet
Accounts Receivable
$250,000
Less: Allowance for Doubtful Accounts * ($4,000)
Net Accounts Receivable
$246,000
– Write off a $4000 account this or next year
Allowance for Doubtful Accounts *
Accounts Receivable
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L O 5 - Uncollectible Accounts
• Allowance method – By estimating the amount
of uncollectable accounts at year end
Net income and receivables are reduced to reflect
potential uncollectable accounts/lower net income
– Good matching – expense in same year as revenue
– Involves estimating the amounts since do not know
specifically which accounts will become uncollectable
in the future, thus conducive to manipulation, i.e.
“window dressing.”
<<The Allowance method records collection losses based on estimates
developed from the company’s collection experience. It’s the best
way to measure bad debts.>>
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L O 5 - Uncollectible Accounts
Allowance – Percent of Sales (2%) approach
– Always estimates Bad Debts Expense – AUA derived
– No ending balance in AUA before adjusting entry
Cash
Accounts
Receivable
Allowance for
Uncollectable
Accounts (AUA)
1000
600
0
Revenue
Bad Debt
Expense
(BDE)
1000
600
400
20
$1,000 credit sales
$ 600 in cash collections
$ 2% x $1000 credit sales = $20
Bad Debts Expense
20
Allowance for Uncollectable Accounts 20
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20
Balance sheet
Accounts Receivable
Less Allowance for Uncollectable
Net Realizable Value
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$20
$380
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L O 5 - Uncollectible Accounts
Allowance – Percent of Receivables approach
– Always estimates end-balance in AUA - BDE derived
– No ending balance in AUA before adjusting entry
Cash
Accounts
Receivable
1000
600
Allowance for
Uncollectable
Accounts (AUA)
0
Revenue
Bad Debt
Expense
(BDE)
1000
600
400
$1,000 credit sales
$ 600 in cash collections
$ 3% x $400 ending receivables = $12
12
12
Balance sheet
12
Accounts Receivable
Less Allowance for Uncollectable
Bad Debts Expense
12
Net Realizable Value
Allowance for Uncollectable Accounts 12
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$12
$388
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L O 5 - Uncollectible Accounts
• Allowance – Percent of Receivables approach
– Could also use an aging of receivables method to
estimate uncollectable receivables
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L O 5 - Uncollectible Accounts
• Either Allowance Method - Write-off followed
by payment in full
a. Customer has $2 balance in his account (A/R)
b. $2 account is written off
c. Customer pays off account in full
c1. Reinstate the account as it was before write-off
c2. Apply the cash payment to the reinstated account
a
b
c1
c2
Accounts
Receivable
2
2
2
2
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Allowance
Uncollectables
Cash
2
2
2
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LO 6 - Assessing Accounts Receivable
• Cash sales produce cash instantly
• Credit sales generally cause sales to increase
but they also delay cash receipts.
– Major credit cards
• Just a few days before credit card company
transfers cash to the company
• Some treat these receivables as cash equivalents
– Company credit cards – using last year’s data
• How long did it take to collect receivables
• Is that length of time acceptable?
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LO 6 - Assessing Accounts Receivable
• Accounts Receivable Turnover Ratio
Credit Sales
Average Receivables
$1,000,000
$115,000 + $112,000
2
= 8.81
– On average, receivables were created then collected
8.81 times in the past year
–Higher turnovers indicate that a company collects its
receivables faster
–Lower turnover indicates slower collection
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LO 6 - Assessing Accounts Receivable
• Number of days to collect Accounts Receivable
365 days per year
Receivables Turnover Ratio
365
8.81
= 41.4 days
– On average, last year receivables were collected 41.4
days after being created
– Higher # days puts more pressure on firm to find
alternative cash sources while awaiting collection
– Lower # days – less pressure
– Varies by company and industries
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LO 7 - Internal Control
• Internal control - a system of checks and
balances that ensure company actions are
proper and approved by management
– Administrative controls spell out responsibilities for
• Reporting
• Budgeting
• Performance evaluation
• Granting credit to customers
• Protecting assets
• Etc.
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LO 7 - Internal Control
– Accounting controls
• protects company assets and ensures that
management maintains accurate financial
records.
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LO 7 - Internal Control
• Internal controls - Accounting controls
–
–
–
–
–
Transactions are what management intended
Recording authorized transactions accurately
Safeguarding assets - prevent unauthorized access
Reconciling records to other records or observations
Valuation - amounts are reviewed for impairment and
write-downs
– Operational efficiency - least amount of waste, errors,
fraud
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LO 7 - Internal Control
• Good internal control systems have these things
in common:
–
–
–
–
–
–
–
–
–
Reliable personnel with clear responsibilities
Separation of duties makes it harder to collude
Adequate documentation (source documents)
Proper authorization for normal/abnormal transactions
Well-documented policies and procedures
Physical safeguards over items of value
Vacations and rotation of duties
Independent review of all systems
Cost-benefit considerations should apply
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LO 7 - Internal Control
• SEC requires publically traded companies to
have an Audit Committee
– Composed of independent members
– Responsible for companies’ financial affairs
• Sarbanes-Oxley Act – 2002 - Requires
management to
– Assess and report on its internal controls
– Requires independent auditors to review
management’s assessment and offer their
assessment of that effort
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LO 8 – Bank Reconciliation
• Purpose is to explain why the bank statement
differs from the account owner’s records
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LO 8 Bank Reconciliation
Complete
Depositor
Bank statement
11,000
11,000
11,000
Deposit
4,000
4,000
4,000
Deposit
6,000
6,000
6,000
Deposit
7,000
7,000
Check
(2,000)
(2,000)
(2,000)
Check
(3,000)
(3,000)
(3,000)
Check
(5,000)
(5,000)
(5,000)
Check
(10,000)
(10,000)
Beginning Balance
Fee
Ending Balance
Adjustment
(20)
7,980
(20)
8,000
10,980
(20)
7,000
Adjustment
Final Balance
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(10,000)
7,980
7,980
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