Chapter 6

Accounting for Sales

Learning Objectives
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.
Estimate and interpret uncollectible accounts and receivable
balances.
Assess the level of accounts receivable.
Develop and explain internal control procedures.
Preparing a Bank Reconciliation Statement
Recognition of Sales Revenue
The timing of revenue recognition is critical to the
measurement of net income. Why???

1. Revenue is part of the calculation of net income.

Net income = Revenue - Expenses

2. 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.
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.
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.
Long Term Contracts
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 1/4 of the work is completed in the 1st

year, of the revenue should be recognized in 1st
year..but what about the expenses?

This is called percentage of completion method.

Measurement of Sales Revenue
Revenue is measured in terms of the cash
equivalent value of the asset received.

Journal entries to record sales:

Cash 10,000
Sales revenue 10,000

OR
Accounts receivable 10,000
Sales revenue 10,000
Types of Credit Sales/ Sales on Account
The period for which the right to receive the
price is deferred is called the credit period.

Credit sales can take 3 forms:

a. Installment Sales
b. Hire Purchase Sales
c. Sale or Return Back
Measuring the amount of sales: Merchandise
returns and 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 called purchase returns from the
customers perspective.
Merchandise Returns
and 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 called purchase allowances from the
customers perspective.
Merchandise Returns
and 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.
Merchandise Returns
and 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
Merchandise Returns
and 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

=========
Discounts
Discounts on sales also affect the
amount reported as sales.

Two major types of discounts:

1. Trade discounts
2. Cash discounts
Trade Discount
Trade discounts - reductions to the gross selling
price for a particular class of customers to arrive
at the actual selling 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
trade discount.
Cash Discounts
Cash discounts - reductions of invoice prices awarded for
prompt payments.

-ADVANTAGES
Encourage prompt payment and reduce manufacturers or
sellers need for cash
Reduces the risk of bad debts (nonpayment)
Terms of Cash discounts can be quoted as:
1. n/30
2. 1/5, n/30
3. 15 E.O.M
Should purchasers take cash
discount???????
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
 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 Revenue 10,000
Accounting for
Net Sales Revenue
Cash discounts and sales returns and
allowances are recorded as deductions from
gross sales.

Gross sales $20,000

Less: Sales returns and allowances $200
Cash discounts on sales 550 750
Net sales $19,250
==================
Accounting for
Net 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.
Warranty
The sale of good or service may entail a present obligation
to service the product or provide after sales service.

The warranty expenditure may not occur in the year of sale.

Hence to match this expense, an estimate is made and

accounted for in Income Statement:

Warranty Sales Expense 1000

Provision for Warranty Expense 1000
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
 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.
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.
Credit Sales and Accounts 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.
 Uncollectible Accounts/ Bad Debts
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.
When and how to grant credit?????

Decision depends on cost benefit trade off.

E.g., 5% of credit sales are Bad debts, administrative

cost of credit department is Rs.5,000 per year and
Rs.20,000 of credit sales take place( earnings of Rs.8,000
before credit cost).
None of the credit sale can take place without granting
credit.

Total credit cost =Rs.5,000+ 5% of 20,000= Rs.6,000< Rs.8,000

Measurement of
Uncollectible Accounts

2 basic ways to record uncollectibles:

1. Specific write-off method - wait to see which

receivables will not be paid and write them off at
that time
2. Allowance method - make estimates
of the portion of accounts receivable
that will not be collected
1. 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
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
If amounts of bad debts are small (immaterial), no
great error in measurement of income occurs.
 2. Allowance Method
The allowance method estimates the amount of
uncollectible accounts to be matched to the
related revenue based on historical experience.

It allows accountants to recognize bad debts during

the proper period, before specific uncollectible
accounts are identified in a subsequent period.
Allowance Method
The allowance method has two basic elements:

a. An estimate of the amounts that will ultimately be

uncollectible

b. 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.
Allowance Method
Allowance for Uncollectible Accounts can
alternatively be also called as:

- Allowance for Bad Debts

- Reserve for Bad Debts
- Reserve for Doubtful debt
- Provision for Bad Debt
- Allowance for Uncollectible Account
 Allowance Method: Journal Entries
1/1 Accounts Receivable 100
Sales 100

31/1 Bad Debt Expense 8

Allowance for Uncollectible Accounts 8

28/2 Allowance for Uncollectible Accounts 8

Accounts Receivable (A) 3
Accounts Receivable (C) 5
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

=========
Applying Allowance method:
a. Percentage of Sales

b. Percentage of Accounts Receivables

c. Ageing of accounts Receivables

I. Applying the Allowance Method Using
% 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 credit sales.
Applying the Allowance Method Using a
% 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?
Applying the Allowance Method Using a
% of Sales
The entry to record the sales:
Accounts receivable 150,000
Sales Revenue 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
II. Applying the Allowance Method Using a %
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 uncollectible to accounts
receivable
Applying the Allowance Method Using a % 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.
 Applying the Allowance Method Using a
% of Accounts Receivable
Calculating the allowance under the percentage of
receivables method:

1. Divide average bad debts by average ending balance of Accounts

Receivable to calculate the historical average uncollectible
percentage.
2. 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.
3. Prepare an adjusting entry to adjust the Allowance account to
the amount determined in step 2.
Applying the Allowance Method Using a
% of Accounts Receivable
Journal Entry:
Suppose the desired balance in Allowance for
uncollectible accounts is Rs.2000. and the Allowance
for uncollectible accounts has a credit balance of
Rs.400
Hence the journal entry:

Bad Debt Expense 1,600

Allowance for uncollectible accounts 1,600
III. 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.
 Applying the Allowance Method Using the
Aging of Accounts Receivable
Accounts receivable aging schedule:

1-30 days 31-90 days Over 90 days

Accounts
receivable $70,000 $30,000 $2,000
Percentage 1% 2% 90%

Total $ 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.
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.
Assessing the Level of
Accounts Receivable
Management should monitor the ability of the
company to control accounts receivable.
They often use accounts receivable turnover for
measuring that ability.

Credit
sales
A/R
turnover
Average
accounts
receiv
Assessing the Level of
Accounts Receivable
Given total credit sales for the year = Rs.1,20,000,
Average Accounts receivables during the year =
Rs.10,000

Hence Accounts Receivable turnover

= 1,20,000/ 10,000= 12

This implies that receivables are collected 12 times in a

year, i.e., after 1 month.
Assessing the Level of
Accounts 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.
Average Collection Period/ Days to
collect accounts receivable
Days to accounts receivable (average collection
period) - an indication of how long it takes to
collect money after a sale is made

365
days
Days
to
collect
A/R
A/R
turnov