The Revenue/ Receivable/Cash Cycle

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The Revenue/The Revenue/ Receivable/CasReceivable/Cas

h Cycleh Cycle

chapterchapter 7

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

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1. Explain the normal operating cycle of a business.

2. Prepare journal entries to record sales revenue, including the accounting for bad debts and warranties for service or replacement.

3. Analyze accounts receivable to measure how efficiently a firm is using this operating asset.

Learning Objectives

ContinuedContinuedContinuedContinued

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4. Discuss the composition, management, and control of cash, including the use of a bank reconciliation.

5. Recognize appropriate disclosures for presenting sales and receivables in the financial statements.

Learning Objectives


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Learning Objectives

6. Explain how receivables may be used as a source of cash through secured borrowing or sale.

7. Describe proper accounting and valuation of notes receivable

8. Understand the impact of uncollectible accounts on the statement of cash flows.

EXPANDED LEARNING OBEJCTIVES:

5Revenue/Receivables/Cash Timeline

DELIVER a product or

service

COLLECT cash

(includes discounts)

RETURNSRETURNS

ACCEPT returned products

STRUGGLEwith

nonpaying customers

PROVIDEcontinuing

services

6The Operating Cycle of a Business

CashCash

AccountsReceivables

Inventory

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Assume that Acme Manufacturing sold merchandise to Harper Company on account.

The Operating Cycle of a Business

When the collection takes place: Cash 1,000

Accounts Receivable 1,000Payment received on account.

When the inventory is sold on account:Accounts Receivable 1,000

Sales 1,000 Sold merchandise to HarperCompany on account.

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• Trade receivables: Receivables arising from normal operating activities.

• Notes receivable: Trade receivables evidenced by a formal written promise to pay.

• Nontrade receivables: All receivables arising from activities other than normal operations.

Receivables are all claims against other entities. They are usually settled in cash.

The Operating Cycle of a Business

9The Operating Cycle of a Business

Nontrade receivables arise from a variety of transactions, such as—

(1) The sale of securities or property other than inventory

(2) Deposits to guarantee contract performance or expense payments

(3) Claims for rebates and tax refunds

(4) Dividends and interest receivable

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Accounting for Sales Revenues

A trade discount may

vary by customer,

depending on the volume of

business or size or order.

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A cash (sales) discount is offered to

customers to encourage

prompt payment of bills.

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Assume on March 15, $1,000 of merchandise is sold on account. The terms of the agreement are 2/10, n/30. The firm uses the gross method for record sales on account.


Entry on date of sale:Accounts Receivable 1,000

Sales 1,000

Gross MethodGross MethodGross MethodGross Method

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If paid within the discount period:Cash 980Sales Discounts 20

Accounts Receivable 1,000If not paid within the discount period:

Cash 1,000Accounts Receivable 1,000

Gross MethodGross MethodGross MethodGross Method

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This time, assume that all sales on account are recording using the net method. Again, the terms of the agreement are 2/10, n/30.


At the point of sale (March 15):Accounts Receivable 980

Sales 980

Net MethodNet MethodNet MethodNet Method

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If paid within the discount period:Cash 980

Accounts Receivable 980

If not paid within the discount period:Cash 1,000

Sales Discounts Not Taken 20Accounts Receivable 980

Net MethodNet MethodNet MethodNet Method

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Sales Returns and Allowances

Red sweaters costing $600 are sold for $1,000. When delivered, it was determined that the sweaters should have been green. The customer agrees to keep the merchandise for a $200 reduction in price.

Sales entry:Accounts Receivable 1,000 Sales 1,000

Cost of Goods Sold 600 Inventory 600

Sales allowance entry:Sales Returns and Allowances 200 Accounts Receivable 200

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Sales Returns and Allowances

Sales return entries:Sales Returns and Allowances 1,000 Accounts Receivable 1,000

Inventory 600Cost of Goods Sold 600

Suppose that instead of the allowance, the customer elects to return the sweaters.

18Sales Discounts and Sales Returns and Allowances

Income Statement

Sales $15,000

Less: Sales discounts $250

Sales returns and allowances 400 (650) Net sales $14,350

Income Statement

Sales $15,000

Less: Sales discounts $250

Sales returns and allowances 400 (650) Net sales $14,350

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Accounting for Bad Debts

Occur when customers do not pay for items or services purchased on credit.

Bad debts are uncollectible accounts receivable.

Bad Debt Expense is reported as a selling or general and administrative expense.

Accounts receivable are reported on the balance sheet at their net realizable value.

20Accounting for Uncollectible Receivables (Direct Method)

Write Off: Bad Debts Expense 400

Accounts Receivable 400 To write off an

uncollectible account.

This entry is made when the account has been determined uncollectible. The direct

write-off method is used by small businesses because of its simplicity.

This entry is made when the account has been determined uncollectible. The direct

write-off method is used by small businesses because of its simplicity.

Since this determination was made after the period in which the sale takes place, the

matching principle is violated. This method is not accepted under GAAP.

Since this determination was made after the period in which the sale takes place, the

matching principle is violated. This method is not accepted under GAAP.

21Accounting for Uncollectible Receivables (Allowance Method)

In this method, an estimate of the total uncollectible accounts is made at the end of the period, and an expense is recognized.

Bad Debts Expense 2,000 Allowance for Bad Debts 2,000 To record estimated

uncollectible accounts.

GAAP requires the use of the allowance method.

GAAP requires the use of the allowance method.

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When the account is then determined to be uncollectible, the write-off entry is:

Accounting for Uncollectible Receivables (Allowance Method)

Allowance for Bad Debts 400 Accounts Receivable 400 To write off an uncollectible

account.

Note: Bad Debt Expense is not debited.Note: Bad Debt Expense is not debited.


What happens if the written off receivable is later collected? Assume that the customer from Slide 22 pays the $400 written-off debt a month after the write-off.Accounts Receivable 400

Allowance for Bad Debts 400 To reverse the entry made to

write off the account.

Note: Before the payment entry, the debt must be restored.

Note: Before the payment entry, the debt must be restored.


Cash 400 Accounts Receivable 400 To record collection of the

account.

What happens if the written off receivable is later collected? Assume that the customer from Slide 22 pays the $400 written-off debt a month after the write-off.


(1) Allowance for Doubtful Accounts is a contra-asset account which is subtracted from Accounts Receivable on the balance sheet.

2) The actual write-off entry for $400 does not reduce net receivables, as shown below:

Accts. Receivable $100,000 Accts. Receivable $99,600Less Allowance for Less Allowance for Doubtful Accounts 2,000 Doubtful Accounts 1,600 Net Receivables $ 98,000 Net Receivables $98,000

26Estimating the Allowance for Uncollectible Accounts

Percentage of credit sales

Percentage of accounts receivable

Aging receivables

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Example: Doubtful Accounts Expense

The ABC company had credit sales of $100,000. The current accounts

receivable balance is $30,500. The allowance for doubtful accounts balance is $350. Historically, 2 percent of the credit

sales are not collected.




Percentage of Credit Sales

What is the entry to record estimated bad debts?What is the entry to record estimated bad debts?

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Example: Doubtful Accounts ExpensePercentage of Credit Sales

Bad Debt Expense 2,000 Allowance for Doubtful Accounts 2,000

To record estimated uncollectible accounts for the year.







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Percentage of Credit Sales

Allowance for Doubtful Accounts

Balance 350Adjusting 2,000Dec. 31, Bal. 2,350

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Example: Doubtful Accounts Expense

The XYZ company had credit sales of $693,000. The current accounts

receivable balance is $50,000. The allowance account balance is $600. Historically, 3 percent of accounts

receivable are not collectible.

The XYZ company had credit sales of $693,000. The current accounts

receivable balance is $50,000. The allowance account balance is $600. Historically, 3 percent of accounts

receivable are not collectible.

Percentage of Accounts Receivable

What is the required adjusting entry to record estimated bad debts?

What is the required adjusting entry to record estimated bad debts?

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($50,000 x .03) – $600


Bad Debt Expense 900 Allowance for Doubtful Accounts 900


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Balance 600Adjusting 900Dec. 31, Bal. 1,500

That’s the desired ending

balance.

That’s the desired ending

balance.


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Adjusting 1,850Dec. 31, Bal. 1,500

Balance 350What if the allowance

account had a debit balance of $350?

What if the allowance account had a debit balance of $350?

I see! The ending balance must be “forced” to be the

calculated amount.

I see! The ending balance must be “forced” to be the

calculated amount.


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Aging Receivables


receivable balance is $47,550. The allowance for doubtful accounts balance is

$620. The firm ages the accounts to determine the expected uncollectibles.


receivable balance is $47,550. The allowance for doubtful accounts balance is

$620. The firm ages the accounts to determine the expected uncollectibles.

Remember, because receivables are Remember, because receivables are involved, the amount derived from involved, the amount derived from

aging provides the desired balance of aging provides the desired balance of the allowance account.the allowance account.

Remember, because receivables are Remember, because receivables are involved, the amount derived from involved, the amount derived from

aging provides the desired balance of aging provides the desired balance of the allowance account.the allowance account.

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Aging Receivables

Uncollectible EstimatedAccounts Amount of

Classification Experience Uncollectible(in days) Balance Percentage Accounts

Not yet due $40,000 2% $ 8001-30 past due 3,000 5 15031-60 past due 1,200 10 12061-90 past due 650 20 13091-180 past due 500 30 150

181-365 past due 800 50 400

+365 past due 1,400 1,120

$47,550 $2,870

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Aging Receivables

Bad Debt Expense 2,250 Allowance for Doubtful Accounts 2,250


Required balance $2,870

Current balance (620)

Adjusting entry $2,250

Required balance $2,870

Current balance (620)

Adjusting entry $2,250

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Balance 620Adjusting 2,250Dec. 31, Bal. 2,870

Aging Receivables

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Accounting for Warranties

MJW Video & Sound sells MJW Video & Sound sells compact stereo systems with a compact stereo systems with a

two-year warranty. Past two-year warranty. Past experience indicates that 10% experience indicates that 10%

of all systems will need of all systems will need repairs in the first year and repairs in the first year and 20% will need repairs in the 20% will need repairs in the second year. The average second year. The average

repair cost is $50 per system.repair cost is $50 per system.

MJW Video & Sound sells MJW Video & Sound sells compact stereo systems with a compact stereo systems with a

two-year warranty. Past two-year warranty. Past experience indicates that 10% experience indicates that 10%

of all systems will need of all systems will need repairs in the first year and repairs in the first year and 20% will need repairs in the 20% will need repairs in the second year. The average second year. The average

repair cost is $50 per system.repair cost is $50 per system.

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The number of systems The number of systems sold in 2004 and 2005 was sold in 2004 and 2005 was

5,000 and 6,000, 5,000 and 6,000, respectively. Actual repair respectively. Actual repair costs were $12,500 in 2004 costs were $12,500 in 2004

and $55,000 in 2005.and $55,000 in 2005.

The number of systems The number of systems sold in 2004 and 2005 was sold in 2004 and 2005 was

5,000 and 6,000, 5,000 and 6,000, respectively. Actual repair respectively. Actual repair costs were $12,500 in 2004 costs were $12,500 in 2004

and $55,000 in 2005.and $55,000 in 2005.


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Warranty Expense 75,000 Estimated Liability Under Warranties 75,000

To record estimated warranty expense based on systems sold.

To record estimated warranty expense:


2004200420042004

(5,000 x 0.30) x $50

(5,000 x 0.30) x $50

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Estimated Liability Under Warranties12,500 Cash 12,500

To record cost of actual repairwork in 2004.

To record the actual cost of doing repairs:


2004200420042004

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Warranty Expense 90,000 Estimated Liability Under Warranties 90,000

To record estimated warranty expense based on systems sold.

To record estimated warranty expense:


2005200520052005

(6000 x 0.30) x $50

(6000 x 0.30) x $50

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Monitoring Accounts Receivable

Average Collection Period: The average number of days that lapse between the time that a sale is made and the time that cash is collected. It is calculated by dividing the average daily sales by the average receivables outstanding.

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WS Corporation had average receivables of $354,250 and average daily sales of $1,650,000. The average collection period can be calculated as follows:

Average Collection Period:

Average receivable $354,250 Average daily sales ($1,650,000/365)

Average collection period = 78 days


=

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Accounts receivable turnover is determined by dividing net sales by the average trade accounts receivable outstanding during the year. For WS Corporation, the 2005 turnover is:

Accounts Receivable Turnover:

Net sales $1,650,000 Average net receivables $354.250

Receivables turnover for year = 4.7 times


=

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Cash Management and Control

o Undeposited Coins and currency (change funds)

o Demand depositso Petty cash fundso Cashier’s checkso Personal checks

What items are classified as “cash”?What items are classified as “cash”?What items are classified as “cash”?What items are classified as “cash”?

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Composition of Cash

Many companies report investments in very short-

term, interest-earning securities as cash equivalents

in the balance sheet.

Many companies report investments in very short-

term, interest-earning securities as cash equivalents

in the balance sheet.

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Composition of Cash

A credit balance in the cash account is known as a cash

overdraft and should be reported as a current liability.

A credit balance in the cash account is known as a cash

overdraft and should be reported as a current liability.

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Management and Control of Cash

1) Specifically assigned responsibilities for handling cash receipts

2) Separation of handling and recording receipts

3) Daily deposits of all cash received

4) Voucher system to control cash payments

5) Internal audits at irregular intervals

6) Double record of cash—bank and books, with reconciliation performed by someone outside the accounting function

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Bank Reconciliation

A comparison of the bank balance with the book’s balance by means of a

summary is a bank reconciliation.

A comparison of the bank balance with the book’s balance by means of a

summary is a bank reconciliation.

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Bank Reconciliation

Deposits in transit. Outstanding checks. Bank debits for items such as

service charges and NSF checks. Bank credits for items such as the

bank collecting a note for the depositor.

Accounting errors.

Common causes of differences:

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Balance per books............. $2,952.49 Additions to bank balance:Interest earned...............…. 98.50 Error by depositor.........…. 18.00 Total............................ $3,068.99

Deductions from book balance:Service charge.............. $ ( 3.16 ) NSF check.................... (118.94 )Corrected book bal. $2,946.89

Balance per bank.... $2,979.72 Additions to bank balance:Deposits in transit.... 658.50Error by bank 12.50 Total................... $3,650.72

Deductions from bank balance:Outstanding checks: Listed individually (703.83)Corrected bank bal. $2,946.89

Svendsen, Inc.Bank ReconciliationNovember 30, 2005

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All adjustments made to the Balance per Books need to be recorded:

Cash 98.50 Interest Revenue 98.50

To record interest earned.

Cash 18.00Advertising Expense 18.00

To record correction for check inpayment of advertising recordedas $64 instead of the actual amount,$46.

Bank Reconciliation


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Accounts Receivable 118.94Miscellaneous General Expense 3.16 Cash 122.10

To record customer’s uncollectible check and bankcharges for November.

Bank Reconciliation

Note:Note: When the item is a plus under When the item is a plus under “Balance per books,” “Balance per books,” CashCash is is debited. When it is a minus, debited. When it is a minus, Cash Cash is credited.is credited.

Note:Note: When the item is a plus under When the item is a plus under “Balance per books,” “Balance per books,” CashCash is is debited. When it is a minus, debited. When it is a minus, Cash Cash is credited.is credited.

55Presentation of Sales and Receivables in the Financial Statements

Receivables qualifying as current items may be grouped for presentation on the balance sheet in the following classes:

1) Notes receivable—trade debtors

2) Accounts receivable—trade debtors

3) Other receivables

56Accounts Receivable as aSource of Cash

• As a sale (either with or without recourse.

• As a secured borrowing.

• As a sale (either with or without recourse.

• As a secured borrowing.

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1. The transferred assets have been isolated from the transferor and its creditors cannot access the assets.

2. The transferee has the right to pledge or exchange the transferred assets.

3. The transferor does not maintain effective control over the assets through either (a) an agreement to repurchase them before their maturity or (b) the ability to cause the transferee to return specific assets.

Accounts Receivable as aSource of Cash

SFAS 140 specified conditions that must be met if a transfer of receivables is to be accounted for as a sale:

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Sal

e of

Acc

ount

s R

ecei

vabl

e

Accounts Receivable Established

Goods and Services Provided

Factoring Accounts Receivable

CustomersCustomers CompanyCompany

FactorFactorFactorFactor

Cas

h fr

om F

acto

ring

A

ccou

nts

Rec

eiva

ble

Pay

men

t of

Acc

ount

s R

ecei

vabl

e

59Accounting for Factoring Accounts Receivable

• Close sold receivables• Close accompanying Allowance for Bad

Debts• Expense any factoring charges• Establish a receivable for any sales price

withheld by the factor• Debit Cash for net proceeds of the sale• Recognize a gain or loss from factoring

60Example: FactoringAccounts Receivable

Assume:Factored Receivables $10,000Allowance for Bad Debts 300Factor Withholding 5

%Sales Price $ 8,500

Let’s journalize this Let’s journalize this transactiontransaction

Let’s journalize this Let’s journalize this transactiontransaction

61Example: FactoringAccounts Receivable

Cash 8,075Receivable from Factor 425Allowance for Bad Debts 300Loss from Factoring Receivables 1,200

Accounts Receivable 10,000Computations

Cash: $8,500 – 425 = $8,075Factor Receivable: $8,500 x 5% = $425Factoring Loss: ($10,000 – 300) – $8,500 = $1,200

62Sale of Receivableswith Recourse

Sale of receivables with recourse is different from factoring, since factoring

is normally sold on a nonrecourse basis.

Sale of receivables with recourse is different from factoring, since factoring

is normally sold on a nonrecourse basis.


When receivables are sold with recourse, a purchaser of receivables retains the right to collect from the seller when the seller’s customers fail to make payments when due.

When receivables are sold with recourse, a purchaser of receivables retains the right to collect from the seller when the seller’s customers fail to make payments when due.


A firm raises funds by selling $5,000 of A firm raises funds by selling $5,000 of its receivables for $4,300. The its receivables for $4,300. The

receivables have a net realizable value of receivables have a net realizable value of $4,700. The receivables are sold $4,700. The receivables are sold with with recourserecourse and the seller estimates (as and the seller estimates (as required by required by SFAS No. 140) SFAS No. 140) that the that the

recourse obligation has a fair value of recourse obligation has a fair value of $250. Assume in this illustration that the $250. Assume in this illustration that the factor does not withhold a percentage of factor does not withhold a percentage of

the purchase price.the purchase price.

A firm raises funds by selling $5,000 of A firm raises funds by selling $5,000 of its receivables for $4,300. The its receivables for $4,300. The

receivables have a net realizable value of receivables have a net realizable value of $4,700. The receivables are sold $4,700. The receivables are sold with with recourserecourse and the seller estimates (as and the seller estimates (as required by required by SFAS No. 140) SFAS No. 140) that the that the

recourse obligation has a fair value of recourse obligation has a fair value of $250. Assume in this illustration that the $250. Assume in this illustration that the factor does not withhold a percentage of factor does not withhold a percentage of

the purchase price.the purchase price.


Cash received $4,300 Estimated value of recourse obligation (250)Net proceeds $4,050

Book value of the receivables $4,700 Net proceeds to be received (4,050)Loss on sale of receivables $ 650


The entry to record the sale:

Cash 4,300Allowance for Bad Debts 300Loss on Sale of Receivables 650

Accounts Receivable 5,000Recourse Obligation 250

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Secured Borrowing

• Assignment of Accounts Receivable – There are no special accounting problems

involved.– Simply record the loan.

• Specific Assignment:– Specified accounts receivable pledged.– Accounts receivable reclassified on balance

sheet.– Footnote disclosure of loan provisions required.

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Notes Receivable

A promissory note is an unconditional written

promise to pay a certain sum of money at a

specified time.

A promissory note is an unconditional written

promise to pay a certain sum of money at a

specified time.

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Notes Receivable

• Initially recorded at present value.

• Two types:– Interest-bearing: Interest rate is stated on

the note.

– Noninterest-bearing: Interest is implied in the face amount of the note.

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Example: Notes Receivable

Assume:Note Receivable $1,000Interest Rate 10%Time to Maturity 2 years

Journalize this note as:1. An interest-bearing note.2. A noninterest-bearing note.

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Example: Notes Receivable

Interest-Bearing Note:Notes Receivable 1,000

Sales 1,000

Noninterest-Bearing Note:Notes Receivable 1,210

Sales 1,000

Discount on Notes Receivable 210

(PV of $1,000 @ 10% for

2 years = $1,210)

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• Discount Rate: The interest rate charged by the financial institution for buying a note receivable.

• Discount Period: The time between the date a note is sold to a financial institution and its maturity date.

Discounting Notes Receivables

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Formulas for Discounting Notes

Interest = Face amount x Interest

rate x Interest period

Maturity value = Face amount + Interest

Discount = Maturity value x Discount

period x Discount rate

Proceeds = Maturity value - Discount

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The EndThe End

chapter chapter 77

The Revenue/ Receivable/Cash Cycle

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