1 chapter 13 revenues and cash collections. 2 chapter overview why is managing and reporting...

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CHAPTER 13

REVENUES AND

CASH COLLECTIONS

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Chapter Overview

Why is managing and reporting liquidity important?

Why might a company offer credit sales, and what management policies should exist for accounts receivable?

How does a company report credit sales and net sales?

How does a company determine the amount of its bad debt expense, and how does it report the related amounts on its financial statements?

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What is an exchange rate, and how does an exchange gain (loss) arise from a credit sale made to a company in another country?

How does a company account for cash collected prior to a sale?

What are the important characteristics of a note receivable, and how is interest computed?

What are cash equivalents and what items does a company include in its cash and cash equivalents?

Chapter Overview

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Liquidity management refers to a company’s policies and activities that control its liquidity position.

It refers to how a company manages cash, receivables, and current liabilities.

Liquidity management is important to both managers and external users, in understanding how a company is maximizing the use of its limited resources.

Liquidity Management

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Current Assets and Current Liabilities

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Company policies and activities affect how transactions and events happen (and therefore how account balances are affected), and

Company policies and activities are not carried out in isolation, but rather occur within the larger business and economic environment.

Key to successful liquidity management is the ability to know how changes in accounts affect a company financial statements.

Evaluating Account Balances

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Can you explain how changes in accounts receivable affect the balance sheet, the income statement, and the statement of cash flows?


Beginning Accounts

Receivable Balance

+

Credit Sales

during the year

-

Cash Collections during the

year

=

Ending Accounts Receivable

Balance

Beginning Balance

Sheet

Income Statement

Cash Flow Statement: Operating

Activities

Ending Balance

Sheet

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The Scope of Liquidity Management

Exhibit 13-3

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Accounts Receivable Management

Establishing policies and procedures to control and

approve creditworthy customers; obtaining letters of

credit or export insurance where appropriate.

Establishing policies and procedures to ensure revenues

are recorded when earned; recording and controlling sales

returns and allowances.

Sending monthly statements to customers; prompt follow up

on outstanding accounts; monitoring balances for

slowed collections.

Under GAAP, accounts receivable is presented at net

realizable value – what the company expects to ultimately

collect from customers.

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If Bayside Candle Company ordered 300 boxes of chocolate from Unlimited Decadence for $1,350 ($4.50 per box, costing Unlimited Decadence $2.50 each), how would this be recorded?

Recording Credit Sales and Returns

Assets = Liabilities + Stockholders’ Equity

+$1,350 (Accounts receivable)

-$750 (Inventory)

+$1,350 (Sales Revenue)

-$750 (+Cost of goods sold)

The sales event

The inventory event

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What happens when Bayside is granted a $300 allowance on its sales price because the candy was not packaged as requested?

This is a sales allowance and reduces both the accounts receivable and the sales revenue previously recognized on the sale.



-$300 (Accounts receivable)

-$300 (Sales

Revenue)

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What happens when Bayside returns 100 boxes of chocolate rather than asking for an allowance?

This is a sales return; it reduces the accounts receivable and the sales revenue previously recognized. In addition, inventory and cost of goods sold must be adjusted to reflect the returned merchandise.



-$450 (Accounts receivable)

+$250 (Inventory)

-$450 (Sales Revenue)

+$250 (-Cost of goods sold)

Adjust inventory

Adjust previous sales

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GAAP requires that accounts receivable be reported at net realizable value (NRV).

NRV means that an allowance for bad debts must be provided against the receivables to reflect amounts estimated to be uncollectible.

Bad debt expense is the estimated cost, for the accounting period, of the eventual noncollection of accounts receivable.

Measuring and Reporting Receivables

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When accounts receivable is reported on the balance sheet, it is net of an allowance for bad debts.

As the allowance for bad debt increases, the net realizable value of accounts receivable decreases. For this reason, the allowance account is called a contra-account:


Accounts receivable 6,000,000$ Allowance for bad debts (11,000)$ Accounts receivable (net) 5,989,000$

Net realizable value of accounts receivable

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The matching principle provides the underlying reason why bad debts are estimated each period, attempting to match the cost of producing revenues with the revenues reported in the period.

Bad debt expense is the estimated cost, for the accounting period, of the eventual noncollection of accounts receivable.

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Recording Bad Debt Expense

If Unlimited Decadence estimates that its bad debt expense for 2004 is $134,000, how would this be recorded?

Assets Stockholders' EquityAccounts Allowance Net Income

Receivable for B.D. Revenue - Expenses$6,000,000 $11,000

$134,000 - 134,000$ $6,000,000 $145,000

Bad debt expense and the allowance

for bad debts increase for $134,000

Net accounts receivable 1/1/04 = $5,989,000

Net accounts receivable at 12/31/04 = $5,866,000

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Bad debt expense is estimated every period, but accounts are not actually written off until they are determined uncollectible.

Accounts receivable is reduced for the bad account. Since the allowance for bad debts is the reserve against future uncollectible accounts, bad accounts are written off against it.

Before Afterwrite-off write-off

Accounts receivable (assumed) 6,000,000$ 5,992,000$ Less: Allowance for bad debts (145,000)$ (137,000)$ Net accounts receivable 5,855,000$ 5,855,000$

If an $8,000 account is

written off, it has no affect on the net amount of

accounts receivable

Writing Off Bad Accounts

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Under GAAP, there are two methods of estimating bad debts during an accounting period and reporting accounts receivable.

The aging method estimates bad debts based on the age of accounts receivable. Since it focuses on the balance sheet, it is often called the “balance sheet approach.”

The percentage of sales method estimates bad debts based on a percentage of net credit sales. Since it focuses on the income statement, it is often called the “income statement approach.”

Reporting Accounts Receivable

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Aging Method: Step 1

The first step in the aging method is to categorize the individual customer accounts receivable into age groups based on the length of time they have been outstanding.

Age Group Amount

Not yet past due 3,000,000$ 1-30 days past due 1,500,000$ 31-60 days past due 900,000$ 61-120 days past due 400,000$ 121+ days past due 200,000$ Total 6,000,000$

When Unlimited Decadence

completes its aging schedule, the $6

million in accounts receivable is

broken down by time outstanding.

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Aging Method: Step 2

The second step in the aging method is to estimate the portion of each amount that is not collectible. This is usually done by applying percentages based on past experiences in collecting receivables or industry estimates.

Estimated EstimatedUncollectible Uncollectible

Age Group Amount % AmountNot yet past due 3,000,000$ X 0.1% = 3,000$

1-30 days past due 1,500,000$ X 1.0% = 15,000$

31-60 days past due 900,000$ X 3.0% = 27,000$

61-120 days past due 400,000$ X 10.0% = 40,000$

121+ days past due 200,000$ X 30.0% = 60,000$

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Aging Method: Step 3 The third step in the aging method is to total the

uncollectible amounts to calculate the required ending balance in the Allowance for Bad Debts account.

Estimated EstimatedUncollectible Uncollectible

Age Group Amount % AmountNot yet past due 3,000,000$ X 0.1% = 3,000$

1-30 days past due 1,500,000$ X 1.0% = 15,000$

31-60 days past due 900,000$ X 3.0% = 27,000$

61-120 days past due 400,000$ X 10.0% = 40,000$

121+ days past due 200,000$ X 30.0% = 60,000$

Total 6,000,000$ 145,000$

Unlimited Decadence estimates that

$145,000 of its $6 million in accounts

receivable will ultimately be

uncollectible. This is the required ending

balance in the allowance account.

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Aging Method: Step 4 The last step is to record the bad debt expense

for the year, an adjustment which will bring the Allowance for Bad Debts account to the amount calculated on the aging schedule.

Assets Stockholders' EquityAccounts Allowance Net Income

Receivable for B.D. Revenue - Expenses$6,000,000 $11,000

$134,000 - 134,000$ $6,000,000 $145,000

Bad debt expense and the allowance

for bad debts increase for $134,000

Balance before adjustment 12/31/04 Net accounts receivable = $5,989,000

12/31/04 balance after adjustment = $5,866,000

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Percentage of Sales Method

In the percentage of sales method, Unlimited Decadence simply estimates some portion of its net credit sales as uncollectible, based on prior history or industry data.

Net credit sales during 2004 72,000,000$ Percentage estimated as uncollectible 0.2%Bad debt expense for 2004 144,000$

This amount is added to bad debt expense and to the allowance account for the period

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Foreign Exchange As U.S companies expand abroad, they frequently become involved in

transactions with customers and suppliers in other countries.

When non-U.S. dollar currency transaction arise, a company must account for the event using exchange rates to convert into their functional currency.

An exchange rate measures the value of one currency in terms of another currency.

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Foreign Exchange Rates

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Foreign Exchange Gains/Losses

Exchange gains or loss result from change in the exchange rate between the date that a company records an event and the date of actual collection.

An exchange gain occurs when the exchange rate increases between the date a receivable is recorded and the date of collection.

An exchange loss occurs when the exchange rate decreases between the date a receivable is recorded and the date of collection.

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Recording Foreign Exchange Events

If Unlimited Decadence sells candy to the Hermann Company, a Germany company, on credit for an agreed price of 300,000 Euros when the exchange rate is $0.92 (1 Euro = $0.92), how would the transaction be recorded?

300,000 Euros X 0.92 = $276,000, the amount of the transaction recorded by Unlimited Decadence.


+$276,000(Accounts receivable)

+$276,000 (Sales

Revenue)

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Recording Foreign Exchange Events

Hermann Company has the obligation to pay 300,000 Euros regardless of exchange rate differences. What happens when the exchange rate falls to $0.90 on the date of collection by Unlimited Decadence?

300,000 Euros X 0.90 = $270,000, the amount of the cash received by Unlimited Decadence. This results in a $6,000 exchange loss.


+$270,000 (Cash)

-$276,000(Accounts receivable)

-$6,000 (+Exchange

loss)

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Unearned Revenue In some industries, it is common for a company to collect cash from customers before

it delivers the goods or provides services.

For example, magazine publishers require customers to pay for subscriptions in advance, before the magazines are provided.

When a company collects cash before it delivers the goods or services, it gives rise to unearned revenue. This represents a liability to provide goods or services at a later date.

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Assume Bookworm Publishing receives a check for $3,600 from Aroma Health Stores to purchase 100 annual subscriptions of a new monthly magazine, called Enlightened Life. How is this transaction recorded?

Bookworm has a $3,600 liability to provide future magazine subscriptions.


+$3,600 (Cash)

+3,600 (Unearned

Subscription Revenue)

Unearned Revenue

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As the subscriptions are delivered, revenue is earned. Bookworm has satisfied its obligation to provide the future subscription.

On December 1, Bookworm sends out 100 issues of the December issue of Enlightened Life. 1/12 of the obligation has been satisfied ($3,600 x 1/12 = $300). How is this event recorded?

+$300 (Subscription

Revenue)


-$300 (Unearned

Subscription Revenue)

Unearned Revenue

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Analysis of the Unearned Revenue Account

Exhibit 13-6

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Beginning Unearned Revenue Balance

+

Cash Collections during the

year

-

Amounts Earned

during the year

=

Ending Unearned Revenue Balance

Beginning Balance Sheet: Current

Liabilities

Cash Flow Statement: Operating Activities

Income Statement

Ending Balance Sheet: Current

Liabilities

Can you explain how changes in the unearned revenue account affects the balance sheet, the income statement, and the statement of cash flows?


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Notes Receivable Many companies sell goods to customers under more formal, extended credit

arrangements.

Customers usually are required to sign a promissory note, making an unconditional promise to pay another party (seller) a certain amount of money in the future.

Because the seller expects to receive cash in the future based on a written commitment, the amount the customer owes is called a note receivable.

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Illustration of a Promissory NoteExhibit 13-7

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Recording a note receivable is virtually the same as a sale on account. The only difference is that the Notes Receivable account is increased rather than the Account Receivable account.

If Unlimited Decadence receives a 6-month, 12%, $10,000 note from John Burgen, Inc. on August 1, 2004 for candy purchased on credit, how would this be recorded?

Recording Receipt of a Note Receivable


+$10,000 (Notes

receivable)

+S10,000 (Sales

revenue)

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The note received by Unlimited Decadence earns 12% interest over the time the note is outstanding, even though the interest is not paid until the note matures.

The total interest on the note is $600, computed as follows:

Recording Accrued Interest on a Note Receivable

Interest = Principal X Interest X Time

Interest = $10,000 X .012 X 6/12

Interest = $600

For each month Unlimited Decadence holds the note, $100 of interest would be earned: $10,000 X .012 X

1/12, or $600/6months

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How Interest Accrues on a Note Receivable

Exhibit 13-8

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At December 31, 2004, Unlimited Decadence has earned 5 months of interest, the time over which the note has been outstanding.

5/6 of the $600 interest must be recognized as interest revenue, or $500. How is this recorded?

Recording Accrued Interest on a Note Receivable


+$500 (Interest

receivable)

+$500 (Interest revenue)

Interest = $10,000 x .12 x 5/12, or

$500

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On February 1, 2005, the note and the interest are paid by the customer, Burgen Candles.

How is this recorded when the note and some of the interest revenue was recorded in the previous year?

Recording Payment on the Note Receivable


+$10,600(Cash)

-$10,000 (Note receivable)

-$500 (Interest receivable)

+$100 (Interest revenue)

When the note and interest are collected, $100 more of

interest revenue must be recognized for the 6th month

the note is outstanding in 2005

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Cash and Cash Equivalents

Under GAAP, a company is required to report Cash and Cash Equivalents on its balance sheet.

Cash equivalents are investments in short-term, interest-bearing, highly liquid investments that involve so little risk that they are considered to be cash.

Examples include short-term government notes and commercial paper (loans) issued by corporations.

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Cash and Cash EquivalentsExhibit 13-9

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