Chapter 9
Revenue Cycle: Sales, Receivables, and Cash
SOLUTIONS
1. The two revenue recognition criteria are:
a. the promised work has been substantially completed (i.e., the company has done something), and
b. cash, or a valid promise of future payment, has been received (i.e., the company has received something of value in return).
If a company has not met the first criterion, then the company has not actually performed the economic activity. If the second criterion is not met, then the company is not sure that its economic efforts will be rewarded with an increase in company assets.
2. Revenue would be recognized by the seller as follows:
a. McDonald’s sells you a Big Mac and some fries—at the time of sale because the goods and services have been provided and McDonald’s has collected the cash.
b. A bank loans you money to buy a house—as time passes and the interest on the loan accrues. The bank does its work by allowing the borrower to use the bank’s money. Of course, the bank would only recognize the accrued interest if it were reasonably sure that the borrower would pay.
c. A health club signs you to a twelve-month membership—evenly over the twelve-month membership period as the health club provides membership services. Again, this is true only if the health club collects the cash in advance or is reasonably sure it can collect the cash.
d. Wal-Mart sells you goods and you pay for them with your MasterCard—at the time of sale because Wal-Mart has provided the goods and has also received its cash instantly from MasterCard.
e. A college accepts you as a student for the upcoming semester—as the college provides education services and as the college becomes convinced that it will collect the tuition fee from you in cash.
3. A cash sale increases the amount of cash on the seller’s balance sheet and also increases the retained earnings portion of the seller’s stockholders’ equity. A cash sale also increases the sales revenue reported on the seller’s income statement. Overall, the accounting equation is kept in balance because the increase in the asset cash is matched by an increase in the retained earnings portion of equity. A credit sale would have the same impact on the financial statements as a cash sale, except that the asset increased would be accounts receivable instead of cash.
4. With a credit policy that is so loose that everyone can obtain credit, a company runs the risk of having more bad debts, bookkeeping costs, and implicit interest carrying charges than can be paid for from the increased revenue generated by the loose credit policy. With a credit policy that is too restrictive, a company runs the risk of turning away potentially profitable credit customers.
5. Sales discounts are cash reductions offered to customers in an attempt to ensure that they make prompt payment on their accounts. A sales discount is offered in order to reduce the amount of cash tied up in the form of accounts receivable. In addition, sales discounts may reduce bad debts by encouraging credit customers to pay soon, thus reducing the chances that they might never pay at all.
6. Sales discounts are reported in the income statement as a reduction from the amount of gross sales. Accordingly, gross sales minus sales discounts equal net sales.
7. This is not necessarily a good policy because, together with elimination of bad debts, the controller may have eliminated the opportunity for additional sales to potentially creditworthy customers. There is a trade-off to be made between the bad debts and additional sales. As long as the incremental revenue exceeds the incremental cost of sales plus incremental bad debts, credit should be extended to the customer.
8. Under the allowance method, the expenses of uncollectible accounts are matched against the sales revenues for the same period. The realizable value of accounts receivable is reduced by an increase in the allowance for uncollectible accounts. This is accomplished by estimating the amount of the bad debt expense using either the percentage-of-sales method or the accounts receivable aging method.
The allowance method of accounting for uncollectible accounts is preferable to the practice of recording bad debts when it becomes clear that the customer has defaulted (often referred to as the direct write-off method) because the allowance method provides a better matching of revenues and expenses. The allowance method ensures that the bad debt expense is recognized in the period in which the sale took place and the receivable was generated, not in the period in which management determined that the customer was unwilling or unable to pay. The problem with the direct write-off method is that it may be the following year before management discovers that a sale made in the current year is not collectible. Waiting to record the bad debt expense in the following year violates the matching convention.
9. The allowance for bad debts account keeps track of estimated bad debts and actual bad debts. The account is credited when an estimate for bad debt expense is recorded. The allowance account is debited when an account is actually written off.
10. The percentage of sales method relies on historical or industry data to estimate what fraction of total credit sales will ultimately be uncollectible. The total credit sales for the year are multiplied by the percentage to determine estimated uncollectible accounts.
The aging method involves examining the accounts still unpaid at the end of the year, looking to see whether the accounts are past due and by how much, and directly estimating how much of those accounts will ultimately be uncollectible. The insight behind the aging method is that the chances that an account will ultimately prove to be uncollectible increase as that account gets older. Based on an aging schedule, each category of past due receivables is multiplied by the estimated percentage of uncollectible accounts. By adding up the amounts for each category, we receive an estimate for uncollectible accounts.
11. The estimation of bad debts decreases total assets (by increasing allowance for bad debts) and decreases stockholders’ equity (by increasing expenses). The actual write-off of accounts has no effect on the accounting equation—the decrease in the allowance for bad debts is balanced by a decrease in accounts receivable, resulting in no change in the net receivable balance.
12. No. Except under the direct write-off method, the amount of bad debts is an estimate. Hence, it is possible that either the estimate was too low, or during this particular year there may have been more than the usual defaults on loans. In either case, the prior year’s financial statements should not be corrected. Over time, an overestimate of bad debt expense in one year would be expected to be balanced by underestimates in other years.
13. The estimated liability for warranties keeps track of future estimated warranty expenses and actual warranty expenses. The account is credited when you estimate future warranty expense. The account is debited when you actually pay for a warranty.
14. This discovery isn’t an actual mistake. Warranties are based on estimates. At the time of the initial estimate, the company made its best guess of warranty expense. If the estimate for warranties was too low last period, management should determine if the estimate for warranties should be increased for future sales.
15. The purpose of separation of duties is to make it difficult for theft or errors to occur unless two or more people are involved. For example, if the cash records are maintained by an employee who also has access to the cash itself, cash can be stolen or “borrowed” and the employee can cover up the shortage by falsifying the accounting records.
16. The primary difference between assigning and factoring receivables is the ownership of the receivables. When assigning receivables for collateral on a loan, the company still maintains actual ownership of the receivables. When factoring the receivables, the receivables are actually sold to another company. Factoring receivables shifts the collection risk away from the company receiving the money. Because the factor assumes the collection risk, they charge the company a fee.
17. Foreign currency exchange rates are used to express transactions in local currency in terms of U.S. dollars and vice versa. For example, if the exchange rate is $1 = 1.15 Euros, and if one wishes to change 100 U.S. dollars into Euros, one will receive $100 ´ 1.15 = 115 Euros, and if one wishes to change 100 Euros to U.S. dollars, one will receive 100 euros/1.15 = $89.96. Foreign currency exchange rates are used to determine the amount at which a foreign currency transaction should be recorded in U.S. dollars.
18. In this situation the British pound increased in value from $1.50 to $1.53. This means the required payment will amount to more money in U.S. dollars. The exchange gain is $1,500 or £50,000 ´ ($1.53 – $1.50).
19. U.S. companies can avoid the risk associated with foreign currency transactions by denominating all transactions in U.S. dollars. As discussed in Chapter 13, another way to avoid foreign currency risk is to naturally hedge foreign currency items by incurring both assets and liabilities in the same foreign currency. In addition, some companies reduce foreign currency risk through the use of derivative contracts.
20. Receivable turnover represents the number of times the average receivable has been collected during a given year. The larger this number, the faster the collection has been. The average collection period is simply a derivative of the receivable turnover and represents the average amount of time that elapses between a sale and the collection of cash. The receivable turnover and the average collection period are inversely related. During an economic recession, a typical department store may experience decreasing turnover and hence an increase in the average collection period.
21. One measure of the quality of receivables is the relationship between the bad debt allowance and the total amount of receivables. As a general rule, the bad debt allowance, as a percentage of total receivables, should be stable from year to year. Any change indicates a change in either the type of credit customers a business is attracting or a change in the economic circumstances of existing customers.
22. A cash budget is an important tool in helping management plan its cash needs. Estimating cash and credit sales, and most important, estimating the pattern of the collection of outstanding accounts receivable are key to the cash receipts budgeting process. The collection pattern for receivables is a function of such factors as industry, firm size, and the firm’s credit policies. The ongoing aging of individual accounts receivable also plays an important role in budgeting cash receipts.
EXERCISES
E 9-1 Recording Sales and Cash Collection
1.
Accounts Receivable 22,000
Consulting Revenue 22,000
To record revenue for consulting services.
Cash 6,000
Accounts Receivable 6,000
To record the collection of cash in November.
2. Assets increased by $22,000 through providing services in November.
3. The collection of cash has no effect on assets because one asset increases while another asset decreases.
E 9-2 Recording Sales and Cash Collection
1.
Accounts Receivable 24,000
Consulting Revenue 24,000
To record revenue for consulting services.
Cash 24,000
Accounts Receivable 24,000
To record the collection of cash.
2. Equation Increase/Decrease/No Effect Amount
Assets Increase $24,000
= Liabilities No effect –
+ Owners’ Equity Increase $24,000
E 9-3 Revenue Recognition
In order to decide when revenue should be recognized, we must consider the following two revenue recognition criteria:
Is the work done?
Is the cash collected or collectible?
Work done: The work is not done when James Dee signs the contract to do the job. If past history shows that the amount of free guarantee is not a large amount, then the work is done, or virtually done, when the job is completed.
Cash collected or collectible: If past history shows that customers generally are reliable in paying, then we do not have to wait until the cash is collected 30 days after the job is completed before recognizing revenue.
In summary, if past history shows that the free guarantee work is not significant and customers are fairly reliable in paying, then revenue should be recognized at the time job is completed, which is option (c). Because the work is guaranteed for five years, James Dee should also set up an Estimated Warranty account to recognize the future liability for re-cleaning jobs.
E 9-4 Evaluating a Credit Policy
Change Amount
Increase in Sales $300,000
Increase in Cost of Goods Sold (70%) 210,000
Increase in Gross Profit 90,000
Implicit interest cost of Accounts Receivable (11,200)
($112,000 ´ 10% = $11,200)
Estimated Bad Debts (26,000)
Cost of new employee to manage accounts (50,000)
Increase in Income $ 2,800
Although the new credit policy will provide an estimated increase in profits of $2,800, the increase isn’t a very large amount. Management needs to determine the accuracy of estimates. If the estimated bad debts are higher than estimated, the company may actually lose money through this credit policy change.
E 9-5 Impact of Sales Discounts
1. $300 ´ 250 ´ (1 – 0.02) = $73,500 Net sales if paid seven days after the sale.
2. $300 ´ 250 = $75,000 Net sales if paid 20 days after sale.
E 9-6 Accounting for Bad Debts