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McMaster University
Teal Mc Ateer

B ANK RECONCILIATION AND RECEIVABLES Study Objectives: 1. Recording sales revenues and related items 2. Accounting for sales discounts 3. Accounting for bad debts 4. Internal controls 5. Bank reconciliations and adjusting entries A CCOUNTING FOR SALES R EVENUE Recall the revenue recognition principle: recognize revenues when the following three conditions are met: 1. The earnings process is complete or nearly complete, 2. An exchange transaction takes place, and 3. Collection is reasonably assured Despite its simple definition, the application of revenue recognition in practice is not that straightforward. In this chapter you w ill learn about revenue recognition for merchandising firms that do not engage in installment sales. For sales transactions, the earnings process is considered complete when goods are delivered. The determination of when the delivery of goods takes place is subject to the shipping terms. In this chapter we will consider only two common shipping terms: 1. F.O.B. Shipping Point: The title of the goods passes from the seller to the buyer as the goods are loaded on the truck or the container at the seller’s location. The seller should recognize the revenue at that point. 2. F.O.B Destination: The title of the goods passes from the seller to the buyer when the goods are delivered to the buyer at the buy er’s location. The seller cannot recognize revenue before this point. Reporting sales on the income statement Sales are reported on the income statement net of the following three Contra-revenue accounts 1. Credit card discounts: when companies accept a credit card as a payment for a sale, they must pay a fee for the credit card company. That fee is called “credit card discount” and is a contra-revenue account. Contra-revenue accounts reduce gross sales. 2. Sales Returns and Allowances: a contra revenue account that accumulates sales returns and allowances. Sales returns ar e products returned by customers, and customers receive full credit. Sales allowances occur when customers receive a credit from the company for keeping low quality merchandise. 3. Sales discounts: also cal led cash discounts, and they are offered to credit customers to encourage early payments. Sales discounts are expressed as follows: 2/10, n/30, which means that buyers will receive two percent discount if they pay within ten days, and the total amount is due in 30 days. Another term for sales discounts is Cash Discounts. Sales discounts should not be confused with trade discounts, which are discounts given by the seller for bulk purchases. Net sales are reported on the income statement as follows: evlesuexx Less: diceduixsx Sales returns and allowances xx Sales discounts xx (xx) salest xx Contra revenue accounts are reported separately to allow the management to learn about sales and credit cards discounts and the sales returns and allowances. A CCOUNTING FOR S ALES D ISCOUNTS Sales and receivables are recorded at te gross amount. Sales discounts taken by customers are debited to the Sales Disounts account, only when the customer pays within the discount period. The sales discount is a contra revenue account, and hence, is reported in the income statement as a reduction of sales. Example: On June 24, 2007 XYZ Inc. sold to ABC Inc. goods for $20,000 on credit with the following terms: (2/10, n/30). On July 2, 2007, ABC paid 60% of the June 24 invoice to XYZ Co. On July 23, 2007 ABC paid the bala nce of their account to XYZ Co. Prepare the journal entries for above transactions on the books of XYZ Inc. under both the gross method and the net method. Solution: June 24, 2007 A/R 20,000 Sale0u,e00 July 2, 2007 The payment was made during the discount period Sales discount = (60% x 20,000) x 2% = $240 Cash received = (60,000 x 20%) – 240 = $11,760 Cash1,760 Sales discount 240 A/R12,000 July 23, 2007 No discount will be given for this payment Remaining balance on A/R= 20,000 -12,000 = $8,000 Cash 8,000 A/R,000 A CCOUNTING FOR B AD D EBTS Accounts receivable are amounts owed by customers as a result of buying the company’s goods and services on account. Ther e is usually no formal written agreement of the terms, other than the detailson the sales invoice. Invoices and shipping documents usually provide the necessary eviden ce of proof that a receivable exists. The time period is usually sh ort (between 30 to 60 da ys), and interest is not usually charged. However, interest may be required if the customer does not make payment within the specified time period. It is highly unlikely that a company that extends credit to its customers will be successful in collecting all of its receivables. Uncollectible accounts are receivables determined to be uncollectible because debtors are unable or unwilling to pay their debts. Uncollectible accounts are a major cost of granting cto customers and are called- Bad Debts Expense. There are two methods to account for receivables that ultimately prove to be uncollectible: the direct write-off method and the allowance method. THE DIRECT W RITE-OFFM ETHOD The direct write-off method assumes that all sales are fully collectible until proved otherwise. We should wait to see which receivables will not be paid and write them off at that time. Thus, it ignores the efof bad debts and the possibility that some receivable might not be paid until it actually happened. The method recognizes the unc ollectible account in the period in which the company determines that the account is uncolltible. When an account is identified as uncollectible, that account is removed from the books by reducing the AR and an expense is recorded in the following journal entry: Dxpadse xx x R / A Although it is simple and extremely inexpensive to use, the direct write-off method fails to apply the matching principle (expensesbe 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. The direct is not allowed under GAAP. THE ALLOWANCE M ETHOD : The allowance method estimates the amount of A/R that will ultimately be uncollectible. It allows accountants to recognize bdebts during the period in which accounts receivable originated, before specific uncollectible accounts are identified in a subsequent period. The allowance method requires a year-end estima te of expected uncollectible accounts based upon credit sales or outstanding receivables. The estimate is recorded via an adjusting entry by debiting an expense, and crediting an allowance account in the period in which the sale is recorded. EDxpadse xx Allowance for Doubtful Accounts xx When an account is deemed to be uncollectib le, an entry is made debiting the allowance account and crediting accounts receivable. Allowance for Doubtful Accounts xx x xR / A The allowance method provides for a proper ma tching of revenues and expenses as well as reflecting a proper carrying value for accounts receivable at the end of the period (i.e., faithful representation). When the allowan ce method is used, the estimated amount of uncollectible accounts is normally based upon a percentage of sales or outstanding receivables. The allowance method has two basic elements: 1. The estimation of the amount of receivables that will be uncollectible. 2. The establishment of a c ontra asset account (allow ance for doubtful accounts), which is deducted from accounts receivable Presentation of Accounts Receivable under the allowance method: Accounts receivable $40,000 Less: Allowance for uncollectible accounts (2,000) Net accounts receivable $38,000 Calculating bad debt expense under the allowance method There are two methods to calculate the bad debt expense under the allowance method: (a) the percentage-of-sales method, and (b) the percentage-of-receivables (or the aging) method. The percentage-of-sales method (The Income Statement Approach) This method attempts to match costs with reve nues, and is frequently referred to as the income statement approach. Under the per centage-of-sales method, the amount recorded as bad debts expense is the amount determin ed by multiplying the estimated percentage of uncollectible credit sales times the credit sales. Example: Martin Company has $150,000 in credit sales. Historically, 2% of credit sales are estimated to be uncollectible. During the year, Martin Company determines that $2,000 of receivables to be uncollectible. Wh at are the entries to record the sales, establish the Allowance account, and write off the uncollectible accounts? The entry to record the sales: Accrecetvable150,000 Sales 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 bad debts 2,000 Accounts receivable 2,000 The percentage-of-receivables method (The Balance Sheet Approach) Percentage of accounts receivable method - an approach to estimating bad debts expense and uncollectible accounts at year end using the historical relations of uncollectible amounts to 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.
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