Chapter 4 revenue

OPEN UNIVERSITY HCMC MBA PREPARATORY COURSE Principles of Financial Accounting Chapter Accounting for Sales Learning Objectives After studying this chapter, you should be able to:     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 Learning Objectives After studying this chapter, you should be able to:    Estimate and interpret uncollectible accounts and receivable balances Assess the level of accounts receivable Develop and explain internal control procedures Recognition of Revenue  The timing of revenue recognition is critical to the measurement of net income • Revenue is part of the calculation of net income  Net income = Revenue - Expenses • 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 Revenue  Some users of financial information want revenues to be recorded as soon as possible  Others want to be sure that a company will actually receive payment before revenues are recorded  Accountants must carefully assess when revenue should be recognized Recognition of 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 received Recognition of 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 Recognition of Revenue  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 one-fourth of the work is completed in the first year, one-fourth of the revenue should be recognized Measurement of Revenue   Revenue is measured in terms of the cash equivalent value of the asset received Journal entries to record sales: Cash Sales revenue 1,000 Accounts receivable Sales revenue 1,000 1,000 OR 1,000 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 purchase allowances from the customer’s 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 Sales revenue 900 900 To record the returns and allowances: Sales returns and allowances Accounts receivable 200 200 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 Less: Sales returns and allowances Net sales ==================== $900,000 80,000 $820,000 Merchandise Returns and Allowances  Discounts on sales also affect the amount reported as sales  Two major types of discounts: • Trade discounts • Cash discounts Merchandise Returns and Allowances  Trade discounts - reductions to the gross selling price for a particular class of customers to arrive at the actual selling price (invoice 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 discount Merchandise Returns and Allowances  Cash discounts - reductions of invoice prices awarded for prompt payment of the invoice • Encourage prompt payment and reduce manufacturer’s or seller’s need for cash • Reduces the risk of bad debts (nonpayment)  Purchasers should always take purchase discounts if possible Accounting for Net Sales Revenue  Cash discounts and sales returns and allowances are recorded as deductions from gross sales Gross sales $20,000 Deduct: 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 Cash  Many companies combine cash and cash equivalents on their balance sheets • Cash equivalents - highly liquid shortterm 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 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 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 receivable 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 Assessing the Level of 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 turnover The Accounting System Accounting system - a set of records, procedures, and equipment that routinely deals with the events affecting the financial performance and position of the entity  • The focus of the accounting system is on repetitive, voluminous transactions that fall into four categories: Cash disbursements Cash receipts Purchase of goods and services, including payroll Sales of goods and services References: Horngren, Introduction to financial accounting [...]... returns and allowances: To record the sale: Accounts receivable Sales revenue 900 900 To record the returns and allowances: Sales returns and allowances Accounts receivable 200 200 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:... Purchasers should always take purchase discounts if possible Accounting for Net Sales Revenue  Cash discounts and sales returns and allowances are recorded as deductions from gross sales Gross sales $20,000 Deduct: 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... gross selling price for a particular class of customers to arrive at the actual selling price (invoice 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 discount Merchandise Returns and Allowances  Cash discounts - reductions of invoice prices awarded for prompt payment... deals with the events affecting the financial performance and position of the entity  • The focus of the accounting system is on repetitive, voluminous transactions that fall into four categories: 1 2 3 4 Cash disbursements Cash receipts Purchase of goods and services, including payroll Sales of goods and services References: Horngren, Introduction to financial accounting