Chapter 6 Study Notes

I. ANALYZE THE IMPACT OF CREDIT CARD SALES, SALES DISCOUNTS, AND

SALES RETURNS ON THE AMOUNTS REPORTED AS NET SALES.

A. Cash Sales vs. Credit Card

1. Cash Sales
a. “Cash” sales are sales for cash (currency) or customer checks.
b. The entry to record cash sales includes a debit to Cash and a credit to Sales Revenue.
2. Credit Card Sales
a. Many companies accept credit cards as “collections” for goods and services.
b. Some widely accepted credit cards are American Express, Discover Card, MasterCard, and
VISA.
c. Reasons that companies accept credit cards for payment:
1. Acceptance will increase the number of customers.
2. Competitors accept credit cards.
3. The cost of directly extending credit to customers is avoided.
4. Bad debts due to NSF checks are avoided.
5. Credit card companies absorb losses from fraudulent card use if the merchant complies
with the credit approval verification process.
6. The credit card receipts are often deposited directly to the company’s bank account, so the
merchant usually receives payment sooner than when directly extending credit.
d. Credit card companies charge a fee for their services.
1. The fee is called a credit card discount, and is usually a percentage of the credit card
receipts.
2. The fee is an expense to the merchant. It may be reported as a contra revenue account (a
reduction of gross revenues in arriving at net sales) or as a selling expense.

B. Sales Discounts to Businesses

1. Credit sales made on open account create a customer’s promise to pay for goods or services at a
later date. This is less formal than a promissory note. Credit sales are granted because of greater
sales potential and competitors’ practices.
2. When credit is extended, credit terms are printed on the invoice. The credit period indicates when
the invoice amount (net of sales returns and allowances) is due.
Example: “n,/30” – net amount is due in 30 days.
3. Sales discount (cash discount) is an incentive to encourage early payment of open account
charges. Early payment must be made within the discount period.
Example: “2/10, n/30” – customer receives a 2% discount on the net amount due if payment is
made within 10 days; otherwise n (net), the full amount, is due within 30 days.
a. Provides significant discount to the customer when considering the discount rate on an
annualized basis.
b. May be reported as a contra revenue account or as a selling expense.

C. Sales Returns and Allowances

1. A contra revenue account used to record the return of goods previously sold. It reduces gross sales
to arrive at the net sales presented on the income statement.
2. Additionally, used to make adjustments to the sales price, as in the case of damaged goods.
3. It’s important to maintain this account rather than to directly debit (reduce) the sales revenue
account, because the SR&A account provides important information for management regarding
the quality of sales and customer satisfaction.
D. Reporting Net Sales

Sales
- Sales Returns and Allowances
- Sales Discounts (if a contra revenue)
- Credit Card Discount (if a contra revenue)
Net Sales

* ANALYZE AND INTERPRET THE GROSS PROFIT PERCENTAGE.

A. Represents the markup percent. For every dollar of net sales, how much winds up as gross profit?

B. The higher the gross profit ratio, the greater the markup.

Gross Profit
Gross Profit Percentage =
Net Sales

II. ESTIMATE, REPORT, AND EVALUATE THE EFFECTS OF UNCOLLECTIBLE

ACCOUNTS RECEIVABLE (BAD DEBTS) ON FINANCIAL STATEMENTS.
A. Measuring and Reporting Receivables.
1. Classifying receivables
a. Receivables are claims against other companies or persons for cash, goods, or services.
b. Two common types of receivables:
1. Accounts Receivables (A/R)
a. Open accounts owed to a company by trade customers.
b. Created when sales are made on credit in the normal course of business.
c. Normally a current asset because all are due within a year.
2. Notes Receivable
a. Written promises to pay evidenced by formal documents.
b. Contains the following information:
i. Sum of money due (principal)
ii. Date the principal is due (maturity date)
iii. Interest rate and interest due dates
c. Companies maintain separate records (subsidiary A/R ledger) for each customer. However,
the total balance of the A/R account (control account) is presented on the balance sheet.
d. Extending credit to customers is not without cost to the company.
1. Billing systems and credit personnel must e maintained.
2. Not all customers will pay their debts to the company.
e. Nontrade receivables
1. Arise from transactions other than in the normal course of business.
2. Current or noncurrent assets, depending on when payment is expected.
3. Examples: loans to officers and employees, not evidenced by notes.

B. Accounting for Bad Debts

1. Bad debt expense is the estimated expense associated with uncollectible accounts.
2. Matching principle requires that bad debt expense is recorded in the same accounting period in
which the sales are recorded.
 3. Allowance method bases bad debt expense on an estimate of uncollectible accounts, since it is
unknown which specific accounts will be uncollectible; i.e., which customers will not pay their
debts to the company.
4. Two primary steps in the allowance method are:
a. Making the end-of-period adjusting entry to record bad debt expense.
b. Writing off specific accounts determined to be uncollectible during the period.
5. Bad debt expense is reported as an adjusting entry at the end of the accounting period:

Bad Debt Expense xxx

Allowance for Doubtful Accounts xxx

a. Allowance for Doubtful Accounts is a contra (offset) asset account containing the estimated
amount of uncollectible accounts receivable.
b. A/R cannot be credited for the estimated amount of uncollectible accounts since it is not
known which specific accounts will not be paid.
c. Bad debt expense is a selling expense on the income statement. It decreases net income and
stockholders’ equity.
6. When it is determined that a specific account is uncollectible, that account should be written off
against the allowance.

Allowance for Doubtful Accounts xxx

Accounts Receivable (name of customer) xxx

a. Note that no expense is recognized at this time because bad debt expense was recognized with
the adjusting entry at the end of the previous period.
b. No income statement accounts are affected when a specific account is written off.
c. Net realizable value of accounts receivable (A/R minus Allowance for Doubtful Accounts)
doesn’t change because both of these accounts are reduced by the same amounts.
7. If a customer pays an account that was previously written off, the entry writing off the account
must be reversed (the account must be reinstated), and then the collection of cash can be reported
in the normal manner.
8. At the end of the accounting period, before the bad debt expense adjusting entry is made, the
Allowance for Doubtful Accounts may have either a debit or a credit balance.
a. A debit balance indicates that more specific accounts were written off than previously
estimated.
b. A credit balance indicates that fewer specific accounts were written off than previously
estimated.
9. After the end-of-period adjusting entry is made, the Allowance will always have a credit balance.
Note that adjustments to prior periods are not made for incorrect estimates.

C. Reporting Accounts Receivable and Bad Debts

1. The Allowance for Doubtful Accounts is netted against A/R to report the “net realizable value” of
accounts receivable for balance sheet reporting.
a. This represents the amounts that the company actually expects to collect.
2. Publicly traded companies include a detailed schedule of bad debt information in their Annual
Report Form 10-K filed with the SEC.

D. Estimating Bad Debts

There are two basic methods for estimating bad debt expense. Both are acceptable under GAAP.
1. Percentage of Credit Sales Method
a. Bases bad debt expense on the historical percentage of credit sales that results in bad debts.
b. Calculation:
 Bad Debt Expense = Net Credit Sales x Bad debt loss rate

c. The amount calculated is the amount of the adjusting journal entry, regardless of any balance
in the allowance account prior to adjustment.

Percent of credit sales example:

Carolyn’s Curtains had total credit sales of $452,000 in 2005. Based on past experience,
Carolyn’s estimates that 2.5% of the credit sales will be uncollectible. Prior to making the
adjusting entry, the Allowance for Bad Debts had a debit balance of $300.
Required:
What is the adjusting entry to recognize bad debt expense for the year, and what will be
the balance in the Allowance for Bad Debts account after the adjustment?
Solution:
Allowan
ce for
Doubtfu
l
Account
s
Balance 3
before
Adjustment
1 Adjustme
nt
1 Balance
after
Adjustme
nt

Bad Debt Expense 11,300

Allowance for Doubtful Accounts 11,300

2. Aging of Accounts Receivable ( YOU ARE NOT RESPONSIBLE FOR THIS ON THE TEST)

a. Relies on the fact that, as accounts receivable become older and more overdue, it is more
likely that they will be uncollectible.
b. Accounts receivable are divided into age categories, and a different loss rate is applied to each
category. The oldest category would have the highest loss rate.
c. The total of the estimated losses for each category should be the balance in the allowance
account after the adjusting entry has been made.
1. The unadjusted amount is compared to the estimated uncollectible amount to determine
the amount of the adjustment needed.
d. The aging of receivables method is more accurate than the percent of sales method.

* ANALYZE AND INTERPRET THE ACCOUNTS RECEIVABLE TURNOVER

RATIO AND THE EFFECTS OF ACCOUNTS RECEIVABLE ON CASH FLOWS.
A. A measure of the effectiveness of a company’s credit granting and collections activities.

B. A higher ratio benefits the company.

Net credit sales

Receivables Turnover =
Averate net trade accounts receivable