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Financial Accounting, Fourth Canadian Edition

Libby, Libby, Short, Kanaan, Gowing


Connect Study Guide
prepared by Robert G. Ducharme, MAcc, CA

CHAPTER 7: Reporting and Interpreting Sales Revenue,


Receivables and Cash
What You Really Need to Know
1. Apply the revenue principle to determine the accepted time to record sales
revenue for typical retailers, wholesalers, manufacturers, and service companies.
Revenue recognition policies are widely recognized as one of the most important
determinants of the fair presentation of financial statements. For most merchandisers and
manufacturers, the required revenue recognition point is the time of shipment or delivery
of goods. For service companies, it is the time at which services are provided.
2. Analyze the impact of credit card sales, sales discounts, and sales returns on the
amounts reported as net sales.
Both credit card discounts and cash discounts can be recorded either as contra-revenues
or as expenses. When recorded as contra-revenues, they reduce net sales. Sales returns
and allowances, which should always be treated as a contra-revenue, also reduce net
sales.
3. Compute and interpret the gross profit percentage.
Gross profit percentage (Gross Profit Net Sales) measures the ability to sell goods or
services for more than the cost to produce or purchase. It reflects the ability to charge
premium prices and produce goods and services at lower cost. Managers, analysts, and
creditors use this ratio to assess the effectiveness of the companys product development,
marketing, and production strategy.
4. Estimate, report, and evaluate the effects of uncollectible trade receivables (bad
debts) on financial statements.
When receivables are material, companies must employ the allowance method to account
for uncollectibles. These are the steps in the process:
a. Preparing the end-of-period adjusting entry to record an estimate of bad debt expense.
Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition
What You Really Need to Know Study Guide
2011 McGraw-Hill Ryerson Ltd.

b. Writing off specific accounts determined to be uncollectible during the period, and
recovery of amounts written off.
The adjusting entry reduces profit as well as net trade receivables. The write-off of trade
receivables affects neither.
5. Analyze and interpret the trade receivables turnover ratio and the effects of trade
receivables on cash flows.
Trade receivables turnover ratio (Net Sales Average Net Trade Receivables)
Measures the effectiveness of credit granting and collection activities. It reflects how
many times average trade receivables were recorded and collected during the period.
Analysts and creditors watch this ratio because a sudden decline in it may mean that a
company is extending payment deadlines in an attempt to prop up lagging sales or even is
recording sales that later will be returned by customers. Alternatively, the average age of
receivables indicates that average number of days it takes to collect from customers.
Effects on cash flows When a net decrease in trade receivables for the period occurs,
cash collected from customers exceeds revenue and cash flows from operations increases.
When a net increase in trade receivables occurs, cash collected from customers is less
than revenue; thus, cash flows from operations declines.
6. Report, control, and safeguard cash.
Cash is the most liquid of all assets, flowing continually into and out of a business. As a
result, a number of critical control procedures, including the reconciliation of bank
accounts, should be applied. Also, management of cash may be critically important to
decision makers who must have cash available to meet current needs yet must avoid
excess amounts of idle cash that produce no revenue.
7. Reconcile cash accounts and bank statements.
A bank reconciliation compares (reconciles) the ending cash balance in the companys
records to the ending cash balance reported by the bank on the monthly bank statement. It
also identifies the accounts that must be adjusted as a result of this process.

Recognize how to find financial information in the financial


statements.
STATEMENT OF FINANCIAL
POSITION
Under Current Assets
Trade receivables (net of allowance for
doubtful accounts)

INCOME STATEMENT
Revenues
Net sales (sales revenue less discounts, if
treated as contra revenues, and sales
returns and allowances)
Expenses

Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition
What You Really Need to Know Study Guide
2011 McGraw-Hill Ryerson Ltd.

Selling expenses (including bad debt


expense and discounts if treated as
expenses)
STATEMENT OF CASH FLOWS
Under Operating Activities (indirect
method)
Profit
+ Decreases in trade and other
receivables (net)
Increases in trade and other
receivables (net)

NOTES
Under Summary of Significant
Accounting Policies
Revenue recognition policy
Under a Separate Note
Bad debt expense and write-offs of bad
debts

What to Watch Out For


Overview
This chapter begins an in-depth discussion of various items reported on the financial
statements. Initially, emphasis is placed on income statement transactions that involve
revenue. Credit card sales, sales on account, sales discounts, trade discounts and sales
returns are analyzed. A variety of reporting issues relating to sales revenues, trade
receivables and cash are addressed, as are the computation and interpretation of the gross
profit percentage and receivables turnover ratio. An overview of the control and
safeguarding of cash concludes the chapter.
Recognizing and Reporting Sales Revenues and Accounts Receivable
You should be comfortable with the application of the revenue principle to record sales
revenue relating to credit card sales and sales on account. Note the differences between
strict application of this principle and common practices for recording sales revenue. You
will be expected to analyze transactions relating to collections from customers (whether
or not they choose to take advantage of the sales discount) and write-offs of customer
account balances.
Extending Credit
By extending credit to customers, a company is likely to attract a greater number of
customers willing to buy from it. However, the costs of extending credit include
increased wage costs, bad debt costs, and delayed receipt of cash. You should be able to
describe the pros and cons of extending credit.

Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition
What You Really Need to Know Study Guide
2011 McGraw-Hill Ryerson Ltd.

Allowance Method Recognizing Bad Debt Expense in Conformity with Matching


Principle
Measurement and reporting issues arise when the collection of accounts receivable is
uncertain. When a company sells to a customer on account, there is a risk that the
customer will not pay what is owed. This risk of loss is a cost (or expense) of doing
business when a company sells on account. That cost is referred to as bad debt expense.
A sale to a customer on account may take place in one accounting period and the
company may discover in a subsequent accounting period that the customer is unable to
pay the amount owed. As you know, revenues earned must be matched with all of the
expenses that were required to generate those revenues. That is, revenues and related
expenses must be recorded in the same period.
The allowance method is required by IFRS (GAAP). When this method is used, bad debts
are estimated (based on past experience, industry averages, current conditions, etc.) and
then recorded in the same period as the revenues earned. Take the time to understand how
this method meets the requirements of the matching process. You will be introduced to
the allowance for doubtful accounts account, a contra-asset account, which represents the
companys estimate of the amount that will not be collected from customers.
Direct Write-Off Method An Unacceptable Approach to Recognizing Bad Debt Expense
For simplicity, some companies use the direct write-off method and record bad debt
expense at the time that it becomes obvious that a customer will not pay. When this
method is used, the revenue from the sale to a customer may be recorded in one period
and the related bad debt expense (that arises if the customer does not pay) in another. You
should understand why the method does not conform to generally accepted accounting
principles; it violates the matching process.
Allowance Method Estimating Bad Debts and Recording the Related Adjusting Entry
As noted above, an estimate must be developed when the allowance method is used. Two
different approaches are used to estimate bad debt expense; both are acceptable; you need
to be familiar with both methods.
When the percentage of sales method is used, bad debt expense is estimated. This
estimate goes directly into the adjusting entry (debit Bad Debt Expense and credit
Allowance for Doubtful Accounts). On the other hand, when the aging of trade
receivables method is used, the required balance of the Allowance for Doubtful Accounts
is estimated. That estimate must then be compared to the existing balance in the
allowance account in order to determine the amount that should be used in the adjusting
entry (debit Bad Debt Expense and credit Allowance for Doubtful Accounts).
The Allowance for Doubtful Accounts is a contra asset account. The allowance account
normally begins the year with a credit balance. During the year, the account decreases
Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition
What You Really Need to Know Study Guide
2011 McGraw-Hill Ryerson Ltd.

(with debits) as accounts are written off. If write-offs during the year exceed the
beginning account balance, the allowance account will end up with a debit balance prior
to the adjusting entry (meaning that last years estimate was too low). On the other hand,
if write-offs are less than the beginning account balance, the account will have a credit
balance prior to the adjusting entry (meaning that last years estimate was too high). As
noted above, when the aging of trade receivables method is used, the amount used in the
adjusting entry depends, in part, on the existing balance in the allowance account. As a
result, you must take the time to determine whether that existing balance is a debit or
credit; that balance will affect the amount used in the adjusting entry. You may find it
helpful to use a T-account to determine the dollar amount to be used in the adjusting
entry.
Financial Statement Matters
In addition to being familiar with the reporting of sales revenues, accounts receivable and
cash, you will need to know how to compute the gross profit percentage and receivables
turnover ratio. You should understand what these ratios are measuring so that you will be
able to interpret them.
Control and Safeguarding of Cash
After a brief discussion of recent business failures and accounting scandals, the essential
role of internal control to all types and sizes of organizations in terms of creating an
ethical business environment and improving financial performance, and the common
principles and limitations of internal control are explained. Then, those internal control
principles are applied to cash receipts and payments. Finally, the limitations of an internal
control system are noted. You should take the time to become familiar with the concept of
internal control and understand the importance of separation of duties.
The bank reconciliation requires determining two categories of items: (1) those that have
been recorded in the company's books but not in the bank's statement of account, and (2)
those that have been reported in the bank's statement of account but not in the company's
books. The second category of items provides the data needed to adjust the Cash account
to the balance that will be reported on the statement of financial position.
You will need to know how to perform an important control procedure, the reconciliation
of the companys cash account with its bank statement. You will also be expected to
identify, analyze and record the transactions that arise from the reconciliation process.

Libby, Libby, Short, Kanaan, Gowing Financial Accounting Fourth Canadian Edition
What You Really Need to Know Study Guide
2011 McGraw-Hill Ryerson Ltd.