CHAPTER 5: RECEIVABLES AND SALES
- Credit sales: transfer of good or services to a customer today while bearing the risk of collecting payment from that customer in the future. Also known as “sales on account” or “services on account”.
- Invoice: a source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale and the payment terms.
Companies record an asset (accounts receivable) and revenue when they sell goods or services to their customers on account, expecting collection in the future. Once the receivable is collected, the balance of accounts receivable is reduced.
- Benefits of extending credit: the seller makes it more convenient for the buyer to purchase goods and services. In the long term, credit sales should benefit the seller by increasing profitability of the company.
- Cost of extending credit: delay in collecting cash from customers, and some customers may end up not paying at all. These disadvantages reduce the operating efficiency of the company and lead to lower profitability.
-Trade discounts: reduction in the listed price of a good or service.
-Sales returns: customer returns a product. CONTRA REVENUE ACCOUNT (account with a opposite or “contra” balance to that related revenue account)
-Sales allowances: seller reduces the customer’s balance owed or provides at least a partial refund because of some deficiency in the company’s good or service. CONTRA REVENUE ACCOUNT (account with a opposite or “contra” balance to that related revenue
account)
-Sales discounts: reduction in the amount to be received from a credit customer if collection on account occurs within a specified period of time. Is intended to provide incentive to the customer for quick payment.
Discount terms are a shorthand way to communicate the amount of the discount and the time period within which it’s available.
Ex: 2/10, n/30.
The term “2/10” indicates the customer will receive a 2% discount if the amount is paid within 10 days. The term “n/30” means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.
- Uncollectible accounts (or “bad debts”): customers’ accounts that no longer are considered collectible.
1. ALLOWANCE METHOD (REQUIRED BY GAAP): method of reporting accounts receivable for the net amount expected to be collected. At the end of the current year, the estimated future uncollectible accounts are reported in a contra asset account, reducing net
accounts receivable.
GAAP require that we account for uncollectible accounting using allowance method.
STEP 1: ESTABLISHING AN ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS
- Allowance for uncollectible accounts: contra asset account representing the amount of accounts receivable not expected to be collected.
STEP 2: WRITING OFF ACCOUNTS RECEIVABLE
STEP 3: ADJUSTING ALLOWANCE IN SUBSEQUENT YEARS
- Percentage-of-receivables method: method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected.
- Aging method: basing the estimate of future bad debts on the various ages of individual accounts receivable, using a higher percentage for “old” accounts
than for “new” accounts. The older the account, the less likely is to be collected.
Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable.
The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.
- DIRECT WRITE-OFF METHOD (NOT GAAP): recording bad debt expense at the time we know the account is actually uncollectible.
This leads to accounts receivable being overstated in the current year. Primarily used for tax reporting.
NOTES RECEIVABLE are similar to accounts receivable except that notes receivable are formal credit arrangements made with a written debt instrument, or note.
- Receivables turnover ratio: number of times during a year that the average accounts receivable balance is collected (or “turns over”).
- Average collection period: approximate number of days the average accounts receivable balance is outstanding.
CHAPTER 6 – INVENTORY AND COSTS OF GOODS SOLD
- Inventory: items a company intends for sale to customers in the ordinary course of business. Also items that are not yet finished products.
Inventory is a current asset reported in the balance sheet and represents the cost of inventory not yet sold at the end of the period.
- Costs of goods sold: cost of the inventory that was sold during the period. Costs of goods sold is an expense reported in the income statement and represents the cost of inventory sold.
- Manufacturing companies: produce the inventories they sell, rather than buying them in finished form from suppliers. They buy the inputs for the products they manufacture. Inventory for a manufacturer:
Raw materials: cost of components that will become part of the finished product but have not yet been used in production
Work-in-process: products that have been started but are not yet complete at the end of the period.
Finished goods: complete items.
- Merchandise companies: assemble, sort, repackage, redistribute, store, refrigerate, deliver or install the inventory but they do not manufacture it.
Wholesalers: resell inventory to retail companies or to professional users.
Retailers: purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.
Service companies record revenues when providing services to customers (not account inventory and COGS).
Merchandising and manufacturing companies record revenues when selling inventory to customers (must account for inventory and COGS).
- Multiple-step income statement: an income statement that reports multiple levels of income (or profitability).
When inventory costs are rising (as in our example), FIFO results in:
1. Higher inventory in the balance sheet.
2. Higher gross profit in the income statement (lower COGS).
3. higher reported profit than does LIFO
Generally, results in higher assets and higher net income when inventor costs are rising.
- FIFO: balance-sheet focus
- LIFO: income-statement focus
LIFO: The primary benefit is tax savings. LIFO results in the lowest amount of reported profits (when inventory costs are rising). When taxable income is lower, the company owes less in taxes to the Internal Revenue Service (IRS).
LIFO conformity rule: IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting.
LIFO DIFFERENCE: to better compare each company’s inventory and profitability, investors must adjust for the fact that managers’ choice of inventory method has an effect on reported amounts.
LIFO reserve: Companies that report using LIFO must also report the difference between the LIFO amount and what that amount would have been if they had used FIFO.
Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. Conversely, LIFO results in a lower
reported inventory and net income, reducing the company’s income tax obligation. Companies use internally FIFO to report externally under LIFO.
- Perpetual inventory system: maintains a continual (perpetual) record of inventory purchased and sold.
- Periodic inventory system: periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.
Using perpetual inventory system:
When companies purchase inventory using perpetual inventory system:
1. They increase inventory account (debit) and either decrease cash or increase accounts payable (credit).
When companies sell inventory they make two entries:
1. They increase an asset account (cash or accounts receivable) (debit) and increase sales revenue (credit).
2. They increase COGS (debit) and decrease inventory (credit).
Freight charges: shipping or delivery charges. FOB (“free on board”): when title (ownership) passes from the seller to the buyer. (Increase COGS)
1. FOB shipping point: title passes when the seller ships the inventory (WHEN LEAVES THE SUPPLIER’S WAREHOUSE).
2. FOB destination: title passes when the inventory reaches the buyer’s destination (WHEN INVENTORY ARRIVES AT THE SHOP).
- Freight-in: cost to transport inventory to the company, which is included as part of inventory cost.
- Freight-out: cost of freight on shipments to customers, which is included in the income statement either as part of COGS or as a selling expense.
- Purchase discounts: allow buyers to trim a portion of the cost of purchase in exchange for payment within a certain period of time. Subtract from the cost of inventory
and therefore reduce COGS of items sold.
- Purchase returns: return the item to a supplier because it is unacceptable for some reason (they are damaged or different form what was ordered).
Freight charges are added to the cost of inventory, whereas purchase returns and purchase discounts are deducted from the cost of inventory.
Some companies choose to report freight charges on outgoing shipments as part of selling expenses instead of COGS.
- Net realizable value: estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal and transportation.
- Lower of cost and net realizable value: method where companies report inventory in the balance sheet at the lower of cost and net realizable value
(where net realizable value equals estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal and transportation).
When net realizable value falls below cost, we adjust downward the balance of inventory from cost to net realizable value.
- Inventory turnover ratio: number of times the firm sells its average inventory balance during a reporting period.
- Average days in inventory: approximate number of days the average inventory is held.
- Gross profit ratio: amount by which the sale of inventory exceeds its cost per dollar of sales.
- Credit sales: transfer of good or services to a customer today while bearing the risk of collecting payment from that customer in the future. Also known as “sales on account” or “services on account”.
- Invoice: a source document that identifies the date of sale, the customer, the specific items sold, the dollar amount of the sale and the payment terms.
Companies record an asset (accounts receivable) and revenue when they sell goods or services to their customers on account, expecting collection in the future. Once the receivable is collected, the balance of accounts receivable is reduced.
- Benefits of extending credit: the seller makes it more convenient for the buyer to purchase goods and services. In the long term, credit sales should benefit the seller by increasing profitability of the company.
- Cost of extending credit: delay in collecting cash from customers, and some customers may end up not paying at all. These disadvantages reduce the operating efficiency of the company and lead to lower profitability.
-Trade discounts: reduction in the listed price of a good or service.
-Sales returns: customer returns a product. CONTRA REVENUE ACCOUNT (account with a opposite or “contra” balance to that related revenue account)
-Sales allowances: seller reduces the customer’s balance owed or provides at least a partial refund because of some deficiency in the company’s good or service. CONTRA REVENUE ACCOUNT (account with a opposite or “contra” balance to that related revenue
account)
-Sales discounts: reduction in the amount to be received from a credit customer if collection on account occurs within a specified period of time. Is intended to provide incentive to the customer for quick payment.
Discount terms are a shorthand way to communicate the amount of the discount and the time period within which it’s available.
Ex: 2/10, n/30.
The term “2/10” indicates the customer will receive a 2% discount if the amount is paid within 10 days. The term “n/30” means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.
- Uncollectible accounts (or “bad debts”): customers’ accounts that no longer are considered collectible.
1. ALLOWANCE METHOD (REQUIRED BY GAAP): method of reporting accounts receivable for the net amount expected to be collected. At the end of the current year, the estimated future uncollectible accounts are reported in a contra asset account, reducing net
accounts receivable.
GAAP require that we account for uncollectible accounting using allowance method.
STEP 1: ESTABLISHING AN ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS
- Allowance for uncollectible accounts: contra asset account representing the amount of accounts receivable not expected to be collected.
STEP 2: WRITING OFF ACCOUNTS RECEIVABLE
STEP 3: ADJUSTING ALLOWANCE IN SUBSEQUENT YEARS
- Percentage-of-receivables method: method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected.
- Aging method: basing the estimate of future bad debts on the various ages of individual accounts receivable, using a higher percentage for “old” accounts
than for “new” accounts. The older the account, the less likely is to be collected.
Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable.
The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.
- DIRECT WRITE-OFF METHOD (NOT GAAP): recording bad debt expense at the time we know the account is actually uncollectible.
This leads to accounts receivable being overstated in the current year. Primarily used for tax reporting.
NOTES RECEIVABLE are similar to accounts receivable except that notes receivable are formal credit arrangements made with a written debt instrument, or note.
- Receivables turnover ratio: number of times during a year that the average accounts receivable balance is collected (or “turns over”).
- Average collection period: approximate number of days the average accounts receivable balance is outstanding.
CHAPTER 6 – INVENTORY AND COSTS OF GOODS SOLD
- Inventory: items a company intends for sale to customers in the ordinary course of business. Also items that are not yet finished products.
Inventory is a current asset reported in the balance sheet and represents the cost of inventory not yet sold at the end of the period.
- Costs of goods sold: cost of the inventory that was sold during the period. Costs of goods sold is an expense reported in the income statement and represents the cost of inventory sold.
- Manufacturing companies: produce the inventories they sell, rather than buying them in finished form from suppliers. They buy the inputs for the products they manufacture. Inventory for a manufacturer:
Raw materials: cost of components that will become part of the finished product but have not yet been used in production
Work-in-process: products that have been started but are not yet complete at the end of the period.
Finished goods: complete items.
- Merchandise companies: assemble, sort, repackage, redistribute, store, refrigerate, deliver or install the inventory but they do not manufacture it.
Wholesalers: resell inventory to retail companies or to professional users.
Retailers: purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.
Service companies record revenues when providing services to customers (not account inventory and COGS).
Merchandising and manufacturing companies record revenues when selling inventory to customers (must account for inventory and COGS).
- Multiple-step income statement: an income statement that reports multiple levels of income (or profitability).
When inventory costs are rising (as in our example), FIFO results in:
1. Higher inventory in the balance sheet.
2. Higher gross profit in the income statement (lower COGS).
3. higher reported profit than does LIFO
Generally, results in higher assets and higher net income when inventor costs are rising.
- FIFO: balance-sheet focus
- LIFO: income-statement focus
LIFO: The primary benefit is tax savings. LIFO results in the lowest amount of reported profits (when inventory costs are rising). When taxable income is lower, the company owes less in taxes to the Internal Revenue Service (IRS).
LIFO conformity rule: IRS rule requiring a company that uses LIFO for tax reporting to also use LIFO for financial reporting.
LIFO DIFFERENCE: to better compare each company’s inventory and profitability, investors must adjust for the fact that managers’ choice of inventory method has an effect on reported amounts.
LIFO reserve: Companies that report using LIFO must also report the difference between the LIFO amount and what that amount would have been if they had used FIFO.
Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. Conversely, LIFO results in a lower
reported inventory and net income, reducing the company’s income tax obligation. Companies use internally FIFO to report externally under LIFO.
- Perpetual inventory system: maintains a continual (perpetual) record of inventory purchased and sold.
- Periodic inventory system: periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.
Using perpetual inventory system:
When companies purchase inventory using perpetual inventory system:
1. They increase inventory account (debit) and either decrease cash or increase accounts payable (credit).
When companies sell inventory they make two entries:
1. They increase an asset account (cash or accounts receivable) (debit) and increase sales revenue (credit).
2. They increase COGS (debit) and decrease inventory (credit).
Freight charges: shipping or delivery charges. FOB (“free on board”): when title (ownership) passes from the seller to the buyer. (Increase COGS)
1. FOB shipping point: title passes when the seller ships the inventory (WHEN LEAVES THE SUPPLIER’S WAREHOUSE).
2. FOB destination: title passes when the inventory reaches the buyer’s destination (WHEN INVENTORY ARRIVES AT THE SHOP).
- Freight-in: cost to transport inventory to the company, which is included as part of inventory cost.
- Freight-out: cost of freight on shipments to customers, which is included in the income statement either as part of COGS or as a selling expense.
- Purchase discounts: allow buyers to trim a portion of the cost of purchase in exchange for payment within a certain period of time. Subtract from the cost of inventory
and therefore reduce COGS of items sold.
- Purchase returns: return the item to a supplier because it is unacceptable for some reason (they are damaged or different form what was ordered).
Freight charges are added to the cost of inventory, whereas purchase returns and purchase discounts are deducted from the cost of inventory.
Some companies choose to report freight charges on outgoing shipments as part of selling expenses instead of COGS.
- Net realizable value: estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal and transportation.
- Lower of cost and net realizable value: method where companies report inventory in the balance sheet at the lower of cost and net realizable value
(where net realizable value equals estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal and transportation).
When net realizable value falls below cost, we adjust downward the balance of inventory from cost to net realizable value.
- Inventory turnover ratio: number of times the firm sells its average inventory balance during a reporting period.
- Average days in inventory: approximate number of days the average inventory is held.
- Gross profit ratio: amount by which the sale of inventory exceeds its cost per dollar of sales.
