University of Economics and

Human Sciences in Warsaw

INTERNATIONAL
FINANCIAL ACCOUNTING
Lecture V
RAFAŁ KUSY
Ph. D. 1
 Learning objectives
After studying this session you should be able to
• 1.Recognize revenue items at the proper time on the income
statement.
• 2.Account for cash and credit sales.
• 3.Compute and interpret sales returns and allowances, sales
discounts, and bank credit card sales.
• 4.Estimate and interpret uncollectible accounts receivable
balances.
• 5.Assess the level of accounts receivable.

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 Recognition of Sales Revenues
Revenue recognition requires a two-pronged
test.
–Goods or services must be delivered to the
customers (the revenue must be earned).
–Cash or an asset virtually assured of being
converted into cash must be received (the
revenue must be realized).
Most companies recognize revenue at the
point of sale. 3
Measurement of Sales Revenues
A €100 cash sale is recorded as
Cash €100
Sales Revenues €100
A €100 credit sale is recorded as

Accounts Receivable €100

Sales Revenues €100

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Merchandise Returns and Allowances
Gross sales are the initial revenues or asset
inflows based on the initial sales price.
Gross sales are decreased by the amount of the
returns and allowances to calculate the net sales.
A sales return occurs when a customer returns
previously purchased merchandise.
A sales allowance is a reduction of the original
selling price.
A contra account to sales revenues (Sales
Returns and Allowances) combines both returns
and allowances in a single account
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 Merchandise Returns and
Allowances -Example
Suppose the ABC company has $ 900,000
of gross sales on credit and $ 80,000 of sales
returns and allowances.
The journal entries are:

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 Merchandise Returns and
Allowances –Example (ctd.)
The Income Statement would show:

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 Cash and Trade Discounts
Trade discounts offer one or more
reductions to the gross selling price for a
particular class of customers.
The gross sales revenue recognized from a
trade discount sale is the price received after
deducting the discount.
Companies set trade discount terms to be
competitive in industries where such
discounts are common or to encourage
certain customer behavior.
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 Cash Discounts
Cash discounts are rewards for prompt payment
Credit Terms and Meaning
n/30 => The full billed price (net price) is due on the
thirtieth day after the invoice date

1/5, n/30 => A 1% discount can be taken for payment

within 5 days of the invoice date: otherwise the full billed
price is due in 30 days

15 E.O.M. => The full price is due within 15 days after

the end-of the-month of sale (an invoice dated December
20 is due January 15)
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Recording Credit Card Transactions
3 major reasons why retailers accept credit
cards:
–To attract credit customers who would otherwise
shop elsewhere.
–To get cash immediately instead of waiting for
customers to pay in due course.
–To avoid the cost of tracking, billing and
collecting customers’ accounts.

Card companies’ service charges are

typically from 1% to 4% of gross sales. 10
Recording Credit Card Transactions
Suppose VISA charges a company a
straight 3% of sales for its credit card
services.
Credit sales of $ 10,000 will result in
cash of only $ 9,700.
The journal entry is:

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Accounting for Net Sales Revenues
A detailed income statement might
contain multiple elements as follows:
Gross sales $ 1,000
Deduct:
Sales returns and allowances $ 270
Cash discounts on sales $ 20 $ 290
Net sales $ 710

Reports to shareholders generally omit

details and show only net sales
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revenues.
 Credit Sales and Accounts
Receivable
Most sales are on credit. They create
Accounts receivable.
Credit sales create a new set of
problems for measuring revenue and
managing the company’s assets.
Credit sales generate potential
uncollectible accounts.
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Credit Sales and Accounts Receivable
Granting credit entails both benefits and
costs:
The main benefit is the boost in sales and profit that a
company generates when it extends credit.
The most significant cost is uncollectible accounts or
bad debts—receivables that some credit customers are
either unable or unwilling to pay.
The cost of granting credit that arises from
uncollectible accounts is called bad debts expense

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 Measurement of Uncollectible
Accounts
Uncollectible accounts require special
accounting procedures.
There are two basic ways to record
uncollectibles:
–The specific write-off method.
–The allowance method.

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 The Specific Write-Off Method
The specific write-off method assumes
that all sales are fully collectible until
proved otherwise.
When a company identifies a specific
customer account as uncollectible, it reduces
the Accounts Receivable.
The journal entry for the write-off of a
specific Account Receivable of $20,000 is:
Bad debts expense $ 20,000
Accounts receivable $ 20,000
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The Specific Write-Off Method
Bad debt expense
Customers (operating expense)

Income statements

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 The Specific Write-Off Method
The specific write-off method fails to
apply the matching principle of accrual
accounting.
Matching requires recognition of the
bad debts expense at the same time as
the related revenue.

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 The Allowance Method
The allowance method has two basic
elements:
–an estimate of the amounts that will
ultimately be uncollectible and
–acontra account (to the account receivable),
which contains the estimated uncollectible
amount that is deducted from the total
Accounts Receivable.

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 The Allowance Method
The contra account is called
allowance for uncollectible accounts.
The contra account recognizes bad
debts in general during the proper
period before uncollectible accounts
from specific individuals are identified
in the following period.

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 The Allowance Method
Bad debt expense Allowance for Uncollectible
(operating expense) Accounts
(Contra-asset account)

Income statements Balance sheet

Customers
-Allowance f.
Uncollectible
Accounts

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The Allowance Method -Example
Suppose that ABC company
–Knows from experience that it will not collect about 2
% of sales.
–Has sales in 2007 of $ 100,000.
–Estimates that 2% of $ 100,000 will be uncollectible.
–Does not know on December 31, 2007, which customers
will fail to pay their accounts.

ABC company still acknowledge the

$2,000 worth of bad debts in 2007.

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The Allowance Method –Example
(ctd.)
The journal entries are:

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 The Allowance Method –Example
(ctd.)
The journal entries for the write-off of
two customer accounts (Mr X: $ 1,400;
Mr Y: $ 600) in 2008 is:
–2008: Write-offs:

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 Applying the Allowance Method
Using a Percentage of Sales
Expressing the amount of bad debts as
a percentage of total sales is known as
the percentage of sales method.
This approach directly calculates the
bad debts expense that appears on the
income statement.
The previous example illustrates this
approach. 25
 Applying the Allowance Method
Using a Percentage of Accounts
Receivable
The percentage of accounts receivable
method estimates uncollectible accounts
based on the historical relationship between
uncollectibles to year-end gross accounts
receivable.
Additions to the allowance account are
calculated to achieve a target ending
balance. 26
Applying the Allowance Method –
Using a Percentage of Accounts
Receivable -Example
Assume the accounts receivable balance is $115,000 at
the end of 2007.
The average percentage of accounts receivable not
collected is applied to the 2007 ending balance ($115,000
x 3.33% = $ 3,833).
Suppose a beginning balance in the Allowance account
of $ 700.
The corresponding adjusting journal entry is:
Bad debts expense $ 3,133
Allowance for uncollectible
Accounts $ 3,133 27
 Applying the Allowance Method –
Using the Aging of Accounts
Receivable
The aging of accounts receivable method
directly incorporates the customers’ payment
histories.
As more time elapses after the sale,
collection becomes less likely.
The $115,000 balance in Accounts
Receivable on December 31, 2007, might be
aged as shown on the next slide.
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 Applying the Allowance Method – Using the Aging of
Accounts Receivable - Example
more than
Name Total 1-30 days 31-60 days 61-90 days 90 days
A € 20 000 € 20 000
B € 10 000 € 10 000
C € 20 000 € 15 000 € 5 000
D € 22 000 € 12 000 € 10 000
E € 4 000 € 3 000 € 1 000
Other € 39 000 € 27 000 € 8 000 € 2 000 € 2 000

Total € 115 000 € 72 000 € 25 000 € 15 000 € 3 000

Historical bad debt
percentages 0,10% 1% 5% 90%
Bad debt allowance to be
provided € 3 772 € 72 € 250 € 750 € 2 700

Assuming a beginning balance of $ 700 in the

Allowance account the adjusting journal entry is:
Bad debts expense $ 3,072
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Allowance for uncollectible accounts $ 3,072
 Bad Debt Recoveries

When bad debt recoveriesoccur, the

write-off is reversed and the collection
is handled as a normal receipt on
account

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 Bad Debt Recoveries -Example
The following October journal entries reverse the
February write-off of an individual account receivable.

Feb. 2007
Allowance for uncollectible accounts XXX
Accounts receivable XXX

Oct. 2007
Accounts receivable XXX
Allowance for uncollectible accounts XXX
Cash XXX
Accounts receivable XXX
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 Assessing the Level of Accounts Receivable

One measure of the ability to control

receivables is the accounts receivable
turnover:
Credit sales / Average Accounts
Receivable
Higher turnovers indicate that a company
collects its receivables quickly.
Lower turnovers indicate slower
collection.
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 Assessing the Level of Accounts Receivable

Suppose credit sales for ABC company in

2008 were $1 million and beginning and
ending accounts receivable were $115,000
and $ 112,000, respectively.

Accounts receivable turnover:

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 Assessing the Level of Accounts Receivable

The days to collect accounts

receivable, or average collection period,
is calculated by dividing 365 by the
accounts receivable turnover.
Days to collect accounts receivable:
365 / 8.81 = 41.4 days
There is significant variability in
accounts receivable turnover levels
among industries.
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