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Do the Financial Statements Give a True and Fair View?
SWIRE PACIFIC, LTD., based in Hong Kong, is one of the largest companies in
the world. The primary operations of the company are in the region of Hong
Kong, China, and Taiwan where it has operated for over 125 years. Swire op-
erates CATHAY PACIFIC AIRWAYS and has extensive real estate holdings in
Hong Kong. The 1996 auditor s report (prepared by PRICE WATERHOUSE) for
Swire Pacific, dated March 14, 1997, read as follows (in part):
An audit includes examination, on a test basis, of evidence
relevant to the amounts and disclosures in the accounts. It
also includes an assessment of the significant estimates
and judgments made by the directors in the preparation of
the accounts, and of whether the accounting policies are
appropriate to the Company s and the Group s circum-
stances, consistently applied and adequately disclosed. . . .
In our opinion the accounts give a true and fair view,
in all material respects, of the state of affairs of the Com-
pany and the Group as at 31st December 1996. . . .
Although the concept of a true and fair view is not part of the auditor s ter-
minology in the United States, it is used by auditors all over the world and is
also discussed as part of International Accounting Standards (IAS). The true
and fair view concept states that an auditor must make sure that the finan-
cial statements give an honest representation of the economic status of the
company, even if the company violates generally accepted accounting princi-
ples in order to do so.
1. Review the opinion language in the auditor s report for MICROSOFT (see
Appendix A). Does the audit report state unconditionally that Microsoft s
financial statements are a fair representation of the economic status of the
company?
2. Auditors in the United States concentrate on performing audits to ensure
that financial statements are prepared in accordance with generally ac-
cepted accounting principles. What economic and legal realities in the
United States would make it difficult for U.S. auditors to apply the true
and fair view concept?
L




ETHICS CASE
Blowing the Whistle on Former Partners
On St. Patrick s Day in 1992, CHAMBERS DEVELOPMENT COMPANY, one of
the largest landfill and waste management firms in the United States, an-
nounced that it had been engaging in improper accounting for years. Wall
Street fear (over what this announcement implied about the company s track
record of steady earnings growth) sent Chambers stock price plunging by 62%
in one day.
230 f231
Ensuring The Integrity Of Financial Information the Integrity of Financial Information CEO Chapter 5
Ensuring




The improper accounting by Chambers had been discovered in the course
of the external audit. The auditors found that $362 million in expenses had not
been reported since Chambers first became a public company in 1985. If this
amount of additional expense had been reported, it would have completely
wiped out all the profit reported by Chambers since it first went public. The
difficult part of this situation was that a large number of the financial staff work-
ing for Chambers were former partners in the audit firm performing the audit.
These accountants had first worked as independent external auditors at Cham-
bers, then were hired by Chambers, and subsequently were audited by their
old partners.
What ethical and economic issues did the auditors of Chambers Develop-
ment Company face as they considered whether to blow the whistle on their
former partners?
L




WRITING ASSIGNMENT
External Auditors
Visit or call a local CPA firm (or the local office of a multi-office CPA firm). Ask
about career opportunities, the size of the firm s staff, who some of its major
clients are, and other facts about the firm. Then, write a one-page summary of
your visit.
L




THE DEBATE
Who Needs Internal Control?
An internal control system is intended to ensure that all transactions are prop-
erly approved and recorded, that assets and records are safeguarded, and that
operations run efficiently. As with any other system in a business, an internal
control system costs money to operate.
Divide your group into two teams.
One team represents the Hire Honest and Smart group. Prepare a two-
minute oral presentation supporting the notion that if a company would
focus on hiring only honest and smart employees, it would not need to
spend money designing and operating an internal control system. Most of
the functions of internal control are to prevent employees from stealing
and to make it difficult for inept employees to commit costly mistakes.
The other team represents the No Trust group. Prepare a two-minute oral
presentation arguing that a company must set up a careful internal control
system because, given the right opportunity and motive, any employee can
turn into a thief. In addition, a company cannot rely on the good intentions
of employees to keep the business running smoothly. Instead, top man-
agement must design systems that will keep things running smoothly in
spite of the mistakes of employees.
L




CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignment
given in Chapter 2. If you completed that spreadsheet, you have a head start
on this one.
1. Refer back to the financial statement numbers for Handyman Company for
2003 [given in part (1) of the Cumulative Spreadsheet Project assignment
in Chapter 2]. Using the balance sheet and income statement created with
those numbers, create spreadsheet cell formulas to compute and display
values for the following ratios:
231
f232 Ensuring The Integrity Of Financial Information
Part 1 CEO Financial Reporting and the Accounting Cycle




a. Current ratio
b. Debt ratio
c. Asset turnover
d. Return on equity
2. To observe the impact that errors and fraudulent transactions can have on
the financial statements, determine what the ratios computed in (1) would
have been if (1) each of the following transactions was recorded as de-
scribed and (2) the transaction was recorded correctly. Treat each transac-
tion independently, meaning that before determining the impact of each
new transaction you should reset the financial statement values to their
original amounts. Each of the hypothetical transactions is assumed to oc-
cur on the last day of the year.
a. Created receivables by creating fictitious sales of $140 all on account.
b. Purchased $80 of inventory on account but incorrectly increased the
property, plant, and equipment account instead of increasing Inventory.
c. Borrowed $60 with a short-term payable. The liability was incorrectly
recorded as Long-Term Debt.
d. An inventory purchase on account in the amount of $90 was not
recorded until the next year.
L




INTERNET SEARCH
Phar-Mor
Access the Web site of PHAR-MOR at http://www.pharmor.com. Sometimes
Web addresses change, so if this address doesn t work, access the Web site
for this textbook (http://albrecht.swcollege.com) for an updated link.
Once you ve gained access to the site, answer the following questions:
1. When was Phar-Mor founded? How many stores does the company have
today? In how many states is the company doing business?
2. Locate Phar-Mor s most recent press release. What is the topic of the press
release?
3. Review Phar-Mor s annual report to determine any lingering effects of the
fraud that was revealed by the company in 1992.
4. Evaluate Phar-Mor s current financial position as compared to 1999.
comprehensive problem 1 5
As a recently hired accountant for a small business, SMC, Inc., you are provided with last year s
balance sheet, income statement, and post-closing trial balance to familiarize yourself with the
business.


SMC, Inc.
Balance Sheet
December 31, 2002

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,500
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $69,700


Liabilities and Stockholders Equity
Liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . .................... $12,000
Salaries payable . . . . . . . . . . . . . . . . . . . . .................... 1,000
Income taxes payable . . . . . . . . . . . . . . . . .................... 3,675
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . .................... $16,675
Stockholders equity:
Capital stock (10,000 shares outstanding) . .................... $25,000
Retained earnings. . . . . . . . . . . . . . . . . . . .................... 28,025
Total stockholders equity . . . . . . . . . . . . . . .................... 53,025
Total liabilities and stockholders equity. . . . .................... $69,700




SMC, Inc.
Income Statement
For the Year Ended December 31, 2002

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,000
Rent revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $111,000
Less cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,000
Less operating expenses:
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400
Salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000
Miscellaneous expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,100 26,500
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,500
Less income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,675
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,825
Earnings per share ($20,825 10,000 shares) . . . . . . . . . . . . . . . . . . $ 2.08
233
f234 Ensuring The Integrity Of Financial Information
Part 1 Comprehensive Problem 1-5



SMC, Inc.
Post-Closing Trial Balance
December 31, 2002
Debits Credits

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000
Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Income Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,675
Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,025
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $69,700 $69,700



You are also given the following information that summarizes the business activity for the cur-
rent year, 2003.
a. Issued 5,000 additional shares of capital stock for $10,000 cash.
b. Borrowed $5,000 on January 2, 2003, from Downtown Bank as a long-term loan. Interest
for the year is $500, payable on January 2, 2004.
c. Paid $3,600 cash on November 1 to lease a truck for one year.
d. Received $1,200 on November 1 from a tenant for six months rent.
e. Paid $600 on October 1 for a one-year insurance policy.
f. Purchased $500 of supplies for cash.
g. Purchased inventory for $100,000 on account.
h. Sold inventory for $150,000 on account; cost of the merchandise sold was $80,000.
i. Collected $120,000 cash from customers accounts receivable.
j. Paid $70,000 cash for inventories purchased during the year.
k. Paid $25,000 for sales reps salaries, including $1,000 owed at the beginning of 2003.
l. No dividends were paid during the year.
m. The income taxes payable for the year were paid. Income taxes are based on a 15% corpo-
rate tax rate.
n. For adjusting entries, all prepaid expenses are initially recorded as assets, and all unearned
revenues are initially recorded as liabilities.
o. At year-end, $150 worth of supplies are on hand.
p. At year-end, an additional $5,000 of sales salaries are owed, but have not yet been paid.
You are asked to do the following:
1. Journalize the transactions for the current year, 2003, using the accounts listed on the fi-
nancial statements and other appropriate accounts (you may omit explanations).
2. Set up T-accounts and enter the beginning balances from the December 31, 2002, post-
closing trial balance for SMC. Post all current year journal entries to the T-accounts.
3. Journalize and post any necessary adjusting entries at the end of 2003. (Hint: Items b, c,
d, e, m, o, and p require adjustment.)
4. After the adjusting entries are posted, prepare a trial balance, a balance sheet, and an in-
come statement for 2003. (Hint: Income before income taxes should equal $39,600.)
5. Journalize and post closing entries for 2003 and prepare a post-closing trial balance.
6. Using the DuPont framework, compute the return on equity for SMC for 2002 and 2003.
7. Interpretive Question: What is your overall assessment of the financial health of SMC, Inc.?
Selling a Product
or a Service

chapter



6
f6
learning objectives After studying this chapter, you should be able to:

describe the business
1 Understand the three basic 6 Match revenues and 8 Understand how receivables
controls necessary to
types of business activities: expenses by estimating and can be used by a company
safeguard cash.
operating, investing, and recording future warranty to get cash immediately.
financing. and service costs associated
4 Record the losses resulting 9 Account for the impact of
with a sale.
from credit customers who
2 Use the two revenue changing exchange rates on
do not pay their bills.
recognition criteria to decide the value of accounts
when the revenue from a sale receivable denominated in
5 Evaluate a company s
or service should be recorded foreign currencies.
management of its
in the accounting records. receivables by computing
7 Reconcile a checking
and analyzing appropriate
3 Properly account for the account.
financial ratios.
collection of cash and
236 chapter f6
Selling A Product Or A Service


fact, the demand was so great that Jerry
Jerry Yang was born in Taiwan in 1968.
and David were spending 20-plus hours a
His father died when he was just two, so
day on their hobby. In addition, the re-
Jerry and his brother were raised by their
sources of the Stanford computer network
mother, an English professor at a univer-
were being taxed by Yahoo! users, and
sity in Taipei. Jerry s mother moved the
university officials asked Jerry and David
family to San Jose, California, in 1978. In
to find another computer to
spite of what he calls a very short atten-
fyi
host their service. Interest in
tion span, Jerry was an excellent stu-
hosting the Yahoo! service
dent he was valedictorian of his high
Jonathan Swift coined the
was high, and representa-
school class, and he completed his bach-
word yahoo in his book Gul-
tives from MCI WORLD-
elor s and master s degrees in electrical
liver s Travels. The yahoos
COM, AOL, and NETSCAPE
engineering at Stanford University in a to-
tal of just four years.1 visited Jerry and David in were savage humans who lived
their disheveled 10-by-10-
David Filo was born in Wisconsin in in a land where horses were the
foot work space in a trailer
1966. He describes his parents as hippie dominant species. Swift, a
on the Stanford campus.
wannabes, who moved their family to
noted satirist, used the term ya-
Jerry and David accepted
Moss Bluff, Louisiana, to join a commune.
hoo to illustrate how easy it is
Netscape s offer of help, and
David eventually left the commune to at-
the Yahoo! service moved
tend Tulane University where he studied to justify committing atrocities
over to the Netscape com-
computer engineering. David then went to against people once they are
puter network in 1995.
Stanford as a graduate student, working categorized with an unfavor-
In March 1995, Jerry
part-time as a teaching assistant. As luck
able label.
and David were finally con-
would have it, one of his students was
vinced that their Web search
Jerry Yang. Jerry and David s friendship
hobby could actually be turned into a busi-
was strengthened when they both went on
ness. They accepted a $4 million invest-
a six-month academic exchange program
ment from SEQUOIA, a venture capital
to Japan in 1992.
firm. Realizing that they lacked business
In 1993, Jerry and David were sup-
expertise, they chose Tim Koogle, another
posed to be working on their Ph.D. theses
Stanford graduate who was running a
in computer-aided design at Stanford. In-
setting the stage
$400 million high-tech equipment com-
stead, they found themselves spending
pany, to join them in running their com-
more and more research time surfing
pany. In essence, Jerry and David hired
through the incredible amount of infor-
Koogle to be their boss. In Yahoo! s orga-
mation available on the newly created
nizational hierarchy, Koogle bears the title
World Wide Web. Their first project was
of chief executive officer (CEO), and Jerry
to write software that scanned the Web
and David are officially titled the Chief Ya-
for NBA player statistics. The first Web
hoos. This team has turned Yahoo! into
site that Jerry designed was dedicated to
the most recognized name among Internet
another of his sports passions sumo
companies. As of June 2000, Yahoo! had
wrestling.
a total market value of $76 billion.
Jerry and David quickly learned that
So, how does Yahoo! make money?
the key to surfing the vast quantities of in-
Throughout its history, Yahoo! has gener-
formation on the Web was to be able to
ated almost all of its revenue through the
organize the information. They compiled a
sale of advertising space on its Web pages.
list of their favorite Web sites, which they
For example, in 1999, 90.4% of Yahoo! s
e-mailed to friends and posted on the Web
$588.6 million in revenue was generated
under the title Jerry s Guide to the World
through advertising. Yahoo! s advertising
Wide Web. This title was a bit unwieldy,
fees are described as follows in the com-
so they came up with the shorthand title
pany s 1998 annual report:
YAHOO! Jerry and David liked the ir-
reverent, lively tone of the name; they then
went back and developed a formal title The Company s standard rates for
to fit the Yahoo! acronym: Yet Another Hi- banner advertising currently range
erarchical Officious Oracle. from approximately $6.00 per thou-
By 1994, thousands were using Ya- sand impressions for run of network
hoo! to access information on the Web. In [general advertising] to approxi-


1 The Yahoo! background material was obtained from the following sources: Beverly Schuch, Yang and Filo: Chief
Yahoos! CNN Pinnacle, November 14, 1999, Transcript #99111400V39; and Brent Schlender, How a Virtuoso Plays
the Web, Fortune, March 6, 2000, p. F-79.
237
f238 Part 2 Selling A Product Or A Service
Operating Activities


mately $90.00 per thousand impres- from 1995 through 1999 averaged 353% per
sions for highly targeted audiences year, as illustrated in Exhibit 6-1. The chal-
and properties. lenge facing Yahoo! is to expand its rev-
enue base from advertising into the ex-
The key factor in generating this advertis-
ploding realm of e-commerce. For example,
ing revenue is maintaining high traffic
Yahoo! plans to significantly increase the
through its Web sites. In March 2000, Ya-
amount of revenue it generates through
hoo! s traffic averaged 625 million page
commissions on e-commerce transactions
views per day, originating from a pool of
facilitated through services such as Yahoo!
145 million different Yahoo! users world-
Shopping and Yahoo! Auctions.
wide. Yahoo! s growth in annual revenues




For Internet companies such as Yahoo!, investors are extremely interested in the amount of revenue
reported in the income statement. In fact, in the gold rush of e-commerce, investors are more con-
cerned about how much e-business a company is doing than about whether the company is able to
generate immediate profits. The amount of revenue reported by an Internet company is a key indi-
cator of how large the company is in the Internet economy. For example, as of 1999, AMAZON.COM
had never reported a profit (revenue minus expenses) in its history; the company lost $720 million in
1999 alone. Yet, because of the $1.6 billion in revenue it reported in 1999, Amazon.com is viewed
as a major player in the burgeoning Internet economy. As a result, Amazon.com had a market value
of $16.4 billion in May 2000.
The amount of revenue reported by traditional companies, such as GENERAL MOTORS,
WAL-MART, and GENERAL ELECTRIC, is also of interest to investors because increased rev-
enues almost always lead to increased profits. Consequently, there is sometimes great pressure on com-
panies to report as much revenue as possible. To balance this pressure, accounting rules have been es-
tablished to govern exactly when it is appropriate for a company to report the revenue from a transaction
in the income statement. These accounting rules are not just conceptual toys for accountants; investor




Growth in Yahoo! Revenue: 1995 1999
exhibit 6-1


Growth In Revenues
(1995“1999)
600
Yahoo! Annual Revenues (in millions)




500


400


300


200


100


0
1995 1999
1998
1996 1997
Year
238 f239
Selling A Product Or A Service Chapter 6
Selling a Product or a Service


concern about whether MICROSTRATEGY, a software company, was correctly applying the ac-
counting rules associated with revenue caused the company s stock price to drop from $333 per share
on March 10, 2000, to $22.25 per share just 10 weeks later.2
In this chapter, you will study the accounting rules governing the proper recognition of revenue.
You will also learn how to account for cash collections and how to handle customer accounts that are
uncollectible. Selling goods and services, collecting the cash, and handling customer accounts are fun-
damental to the operation of any business. Accordingly, properly recording these activities is funda-
mental to the practice of accounting.


1 MAJOR ACTIVITIES OF A BUSINESS
Understand the three basic
In the first five chapters, you were introduced to the accounting environment, the basic finan-
types of business activities:
operating, investing, and cial statements, and the accounting cycle (the way business transactions are entered into the ac-
financing.
counting records). That material was necessary for you to understand some basic terminology
and procedures used in accounting. Accounting has often been called the language of business.
By studying the first five chapters, you should now be somewhat familiar with this new busi-
ness language.
With the basics behind us, it is now time to use accounting to understand how businesses
work, how the various activities of business are accounted for, and how businesses report their
operating results to investors. The activities of most businesses can be divided into three groups:
Operating activities
Investing activities
Financing activities
Operating activities involve selling products or services, buying inventory for resale, and
operating activities Trans-
actions and events that in- incurring and paying for necessary expenses associated with the primary activities of the busi-
volve selling products or
ness. The operating activities of a motel, for example, would include renting rooms (the selling
services and incurring the
activity); buying soap, shampoo, and other supplies to operate the motel; and incurring and pay-
necessary expenses associ-
ing for electricity, heat, water, cleaning, television and telephone service, and salaries and taxes
ated with the primary activ-
of workers. The operating activities of a grocery store would include buying produce, meats,
ities of the business.
canned goods, and other items for resale; selling products to customers; and incurring and pay-
ing for expenses associated with the store s operations such as utilities, salaries, and taxes. The
operating activities of YAHOO! include selling advertising space on the company s Web pages,
paying employees to maintain the Yahoo! system
A motel deals with operat-
and to develop new software, and paying to ad-
ing activities on a daily
vertise the Yahoo! brand name on TV and in mag-
basis when renting
azines. It is easy to identify operating activities be-
rooms, buying supplies,
and paying utility ex-
cause they are always associated with the primary
penses.
purpose of a business.
In this chapter we cover the operating activ-
ities for selling products and services, the recog-
nition of revenues from those sales, accounting for
cash, and problems associated with collecting re-
ceivables arising from sales. In Chapter 7 we ex-
amine the purchase of inventory for resale to cus-
tomers and the necessary accounting procedures.
In Chapter 8 we conclude our discussion of op-
erating activities by considering other operating
expenses and how revenues and expenses are com-
bined to compute the net income of a business.
Incurring and paying for operating expenses such


2 Michael Schroeder, SEC Widens MicroStrategy Inves-
tigation, The Wall Street Journal, May 24, 2000, p. C1.
239
f240 Part 2 Selling A Product Or A Service
Operating Activities


as employee compensation, insurance, advertising, research and development, and income taxes
are also covered in Chapter 8.
Investing activities involve the purchase of assets for use in the business. The assets pur-
investing activities Transac-
tions and events that in- chased as part of investing activities include property, plant, and equipment, as well as financial
volve the purchase and sale
assets such as investments in stocks and bonds of other companies. Investing activities are dis-
of property, plant, equip-
tinguishable from operating activities because they occur less frequently and the amounts in-
ment, and other assets not
volved in each transaction are usually quite large. For example, while most businesses buy and
generally held for resale.
sell inventory or services to customers on a daily basis (operating activities), only rarely do they
buy and sell buildings, equipment, and stocks and bonds of other companies. It is important to
note that buying inventory for resale is an operating activity, not an investing activity. Invest-
ing activities are covered in Chapters 9 and 12.
Financing activities involve raising money to finance a business by means other than op-
financing activities Transac-
tions and events whereby erations. In addition to earning money through profitable operations, there are two other ways
resources are obtained
to fund a business: (1) money can be borrowed from creditors (debt financing), or (2) money
from, or repaid to, owners
can be raised by selling stock or ownership interests in the business to investors (equity financ-
(equity financing) and credi-
ing). Debt financing is the subject of Chapter 10, while equity financing will be discussed in
tors (debt financing).
Chapter 11.
Once you have studied Chapters 6 through 12, you will have a good understanding of how
businesses operate, invest, and are financed. That knowledge should be helpful in the future if you
own your own business, invest in companies as a stockholder, work for a financial institution (or
other lender of funds), or work in any position where a knowledge of business is essential.
After studying the operating, investing, and financing activities of a business, you will be
ready to combine your knowledge of how businesses operate with the basic accounting knowl-
edge you gained from Chapters 1 through 5. To do this, we will study in detail the statement
of cash flows, which is structured around the three activities of a business (Chapter 13). You
will discover that preparation of a statement of cash flows requires a sound understanding of the
balance sheet and the income statement, as well as a good grasp of how the activities of a busi-
ness tie together. Exhibit 6-2 provides a graphical road map of the business and reporting ac-
tivities that will be discussed in the subsequent eight chapters.
Although Chapters 6 through 12 are organized around business activities, it is important
to understand how these activities relate to the basic financial statements. To help you under-
stand these relationships, at the beginning of each of the next seven chapters, we present basic
financial statements that highlight the accounts that will be covered in that chapter. As you can




Major Activities of a Business
exhibit 6-2


Operating Activities
1. Sell products and services (Ch. 6)
2. Acquire inventory for resale
(Ch. 7)
3. Acquire and pay for other
operating items and report
profitability (Ch. 8)
Financing Activities Investing Activities
1. Buying and selling property,
1. Debt financing (Ch. 10)
plant, and equipment (Ch. 9)
2. Equity financing (Ch. 11)
2. Buying and selling stocks and
bonds of other companies
(Ch. 12)
Financial Statement
Summary and Review
1. Statement of cash flows (Ch. 13)
240 f241
Selling A Product Or A Service Chapter 6
Selling a Product or a Service



Financial Statement Items Covered in This Chapter
exhibit 6-3



Statement of
Balance Sheet Cash Flows
Current assets
Operating activities
Cash
Receipts from
Accounts receivable
customers
Current liabilities
Warranty liability




Income
Statement
Revenue
Sales of goods
and services

Expenses
Bad debt expense
Warranty expense




see in Exhibit 6-3, Cash, Accounts Receivable, and Warranty Liability on the balance sheet;
Sales, Bad Debt Expense, and Warranty Expense on the income statement; and Receipts from
Customers on the statement of cash flows are covered in Chapter 6.



to summarize
Activities of a business can be divided into (1) operating activities, (2) invest-
ing activities, and (3) financing activities. Operating activities involve selling
products or services, buying inventory for resale, and incurring and paying for
necessary expenses associated with the primary activities of a business. In-
vesting activities include purchasing assets for use in the business and mak-
ing investments in such items as stocks and bonds. Financing activities include
raising money to finance a business by means other than operations.




RECOGNIZING REVENUE
2
Use the two revenue
The operations of a business revolve around the sale of a product or a service. MCDONALD S
recognition criteria to
decide when the revenue sells fast food; MICROSOFT sells software and continuing customer support; BANK OF
from a sale or service
AMERICA loans money and sells financial services; YAHOO! sells advertising space on its Web
should be recorded in the
pages. Just as the sale of a product or service is at the heart of any business, proper recording of
accounting records.
the revenue from sales and services is fundamental to the practice of accounting. A simple time
line illustrating the business issues involved with a sale is given in Exhibit 6-4.
Consideration of this time line raises a number of very interesting accounting questions:
When should revenue be recognized when the initial order is placed, when the good or
service is provided, when the cash is collected, or later, when there is no longer any chance
that the customer will return the product or demand a refund because of faulty service?
241
f242 Part 2 Selling A Product Or A Service
Operating Activities



Time Line of Business Issues Involved with a Sale
exhibit 6-4




RETURNS




ACCEPT ACCEPT PROVIDE
DELIVER COLLECT STRUGGLE
an order returned continuing
a product or cash with nonpaying
service
a service customers
products



What accounting procedures are used to manage and safeguard cash as it is collected?
How do you account for bad debts, that is, customers who don t pay their bills?
How do you account for the possibility that sales this year may obligate you to make war-
ranty repairs and provide continuing customer service for many years to come?
The following sections will address these accounting issues, beginning with the important ques-
tion of when to recognize revenue.

When Should Revenue Be Recognized?
Revenue recognition is the phrase that accountants use to refer to the recording of a sale through
revenue recognition The
process of recording rev- a journal entry in the formal accounting records. Revenue is usually recognized when two im-
enue in the accounting portant criteria have been met:
records; occurs after (1) the
work has been substantially 1. The work has been substantially completed (the company has done something), and
completed and (2) cash col-
2. Cash, or a valid promise of future payment, has been received (the company has received
lection is reasonably as-
something in return).
sured.
As a practical matter, most companies record sales when goods are shipped to customers.
Credit sales are recognized as revenues before cash is collected, and revenue from services is usu-
ally recognized when the service is performed, not necessarily when cash is received.
fyi
To illustrate, we will assume that on a typical business day Farm Land Products sells
In the majority of companies, 30 sacks of fertilizer for cash and 20 sacks on credit, all at $10 per sack. Given these data,
the most frequent types of jour- the $500 of revenue is recorded as follows:
nal entries are those to record
sales, cash collections, pur-
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
chases, and payments to sup-
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
pliers. Because such transac- Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
tions are so frequent, most Sold 30 sacks of fertilizer for cash and 20 sacks on credit.
firms maintain four separate
special journals: (1) the sales
Although the debit entries are made to different accounts, the credit entry for the full
journal, (2) the purchases jour-
amount is to a revenue account. Thus, accrual-basis accounting requires the recognition
nal, (3) the cash receipts jour-
of $500 in revenue instead of the $300 that would be recognized if the focus were merely
nal, and (4) the cash disburse- on cash collection.
ments journal. These journals This example is a simple illustration of how sales are recorded and revenue is rec-
were noted in Appendix B (Spe- ognized. In reality, sales transactions are usually more complex, involving such things
as uncertainty about exactly when the transaction is actually completed and whether a
cial Journals) at the end of
valid promise of payment has actually been received from the customer. These diffi-
Chapter 4.
culties are compounded by the fact that companies often have an understandable de-
242 f243
Selling A Product Or A Service Chapter 6
Selling a Product or a Service


sire to report revenue as soon as possible in order to enhance their reported performance and
make it easier to get loans or attract investors. The discussion below will further examine the
two revenue recognition criteria (work done and cash collectible) to see how accountants ap-
ply these rules to ensure that reported revenue fairly reflects the economic performance of a
business.

Application of the Revenue Recognition Criteria
The Farm Land example was used to illustrate a straightforward case of revenue recognition
at the time a sale is made. The Farm Land customers bought $500 worth of fertilizer, pay-
ing $300 cash and promising to pay $200 later; the $500 of revenue was recognized imme-
diately. But what if the terms of the sale had also required Farm Land to deliver the fertil-
izer to the customers at no extra charge? In this case, proper application of the work done
revenue recognition criterion would require that the revenue not be recorded until actual de-
livery had taken place. Alternatively, assume that the fertilizer sale was accompanied by a
guarantee that, within 30 days, customers could return the unused portion of fertilizer for a
net work full refund. If very few customers ever seek a refund, revenue should still be recognized at
the time of sale. But, for example, if over 70% of fertilizer customers later seek refunds, the
You have probably ac-
cessed Yahoo! s Web site cash collectible revenue recognition criterion suggests that no revenue should be recognized
(http://www.yahoo.com)
until the completion of the 30-day return period; Farm Land then becomes reasonably as-
hundreds of times, but you
sured of the amount of cash it will collect from the $500 in sales. This situation illustrates
were always on your way
to somewhere else. This the need for accountants to exercise professional judgment and account for the economic re-
time, stop to find out some-
ality of a transaction instead of blindly relying on technical legal rules about whether a sale
thing about Yahoo! itself.
has taken place. Other examples of the application of the revenue recognition criteria are
First, access Yahoo! s com-
pany press release file to given below.
find out how much revenue
Yahoo! reported in the
As mentioned in the opening scenario of this chapter, Yahoo! derives most of its
YAHOO!
most recent fiscal year.
Then, use Yahoo! s stock revenue from the sale of banner advertising space on its Web pages. In 1998, Yahoo! s stan-
quote search engine to find
dard rates ranged from 0.6 cents per impression (the appearance of an advertisement on a
out Yahoo! s current market
page viewed by a user) for general markets to 9 cents per impression for more focused mar-
value (ticker symbol:
YHOO). Comment on the kets. In general, Yahoo! recognizes advertising revenue as the impressions occur. This revenue
relationship between re-
recognition practice makes sense if Yahoo! is reasonably certain of collecting payment for these
ported revenue and current
impressions because Yahoo! has completed its work of providing the impressions. Yahoo! often
market value.
guarantees an advertiser a minimum number of impressions. To the extent that the minimum
guaranteed impressions are not met as of the date the financial statements are prepared, Ya-
hoo! delays recognizing the advertising revenue until the guaranteed number of impressions is
reached.

The nature of the computer software industry presents several
MICROSOFT
As you might expect, not sticky revenue recognition issues. The installation of software and the promise
of software upgrades require software companies to consider when the earnings
all software companies support this rev-
enue recognition practice; they would prefer process is substantially complete. Are the revenue recognition criteria satisfied
to recognize all of the revenue from a soft- at the point of sale, when the software is installed, or after promised upgrades
are delivered? Microsoft recognizes a portion (80% for the Office 97 software)
ware sale immediately at the time of the
of the software price as revenue immediately upon delivery of the software to
sale. Microsoft, on the other hand, has been you. The rest of the software price is recognized as revenue gradually over time
very supportive of the rule. Why do you as the technical support service is provided.
think Microsoft supports the accounting rule
BOEING recognizes revenue from commercial aircraft sales at the
BOEING
that many other software firms oppose?
time the aircraft is delivered to the airline. For example, in 1999 Boeing rec-
ognized revenue from the delivery of 620 commercial aircraft, including 320 737s. In contrast,
many of Boeing s government contracts require years of work before any product is delivered.
If Boeing did not recognize any revenue during this extended production period, its economic
activity for that period would be understated. Thus, the accounting rules allow Boeing to rec-
ognize revenue piecemeal as it reaches scheduled performance milestones. This type of pro-
243
f244 Part 2 Selling A Product Or A Service
Operating Activities



business environment essay


Worried about Revenues! Today the to- led, the Securities and Exchange Commission moni-
bacco industry faces an unprecedented tors these disclosures to make sure that they are not
antismoking onslaught. An increasing overly optimistic. Accordingly, these financial state-
number of lawsuits are alleging that ment disclosures contain a much more evenhanded
smoking, and even secondhand smoke, view than do most public statements on this contro-
causes cancer and other diseases and versial issue.) Although they are very large and ex-
that the tobacco companies are at fault tremely profitable, the tobacco companies are worried
because their sales practices get people about future revenues. They are concerned that anti-
hooked on addictive drugs. (By the way, smoking activity will result in fewer smokers and
if you wish to read a careful assessment fewer sales. As a result, the big tobacco companies
of the health risks associated with cigarettes, read the have been diversifying into other businesses, so that
financial reports of the tobacco companies. By federal now a significant amount of their revenues comes
law, these reports must be provided to all interested from nontobacco sales. For example, two large to-
investors, and, to ensure that investors are not mis- bacco companies now own the following:




portional performance technique is commonly used to recognize revenue from transactions that
extend over a long time period, such as for highway construction projects or season tickets for
a professional sports team.


RENT-A-CENTER operates 2,440 rent-to-own stores in the United
RENT-A-CENTER
States under both its own name and the name ColorTyme. Customers rent furniture, VCRs,
and other consumer goods under an agreement giving them ownership of the item if they con-
tinue to make their payments for the entire rental period. Rent-to-own stores attract customers
who cannot afford the outright purchase of consumer goods and who anticipate difficulty in re-
ceiving credit through normal channels. Thus, a big concern for Rent-A-Center is collecting the
full amount of cash due under a rental contract. In fact, Rent-A-Center states that only about
25% of its customers complete the full term of their agreement. With such a high likelihood of
customers stopping payments on their rental agreements, Rent-A-Center recognizes revenue from
a specific contract only gradually as the cash is actually collected.


fyi Discount-club retailers, such as SAM S CLUB, are an increasing presence
CENDANT
in the market. In 1999, for example, Sam s Club locations had total sales of $24.8 bil-
According to generally accepted
lion. The revenue recognition issue with these clubs is when to recognize the revenue from
auditing standards, auditors are
the up-front membership fees. In 1998, a dispute about the accounting for membership
often required to confirm Ac-
fees exploded in the face of CENDANT, which markets consumer goods and travel ser-
counts Receivable balances di-
vices to its members. Cendant had been recognizing its membership fees evenly over the
rectly with the company that 12-month membership period. However, the Securities and Exchange Commission ruled
supposedly owes the money. that, because members can cancel at any time and get their money back, Cendant should
This can provide an indepen- not recognize any revenue until the end of the membership period. The change caused
Cendant to revise its reported 1997 results from a net income of $55.4 million to a net
dent check on the existence of
loss of $217.2 million. The uproar over this change caused the company s market value
the receivables.
to plummet by $20 billion.
244 f245
Selling A Product Or A Service Chapter 6
Selling a Product or a Service




Philip Morris Loews

Major Cigarette Brands Marlboro Newport
Benson & Hedges Maverick
Merit Kent
Virginia Slims True
Basic Old Gold
Other Major Businesses Post Cereals 14 hotels
and Products Jell-O Diamond Offshore Drilling
Kool-Aid CNA Financial
Oscar Mayer Bulova
Miller Beer
Kraft
1999 Revenues (billions) $78.6 $21.5
% of Revenue from Tobacco Sales 60% 18.9%


Sources: 1999 Form 10-K filings by Philip Morris and Loews. In addition to these two tobacco companies, R.J.
Reynolds Tobacco was, until 1999, part of the same company as Nabisco. Those two have now been split.




As mentioned initially, the accounting for most sales transactions is straightforward the
revenue is recognized when the sale is made. However, as illustrated by the examples in this sec-
tion, when the work associated with a sale extends over a significant period
of time, or when cash collectibility is in doubt, the accountant must use pro-
Many colleges and uni-
fessional judgment in applying the revenue recognition criteria to determine
versities prepare financial statements that
the proper time to record the sale.
are released to the public. When do you
Properly recognizing revenue is made more difficult by the fact that com-
think a college or university should recog- panies often have an understandable desire to report revenue as soon as possi-
nize revenue from student tuition? ble. For example, for a company that is applying for a large loan or making an
initial public offering of stock, it is critical that reported revenue, and thus re-
ported net income, be as high as possible. In addition, company managers are often scrambling
to make revenue or profit targets. In many cases, the managers bonuses depend on whether
these targets are met. Accordingly, managers often have great interest in making sure that rev-
enue is recognized this year rather than waiting until next year. Receivables and revenue con-
tinue to be ripe areas for abuse or outright fraud because the associated accounting journal en-
try is so temptingly easy to make: debit Accounts Receivable and credit Revenue.




to summarize
Revenue is recognized when the work is done and when cash collectibility is
reasonably assured. The entries to record revenue from the sale of merchan-
dise or from the performance of a service involve debits to Cash or Accounts
Receivable and credits to Sales Revenue or Service Revenue.
245
f246 Part 2 Selling A Product Or A Service
Operating Activities



3 CASH COLLECTION
Properly account for the
Recall the Farm Land Products example in which fertilizer was sold, partially for cash and par-
collection of cash and
describe the business tially on credit. Farm Land recorded the sales as follows:
controls necessary to
safeguard cash.
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Sold 30 sacks of fertilizer for cash and 20 sacks on credit.


Subsequent collection of the $200 accounts receivable is recorded as follows:

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Collected cash for $200 credit sale.


Note that Sales Revenue is not credited again when the cash is collected; the revenue was al-
ready recognized when the sale was made.
The following T-accounts show that the net result of these two transactions is an increase
in Cash and Sales Revenue of $500.

Cash Accounts Receivable Sales Revenue

Original sale 300 200 500
Collection of account 200 200
Final balances 500 500
To balance To income
sheet statement


These two entries illustrate simple sales and collection transactions. Many companies, however,
offer sales discounts and must deal with merchandise returns. The accounting for discounts and
returns is explained below.

Sales Discounts
In many sales transactions, the buyer is given a discount if the bill is paid promptly. Such incen-
tives to pay quickly are called sales discounts, or cash discounts, and the discount terms are typ-
sales discount A reduction
in the selling price that is ically expressed in abbreviated form. For example, 2/10, n/30 means that a buyer will receive a 2%
allowed if payment is re-
discount from the selling price if payment is made within 10 days of the date of purchase, but that
ceived within a specified
the full amount must be paid within 30 days or it will be considered past due. (Other common
period.
terms are 1/10, n/30 and 2/10, EOM. The latter means that a 2% discount is granted if payment
is made within 10 days after the date of sale; otherwise the balance is due at the end of the month.)
A 2% discount is a strong incentive for a customer to pay within 10 days because it is equivalent
to paying an annual interest rate of about 36% to wait and pay after the discount period.3 In fact,
if the amount owed is substantial, most firms will borrow money, if necessary, to take advantage
of a sales discount. The interest rate they will have to pay a lending institution to borrow the money
is considerably less than the effective interest rate of missing the sales discount.
If an account receivable is paid within a specified discount period, the entry to record the
receipt of cash is different from the cash receipt entry shown earlier. Thus, if the $200 in Farm

3 This is calculated by computing an annual interest rate for the period that the money is sacrificed. With
terms 2/10, n/30, a buyer who pays on the 10th day instead of the 30th sacrifices the money for 20 days. Since
2% is earned in 20 days, and there are just over 18 periods of 20 days in a year, earnings would be 18 2%,
or approximately 36% annual interest.
246 f247
Selling A Product Or A Service Chapter 6
Selling a Product or a Service


Land credit sales were made with discount terms of 2/10, n/30, and if the customers paid within
the discount period, the entry to record the receipt of cash is:

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
Sales Discounts ($200 0.02) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Collected cash within the discount period for $200 credit sale.


Sales Discounts is a contra account (specifically, a contra-revenue account), which means that
contra account An account
that is offset or deducted it is deducted from sales revenue on the income statement. This account is included with other
from another account. revenue accounts in the general ledger, but unlike other revenue accounts, it has a debit balance
rather than a credit balance.

Sales Returns and Allowances
Customers often return merchandise, either because the item is defective or for a variety of other
reasons. Most companies generally accept merchandise returns in order to maintain good cus-
tomer relations. When merchandise is returned, the company must make an entry to reduce rev-
enues and to reduce either Cash (a cash refund) or Accounts Receivable (an adjustment to the
customer s account). A similar entry is required when the sales price is reduced because the mer-
chandise was defective or damaged during shipment to the customer.
To illustrate the type of entry needed, we will assume that before any payments on account
are made, Farm Land customers return goods costing $150; $100 in returns were made by cash
customers, and $50 in returns were made by credit customers. The entry to record the return
of merchandise is:

Sales Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Received $150 of returned merchandise; $100 from cash customers
and $50 from credit customers.


The credit customers will be sent a credit memorandum for the return, stating that credit
has been granted and that the balance of their accounts (in total) is now $150 ($200 original
credit purchase $50 returns). Like Sales Discounts, Sales Returns and Allowances is a con-
sales returns and al-
lowances A contra-revenue tra account that is deducted from sales revenue on the income statement. The income statement
account in which the return
presentation for the revenue accounts, assuming payment within the discount period on the
of, or allowance for reduc-
$150 balance in Accounts Receivable, is as follows:
tion in the price of, mer-
chandise previously sold is
recorded.
Income Statement

Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500
Less: Sales discounts* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3)
Less: Sales returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (150)
Net sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $347

*($200 $50) 0.02 $3
Note that when merchandise is returned, sales discounts for the subsequent payment are granted only on the
selling price of the merchandise not returned.



It might seem that the use of contra accounts (Sales Discounts and Sales Returns and Al-
lowances) involves extra steps that would not be necessary if discounts and returns of merchan-
dise were deducted directly from Sales Revenue. Although such direct deductions would have
the same final effect on net income, the contra accounts separate initial sales from all returns,
247
f248 Part 2 Selling A Product Or A Service
Operating Activities


allowances, and discounts. This permits a company s management to analyze the extent to which
gross sales Total recorded
sales before deducting any customers are returning merchandise, receiving allowances, and taking advantage of discounts.
sales discounts or sales re-
If management find that excessive amounts of merchandise are being returned, they may decide
turns and allowances.
that the company s sales returns policy is too liberal or that the quality of its merchandise needs
improvement.
net sales Gross sales less
sales discounts and sales A company s total recorded sales, before any discounts or returns and allowances, are re-
returns and allowances.
ferred to as gross sales. When sales discounts or sales returns and allowances are deducted from
gross sales, the resulting amount is referred to as net sales.
cash Coins, currency,
money orders, checks, and
funds on deposit with fi-
Control of Cash
nancial institutions; the
most liquid of assets. Cash includes coins, currency, money orders and checks (made payable or endorsed to the com-
pany), and money on deposit with banks or savings institutions that are available for use
fyi to satisfy the company s obligations. All the various transactions involving these forms of
cash are usually summarized and reported under a single balance sheet account, Cash.
In its balance sheet (see Ap-
Because it is the easiest asset to spend if it is stolen, cash is a tempting target and
pendix A), MICROSOFT follows
must be carefully safeguarded. Several control procedures have been developed to help
the common practice of com-
management monitor and protect cash. In Chapter 5, internal controls for cash and other
bining cash and short-term in-
assets were discussed. Because cash is particularly vulnerable to loss or misuse, however,
vestments (bonds and U.S.
we will discuss three important controls that are an integral part of accounting for cash.
Treasury securities) for the to- One of the most important controls is that the handling of cash be separated from
tal Cash amount. the recording of cash. The purpose of this separation of duties is that it becomes more
difficult for theft or errors to occur when two or more people are involved. If the cash
records are maintained by an employee who also has access to the cash itself, cash can be
fyi stolen or borrowed, and the employee can cover up the shortage by falsifying the ac-
counting records.
Consider the case of an em-
A second cash control practice is to require that all cash receipts be deposited daily
ployee who both receives pay-
in bank accounts. This disciplined, rigid process ensures that personal responsibility for
ments and keeps the books. He
the handling of cash is focused on the individual assigned to make the regular deposit. In
or she could pocket a cash pay-
addition, this process prevents the accumulation of a large amount of cash even the most
ment from one customer and
trusted employee can be tempted by a large cash hoard.
not record the receipt until pay- A third cash control practice is to require that all cash expenditures (except those paid
ment is received from a second out of a miscellaneous petty cash fund) be made with prenumbered checks. As we all know
customer. The second cus- from managing our personal finances, payments made with pocket cash are quickly for-
gotten and easily concealed. In contrast, payments made by check are well documented,
tomer s payment could be
both in our personal check registers and by our bank.
recorded when a third customer
In addition to safeguarding cash, a business must ensure that cash is wisely managed.
pays, and so on. This type of de-
In fact, many businesses establish elaborate control and budgeting procedures for moni-
layed recording of payments is
toring cash balances and estimating future cash needs. Companies also try to keep only
called lapping; it allows an em-
minimum balances in no-interest or low-interest checking accounts; other cash is kept in
ployee to use company money
more high-yielding investments such as certificates of deposit.
for extended periods of time.




to summarize
The amount of cash collected from customers can be reduced because of sales
discounts and sales returns and allowances. On the income statement, sales
discounts and sales returns and allowances are subtracted from gross sales to
arrive at net sales. Cash is a tempting target for fraud or theft, so companies
must carefully monitor and control the way cash is handled and accounted for.
Common controls include (1) separation of duties in handling and accounting
for cash, (2) daily deposits of all cash receipts, and (3) payment of all expen-
ditures by prenumbered checks.
248 f249
Selling A Product Or A Service Chapter 6
Selling a Product or a Service



4 ACCOUNTING FOR CREDIT CUSTOMERS WHO
DON T PAY
Record the losses resulting
from credit customers who
do not pay their bills.
The term receivables refers to a company s claims for money, goods, or services. Receivables are
created through various types of transactions, the two most common being the sale of mer-
receivables Claims for
chandise or services on credit and the lending of money. On a personal level, we are all famil-
money, goods, or services.
iar with credit. Because credit is so readily available, we can buy such items as cars, refrigera-
accounts receivable A cur-
tors, and big-screen TVs, even when we cannot afford to pay cash for them. Major retail
rent asset representing
companies such as SEARS, oil companies such as SHELL, and credit card companies such as
money due for services per-
VISA, MASTERCARD, and AMERICAN EXPRESS have made credit available to almost every
formed or merchandise
person in the United States. We live in a credit world not only on the individual level, but
sold on credit.
also at the wholesale and manufacturing business levels.
In business, credit sales give rise to the most common type of receivables: accounts
fyi
receivable. Accounts receivable are the amounts owed to a business by its credit customers
Credit card sales can be viewed and are usually collected in cash within 10 to 60 days. Accounts receivable result from in-
formal agreements between a company and its credit customers; a more formal contract,
as a way for a business to reap
including interest on the unpaid balance, is called a note receivable. Other receivables may
the benefit of increased credit
result from loans to officers or employees of a company, for example. To identify and
sales without having to set up
maintain the distinction between these receivables, businesses establish a separate general
a bookkeeping and collection
ledger account for each classification. If the amount of a receivable is material, it is sepa-
service for accounts receivable.
rately identified on the balance sheet. Receivables that are to be converted to cash within
The credit card company
a year (or the normal operating cycle) are classified as current assets and listed on the bal-
screens customers based on
ance sheet below Cash. In this section of the chapter, we discuss the accounting issues as-
their creditworthiness, sends
sociated with credit customers who don t pay.
out the bills, collects the cash,
When companies sell goods and services on credit (as most do), there are usually some
and bears the cost of any un-
customers who do not pay for the merchandise they purchase; these are referred to as bad
collectible accounts. A busi- debts. In fact, most businesses expect a small percentage of their receivables to be uncol-
ness that accepts credit card lectible. If a firm tries too hard to eliminate the possibility of losses from nonpaying cus-
tomers, it usually makes its credit policy so restrictive that valuable sales are lost. On the
sales pays a fee ranging from 1
other hand, if a firm extends credit too easily, the total cost of maintaining the accounts
to 5 percent of credit card sales.
receivable system may exceed the benefit gained from attracting customers by allowing
them to buy on credit (due to the number of accounts to track and uncollectible receivables to
try to collect). Because of this dilemma, most firms carefully monitor their credit sales and ac-
bad debt An uncollectible
account receivable. counts receivable to ensure that their policies are neither too restrictive nor too liberal.
When an account receivable becomes uncollectible, a firm incurs a bad debt loss. This loss
is recognized as a cost of doing business, so it is classified as a selling expense. There are two
ways to account for losses from uncollectible accounts: the direct write-off method and the al-
lowance method.


Direct Write-Off Method
With the direct write-off method, an uncollectible account is recognized as an expense at the
direct write-off method The
recording of actual losses time it is determined to be uncollectible. For example, assume that during the year 2003, Farm
from uncollectible accounts Land Products had total credit sales of $300,000. Of this amount, $250,000 was subsequently
as expenses during the pe-
collected in cash during the year, leaving a year-end balance in Accounts Receivable of $50,000
riod in which accounts re-
($300,000 $250,000). The summary journal entries to record this information are:
ceivable are determined to
be uncollectible.

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
Sales Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
To record total credit sales for the year.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
To record total cash collections for the year.
249
f250 Part 2 Selling A Product Or A Service
Operating Activities



business environment essay


Overstating Receivables One of the eas- Coated Sales was started as the second career of
iest ways to overstate income is to over- millionaire entrepreneur Michael Weinstein, who had
state receivables. For example, Michael retired in his 30s and sold the discount drug store
Weinstein, former chairman and CEO of chain he had built. Looking for a new business, he be-
COATED SALES, INC., orchestrated a fi- came interested in textiles through a friend. The
nancial fraud scheme that ultimately proposition was simple: take unfinished textiles,
cost investors close to $100 million. known as gray goods, and finish them with special-
Coated Sales, Inc., was a New Jersey ized coatings or treatments. The company s earnings,
company that manufactured textiles though minuscule at first, began to double and even
coated with special chemicals, used for triple every year sometimes every six months.
making such products as yacht sails, bullet-proof The fraud was instigated by inflating Coated s sales
vests, conveyor belts, and parachutes. The company and earnings through the creation of phony invoices
was best known for supplying the fabric used in the purporting to show sales of goods. Coated officials
sails of the America s Cup winning yacht Stars and prebilled invoices to customers so they could ob-
Stripes. tain payment for goods before they were shipped.




Assume that one credit customer, Jake Palmer, has an account balance of $1,500 that remains
unpaid for several months in 2004. If, after receiving several past-due notices, Palmer still does not
pay, Farm Land will probably turn the account over to an attorney or a collection agency. Then,
if collection attempts fail, the company may decide that the Palmer account will not be collected
and write it off as a loss. The entry to record the expense under the direct write-off method is:


Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
To write off the uncollectible account of Jake Palmer.


Bad Debt Expense is usually considered a selling expense on the income statement. Al-
bad debt expense An ac-
count that represents the though the direct write-off method is objective (the account is written off at the time it proves
portion of the current pe-
to be uncollectible), it most likely would violate the matching principle, which requires that all
riod s credit sales that are
costs and expenses incurred in generating revenues be identified with those revenues period by
estimated to be uncol-
period. With the direct write-off method, sales made near the end of one accounting period may
lectible.
not be recognized as uncollectible until the next period. In this example, the revenue from the
sale to Jake Palmer is recognized in 2003, but the expense from the bad debt is not recognized
until 2004. As a result, expenses are understated in 2003 and overstated in 2004. This makes
the direct write-off method unacceptable from a theoretical point of view. The direct write-off
method is allowable only if bad debts involve small, insignificant amounts.

The Allowance Method
The allowance method satisfies the matching principle because it accounts for uncollectibles
allowance method The
recording of estimated during the same period in which the sales occurred. With this method, a firm uses its experi-
losses due to uncollectible
ence (or industry averages) to estimate the amount of receivables arising from this year s credit
accounts as expenses dur-
sales that will ultimately become uncollectible. That estimate is recorded as bad debt expense in
ing the period in which the
the period of sale. Although the use of estimates may result in a somewhat imprecise expense
sales occurred.
figure, this is generally thought to be a less serious problem than the direct write-off method s
failure to match bad debt expenses with the sales that caused them. In addition, with experi-
ence, these estimates tend to be quite accurate.
250 f251
Selling A Product Or A Service Chapter 6
Selling a Product or a Service




Coated then began sending out false invoices to cus- counts receivable account to secure large bank loans.
tomers, recording receivables, and obtaining funds for For example, BANCBOSTON FINANCIAL COMPANY
sales that never occurred. To prevent the customers loaned Coated $45 million, based on the supposed ex-
from denying the sales, the company involved the cus- istence of $51 million in accounts receivable that
tomers in the racket. For example, Robert Solomon of served as collateral for the loan.
GLOBE SPORTS PRODUCTS paid the fictitious bills Coated s auditor, KPMG PEAT MARWICK, with-
and would then receive the money back from Wein- drew because of its suspicions. Within days, Coated
stein. Due to the inflated sales and receivables, the Sales stock value tumbled from $8 to $2 a share.
value of Coated s stock rose from $1.50 per share in Shortly thereafter, the corporation s credit dried up,
its initial public offering to over $12 per share in 1987. forcing it to declare bankruptcy.
From 1984 to 1987, sales allegedly rose from $9.9 mil-
lion to over $90 million.
In addition, Weinstein inflated accounts receivable Source: Graham Button, Homeless Jailbird, Forbes, August 17,
by billing fictitious customers. He used the inflated ac- 1992, p. 13.




To illustrate the allowance method, assume that Farm Land Products estimates that the bad
debts created by its $300,000 in credit sales in 2003 will ultimately total $4,500. Note that this
is a statistical estimate on average, bad debts will be $4,500, but Farm Land does not yet know
exactly which customers will be the ones who will fail to pay. The entry to record this estimated
bad debt expense for 2003 is:

Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500
To record the estimated bad debt expense for the current year.


Bad Debt Expense is a selling expense on the income statement, and Allowance for Bad
allowance for bad debts A
contra account, deducted Debts is a contra account to Accounts Receivable on the balance sheet. An allowance account
from Accounts Receivable, is used because the company does not yet know which receivables will not be collected. Later
that shows the estimated
on, for example, in 2004, as actual losses are recognized, the balance in Allowance for Bad Debts
losses from uncollectible
is reduced. For example, if in 2004 Jake Palmer s receivable for $1,500 is specifically identified
accounts.
as being uncollectible, the entry is:

Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
To write off the uncollectible account of Jake Palmer.


Note that the write-off entry in 2004 does not affect net income in 2004. Instead, the net
income in 2003, when the credit sale to Jake Palmer was originally made, already reflects the
estimated bad debt expense. Think of this entry as follows: The $1,500 Jake Palmer account has
been shown to be bad, so it is thrown away via a credit to Accounts Receivable. In addition,
Allowance for Bad Debts, which is a general estimate of the amount of bad accounts, is reduced
by $1,500 because the bad Palmer account has been specifically identified and eliminated. In
one entry, the amounts in Accounts Receivable and Allowance for Bad Debts have been reduced.
Assume that the balance in Accounts Receivable was $50,000 and the balance in Allowance for
Bad Debts was $4,500 before the Palmer account was written off. The net amount in Accounts
251
f252 Part 2 Selling A Product Or A Service
Operating Activities


Receivable after the $1,500 write-off is exactly the same as it was before the entry, as shown
here.


Before Write-Off Entry After Write-Off Entry

Accounts receivable . . . . . . . . . . . . $50,000 Accounts receivable
($50,000 $1,500) . . . . . . . . . . . $48,500
Less allowance for Less allowance for bad
bad debts . . . . . . . . . . . . . . . . . . 4,500 debts ($4,500 $1,500) . . . . . . . 3,000
Net balance . . . . . . . . . . . . . . . . . . $45,500 Net balance . . . . . . . . . . . . . . . . . $45,500



The net balance of $45,500 reflects the estimated net realizable value of accounts receivable,
net realizable value of ac-
counts receivable The net that is, the amount of receivables the company actually expects to collect.
amount that would be re- The following T-account shows the kinds of entries that are made to Allowance for Bad Debts:
ceived if all receivables
considered collectible were
Allowance for Bad Debts
collected; equal to total ac-
counts receivable less the
Actual write-offs of Estimates of
allowance for bad debts.
uncollectible accounts uncollectible accounts


Occasionally, a customer whose account has been written off as uncollectible later
fyi
pays the outstanding balance. When this happens, the company reverses the entry that
Sears discloses in its 1999 an-
was used to write off the account and then recognizes the payment. For example, if Jake
nual report that it writes an ac- Palmer pays the $1,500 after his account has already been written off, the entries to cor-
count off as uncollectible after rect the accounting records are:
a customer has failed to make
a required payment for eight
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
billing cycles in a row.
Allowance for Bad Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
To reinstate the balance previously written off as uncollectible.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Received payment in full of previously written-off accounts
receivable.


Because customers sometimes pay their balances after their accounts are written off,
fyi
it is important for a company to have good control over both the cash collection proce-
Banks often recover loan
dures and the accounting for accounts receivable. Otherwise, such payments as the previ-
amounts that were previously
ously written-off $1,500 could be pocketed by the employee who receives the cash, and
written off as uncollectible. For it would never be missed. This is one reason that most companies separate the handling
example, for the three-year pe- of cash from the recording of cash transactions in the accounts.
Because the amount recorded in Bad Debt Expense affects both the reported net re-
riod ending in 1997, CITICORP

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