The following points highlight the four main adjustments to be made to determine revenue. The adjustments are: 1. Discounts 2. Sales Returns and Allowances 3. Bad Debts 4. Revenue Measurement in Non-Cash Transactions.
Adjustment # 1. Discounts:
Discounts may be generally of two types—trade discount and cash discount. Trade discounts are used in determining the invoice prices, i.e., actual selling price from published catalogs or list price, say list price less 30 per cent.
Trade discounts and list prices do not appear in the accounting records of either the purchaser or seller and are disregarded. The amount of trade discount is deducted from the sales figure directly, without showing it as a separate item on the profit and loss account. Thus, the sales revenue will be recorded at not more than the sale value of actual transaction.
Trade discounts enable a supplier to vary prices for small and large purchasers and by changing the discount schedules, to alter price periodically without the inconvenience and expense of revising catalogs and price lists.
Cash discounts, also known as sales discounts, are the amounts offered to the customers for making prompt payments. To encourage early payment of bills, many firms designate a discount period that is shorter than the credit period. Purchasers who remit payment during this period are entitled to deduct a cash discount from the total payment.
The cash discount can be recorded in any of the two ways:
(i) If customers are making payment at the time of sales, cash discount can be deducted from gross sales and thus sales revenue will be recorded at the net amount of sales.
(ii) If customers are not making payments at the time of sales, but subsequently during the discount period, cash discount can be recorded as an expense of the period and sales revenue, then, will be recorded at the amount of gross sales without deducting the amount of cash discount
Adjustment # 2. Sales Returns and Allowances:
Sometimes, the purchasers return a part of goods purchased to the seller if they are dissatisfied with the goods. In these cases, the amount of cash finally to be received can be expected to be less than the stated selling prices.
The amounts of sales returns and allowances are therefore deducted from the gross sales and the remaining amount is recognised as the revenue. The amount of sales returns and allowances are shown separately in the profit and loss account and deducted from the gross sales amount.
It should be noted that sales returns and allowances deducted from the gross sales of a period may not relate totally to the actual sales of that period. This practice is a deviation from the matching concept but is followed because the amounts of sales returns are difficult to estimate in advance, even at the time of preparing profit and loss account.
Adjustment # 3. Bad Debts:
Some customers usually do not make payments and the firm incurs a bad debt expense. Bad debt expense is classified as a selling expense on the profit and loss account, although some business enterprises include it with administrative expenses.
There are two methods to deal with bad debt expense in accounting:
(i) Direct write off method.
(ii) Allowance method.
Under the Direct write off method, bad debts are shown as expenses in the period when they are discovered. In this method, bad debts losses shown in the income statement of a period may not match with related sales of that period. The result is that sales and corresponding bad debts may appear in the income statements of different periods.
Also, in some years, larger amount of bad debts will flow into the income statement as compared to lower amount in other years which may bring wide fluctuations and inconsistencies in reported net income figures of the different years. Since generally accepted accounting principles suggest that receivables and debtors be shown at the amount the firm expects to collect, most firms disapprove of the direct write off method.
The Allowance method is based on the matching concept. In this method, the amount of bad debt expense is estimated in advance that will result from a period’s sales in order to show the bad debt expense in the same period. This procedure not only matches bad debt losses with related sales revenue but also results in an estimated realisable amount for debtors and accounts receivables in the balance sheet at the end of the period.
The amount of revenue to be recognised for a period should be adjusted for estimated bad debts expenses. This adjustment of revenue is done in the period when revenue is recognised and not in a later period when some customer’s accounts are found to have bad debts to be uncollectible.
If the adjustments of bad debts are postponed to future periods, reported income of subsequent periods would be affected by earlier decisions to extend credit to customers or to record bad debts when they occur. Thus, the performance of a business enterprise for the period of sale and the period when a customer’s account is judged uncollectible would be measured inaccurately.
Adjustment # 4. Revenue Measurement in Non-Cash Transactions:
If a sale involves a non-cash transaction or non-cash assets, such as the trade-in of an old car for a new car, the amount of revenue to be recorded will be the cash equivalent of the goods received or given up, whichever is more clearly determinable.