Financial Accounting Exam 2

sales revenue/sales

primary source of revenue

operating cycle of a merchandising company

longer than that of a service company

cost of goods sold

total cost of merchandise sold during the period

how to get gross profit

gross profit = sales revenue - cost of goods sold

how to get net income

net income = gross profit - operating expenses

perpetual inventory system

at any point in time, the company has inventory to sell at the end of the period, the merchandise is either sold (cost of goods sold) or the company still has it (ending inventory)

flow of costs in the perpetual inventory system

• maintains detailed records of the cost of each inventory purchase and sale

• records continuously slow inventory that should be on hand for every item

• company determines cost of goods sold each time a sale occurs

flow of costs in the periodic system

• doesn’t keep detailed records of the goods on hand

  • purchases and sales are recorded, but cost of goods sold is not calculated with each sale

• cost of goods sold is determined by count at the end of the accounting period

how to determine costs of goods sold in the periodic system

1. Beginning inventory + purchases + net goods available for sale

2. Subtract ending inventory

3. = Costs of Goods sold

advantages of the perpetual system

• traditionally used for merchandise with high unit values

• shows the quantity and the cost of inventory that should be on hand at any time

• provides better control over inventories than a periodic system

how to record purchases under a perpetual inventory system

• made using cash or credit (on account)

• normally record when goods are received from the seller

• purchase invoice should support each credit purpose

FOB Shipping Point

• ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller

• buyer pays freight costs

FOB Destination

• ownership of the goods remains with the seller until the goods reach the buyer

• seller pays freight costs

freight costs incurred by the seller are an _____________

operating expense

purchase return

• return goods for credit if the sale was made on credit

  OR

• return goods for cash if the purchase was for cash

purchase allowance

may choose to keep the merchandise if the seller will grant a reduction from the purchase price

credit terms

may permit buyer to claim a cash discount for prompt payment

advantages of purchase discounts

• purchaser saves money

• seller shortens the operating cycle by converting its accounts receivable into cash more quickly

credit terms: 2/10, n/30

• 2% discount if paid within 10 days

• otherwise, net amount due within 30 days

credit terms: 1/10 EOM

1% discount if paid within first 10 days of next month

credit terms: n/10 EOM

net amount due within the first 10 days of the next month

how to record sales under a perpetual inventory system

• made using cash or credit (on account)

• sales revenue, like service revenue, is recorded when the performance obligation is satisfied

• performance obligation is satisfied when the goods are transferred from the seller to the buyer

• sales invoice should support cash credit sale

how to make a journal entry to record a sale

1. debit cash or accounts receivable and credit sales revenue

   1. to show the selling price

2. debit cost of goods sold and credit inventory

   1. to reflect cost

sales returns and allowances

• “flip side“ of purchase returns and allowances

• contra-revenue account to sales revenue (debit)

• sales not reduced (debited) because

  • would obscure the relative importance of sales returns and allowances as a percentage of sales

  • could distort comparisns between total sales in different accounting periods

if a company expects significant returns, what are the implications for revenue recognition?

• should make an adjusting entry at the end of the year to increase sales returns and allowances by the estimated amount of sales returns

• necessary to not overstate the amount of revenue recognized in the period

sales discount is offered to customers to

promote prompt payment of the balance due

in order to show a sales discount in the journal,

contra-revenue account (debit) to sales revenue

adjusting entries to merchandising companies

• generally the same as.a service company

• one additional adjustment to make the records agree with the actual inventory on hand

• involves adjusting inventory and cost of goods sold

multiple-step income statement

• shows several steps in determining net income

• two steps relate to principal operating activities

• distinguishes between operating and non-operating activities

multiple step key items

• net sales

• gross profit

• operating expenses

• non-operating activities

• net income

Why have investors and analysts demanded more accuracy in isolating “other gains and losses“ from operating items?

greater accuracy in the classification of operating vs. non-operating items permits investors and analysts to judge the real operating margin, the results of continuing operations, and management’s ability to control operating expenses

single-step income statement

• subtract total expenses from total revenues

two reasons for using the single-step format

1. company does not realize any profits until total revenue exceed total expenses

2. format is simpler and easier to read

how to classify inventory for the merchandising company

inventory

how to classify inventory for the manufacturing company

three classifications:

• raw materials

• work in process

• finished goods

regardless of the classification, companies report all inventories under _____________ on the balance sheet

current assets

determining inventory quantities

involves counting, weighing, or measuring each kind of inventory on hand

when do companies take inventory

• when the business is closed or business is slow

• at the end of the accounting period

how to determine ownership of goods if they are in transit

• these are purchased goods not yet received or sold goods not yet delivered

  • goods in transit should be included in the inventory of the company that has legal title to the goods

how is legal title determined

by the terms of the sale

consigned goods

to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods

why do many car, boat, and antique dealers sell goods on consignment

to avoid the risk of purchasing an item that they will not be able to sell

inventory is accounted for at _____

cost

cost of inventory accounted for includes

all expenditures necessary to acquire goods and place them in a condition ready for sale

why are unit costs applied to quantities

to compute the total cost of the inventory and the cost of goods sold using the following cost methods:

• specific identification

• first in first out (FIFO)

• last in, first out (LIFO)

• average cost

what methods of accounting for cost are cost flow assumptions

• FIFO

• LIFO

• average cost

specific identification

actual physical flow costing method in which items still in inventory are specifically costed to arrive at the total cost of the ending inventory

why is specific identification rare in practice

companies use cost flow assumptions about which units were sold

disadvantage of the specific identification method

management may not be able to manipulate net income

i.e. it can boost net income by selling units purchased at low cost or reduce net income by selling units purchased at a high cost

FIFO

• cost of the earliest goods purchased are the first to be recognized in determining costs of goods sold

• often parallels actual physical flow of merchandise

• aka: last in, still here

under FIFO, how do companies determine the cost of ending inventory

taking the unit cost of the most recent purchase and work backwarrd until all units of inventory have been costed

LIFO

• cost of the latest goods purchased are the first to be sold

• seldom coincides with the actual flow of inventory

• exceptions include goods stored in piles such as coal or hay\

• aka: first in, still here

average cost

• allocates cost of goods available for sale on the basis of weighted-average unit cost incurred

• applies weighed average to unit cost to the units on hand to determine cost of the ending inventory

most commonly used cost flow assumptions in the US

1. FIFO

2. LIFO

3. average cost

4. other

each of the three cost flow methods is acceptable under

GAAP

FIFO user examples

Reebok and Wendy’s

LIFO user examples

Campbell soup, Kroger, Walgreens

average-cost user examples

Bristol Myers Squib, Starbucks, Motorola

companies who use LIFO for domestic inventories and FIFO for foreign inventories

Stanley Black, Decker Manufacturing

why should cost flow methods be used consistently

• enhances compatibility from one accounting period to another

  • although preferred, companies can change their method

major advantage of FIFO method

in a period of inflation, the costs allocated to ending inventory will approximate their current cost

major shortcoming of LIFO

in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost

in a period of inflation, the cost flow method that results in lowest income taxes is

LIFO method

both inventory and net income is higher when companies use _________ during periods of inflation

FIFO

the lowest income taxes during times of rising costs can be found under which cost assumption

LIFO due to lower income before tax

LIFO conformity rule

• tax rule

  • requires that if companies use LIFO for tax purposes, they must also use it for financial reporting purposes

What are the arguments for and against the use of LIFO?

• advantage: matches most recent cost with the most recent selling price

  • disadvantage: artificially understates the company’s net income and thus reduces tax payments

because foreign companies cannot use LIFO, why is this a disadvantage

its use by US companies reduces the ability of investors to compare US companies with foreign companies

common cause of inventory errors on the financial statements

• failure to count or cost inventory correctly

  • not properly recognizing the transfer of legal title to goods in transit

what financial statements are effected by inventory errors

income statement and balance sheet

inventory errors on the income statement

affect the computation of cost of goods sold and net income in two periods

when the inventory error understates beginning inventory, what is the result on cost of goods sold and net income

• cost of goods sold: understated

  • net income: overstated

when the inventory error overstates beginning inventory, what is the result on cost of goods sold and net income

• cost of goods sold is overstated

• net income is understated

when the inventory error understates ending inventory, what is the result on cost of goods sold and net income

• cost of goods sold are overstated

  • net income is understated

when the inventory error overstates ending inventory, what is the result on cost of goods sold and net income

• cost of goods sold: understated

  • net income: overstated

how to find cost of goods sold on the income statement

beginning inventory + cost of goods purchased - ending inventory

an error on the income statement in ending inventory of the current period will

• have a reverse effect on the net income of the next accounting period

• over the two years, the total net income is correct because the errors offset each other

• ending inventory depends entirely on the accuracy of the counting and costing of inventory

understating ending inventory on the income statement will overstate

cost of goods sold

effect of inventory errors on the balance sheet is determined by

using the basic accounting equation

ending inventory is overstated on the balance sheet, causing what to happen to the parts of the basic accounting equation

• assets overstated

• liabilities no effect

• stockholder’s equity overstated

ending inventory is understated on the balance sheet, causing what to happen to the parts of the basic accounting equation

• assets: understated

• liabilities: no effect

• stockholder’s equity: understated

on the balance sheet, how is inventory classified

as a current asset

on the income statement, how do we account for cost of goods sold

• it is subtracted from sales

  • there should also be disclosure of the major inventory classifications, basis of accounting (cost of LCNRV), and cost method (FIFO, LIFO, AC)

lower-of-cost-or-net realizable value

when the value of inventory is lower than its cost

• companies must write down the inventory to its net realizable value

net realizable value

• amount that a company expects to realize (receive from the sale of inventory)

• example of conservatism

high inventory levels in presentation and analysis

• may incur high carrying costs

• i.e. investment, storage, insurance, obsolescence, and damage

low inventory levels in presentation and analysis

may lead to stock-outs and lost sales

inventory turnover measures

the number of times on average the inventory is sold during the period

how to calculate inventory turnover

cost of goods sold / average inventory

days in inventory measures

the average number of days inventory is held

how to measure days in inventory

days in year (365)/ inventory turnover

gross profit method

• estimates cost of ending inventory by applying a gross profit rate to net sales

  • company must know: net sales, cost of goods available for sale, and gross profit rate

steps to find gross profit

1. net sales - estimated gross profit = estimated cost of goods sold

2. cost of goods available for sale - estimated cost of goods sold = estimated cost of ending inventory

retail inventory method

• retail companies establish a relationship between cost and sales price

• company applies cost-to-retail percentage to ending inventory at retail prces to determine inventory at cost

retail inventory method calculation

1. goods available for sale at retail - net sales = ending inventory at retail

2. goods available for sale at cost / goods available for sale at retail = cost-to-retail ratio

3. ending inventory at retail * cost to retail ratio = estimated cost of ending inventory

major advantage of the retail method

• it is an averaging technique

• may produce an incorrect inventory value if the mix of the ending inventory is not representative of the mix in the goods available for sale

fraud

dishonest act by an employee that results in personal benefit to the employee at a cost to the employer

three factors that contribute to fraud

• opportunity

• financial pressure

• rationalization

Sarbanes-Oxley Act

• applies to publicly traded US corporations

• required to maintain an adequate system of internal control

• corporate executives and board of directors must ensure that these controls are reliable and effective

• independent outside auditors must attest to the adequacy of the internal control system

  • created the public company accounting oversight board (PCAOB)

internal control methods and measures are adopted to

• safeguard assets

• enhance the reliability of accounting records

• increase efficiency of operations

• ensure compliance with laws and regulations