Financial Accounting Exam 2

Inventory

Merchandise that the company intends to sell to its customers

Merchandising Companies

Companies that sell, but not manufacture, merchandise to customers; wholesale and retail companies such as Wal-Mart, Nieman Marcus

Manufacturing Companies

Create merchandise from underlying raw materials; Exxon and Boeing

Service Companies

Provide services to customers; law firms, consulting companies

True

Accounting for inventories is important because it can have a material effect on both the BALANCE SHEET (ENDING INVENTORY) and the INCOME STATEMENT (COST OF GOODS SOLD)

Gross Sales Revenue

Measures the value of inventory delivered to, and billed to, customers, often referred to as the "invoice value"

Sales Returns and Allowances

Contra-revenue account used to record customer refunds or credits given to their accounts. Represents a reduction of sales revenue for the return of (or allowance granted for) unsatisfactory goods

Sales Discounts

Contra-revenue account used to record discounts given to customers for early payment of their account

Freight-Out

Transportation cost paid by the seller on merchandise deliverd to the customer; this is a selling expense, not a contra-revenue account; not included in net sales

Net Sales

Gross Sales less all contra-revenue accounts (sales returns and allowances and sales discounts)

Gross Purchase Cost

Measures the cost of inventory acquired as billed to the company by the supplier

Purchase Returns and Allowances

Account used to record the decrease of the purchase cost for the return of (or allowance granted for) unsatisfactory goods purchased

Purchase Discounts

Account used to record the decrease of the purchase cost for discounts granted by the supplier for early payment of account payable

Freight-In

Account used to record the increase in the purchase cost of inventory due to transportation costs paid by the buying company; included in net purchases

Net Purchases

Gross Purchase Cost - Purchase Returns and Allowances - Purchase Discounts + Freight-In

FOB Shipping Point

Title passes to the buyer when the goods are placed on the common carrier and the buyer pays the shipping costs

FOB Destination

Title passes to the buyer when the goods arrive at the buyer's location and the seller pays the shipping costs

COGS

Expense on the income statement representing the cost of inventory sold to customers to generate Sales Revenue

COGS Model

Beginning inventory cost (BI) + Net purchase cost (P) - Ending inventory cost (EI)

Gross Profit

Net Sales Revenue - COGS

Gross Profit Rate

Net Sales Revenue - COGS / Net Sales Revenue

Perpetual Inventory System

This inventory account maintains a continuous running record of cost of inventory on hand; facilitates inventory planning; provides data on losses due to shrinkage (theft); however, it increases bookkeeping costs

Periodic Inventory System

This inventory account contains the cost of the inventory on hand at the beginning of the year and it is NOT updated for purchases; at the end of the year, the inventory account is updated by making an actual physical count of inventory on hand using the COGS model; advantages are that it minimizes bookkeeping costs and disadvantages are that it assumes all goods not accounted for by physical count have been sold ("shrinkage" [theft] buried in COGS)

GAAP

This currently requires that a company's inventory be valued on the Balance Sheet at the lower-of-cost-or-market

"Market"

This means current replacement cost - what it would cost the company to replace the inventory it holds on the balance sheet date at prices that prevail on the balance sheet date

"Cost"

This means either specific unit cost, first-in, first-out (FIFO) cost, or average cost. Companies must choose one of these 4 methods for measuring this.

Specific Unit Cost

Cost flows follow the physical flow of inventory

Cost of Goods Available for Sale

Selection of cost flow assumption (FIFO, LIFO, Weighted Average) determines how total THIS will be allocated between balance sheet and income statement

LIFO Conformity Rule

Any of the cost flow assumption (FIFO, LIFO, Weighted Average) methods can be used for financial reporting. However, if LIFO is used for TAX REPORTING, it MUST also be used on the company's financial statements

FIFO

Allocates the oldest unit costs to COGS and allocates the most recent (newest) unit costs to Ending Inventory (the goods on hand)

LIFO

Allocates the most recent (newest) unit costs to COGS and allocates the oldest unit costs to the Ending Inventory (the goods on hand)

Weighted Average

Cost per unit is total dollars of inventory available for sale divided by the total units of inventory available for sale. Example: $165 (total)/10 units = $16.50 per unit

FIFO

When prices are increasing, it has the lowest COGS (IS), highest net income (IS), and highest ending inventory balance (BS)

LIFO

When prices are increasing, it has the highest COGS (IS), lowest net income (IS), and lowest ending inventory balance

FIFO

When prices are decreasing, it has the highest COGS (IS), lowest net income (IS), and lowest ending inventory balance

LIFO

When prices are decreasing, it has the lowest COGS (IS), highest net income (IS), and highest ending inventory balance (BS)

IFRS

Does not permit the use of LIFO; it also defines market to mean net realizable value (selling price less selling costs); allows plant assets to be valued at fair value

LIFO Liquidation

An event where the number of units of inventory sold during the year exceeds the number of units purchased during the year so that the number of units in the ending inventory is less that the number in the beginning inventory; results in a large increase in the company's net income

Lower-of-Cost-or-Market

Ending inventory reported on the company's balance sheet must be valued at this; when inventory is written down to market, the loss in value increases COGS

LIFO Footnote

GAAP requires that all LIFO companies present, in the notes to their financial statements, an estimate of the amount that beginning and ending inventories using FIFO exceed those using LIFO. These estimates are called "LIFO Reserves"

LIFO Reserve

For the end of the year, it is EI FIFO - EI LIFO. For the beginning of the year, it is BI FIFO - BI LIFO.

Change in the LIFO Reserve

COGS LIFO - COGS FIFO; this equals (EI FIFO - EI LIFO) - (BI FIFO - BI LIFO)

Pretax Income using FIFO

Pretax income using LIFO + Increase (or - Decrease) in LIFO Reserve

Net Income using FIFO

After tax: Net income (after tax) using LIFO + [Increase (or - Decrease) in LIFO Reserve x (1.0 - Tax Rate)]

Increase

________ in the LIFO reserve X tax rate determines the amount of income taxes the company saved during the current year by using LIFO

Decrease

________ in the LIFO reserve X tax rate determines the amount of additional taxes the company paid during the current year by using LIFO

Year-End Balance

________ in the LIFO reserve X tax rate determines the cumulative tax saving since the company began using LIFO

Inventory Turnover

Indication of how well a company manages its inventories. Again the higher the turnover, the more efficient inventory management; therefore the better management is performing

Inventory Turnover

COGS / Average Inventory/2 ([Beginning + Ending])

Average Holding Period

Indicates the average number of days that goods remain unsold (in inventory). Lower the number of days, the better job the company is doing; 360/Inventory Turnover

Inventory Errors

Impact both a company's income statement and balance sheet. Generally have one effect in one year and have the opposite effect in the second year

True

On the Income Statement, if beginning inventory is understated and ending inventory is overstated, COGS is understated and NI is overstated. If beginning inventory is overstated and ending inventory is understated, COGS is overstated and NI is understated

True

On the Balance Sheet, if the ending inventory error is overstated, assets are overstated, liabilities do not change, and equity is overstated. If the ending inventory error is understated, assets are understated, liabilities do not change, and equity is understated.

Gross Profit

Method used to make an estimated inventory on hand

Plant Assets

Long-lived assets usually called PPE or Fixed Assets

Intangible Assets

Long-lived assets without physical substance. These assets convey various benefits, often contractual in nature, to the company

Acquisition Cost

Cash and cash equivalents paid to acquire the asset and make it ready for its intended use. Also referred to as Historical Cost or Original Cost

Net Plant Assets

Acquisition cost of depreciable plant assets less accumulated depreciation - referred to as book value or carrying value

Basket Purchase

When more than one plant asset is acquired for a single amount, the original cost of each asset acquired is based on the relative market values of each of the individual assets acquired

Capital Expenditure

An expenditure on a plant asset that improves its economic capacity, efficiency, or extends its useful life. The expenditure is recorded as an addition to the cost of the asset, included on the balance sheet, and depreciated; aka changing an engine

Revenue Expenditure

An expenditure on a plant asset that maintains the asset in its normal operating condition. The expenditure is recorded as an expense and reported on the income statement in the period incurred (or "immediate expense"); aka an oil change

Depreciation

Systematic process of allocating the cost of a fixed asset to expense over the asset's productive life

Accumulated Depreciation

This is a permanent contra-asset account and is increased by crediting it. It is NOT an amount of cash set aside to replace the asset at the end of its useful life. It is offset against the cost of the asset, thus reducing the asset to its carrying value or book value

Book Value

This "value" does NOT measure the asset's worth if sold, or cost if it were to be replaced

Salvage Value

Also called residual value; the amount the company expects to receive from selling the asset at the end of its service life

Depreciable Cost

The original acquisition cost of a depreciable asset minus its salvage value. This is the amount in accumulated depreciation at the end of the asset's useful life

Straight-Line Method

Allocates the same amount of depreciable cost (original cost minus salvage value) to each accounting period. Used for those plant assets whose services are used up approximately equally over the asset's useful life; Cost - Salvage Value / Useful Life (n)

Units-of-Production Method

Allocates the same dollar amount of depreciation expense to each unit of output. The amount allocated to each accounting period equals the amount of depreciation per unit of output times the number of units of output occurring in the current accounting period. Used for those assets that depreciate mainly because of wear and tear (physical factors); (Asset cost - Salvage value) / Total output = Cost per unit x Current output = Depreciation

Double-Declining Balance Method

This method is a special case of several methods referred to as accelerated depreciation methods. These methods share the property that depreciation expense is largest in the first year of the asset's life and becomes progressively smaller with each succeeding year of the asset's life. It is used for those assets that depreciate mainly because of obsolescence; (Cost - Accumulated Depreciation at BOY) x (2/Useful Life)

MACRS

Some companies prefer to use an accelerated depreciation method because the higher depreciation deductions during the early years of the asset's life results in the company paying less tax, giving the companies a cash flow advantage over straight-line called Modified Accelerated Cost Recovery System

Depletion

The process of allocating the cost of natural resources to expense over the resource's estimate useful life

Amortization

The cost of the asset is allocated to expense over the life of the asset as the benefits embodied in the asset get used up

Salvage Value

This of intangible assets with estimable useful lives are almost always zero

Asset Impairment

Intangible assets without estimate useful lives are not amortized, but are instead tested for this; companies are required to periodically test whether the FMV of the asset is less than the recorded amount

Goodwill

Amount paid - FMV of company's net assets

Contingent Liabilities

A potential liability, the existence of a liability is in doubt and depends upon the occurrence of a future event. Examples include: Litigation claims, premium claims (rebates, jewelry), product warranties

Probable

If the likelihood for this future event is this, we record the liability as a dollar amount as reasonably amount. We disclose in the notes if it is not reasonably estimable

Reasonably Possible

If the likelihood for this future event is this, we disclose this event in the notes

Remote

If the likelihood for this future event is this, no disclosure is required

Future Value

The amount of money on some future date; these values get larger because they include accumulated interest; maturity value

Present Value

The amount of money today; these values get smaller because they exclude accumulated interest

Simple Interest

Computes interest on the amount of the initial principal only. Interest = Principal x Rate x Time

Compound Interest

Computes interest on the principal plus all accumulated interest to date that has not been paid or received; this is the norm for investments over one year in duration

Annuity

Series of equal periodic cash receipts or payments, separated by equal intervals of time

N

Number of interest periods during which interest is being earned (for a single cash flow); number of cash flows (for an annuity)

R

Used in annuity calculations. Represents the amount of the equal periodic cash flow being received or paid out; coupons payments = face value x STATED rate

Face Value

A fixed amount at a specified maturity date in the future

Coupon Interest Payment

Payments every 6 months (or every year) between the issue date and the maturity date

Debentures

Unsecured bonds

Convertible Bonds

Bonds that can be exchanged for other securities of the borrowing company

Callable Bonds

Bonds that the issuer can retire prior to their scheduled maturity at a fixed contract price

Market Rate

The interest rate that lenders must earn if they are to buy the bonds; this is also the interest rate lenders use to discount the cash flows promised by the borrowing company to present value which equals the selling price of the bonds

Par

The amount received for the bonds might equal the Face Value of the bonds in which case the bonds are said to be issued at:

Discount

If the amount received is less than the Face Value, the bonds are issued at a:

Premium

If the amount received is more than the Face Value, the bonds are issued at a:

Effective-Interest Method

On each interest payment date, the difference between the amount of interest expense and the amount of the stated interest paid in cash will reduce the Bond Discount or Premium account. This method of reducing the Bond Discount or Premium accounts is called:

Bond Carrying Value

Bond Payable (aka Face Value) - Discount [or + Premium]

Capital Lease

A lease that transfers most of the risks and rewards of asset ownership from the lessor (the party having legal title to the asset) to the lessee (the party that uses the asset but does not own it)

Capital Lease

This type of lease contains these:

1) Transfers ownership

2) Bargain purchase option

3) Lease term

4) Present value of the payment

Operating Lease

If the lease agreement does not contain any of these:

1) Transfers ownership

2) Bargain purchase option

3) Lease term

4) Present value of the payment

It is an: