ACCT Exam 2 (Ch 4-7)

2 Kinds of Merchandiser

1. Wholesaler: buys products from manufacturers and sells them to retailers

2. Retailer: buys products from manufacturers or wholesalers and sells them to consumers

Net Income for Service Companies

Revenues - Expenses = Net income

• Service companies sell TIME to earn revenue (ex: accounting, law firms, and plumbing services)

Net Income for Merchandising Companies

• Net Sales - Cost of Goods Sold = Gross Profit

• Gross profit - expenses = Net income

• Merchandise companies sell PRODUCTS to earn revenue (ex: sporting goods, clothing, etc)

Inventory Cost

Cost to buy the goods, ship them to the store (freight-in), and make them ready for sale

• CURRENT asset with DEBIT balance

• NOT INCLUDED: freight-out (ship to customer), selling and administrative costs (advertising, sales, commissions)

Operating Cycle for Merchandiser

1. Cash purchases of merchandise

2. Inventory for sale

3. Credit sales

4. Accounts receivable

5. Receipt of cash

• Try to keep as SHORT as possible (assets in inventory and accounts receivable are not productive)

• DIFFERS depending on company:

  • Department stores: 2-5 months

  • Grocery stores: 2-8 weeks

• Cash sales SHORTEN operating cycle

Merchandise Inventory System Cost Flows

Cost of Goods Sold (COGS)

The expense of buying and preparing merchandise

• EXPENSE on Income Statement (Debit balance)

• FORMULA:

  • Net purchases + beginning inventory - ending inventory = COGS

2 Ways for Companies to Account for Inventory

1. Perpetual: record cost of goods sold at the TIME OF EACH SALE (continuously)

   1. More expensive but more accurate (increases profit)

   2. Tech has increased use of perpetual

   3. Every purchase, return, discount, entered immediately

   4. NO temporary accounts

2. Periodic: records cost of goods sold at END OF THE PERIOD

   1. Cheaper

   2. TEMPORARY ACCOUNTS:

      1. DR: purchases, transportation-in, sales R&A

      2. CR: purchase discounts, purchase R&A

Credit terms

Description of the amounts and timing of payments that a buyer (debtor) agrees to make in the future

• Ex: n/60 = net 60 days

  • seller requires full payment within 60 days after invoice

Cash discount

reduction in price of merchandise granted by a seller to a buyer when payment is made within discount period

• Purchase discount = BUYER’s POV

• Sales discount = SELLER’s POV

EX: 2/10, n/30

• 2% discount within first 10 days, net amount due in 30 days after initial invoice date

WHY?

• encourages buyer to pay EARLIER

Gross Method

Records purchases at FULL invoice price (gross amount) WITHOUT DEDUCTING any cash discounts

• Don’t anticipate discount; record discount LATER if paid within discount period

• Often used because it complies with revenue recognition rules, used more in practice, easier and less costly to apply

Net Method

Records invoices WITH DISCOUNT

• Assumes ALL DISCOUNTS are TAKEN

• Any discounts not taken are recorded in “Discounts Lost Expense Account”

When do cash managers want to pay their invoices?

THE LAST DAY

• Buyer can use that money until last payment is required

Purchase Returns

Merchandise a buyer purchases and then returns

• DEBIT CASH

• CREDIT MERCH INVENTORY

Purchase Allowances

Seller granting a reduction (allowance) in price to a buyer of defective or unacceptable merchandise

• Customer KEEPS product and gets partial refund

• DEBIT LIABILITIES

• CREDIT MERCH INVENTORY

FOB point (Free on Board)

Point when ownership transfers to the buyer

2 Kinds of FOB points

1. FOB Shipping point

   1. BUYER accepts ownership when the goods depart the seller’s place of business

   2. BUYER pays shipping costs and has RISK of loss in transit

   3. “FREIGHT-IN” or transportation-in

   4. Goods are part of buyer’s inventory during transit

2. FOB Destination

   1. Ownership of goods transfers to the buyer when goods arrive at buyer’s place of business

   2. SELLER pays shipping costs

   3. SELLER has risk of loss in transit

   4. Seller does not record revenue until goods arrive at the destination

   5. “Freight-out” (transportation-out) = Delivery expense

Supplementary Records

refers to info outside the usual ledger accounts

2 entries required for perpetual inventory system for EACH transaction

1. Revenue recorded

2. Cost of goods sold

Sales Discount Account

• Contra account for Sales

• Normal DEBIT balance

Sales Returns and Allowances Account

Contra account to Sales

• Normal DEBIT balance

1. Returns (non-defective and can be resold)

   1. DR: Merch Inventory

   2. CR: Cost of Goods sold

2. Allowances (inventory is not returned)

   1. DR: Sales R&A

   2. CR: Cash/Accounts Receivable

Net Cost of Merchandise Purchases Formula

Invoice cost + transportation cost - purchase discounts - purchase R&A

Shrinkage

Loss of inventory (ex: theft and deterioration)

• Computed by comparing a physical count of inventory with recorded amounts

• DR: Cost of Goods sold, CR: Merch Inventory

• Used by PERPETUAL inventory systems

Closing Entries for Merchandisers

1. Close credit balances by DEBITING them to income summary

• Temporary Account: Sales

2. Close debit balances by CREDITING them to income summary

• Temporary Accounts: Sale Discounts, sale returns and allowances, and cost of goods sold

3. Close Income Summary

4. Close Dividends

• DR. Retained Earnings, CR Dividends

DIFFERENCE BETWEEN MERCHANDISER AND SERVICE COMPANY:

• Only merchandisers have the temporary accounts

Multiple-Step Income Statement

Details net sales and expenses, and reports subtotals for various types of items

3 MAIN PARTS:

1. Gross profit

2. Income from operations (gross profit - operating expenses)

3. Net income (income from operations ± nonoperating items)

OPERATING EXPENSES (separated into 2):

1. Selling expenses: costs to market and distribute products and services (ex: advertising)

2. General and Administrative expenses: costs to administer a company’s overall operations (ex: office salaries and equipment)

NONOPERATING EXPENSES:

• Other expenses, revenues, losses, gains that are unrelated to a company’s operations

Single-Step Income Statement

Total revenues - total expenses (inc. COGS)

• expenses are commonly grouped into categories

• net income is same under single and multiple step income statement so companies choose the format that best informs users

Current Ratio

Current assets/Current liabilities

Gross margin and gross margin ratio

Gross margin: net sales - COGS

Gross margin ratio: (net sales - cost of goods sold) / net sales

Balance Sheet

Reports inventory as a CURRENT asset AFTER accounts receivable according to how quickly they can be converted to cash (liquidity)

• inventory after acc. rec. because it is converted slower since inventory has to be sold before cash can be received

Acid-test ratio

FORMULA: (cash and cash equivalents + short-term investments + current receivables) / (current liabilities)

• a way to measure a merchandiser’s ability to pay its current liabilities

• quick assets/current liabilities

• answer should be at LEAST 1.0

Allowance for Sales Discounts Account

Contra account for accounts receivable

• normal CREDIT balance

Sales Refund Payable Account and Inventory Returns Estimated Account

Sales Refund Payable Account: Current LIABILITY showing amount expected to be refunded to customers

• normal CREDIT balance

Inventory Returns Estimated Account: Current ASSET showing inventory estimated to be returned

ACCOUNTS ARE ONLY CHANGED DURING ADJUSTING PROCESS, remains unchanged during active period

Freight-In vs Freight-Out (both for FOB shipping)

Freight-In:

• Shipping costs paid to bring inventory INTO store

• Account used: Merch Inventory (or freight-in)

• Recorded at time of purchase

• AFFECTS BALANCE SHEET

Freight-Out:

• shipping costs paid to deliver merch to customers

• Account used: Delivery expense (freight-out)

• Recorded at time of sale

• AFFECTS INCOME STATEMENT

NO freight in or out for FOB destination because SELLER pays

What items does Merchandise Inventory include?

ALL GOODS that a company owns and holds for sale

• REGARDLESS of where the goods are located when inventory is counted

• Special attention directed towards:

  • Goods in transit

  • Goods on consignment

  • Goods that are damaged or obsolete

Goods on Consignment

• Consigner: owner of goods sent to consignee

• Consignee: sells goods for the owner

• Merchandise is in consigner’s inventory

• Consignee NEVER reports consigned goods in inventory

Goods Damaged or Obsolete

• damaged or obsolete goods are NOT reported in inventory (if they can not be sold)

• if they CAN be sold, they are included in inventory at “Net realizable value” (NVR)

  • NRV = sales price - selling costs

  • LOSS is recorded

Inventory Costs

ALL expenditures necessary to bring an item to a salable condition and location

• INVENTORY COST: invoice cost - discounts + other costs

Other Costs:

• shipping

• storage

• insurance

• import duties

How often do you take a physical count of inventory?

At LEAST ONCE a YEAR

4 Methods of Inventory Costing under a PERPETUAL System

1. Specific Identification (SI): when each item in inventory can be matched with a specific purchase and invoice

   1. RECORD: Date, goods available for sale, COGS, and ending inventory

   2. Common for custom-made inventory such as jewelry

2. First in, first out (FIFO): assumes that inventory items are sold in the order acquired

3. Last in, first out (LIFO):assumes the most recent purchases are sold first

4. Weighted Average (WA):requires that we use the weighted average cost per unit of inventory at the time of each sale

→ Formula: (cost of goods available for sale at each sale) / (# units available for sale at each sale)

Physical flow and cost flow do NOT have to be the same

Financial and Tax Reporting Effects of Different Inventory Costing Methods

RISING COSTS EFFECTS:

• FIFO reports lowest COGS yielding HIGHEST GROSS PROFIT AND NET INCOME

• LIFO reports highest COGS yielding LOWEST gross profit and net income

• WA reports value b/w FIFO and LIFO

LOWERING COSTS EFFECTS:

• FIFO reports highest COGS yielding LOWEST gross profit and net income

• LIFO reports lowest COGS yielding HIGHEST GROSS PROFIT AND NET INCOME

  • Many companies use LIFO to gain temporary tax advantage (b/c it has less income to be taxed)

  • LIFO Conformity Rule:IRS requires that when LIFO is used for tax reporting, it is also used in financial reporting

4 Inventory Costing Methods and their Advantages

1. FIFO: Ending inventory on the balance sheet APPROXIMATES its CURRENT COST; follows actual cash flow for most businesses

2. LIFO: COGS on income statement APPROXIMATES its CURRENT COST; better matches current costs with revenues

3. WA: smooths out any price changes

4. SI: matches the costs of items with the revenues they generate

Lower of Cost or Market (LCM) and Lower of Cost or Net Realizable Value (LCNRV)

LCM: Required method to report inventory at market replacement cost when that market cost is lower than recorded cost

• Applies to firms using LIFO

• Applied to individual units, major categories, or entire inventory

LCNRV: required method to report inventory at net realizable value (NRV) when that value is lower than recorded cost

• Applies to firms using: FIFO, WA, SI

• NRV = sales price - selling costs

WHEN:

• Cost > Market → USE MARKET

• Cost < Market → USE COST

HOW:

• DR: COGS

• CR: Merchandise Inventory

*Inventory is adjusted DOWNWARD when LCM or LCNRV < Total cost of inventory

Why are inventory errors believed to be self-correcting?

They only affect year 1 and year 2 periods

Effects of Inventory Errors on the Income Statement

Balance Sheet Effects of Inventory Errors

Inventory Turnover Formula

FORMULA: (COGS) / Average Inventory

*Avg inventory = (beg inv + end inv) / 2

• HIGH ratio is preferred

• Shows short-term liquidity

• # of times a company turns over (sells) its inventory in a period

Day’s Sales in Inventory

FORMULA: (Ending Inventory / COGS) * 365

Key idea: # of days one can sell from existing inventory if no new items are purchased; useful in evaluating how quickly inventory is being sold

4 Inventory Costing Methods for PERIODIC Inventory Systems

1. SI (same as perpetual)

2. FIFO (same as perpetual)

3. LIFO (begin with very last units purchased)

4. WA (take average of entire inventory then use that for all sales)

2 methods to estimate inventory

• Retail inventory method: based on RATIO of amount of goods for sale at cost at amount of goods for sale at retail

  • STEPS:

    • Good avail. for sale @ retail - net sales retail = End inventory retail

    • Goods avail. for sale @ cost / good avail. for sale retail = Cost retail ratio

    • Ending inventory ratio / Cost retail ratio = Estimated ending inventory

• Gross Profit Method: applies gross profit ratio to net sales (at retail)

  • STEPS:

    • (Net sales @ retail) x (1.0 - gross profit) = Estimated cost goods sold

    • Goods avail for sale @ cost - est. cost of goods sold = Estimated ending inventory

Internal Control System (IMPORTANT)

Policies and procedures used to:

• Protect assets

• Ensure reliable accounting

• Promote efficient operations

• Uphold company policies

WHY?

• Prevent avoidable losses

• Plan operations

• Monitor company and employee performance

Sarbanes-Oxley Act (SOX)

Requires managers and auditors of companies whose stock is traded on an exchange to document and verify internal controls

• must have effective internal controls

• auditors must evaluate internal controls

• violators recieve harsh penalties (up to 25 years in jail)

Committee of Sponsoring Organizations (COSO)

5 components of internal control that increase quality of accounting info:

1. Control environment (company structure, ethics, integrity)

2. Risk assessment

3. Control activities (policies and procedures to reduce risk)

4. Info and communication (report to internal and external parties)

5. Monitoring (regular review of internal control effectiveness)

7 Principles of Internal Control (IMPORTANT)

1. Establish responsibilities (easily determine who is at fault)

2. Maintain adequate records

3. Insure assets and bond key employees

4. Separate record keeping from custody of assets (ex: person with access to cash must not have access to cash’s accounting records)

5. Divide responsibility for related transactions (“separation of duties”)

6. Apply technological controls (ex: cash registers, time clocks, VPNs, 2FA)

7. Perform regular and independent reviews (done by ind. auditors)

Blockchain

New, more secure type of accounting ledger that continuously and simultaneously updates and verifies

• makes it difficult for changes to be made without people noticing

Limitations of internal control

• human fraud (deliberate action)

• human error (carelessness)

• fraud triangle (opportunity, rationalization, pressure)

• cost-benefit constraint

3 basic guidelines for control of cash

1. Person handling cash is separate from record keeping of cash

2. Cash receipts are promptly deposited in bank

3. Cash payments are made by check or electronic funds transfer (EFT)

Liquidity and liquid assets definition

Liquidity: company’s ability to pay for its current liabilities

Liquid assets: cash and similar assets that can readily be used to pay for liabilities

Cash and cash equivalents definitions

Cash: currency, coins, deposits in bank accounts, money orders, and customer, cashier, and certified checks

Cash equivalents: short-term, highly liquid investment assets that are:

1. readily convertible to a known cash amount

2. close enough to their due date so their market value won’t greatly change

3. ex: US treasury bills

Over-the-Counter Cash (cash receipt)

Should be recorded on a cash register after each sale, and customers should get a receipt

• Transactions should be stored in the cloud/on file

• Anyone with access to cash should NOT be able to access cash records and vice versa

• No one can make a mistake or steal cash without being noticed

Cash Over and Short

Income statement account used to record cash overages and shortages arising from errors in cash receipts or payments

• Normal DEBIT balance (expense)

Control of Cash Payments

• Require ALL payments to be made by check (except for petty cash payments)

• Limit access to accounting records except for those with authority to sign checks or make EFTs

Cash budget

Projected cash receipts and cash payments are summarized here

• if enough cash for operations, companies try to minimize the cash they hold to reduce risk of theft

Voucher system

A set of procedures and approvals designed to control cash payments and the acceptance of liabilities that consist of:

• Verifying, approving, and recording liabilities for cash payment

• Issuing checks for payment of verified, approved, and recorded liabilities

Enterprise Resource Planning (ERP) System

Used to streamline electronic cash receipts and payments

Petty Cash System

Small payments for items including shipping fees, minor repairs, and low cost supplies

• DEBIT to INCREASE

• CREDIT to DECREASE

6 basic bank services

1. bank accounts

2. signature checks

3. deposit ticket

4. check

5. EFT

6. Bank statement (once a month sent to user)

Bank Reconciliation (IMPORTANT)

a report prepared periodically to explain the difference between cash reported on bank statement and cash balance on company’s books

BANK BALANCE ADJUSTMENTS:

• ADD: Deposits in transit (deposits made and recorded in depositor’s books but not yet listed on bank statement)

• SUBTRACT: Outstanding checks (checks not yet turned into the bank for payment by bank statement close)

• ADD/SUBTRACT: Bank errors

BOOK BALANCE ADJUSTMENTS:

• ADD: Interest earned and unrecorded cash receipts

• ADD: Bank fees and NSF checks (non-sufficient funds)

• ADD/SUBTRACT: Book errors

ONLY ITEMS that ADJUST BOOK BALANCE need journal entries

Days’ sales uncollected

(Accounts receivable / net sales) * 365

Indicates how much time is likely to pass before we receive cash receipts from credit sales

• measure of liquidity

• shorter time = BETTER

Documents and Verification used to Control Cash Payments

• Purchase requisition

• Purchase order

• Invoice

• Receiving report

• Invoice approval

Accounts receivable

amounts due from customers for credit sales

• sales on credit

Why do sellers allow customers to use credit cards?

1. Doesn’t have to decide who gets credit and how much

2. Avoids risk of customer not paying

3. Receives cash faster

4. More credit options = more sales

Direct Write-Off Method

Records the loss of an uncollectible account receivable when it’s determined to be collected

• NO attempt at predicting bad debts expense

Recording Bad Debt Expense:

• DR: Bad debt expense

• CR: Account receivable

• NO ALLOWANCE DW ACCOUNT USED

To Recover a Bad Debt:

1. DR: accounts rec., CR: bad debt expense

2. DR: cash, CR: Accounts rec.

Advantages:

1. simple

2. no estimates needed

Disadvantages:

1. Receivables and income temporarily become overstated

2. Bad debts expense often not matched with sales

Allowance Method

Matches estimated loss from uncollectible accounts receivable against sales they helped produce

• ESTIMATES TOTAL BAD DEBT EXPECTED

Recording Bad Debt Expense:

• DR: Bad debt expense

• CR: Allowance for Doubtful Accounts

Writing off a Bad Debt:
- DR: Allowance DA

- CR: Accounts Rec.

Recovering a Bad Debt:

• DR: Accounts Rec. , Cr: Allowance DA

• DR: Cash, CR: Accounts Rec.

Allowance for Doubtful Accounts: contra ASSET account with normal CREDIT balance

Advantages:

• Records estimated bad debt expense in period when related sales are recorded

• Reports account receivable on balance sheet at estimated amount to be collected

Disadvantages:

• Estimates needed

3 Methods to Estimate Bad Debts for Allowance Method

1. Percent of Sales Method (Income statement)

• assumes percent of CREDIT SALES for the period is uncollectible

• FORMULA: (current period sales * bad debt percent)

2. Percent of Accounts Receivable Method (balance sheet)

• assumes percent of COMPANY’S RECEIVABLES are uncollectible

• FORMULA:

  • Total Estimated Bad Debt Expense: (Total Receivables * Bad Debt %)

  • Current Bad Debt Expense: (Total Est. Bad Debt Expense - Previous Balance of Allowance Account)

3. Aging of Accounts Receivable Method (balance sheet)

• applied like percent of receivables except several percentages are used to establish allowance

• Each receivable is CATEGORIZED by HOW LONG PAST DUE DATE (longer = more likely to be uncollectible)

• Each group is multiplied by its established debt percentage

• All groups are totaled

→ MOST ACCURATE METHOD

Notes receivable (promissory note)

Promissory Note: a written promise to pay a specific amount, usually with interest ,either on demand or at a stated future date

Maker: person making/signing the note (borrower of money)

Payee: person to whom the note is payable

Maturity date: day the note (principal and interest) must be repaid

Interest Computation: (Principal * Annual interest rate * Time expressed in fraction of days) (←ex: x/360)

Recoding Honored and Dishonored Notes + End-of-Period Interest Adjustment

Honored:

• Dr: Cash

• Cr: Notes receivable (principal) and interest revenue (interest)

Dishonored:

• Dr: accounts receivable

• Cr: Notes receivable (principal) and interest revenue

End-of-Period Interest Adjustment

• Dr: Interest receivable

• Cr: Interest revenue

How Receivables can be Converted to Cash BEFORE their Maturity

1. Selling Receivables

• Buyer = “factor”

  • acquires ownership

• Seller is charged “factoring fee”

  • gets cash earlier

  • transfers risk of bad debts to factor

  • avoids costs of billing and accounting

2. Pledging receivables

• Pledge receivables as security for the loan

• company retains ownership and risk of receivables

Accounts Receivable Turnover

Measures how often, on average, receivables are collected during the period

FORMULA: Net sales / Avg accounts receivable

*Avg accounts rec. = (beg balance + end balance) / 2

HIGH turnover = use LESS STRICT credit terms to increase sales

LOW turnover = use MORE STRICT credit terms and MORE AGGRESSIVE collection efforts to avoid having assets tied up in accounts receivable