Financial Accounting Exam 3

What is the perpetual inventory system?

-updates inventory records continuously with every purchase and sale

-cost of goods sold (COGS) and ending inventory are determined in real-time

-requires detailed recordkeeping but provides accurate, up-to-date information

What is periodic inventory system?

-inventory is only updated at the end of the accounting period

-COGS is determined by: COGS=Beginning inventory + Purchases-Ending inventory

-physical counts are necessary to determine ending inventory

First-In, First-Out (FIFO)

-periodic and perpetual is the same

-assumes the oldest costs are assigned to COGS, newest cost remain in ending inventory

-Under rising prices:

• Lower COGS

• Higher net income

• Higher ending inventory value

Last-In, First-Out (LIFO)

-usually used for tax purposes

-assumes most recent costs are assigned to COGS, oldest cost remain in ending inventory

-Under rising prices:

• Higher COGS

• Lower net income

• Lower ending inventory value

What is the average cost method?

-assigns a weighted average cost per unit to all items

-average cost per unit= cost of goods available for sale/ units available for sale

-used in both perpetual and periodic (perpetual has a “moving average”)

What is the gross profit method?

-used when physical inventory counts are not possible (e.g. fire or theft)

-estimate COGS as: Net sales x (1-gross profit rate)

-estimate ending inventory as: cost of goods available for sale- estimated COGS (ratio is net sales-COGS/net sales)

-useful for interim financial statements

What is the retail method?

-used by retailers to estimate inventory at cost

-compute cost-to-retail ratio: Goods available for sale at cost/ Goods available for sale at retail

-compute ending inventory at retail: goods available for sale at retail- sales at retail

-estimate ending inventory at cost: ending inventory at retail x cost-to-retail ratio

What is the concept of LCM (Lower of Cost or Market)?

-inventory must be reported at lower of cost or market value

-”Market” generally means replacement cost (what it would cost to replace the item today)

-ensures inventory is not overstated on financial statements

What is petty cash?

-a small fund used for minor, immediate expenses (e.g. postage, office supplies).

-Controlled through Petty Cash voucher system:

• Establish the fund

• Make small payments with vouchers.

• Reimburse and record expenses periodically

-The petty cash balance should always equal cash on hand + vouchers

What is bank reconciliation?

-ensures that the company’s cash records match the bank statement

-common reconciling items include:

• Outstanding checks

• Deposits in transit

• Bank service charges

• Errors (either by the bank or company)

-Purpose: Detect errors and fraud, ensure accurate cash balances

Definition of internal controls?

policies and procedures designed to safeguard assets, enhance reliability of accounting records, and promote efficient operations

What are the key principles of internal control?

-establishment of responsibility: assign specific duties to specific individuals

-segregation of duties: separate authorization, recordkeeping, and custody of assets

-documentation procedures: use pre-numbered documents and maintain proper records

-physical controls: safes, locked storage, passwords, etc.

-independent internal verification: periodic review by employees not responsible for daily transactions

-human resource controls: bonding employees, rotating duties, requiring vacations, etc.

Fraud triangle components

• opportunity: the ability to commit fraud due to weak internal controls

• pressure (incentive): financial or personal motivation to commit fraud

• Rationalization: the individual justifies unethical actions (“I’ll pay it back later.”)

Fraud prevention

-strengthen internal controls

-enforce ethical codes of conduct

-encourage transparency and whistleblower mechanisms