Accounting Exam 2

periodicity assumption

accounting divides the economic life of a business into artificial time periods - accounting time periods are generally a month, quarter, / a year

fiscal year

accounting time period that is one year long

revenue recognition principle

recognize revenue in the accounting period in which the performance obligation is satisfied - performing a service / providing a good to a customer

five-step revenue recognition principle

1) identify the contract with customers

2) identify the separate performance obligations in the contract

3) determine the transaction price

4) allocate the transaction price to the separate performance obligations

5) recognize revenue when each performance obligation is satisfied

expense recognition principle

practice of expense recognition, expense recognition is tied to revenue - recognize expense in the period when the company makes efforts to generate revenue

accrual-basis accounting

transactions that change a company’s financial statements are recorded in the periods in which events occur, even if cash was not exchanged

cash-basis accounting

companies record revenue at the time they receive cash - is not in accordance with GAAP

adjusting entries

ensure that the revenue recognition and expense recognition principles are followed - required every time a company prepares financial statements (one income statement account and one balance sheet account)

deferrals

expenses / revenues that are recognized at a date later than the point when cash was originally exchanged (prepaid expense and unearned revenue)

prepaid expenses

expenses paid in cash before they are used / consumed - costs that expire either with the passage of time / through use

• increase (debit) to an expense account and a decrease (credit) to an asset account

ex) supplies used, record supplies expense

ex) insurance expired, record insurance expense

depreciation

process of allocating the cost of an asset to expense over its useful life (period of service)

accumulated depreciation

contra asset account, offset against an asset account

book value

difference between the coast of any depreciable asset and it related accumulated depreciation

unearned revenue

companies record cash received before services are preformed by increasing (crediting) a liability account - company has a performance obligation to provide a service for one of its customers

• decrease (debit) to a liability and increase (credit) to a revenue

accruals

expenses / revenues that are recognized at a date earlier than the point when cash is exchanged - increase both a balance sheet and income statement account

accrued revenues

revenues for services performed but not yet recorded at the statement date

• increase (debit) to an asset account and increase (credit) to a revenue account

accrued expenses

expenses incurred but not yet paid / recorded at the statement date (interest, taxes, utilities, salaries)

• increase (debit) to an expense account and increase (credit) to a liability account

accrued interest

face value of note, interest rate, and length of time the note is outstanding

accrued salaries and wages

after services have been performed

adjusted trial balance

prove the equality of the total debit balances and total credit balances in the ledger after all adjustments - primary basis for the preparation of financial accounting, companies can prepare financial statements directly from an adjusted trial balance

earnings management

planned timing of revenues, expenses, gains, and losses to reduce volatility in reported net income

quality of earnings

provides full and transparent information that will not confuse / mislead financial statement users

temporary accounts

revenues, expenses, and dividends relate only to a given accounting period (zero balance)

permanent accounts

balances are carried forward into future accounting periods (all balance sheets accounts)

• are not closed

closing entries

transfer net income (net loss) and dividends to retained earnings, so the balance in retained earnings agrees with the retained earning statement

income summary

close the revenue and expense accounts to a temporary account

robotic process automation (rpa)

involves the use of computer programs, instead of humans, to perform repetitive rules-based tasks

post-closing trial balance

after a company journalizes and posts all closing entries, it prepares another trial balance - list of all permanent accounts

retailers

merchandise companies that purchase and sell directly to consumers

wholesalers

merchandising companies that sell to retailers

sales revenue

primary source of revenue for merchandising companies is the sale of merchandise

cost of goods sold

total cost of merchandise sold during the period

• beginning inventory + cost of goods purchased - ending inventory = cogs

operating expenses

incurred in the process of earning sales revenue

gross profit

difference between sales revenue and cost of goods sold

inventory

merchandise that companies buy and sell to customers (current asset)

perpetual inventory

companies keep detailed records of the cost of each inventory purchase and sale - records continuously and cost of goods sold each time a sale occurs

periodic inventory

companies do not keep detailed inventory records of the goods on hand throughout the period - cost of goods sold only at the end of the accounting period (periodically)

purchase invoice

should support each credit purchase - indicates the total purchase price

• companies record purchases of merchandise for resale in the inventory account

freight costs

freight terms are agreed to by the buyer and seller - who is responsible for paying the freight charges (shipping costs) and who is responsible for the risk of loss / damage to the merchandise during transport

FOB

free on board - until the point where ownership is transferred

FOB shipping point

ownership of goods passes to the buyer when the public carrier accepts the goods from the seller - buyer is responsible for freight costs

FOB destination

ownership of goods remains with the seller until the goods reach the buyer - seller pays the freight costs

freight costs incurred by the buyer

buyer incurs the transportation costs, a part of purchasing inventory

• buyer debits inventory account

freight costs incurred by the seller

on outgoing merchandise are an operating expense to the seller

purchase return

return goods to seller for credit / cash

purchase allowance

keep merchandise if seller grants an allowance (deduction) from the purchase price

purchase discounts

credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment

• buyer calls this cash discount

credit terms

amount of the cash discount and time period in which it is offered (discount period), when the buyer pays an invoice within the period, the amount of the discount decreases the inventory

ex) 1/10 EOM (end of month)

business document

should support every sales transaction to provide written evidence of the sale - cash register documents provide evidence of cash sales

sales invoice

provides support for a credit sale - seller makes two entries

1) seller debits cash / accounts receivable and credits sales revenue

2) seller debits costs of goods sold and credits inventory

sales returns and allowances

transactions where the seller either accepts goods back from the buyer / buyer will keep the goods

1) debit sales returns and allowances and credit accounts receivable

2) debit inventory and credit cost of goods sold

contra revenue account

offset against a revenue account on the income statement

sales discounts

seller may offer the customer a cash discount (called a sales discount by seller)

• prompt payment of the balance due

• invoice price less returns and allowances

single-step income statement

only one step, subtract total expense from total revenues

revenues

both operating and non-operating revenues and gains

expenses

cost of goods sold, operating expenses, and non-operating expenses and losses

multiple-step income statement

highlights components of net income

gross profit

subtract cost of goods sold from net sales - uses net sales which takes into account sales returns and allowances and sales discount

• represents the merchandising profit, it is not a measure of the overall profit

income from operations

deduct operating expenses from gross profit

net income

add / subtract the results of activities not related to operations to income from operations

net sales

deducts sales returns and allowances and sales discounts from sales revenue

operating expenses

subtract from gross profit to get the income from operations

non-operating activities

various revenues / expenses and gains / losses that are unrelated to the company’s main line of operations

• other revenues / gains: interest, dividends, rent revenue

• other expenses / losses: interest expenses, casualty losses

income tax expense

income before income tax multiplied by company’s corporate income tax rate

gross profit rate

express gross profit as a percentage by dividing the amount of gross profit by net sales

• more informative because it expresses a more meaningful (qualitative) relationship between gross profit and net sales

• helps companies decide if the prices of their goods are in line with changes in the cost of inventory

profit margin

measures the percentage of each dollar of sales that results in net income

• dividing net income by net sales (revenue) for the period

• helps companies decide if they are maintaining an adequate margin between sales and expenses

how do gross profit rate and profit margin differ?

• gross profit rate measures the margin by which selling price exceeds the cost of goods sold

• profit margin measures the extent by which the selling price covers all expenses (including cost of goods sold)

quality of earnings ratio

calculated as net cash provided by operating activities divided by net income

• less than one suggests that a company may be using more aggressive accounting

merchandise inventory

• owned by the company

• form ready for sale to customers in the ordinary course of business

manufacturing companies

classify inventory into three categories…raw materials, work in process, and finished goods

raw materials

basic goods that will be used in production but have not yet been placed into production

work in process

portion of manufactured inventory that has been placed into the production process but is not yet completed

finished goods

manufactured items that are completed and ready for sale

just-in-time (jit) inventory

companies manufacture / purchase goods only when needed - significantly lowered inventory levels and costs

physical inventory

counting, weighting, / measuring each kind of inventory on hand

• determines amount of inventory lost due to “shrinkage”

shrinkage

wasted raw materials, shoplifting, / employee theft

determining ownership of goods

1) do all of the goods included in the count belong to the company?

2) does the company own any goods that were not included in the count?

goods in transit

on board a truck, train, ship, / plane

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

consigned goods

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

• many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell

specific identification method

units it sold and which are still in ending inventory (inventory costing) - companies can accurately determine ending inventory and cost of goods sold

• requires companies keep records of the original cost of each individual inventory item

• disadvantage: management may be able to manipulate net income

cost flow assumptions

assume flow of costs that may be unrelated to the physical flow of goods

first-in, first-out (fifo) method

assumes that the earliest goods purchased are the first to be sold

• parallels the actual physical flow of merchandise

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

• costs of the oldest units are recognized first

under fifo, companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backwards until all units of inventory have been costed

last-in, first-out (lifo) method

assumes that the latest goods purchased are the first to be sold

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

under lifo, companies determine the cost of the ending inventory by taking the unit cost of hte earliest goods avaliable for sale and working forward until all units of inventory have been costed

average cost method

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

• assumes that goods are similar in nature

weighted average unit cost

average cost that is weighted by the number of units purchased at each unit cost

• do not use the average of the unit costs

• uses the average wighted by the quantities purchased at each unit cost

• cost of goods available for sale / total units available for sale = weighted average unit cost

income statement effects: inflation

• fifo produces a higher net income

• lifo produces a lower net income

• high net income is an advantage

paper / phantom profits

earnings that do not really exist

balance sheet effects

• fifo advantage during inflation, the costs allocated to ending inventory will approximate their current cost

• lifo shortcoming during inflation, the costs allocated to ending inventory may be significantly understated in terms of cost

tax effects

• inventory on the balance sheet and net income on the income statement are higher when using fifo in a period of inflation

• lifo results in the lowest income taxes

consistency concept

a company uses the same accounting principles and methods from year to year

lower-of-cost-or-net realizable value (lcnrv)

in the period in which the cost decline occurs

net realizable value

the net amount that a company expects to realize (receive) from the sale of inventory - the estimated selling price in the normal course of business, less estimated costs to complete and sell

accounting conservatism

accountants select a method of reporting that is least likely to overstate assets and net income

inventory turnover

calculated as cost of goods sold divided by average inventory

• liquidity of inventory by measuring the number of times the average inventory “turns over” (is sold) during the year

days in inventory

inventory turnover divided by 365 days - average number of days inventory is held

adjustments for lifo reserve

• increasing prices, fifo results in higher income

• balance sheet, fifo results in higher inventory

lifo reserve

companies using lifo are required to report the difference between inventory reported using lifo and inventory using fifo

• enables analysts to make adjustments to compare companies that use different cost flow methods