introduction to financial accounting exam 2

Merchandising company

A business that buys and sells physical goods (inventory) to earn revenue, unlike a service company that earns by performing services.

Cost of Goods Sold (COGS)

The total cost of merchandise that was sold during the period. Formula: Beginning Inventory + Purchases - Ending Inventory

Perpetual Inventory System

Tracks every purchase and sale in real time. Updates inventory and COGS with each transaction.

Periodic Inventory System

Does NOT track inventory continuously. Ending inventory is determined by a physical count at end of period; COGS is calculated then.

FOB Shipping Point

"Free On Board Shipping Point" — buyer owns the goods the moment the seller ships them. Buyer pays freight. Buyer includes in-transit goods in inventory.

FOB Destination

Seller owns the goods until they arrive at the buyer's location. Seller pays freight. Seller keeps in-transit goods in inventory.

Consignment goods

Goods held and sold by one party (consignee) on behalf of the owner (consignor). Consignee does NOT own them; they stay in consignor's inventory.

Purchase discount (2/10, n/30)

A cash discount for early payment. "2/10, n/30" means: take 2% off if paid within 10 days, otherwise full amount due in 30 days.

Journal entry to record a purchase on account

Dr. Inventory / Cr. Accounts Payable (perpetual system)

Journal entry to record freight-in (buyer pays)

Dr. Inventory / Cr. Cash — freight paid by buyer increases the cost of inventory.

Journal entry for a purchase return

Dr. Accounts Payable / Cr. Inventory — reduces what you owe and reduces inventory.

Journal entry for a purchase discount taken

Dr. Accounts Payable (full amount) / Cr. Cash (net of discount) / Cr. Inventory (discount amount)

Journal entry to record a SALE on account (perpetual)

TWO entries: (1) Dr. Accounts Receivable / Cr. Sales Revenue; (2) Dr. Cost of Goods Sold / Cr. Inventory

Sales Returns and Allowances

A contra-revenue account (debit). Records merchandise returned by customers or price reductions given to unhappy customers.

Sales Discount

A contra-revenue account (debit). Offered to customers for early payment. Works just like purchase discounts from the seller's side.

Gross Profit

Net Sales minus Cost of Goods Sold. The profit before operating expenses are deducted.

Net Sales

Sales Revenue minus Sales Returns & Allowances minus Sales Discounts.

Multiple-Step Income Statement

Shows several profit subtotals: Net Sales → Gross Profit → Operating Income → Net Income. Used by merchandising companies.

Single-Step Income Statement

Subtracts ALL expenses from ALL revenues in one step. Simpler but shows less detail.

COGS formula (periodic system)

Beginning Inventory + Net Purchases + Freight-in - Ending Inventory = COGS

FIFO (First-In, First-Out)

Inventory cost flow method: assumes the FIRST units purchased are the FIRST sold. Ending inventory = most recent (highest) costs in inflation.

LIFO (Last-In, First-Out)

Inventory cost flow method: assumes the LAST units purchased are the FIRST sold. Ending inventory = oldest (lowest) costs in inflation. Lowest taxes in inflation.

Weighted-Average Cost Method

Divides total cost of goods available for sale by total units available to get an average cost per unit. Apply to units sold and units remaining.

Specific Identification Method

Tracks the actual cost of each individual item. Used for unique, high-value items (e.g., cars, jewelry, antiques).

Inventory error effect (understated ending inventory)

Understated ending inventory → Overstated COGS → Understated Net Income in the CURRENT year. Next year, the error REVERSES.

LCNRV (Lower-of-Cost-or-Net Realizable Value)

Inventory must be written down if its market value falls below cost. Conservatism principle.

Inventory Turnover Ratio

COGS ÷ Average Inventory. Measures how many times inventory is sold per year. Higher = more efficient.

Days in Inventory

365 ÷ Inventory Turnover. Average number of days to sell inventory.

Gross Profit Method (estimating inventory)

Estimate ending inventory using a known gross profit rate: Net Sales × GP% = Estimated Gross Profit; then subtract from net sales to get estimated COGS.

Retail Inventory Method

Estimates inventory cost using a cost-to-retail ratio. Cost of goods available ÷ Retail value of goods available = Cost ratio; multiply by ending retail inventory.

Fraud (definition)

A dishonest act by an employee that results in personal benefit at the employer's expense. Caused by opportunity, financial pressure, and rationalization.

Sarbanes-Oxley Act (SOX)

Law requiring publicly traded companies to maintain adequate internal controls. External auditors must attest to their adequacy.

Establishment of Responsibility

Internal control principle: assign each task to only ONE person so accountability is clear.

Segregation of Duties

Internal control principle: separate record-keeping from physical custody of assets. Separate authorization, custody, and recording.

Documentation Procedures

Use prenumbered documents; account for all documents; source documents forwarded promptly to accounting.

Physical Controls

Locks, safes, cameras, passwords — limit access to assets and records to authorized personnel only.

Independent Internal Verification

A separate employee periodically reviews and reconciles records without involvement in the original transaction.

Human Resource Controls

Background checks, bonding employees, requiring vacations, rotating duties — reduce opportunity for fraud.

Accounts Receivable

Amounts customers owe from selling goods/services on account (credit). Current asset.

Notes Receivable

A formal written promise (promissory note) to pay a specific amount plus interest by a specific date.

Direct Write-Off Method

Writes bad debt directly to Bad Debt Expense when a specific account is deemed uncollectible. NOT GAAP-compliant for financial reporting.

Allowance Method

Estimates bad debts in the same period as sales (matching principle). REQUIRED by GAAP. Uses Allowance for Doubtful Accounts (contra-asset).

Journal entry to estimate bad debts (allowance method)

Dr. Bad Debt Expense / Cr. Allowance for Doubtful Accounts

Journal entry to write off a specific account (allowance method)

Dr. Allowance for Doubtful Accounts / Cr. Accounts Receivable

Cash realizable value

The net amount of accounts receivable expected to be collected: Accounts Receivable - Allowance for Doubtful Accounts

Recovery of a written-off account (2 entries)

(1) Reverse the write-off: Dr. A/R / Cr. Allowance; (2) Record collection: Dr. Cash / Cr. A/R

Aging Schedule

Groups accounts receivable by how long they've been outstanding; older accounts get higher uncollectibility percentages.

Adjusting entry with existing CREDIT balance in Allowance account

Bad Debt Expense = (Required allowance balance) - (Existing credit balance). Debit BDE, credit Allowance for difference.

Adjusting entry with existing DEBIT balance in Allowance account

Bad Debt Expense = (Required allowance balance) + (Existing debit balance). Debit BDE, credit Allowance for the FULL sum.

Factoring receivables

Selling accounts receivable to a finance company (factor) for immediate cash minus a service fee. Entry: Dr. Cash + Dr. Service Charge Expense / Cr. A/R

Credit card (national) sales entry

Dr. Cash (net of fee) / Dr. Service Charge Expense (fee %) / Cr. Sales Revenue (full amount)

Interest on a note formula

Principal × Annual Rate × (Time/12 or Time/365)

Honoring a note receivable (collection at maturity)

Dr. Cash (principal + interest) / Cr. Notes Receivable (principal) / Cr. Interest Revenue (interest earned)

Dishonoring a note (if collection expected)

Dr. Accounts Receivable (principal + interest) / Cr. Notes Receivable / Cr. Interest Revenue

Plant Assets (PP&E)

Long-lived tangible assets used in operations and NOT for sale: land, buildings, equipment, land improvements.

Historical Cost Principle

Plant assets are recorded at the FULL cost to acquire them and make them ready for use.

Cost of Land

Purchase price + closing costs + broker commissions + back taxes + demolition of old building (net of salvage). Land is NEVER depreciated.

Land Improvements

Additions to land (parking lots, fences, landscaping) that have LIMITED useful lives and ARE depreciated.

Cost of Equipment

Purchase price + sales tax + freight + insurance during transit + installation + testing. Does NOT include license or insurance after placed in service.

Revenue Expenditures

Ordinary repairs that maintain current operating efficiency. Expensed immediately. Example: oil change.

Capital Expenditures

Additions or improvements that increase capacity, efficiency, or useful life. Capitalized (added to asset account).

Depreciation

Allocating the COST of a plant asset to expense over its useful life. It is cost allocation, NOT a decrease in market value. Land is NEVER depreciated.

Straight-Line Depreciation formula

(Cost - Salvage Value) ÷ Useful Life in Years = Same depreciation expense every year.

Units-of-Activity Depreciation

(Cost - Salvage Value) ÷ Total Estimated Units = Cost per unit; then multiply by actual units used each period.

Double-Declining-Balance (DDB) Depreciation

Rate = 2 × Straight-Line rate; apply to BOOK VALUE (not depreciable cost). Stop when book value = salvage value. Accelerated method.

Book Value of a plant asset

Cost - Accumulated Depreciation. NOT fair market value.

Accumulated Depreciation

A contra-asset account that totals all depreciation taken on an asset since purchase. Shown as a deduction from the asset on the balance sheet.

Revising Depreciation (change in estimate)

No prior period correction. Calculate new depreciable base (Book Value - new Salvage Value) ÷ remaining useful life = new annual depreciation.

Retirement of plant asset (fully depreciated, no proceeds)

Dr. Accumulated Depreciation / Cr. Equipment (at cost). No gain or loss.

Retirement with a loss (not fully depreciated)

Dr. Accumulated Depreciation + Dr. Loss on Disposal / Cr. Equipment

Sale of plant asset — GAIN

Proceeds > Book Value → Credit Gain on Disposal

Sale of plant asset — LOSS

Proceeds < Book Value → Debit Loss on Disposal

Journal entry for sale of plant asset

Dr. Cash + Dr. Accumulated Depreciation ± Gain or Loss / Cr. Equipment (at cost)

Natural Resources

Physical assets extracted from the earth: coal, oil, timber. Subject to DEPLETION.

Depletion

Allocating the cost of a natural resource to expense based on units extracted. Like depreciation for plant assets.

Depletion cost per unit formula

(Cost - Salvage Value) ÷ Total Estimated Units = Depletion rate per unit

Intangible Assets

Non-physical assets with long-term value: patents, copyrights, trademarks, franchises, goodwill.

Amortization

Allocating the cost of a LIMITED-LIFE intangible asset to expense over its useful life. Credited directly to the asset account (no contra account).

Patent

Exclusive right to make/sell an invention for 20 years. Amortize over 20 years OR useful life, whichever is shorter. Defend legally → capitalize legal fees.

Copyright

Exclusive right to reproduce/sell creative works. Life of creator + 70 years. Amortize over useful life.

Trademark

Word/symbol identifying a company or product. Indefinite life; NO amortization.

Goodwill

Excess of purchase price over fair value of net assets acquired. Indefinite life; NOT amortized. Tested annually for impairment.

Research & Development Costs (R&D)

ALL R&D costs are expensed immediately when incurred. They are NOT intangible assets on the balance sheet.

Accounts Receivable Turnover

Net Credit Sales ÷ Average Net Accounts Receivable. Measures how quickly receivables are collected.

Average Collection Period

365 ÷ Accounts Receivable Turnover. Average days to collect receivables.