Principles of Financial Accounting Exam #3

inventory

a tangible resource that is held for resale in the normal course of operation; recorded at acquisition cost; becomes an expense when it is sold

gross margin

the amount of resources that are left to pay operating expenses (selling and administrative expenses) and provide for net income

revenue - cost of goods sold = gross margin

gross margin equation

merchandisers

companies (either retailers or wholesalers) that purchase inventory in a finished condition and hold it for resale without further processing

manufacturers

companies that buy and transform raw materials into a finished product which is then sold

raw materials, work in process, finished goods

3 classifications of inventory

raw materials inventory

are the basic ingredients used to make a product. When these raw materials are purchased, the Raw Materials Inventory account is increased. As raw materials are used to manufacture a product, they become part of work-in-process inventory.

work in process inventory

consists of the raw materials that are used in production as well as other production costs such as labor and utilities. These costs stay in this account until the product is complete. Once the production process is complete, these costs are moved to the Finished Goods Inventory account.

finished goods inventory

represents the cost of the final product that is available for sale. When the finished goods inventory is sold to a customer, it becomes an expense called cost of goods sold, which appears on the income statement

beginning inventory + purchases = cost of goods available for sale - ending inventory = cost of goods sold

cost of goods sold model

perpetual inventory system

balances for inventory and cost of goods sold are continually (perpetually) updated with each sale or purchase of inventory. This type of system requires that detailed records be maintained on a transaction-by-transaction basis for each purchase and sale of inventory.

periodic inventory system

does not require companies to keep detailed, up-to-date inventory records. Instead, a periodic system records the cost of purchases as they occur (in an account separate from the inventory account), takes a physical count of inventory at the end of the period, and applies the cost of goods sold model to determine the balances of ending inventory and cost of goods sold

perform a physical count of inventory

estimate the amount of inventory using an acceptable estimation technique

If a company using the periodic system needs to know the balance of inventory or cost of goods sold during a period, it must do either of the following:

relatively inexpensive to operate

The principal advantage of a periodic system is that it is.....

purchases

refers to the cost of merchandise acquired for resale during the accounting period.

increasing the inventory account

the purchase of inventory is recorded by...

purchase discounts

early pay discounts taken. These reduce the inventory account.

2/10, n30- 2% discount if paid in 10 days, net due in 30 days

reduces the inventory account for the amount of the discount taken, resulting in the inventory reflecting the net cost of the purchase

If a purchase discount is taken, the purchaser.....

purchase return

The cost of merchandise returned to suppliers is called a

purchase allowance

In some instances, the purchaser may choose to keep the merchandise if the seller is willing to grant a deduction (allowance) from the purchase price. This situation is called a

decreasing inventory

Because inventory was increased when the purchase was initially made, a purchase return or allowance is recorded by.....

FOB shipping point

Ownership of the inventory passes from the seller to the buyer at the shipping point. The buyer normally pays the transportation costs, commonly termed freight-in. These costs are considered part of the total cost of purchases and the inventory account is increased. The seller would normally recognize revenue at the time of the shipment.

FOB destination point

Ownership of the inventory passes when the goods are delivered to the buyer. The seller is usually responsible for paying the transportation costs, commonly termed freight-out. In this case, the transportation costs are not considered part of inventory; instead, the seller will expense these costs as a selling expense on the income statement. Revenue is not normally recognized until delivery of the goods has occurred.

cost of inventory

freight in is included as

expense on seller's income statement

freight out if included as

consignment

Sometimes goods owned by one party are held and offered for sale by another. This arrangement is called....

consignment info

In a consignment, the seller (or consignee) earns a fee when the consigned goods are sold, but the original owner (or consignor) retains ownership of the goods. Manufacturers often use consignments to encourage large retailers, such as Wal-Mart and Target, to offer their products for sale. Retailers find these arrangements attractive because it enables them to reduce their investment in inventory. In consignment arrangements, the goods are not included in the seller's inventory

increased; reduce

Therefore, the inventory account is __________ for the invoice price of a purchase as well as any transportation costs paid for by the buyer. Any purchase discounts, returns, or allowances __________ the inventory account

In the first journal entry, sales revenue is recognized.

The second journal entry recognizes, consistent with the expense recognition principle, the cost of the goods related to the products that are sold. It also reduces the inventory account so that the perpetual inventory system will reflect an up-to-date balance for inventory.

The recording of sales revenue involves two journal entries:

the company will make an adjustment to sales. In addition, the company must make a second entry to decrease cost of goods sold and increase inventory to reflect the return of the merchandise.

If a customer returns an item for some reason,

net method recording of sales returns and allowances

Returns & Allowances Liability is debited and A/R or Cash is credited

gross method of recording sales and allowances

Revenue account is debited and A/R or Cash is credited.

specific identification method

determines the cost of ending inventory and the cost of goods sold based on the identification of the actual units sold and in inventory. This method does not require an assumption about the flow of costs but assigns cost based on the specific flow of inventory. It requires that detailed records of each purchase and sale be maintained so that a company knows exactly which items were sold and the cost of those items.

first in-first out (FIFO) method

is based on the assumption that costs move through inventory in an unbroken stream, with the costs entering and leaving the inventory in the same order. In other words, the earliest purchases (the first in) are assumed to be the first sold (the first out), and the more recent purchases are in ending inventory. Every time inventory is sold, the cost of the earliest (oldest) purchases that make up cost of goods available for sale is allocated to cost of goods sold, and the cost of the most recent purchases is allocated to ending inventory.

last in-first out (LIFO) method

allocates the cost of goods available for sale between ending inventory and cost of goods sold based on the assumption that the most recent purchases (the last in) are the first to be sold (the first out). Under the LIFO method, the most recent purchases (newest costs) are allocated to the cost of goods sold and the earliest purchases (oldest costs) are allocated to inventory; seldom reflects the actual flow of goods

average cost method

allocates the cost of goods available for sale between ending inventory and cost of goods sold based on a weighted average cost per unit

cost of goods available for sale / units available for sale

weighted average cost per unit =

units on hand x weighted average cost per unit

ending inventory =

units sold x weighted average cost per unit

cost of goods sold =

sold during the year

The "Cost of Goods Sold" account represents the cost of inventory....

remaining in the inventory account at the end of the period

Purchased during the year plus inventory sold

Sold during the year

Available for sale at the beginning of the year

increase; no change

When inventory is bought under the perpetual inventory system, what happens to the Inventory and Cost of Goods Sold accounts, respectively?

No change, Increase

Increase, no change

Increase, Increase

Decrease, no change

highest ending inventory, lowest cost of goods sold, highest income

For rising purchasing prices, FIFO produces:

lowest ending inventory, highest cost of goods sold, lowest income

For rising purchasing prices, LIFO produces:

lowest ending inventory, highest cost of goods sold, lowest income

For falling purchasing prices, FIFO produces:

highest ending inventory, lowest cost of goods sold, and highest income

For falling purchasing prices, LIFO produces:

LIFO

___________ results in the more realistic amount for income because it matches the most current costs, which are closer to the current market value, against revenue.

FIFO

__________ results in the more realistic amount for inventory because it reports the most current costs, which are closer to the current market value, on the balance sheet.

lower cost market rule

Under _______, if the market value of a company's inventory is lower than its cost, the company reduces the amount recorded for inventory to its market value; market value = current replacement costs

gross profit / net sales

gross profit ratio =

cost of goods sold / average inventory

inventory turnover ratio =

365 days / inventory turnover

average days to sell inventory =

purchases, purchase discounts, purchase returns and allowances, transportation-in

As purchase transactions occur, they are recorded in one of four temporary accounts:

purchases

account accumulates the cost of the inventory acquired during the period.

purchase discounts

account accumulates the amount of discounts on purchases taken during the period

purchase returns and allowances

account accumulates the cost of any merchandise returned to the supplier or any reductions (allowances) in the purchase price granted by the seller.

transportation in

account accumulates the cost paid by the purchaser to transport inventory from suppliers

companies using periodic system

Figure out inventory on hand at the end of the period

Calculate COGS

companies using perpetual system

Check accuracy of inventory records

Determine spoilage/loss/theft

COGS understated

Net Income overstated

Understate Beginning Inventory (Income Statement)

COGS overstated

Net Income understated

Overstate Beginning Inventory (Income Statement)

COGS overstated

Net Income understated

Understate Ending Inventory (Income Statement)

COGS understated

Net Income overstated

Overstate Ending Inventory (Income Statement)

Both the balance sheet and income statement are affected

If the amount assigned to ending inventory is incorrect, then:

The balance sheet is affected, but the income statement is not

The income statement is affected, but the balance sheet is not.

The balance sheet is affected, but Cost of Goods Sold is not

Both the balance sheet and income statement are affected

Assets are overstated

Liabilities are not effected

Stockholders' Equity is overstated

Ending Inventory overstated (Balance Sheet)

Assets are understated

Liabilities are not effected

Stockholders' Equity is understated

Ending Inventory understated (Balance Sheet)

LIFO reserve

is the difference between the inventory reported on the balance sheet on LIFO basis and what inventory would be if reported on FIFO basis.

operating assets

which are the long-lived assets that are used by the company in the normal course of operations; represent future economic benefit to company; recorded at cost (capitalized); amount of asset used up is allocated to expense during period of economical benefit

plant, property, equipment (fixed assets or plant assets)

tangible operating assets that can be seen and touched. They include, among other things, land, buildings, machines, and automobiles.

intangible assets

which generally result from legal and contractual rights, do not have physical substance. They include patents, copyrights, trademarks, licenses, and goodwill.

natural resources

are naturally occurring materials that have economic value. They include timberlands and deposits such as coal, oil, and gravel

capitalized

These costs are said to be ______________, which means that they are reported as long-term assets with a service potential of greater than 1 year

depreciation; amortization; depletion

This allocation is called ______________ for property, plant, and equipment assets, _____________ for intangible assets, and ___________ for natural resources.

cost

any expenditure necessary to acquire the asset and to prepare the asset for use

depreciation

is the process of allocating, in a systematic and rational manner, the cost of a tangible fixed asset (other than land) to expense over the asset's useful life; process of cost allocation NOT asset valuation

depreciation expense

depreciation on income statement

accumulated depreciation

depreciation on balance sheet

land

depreciation does NOT include...

cost, useful life, salvage (residual) life

factors to compute depreciation

useful life

of an asset is the period of time over which the company anticipates deriving benefit from the use of the asset

residual value (salvage value)

is the amount of cash or trade-in consideration that the company expects to receive when an asset is retired from service

depreciable cost

The cost of the asset minus its residual value gives an asset's

straight line, declining balance, and units-of-production

3 most common depreciation methods

depreciable cost (cost minus residual value) of the asset.

For any of these depreciation methods, the total amount of depreciation expense that has been recorded (accumulated depreciation) over the life of the asset will never exceed the....

straight line method

allocates an equal amount of an asset's cost to depreciation expense for each year of the asset's useful life. It is appropriate to apply this method to those assets for which an equal amount of service potential is considered to be used each period; most widely used method because it is simple to apply and is based on a pattern of declining service potential that is reasonable for many fixed assets.

(cost - residual value) / expected useful life

straight line depreciation equation =

straight line rate

1 / useful life =

double declining balance method

is an accelerated depreciation method that produces a declining amount of depreciation expense each period by multiplying the declining book value of an asset by a constant depreciation rate. It is called an accelerated method because it results in a larger amount of depreciation expense in the early years of an asset's life relative to the straight-line method. However, because the total amount of depreciation expense (the depreciable cost) must be the same under any depreciation method, accelerated methods result in a smaller amount of depreciation expense in the later years of an asset's life. It is appropriate for assets that are subject to a rapid decline in service potential due to factors such as rapid obsolescence.

(m) x straight line rate

double declining balance rate =

declining balance rate x book value

double balance depreciation expense =

units of production method

However, when the decline in an asset's service potential is proportional to the usage of the asset and asset usage can be measured, depreciation expense can be computed using the .........

(cost - residual value) / expected usage of asset

depreciation cost per unit =

depreciation cost per unit x actual usage of asset

unit of production depreciation expense =

straight line method

a constant amount of depreciation expense each period corresponding a constant rate of decline in service potential

double declining balance

accelerated depreciation in early years of the assets life corresponding to a decreasing rate of decline in service potential

units of production

Depreciation expense rises and falls with asset's use

internal revenue code

specifies which depreciation method a company should use to prepare tax returns

Modified Accelerated Cost Recovery System (MACRS)

Most companies use the __________________________ to compute depreciation expense for their tax returns, which is similar to the declining balance method. __________ is not acceptable for financial reporting purposes

(added to an asset account) ; (reported in total on the income statement)

Companies must decide whether these expenditures should be capitalized __________________ or expensed _______________________

revenue expenditures

Expenditures that do not increase the future economic benefits of the asset are called _________________ and are expensed in the same period the expenditure is made. They occur frequently, typically involve small dollar amounts, maintain level of benefits provided by asset, and are in the current period; EXPENSES ON INCOME STATEMENT

capital expenditures

Expenditures that extend the life of the asset, expand the productive capacity, increase efficiency, or improve the quality of the product, are these; Because these expenditures provide benefits to the company in both current and future periods, they are added to an asset account and are subject to depreciation. These expenditures typically involve relatively large dollar amounts; INCLUDED IN ASSETS ON BALANCE SHEET