ACCT201 Exam #2 Study Guide

ACCT201 Exam #2 Study Guide

Exam Format

  • Exam Composition: 50 multiple choice questions
  • Scoring: 2 points each, totaling 100 possible points
  • Weighting: 55% calculation; 45% conceptual understanding

Inventory Systems

  • Perpetual Inventory System vs Periodic Inventory System
    • Perpetual Inventory System: This system continuously updates inventory records (inventory account and cost of goods sold account) after every purchase and sale transaction. It provides real-time data on the quantity and cost of inventory on hand.
    • Periodic Inventory System: This system updates inventory accounts only at specific intervals, such as monthly or annually. A physical count of inventory is required to determine the ending inventory balance and calculate the cost of goods sold.
  • Journal Entries for Buyers and Sellers:
    • Journal entries for purchases, sales, returns, and discounts differ significantly between perpetual and periodic systems due to when and how inventory and cost of goods sold are recorded.
  • Conceptual Differences:
    • Perpetual provides real-time information, which is useful for inventory management, reordering, and tracking profitability on a per-sale basis. Periodic is simpler to maintain but lacks up-to-the-minute data.
  • Calculation of Ending Inventory and COGS Differences:
    • Because of the different timing and methods of recording, ending inventory and cost of goods sold (COGS) amounts can vary. Under the perpetual system, COGS is recorded with each sale, while under the periodic system, COGS is calculated at the end of the period.

Calculations Related to Inventory

  • Net Cost of Goods Calculation (if buyer pays within discount period): This calculates the actual cost of goods purchased after considering all reductions.
    • Formula: \text{Purchase Cost} - \text{Returns} - \text{Discounts}
  • Journal Entry for Payment Within Discount Period: This involves debiting Accounts Payable for the full amount, crediting Cash for the amount paid (purchase price minus discount), and crediting Inventory (or Purchase Discounts, if a gross method is used initially) for the discount taken.
  • Inventory Balance Calculation: The ending inventory balance is determined by starting with beginning inventory, adding net purchases (purchases, less returns and discounts, plus freight-in), and then subtracting the cost of goods sold (under perpetual) or determining inventory based on a physical count (under periodic).
    • Includes factors such as purchases of goods, returns, freight charges (cost to bring goods to location), and discounts (similar to Chapter 5 Quiz, question #4).
  • Key Calculations:
    • Net Sales: This represents the actual revenue earned from sales after accounting for reductions.
    • Formula: \text{Sales} - \text{Sales Returns} - \text{Allowances} - \text{Sales Discounts}
    • Gross Profit: This is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with its services.
    • Formula: \text{Net Sales} - \text{COGS}
    • Gross Profit Rate: This measures the percentage of revenue that exceeds the cost of goods sold.
    • Formula: \text{Gross Profit} / \text{Net Sales}
    • Net Income: This is a company's total earnings (or profit) after subtracting all expenses, including operating expenses, from revenue.
    • Formula: \text{Gross Profit} - \text{Operating Expenses}
    • Profit Margin: This is a profitability ratio that measures the amount of net income generated as a percentage of revenue.
    • Formula: \text{Net Income} / \text{Net Sales}

Shipping Terms

  • FOB Shipping Point vs FOB Destination: These terms specify when ownership of goods transfers from seller to buyer and who pays for shipping costs.
    • FOB Shipping Point: The buyer assumes ownership of goods, bears the risk of loss, and is responsible for shipping costs once the goods leave the seller's location (shipping point). The goods are considered part of the buyer's inventory in transit.
    • FOB Destination: The seller retains ownership and risk of loss, and is responsible for shipping costs until the goods physically reach the buyer's location (destination). The goods are considered part of the seller's inventory in transit.

Legal Title to Inventory

  • Ownership During Transit: Legal title to inventory depends entirely on the agreed-upon shipping terms (FOB Shipping Point or FOB Destination). This is crucial for correctly recognizing revenue (for the seller) and including inventory on the balance sheet (for the buyer).
  • Consignment: This is an arrangement where goods are left by a consignor (seller) with a consignee (agent) for sale. The consignor retains legal title to the goods until they are sold by the consignee to an end customer. This means consigned goods are part of the consignor's inventory, not the consignee's.

COGS and Inventory Method Calculations

  • Calculation of COGS and Ending Inventory Using FIFO and LIFO: These are cost flow assumptions used to assign costs to inventory and cost of goods sold. The choice of method can significantly impact financial statements.
    • FIFO (First In, First Out): Assumes that the first units of inventory purchased are the first ones sold. This generally results in higher ending inventory and lower COGS during periods of rising prices, leading to higher reported net income.
    • LIFO (Last In, First Out): Assumes that the last units of inventory purchased are the first ones sold. This generally results in lower ending inventory and higher COGS during periods of rising prices, leading to lower reported net income and often lower tax liabilities (in the U.S.).
  • Periodic and Perpetual Methods: The application of FIFO and LIFO interacts with the inventory system used. For FIFO, the results are generally the same under both perpetual and periodic systems. However, for LIFO, the ending inventory and COGS can differ significantly between perpetual and periodic calculations due as the 'last in' changes with each sale under perpetual LIFO.
  • Conceptual Understanding of Inventory Flow Methods: Understanding these methods is key to analyzing how a company's choice of inventory costing method impacts its reported profits, inventory valuation on the balance sheet, and ultimately, its tax liabilities. Management selects a method based on accounting principles and its desired financial reporting outcomes.

Asset Valuation

  • Lower of Cost or Net Realizable Value (LCNRV): This concept dictates that inventory must be reported on the balance sheet at the lower of its historical cost (the original amount paid) or its net realizable value (NRV). NRV is the estimated selling price in the ordinary course of business less estimated costs to complete and sell. This principle prevents overstating inventory value when its market value declines.

Inventory Management Metrics

  • Inventory Turnover and Days in Inventory Calculations: These ratios assess how efficiently a company is managing its inventory.
    • Inventory Turnover Formula: This ratio indicates how many times a company has sold and replaced inventory during a period.
      \text{Inventory Turnover} = \frac{\text{COGS}}{\text{Average Inventory}}
      where Average Inventory = (\text{Beginning Inventory} + \text{Ending Inventory}) / 2
    • Average Days in Inventory Formula: This measures the average number of days it takes for a company to sell its inventory.
      \text{Average Days in Inventory} = \frac{365}{\text{Inventory Turnover}}

Internal Controls

  • Importance of Internal Control Procedures: Strong internal controls are crucial for any business, including financial reporting. They are procedures and policies designed to safeguard assets, ensure the accuracy and reliability of accounting records, promote operational efficiency, and encourage adherence to management policies. This mitigates risks of errors, fraud, and misstatements in financial reporting, ensuring compliance with regulations.

Financial Management Concepts

  • Petty Cash Management: Petty cash is a small fund of cash kept on hand for minor, day-to-day expenses that are too small to justify issuing a check (e.g., postage, office supplies). It requires careful record-keeping, tracking disbursements with receipts, and periodic reconciliation to ensure accountability and prevent misuse.
  • Bank Reconciliation: This process involves comparing a company's cash balance as reported in its general ledger (book balance) with the cash balance shown on the bank statement. Differences arise from items recorded by one party but not the other (e.g., outstanding checks, deposits in transit, bank service charges, interest earned). The reconciliation identifies these differences and makes adjustments to both the bank and book balances to arrive at a true cash balance.
    • Includes adjustments for bank items (deposits in transit, outstanding checks, bank errors) and book items (bank service charges, interest revenue, NSF checks, book errors).
  • Cash Equivalents: These are highly liquid investments that are readily convertible to a known amount of cash and are so near their maturity that they present insignificant risk of changes in value due to interest rate changes. They typically have original maturities of three months or less.
    • Examples: treasury bills, commercial paper, money market funds.
  • Allowance Method for Recording Bad Debt: This method estimates uncollectible accounts receivable at the end of each accounting period. Instead of waiting for specific accounts to become uncollectible, an expense is recognized in the same period as the related revenue.
    • It utilizes an Allowance for Doubtful Accounts (a contra-asset account) to reduce Accounts Receivable to its net realizable value.
    • Requires periodic adjustments to the allowance account to reflect changes in the estimate of uncollectible accounts.
  • T-Account Representation: A T-account for the Allowance for Doubtful Accounts is used to estimate the required ending balance, considering the beginning balance and specific write-offs during the period, to determine the adjusting entry amount needed.
  • Recording Receipt of Note Receivable: A journal entry is made to reflect the receipt of a promissory note from a customer to settle an open accounts receivable. This typically involves debiting Notes Receivable and crediting Accounts Receivable.
  • Recording Payment of Note After Accrued Interest: This involves recording the cash received, removing the Note Receivable, and recognizing the interest revenue earned. If interest was previously accrued at year-end, the entry must also reverse the Interest Receivable and recognize only the additional interest earned during the current period. (Similar to Chapter 4 Quiz, question #4, documenting interest owed at year-end on note receivable).

Accounts Receivable Management

  • Accounts Receivable Turnover and Average Collection Period for Accounts Receivable Calculations: These ratios evaluate the efficiency of a company in collecting its receivables.
    • Accounts Receivable Turnover Formula: This ratio measures how many times, on average, a company collects its accounts receivable during an accounting period.
      \text{Accounts Receivable Turnover} = \frac{\text{Net Sales}}{\text{Average Accounts Receivable}}
      where Average Accounts Receivable = (\text{Beginning Accounts Receivable} + \text{Ending Accounts Receivable}) / 2
    • Average Collection Period Formula: This measures the average number of days it takes for a company to collect its accounts receivable.
      \text{Average Collection Period} = \frac{365}{\text{Accounts Receivable Turnover}}
  • Impact of Service Charge Expense for Credit Card Use: When customers pay with credit cards, companies incur a service charge expense (a percentage of the sale) from the credit card processor. This expense reduces the net amount of cash received from the sale and impacts net revenue reporting by reducing the effective sales revenue.
  • Factoring Accounts Receivable: This is a financial transaction where a business sells its accounts receivable (invoices) to a third party (a factor) at a discount. The company receives immediate cash, improving cash flow and reducing or eliminating the need to collect receivables. It requires an understanding of the factoring fees (costs) and how it impacts the company's financial statements (e.g., removal of receivables from the balance sheet, recognition of loss on sale).