ACCT 211 Exam 2 (Ch. 5-8)
Inventory turnover
- (COGS) / (Average inventory) - Indicates how many times a year, on average, a firm sells its inventory
Gross profit percentage
- (Gross profit on sales) / (Net sales) - Indicates a company's ability to sell its products at acceptable prices
Return on sales ratio
- (Net income) / (Net sales) - Reveals the net income earned on each dollar of sales
Days' sales in inventory
- 365 / Inventory turnover - indicates how many days, on average, it takes a company to sell its inventory
Key characteristics of notes receivable
- A fixed due date or on demand - A certain principal sum to be paid - An interest rate usually stated as an annual rate
LIFO Inventory Reserve
- A measure of the difference between the value of a company's ending inventory reported under LIFO and what the inventory would have been valued under FIFO - Companies using LIFO must disclose the value of the inventory reserve in the financial statement notes - Enables users to use the LIFO reserve to determine the fair market value of the LIFO ending inventory - Enables users to restate gross profit under LIFO
Operational audit
- An evaluation of activities, systems, and internal controls - Used to determine efficiency, effectiveness, and economy
LIFO method
- Assumes that the first units purchased remain on hand - Assumes that later units purchased are the first units sold
FIFO method
- Assumes that the units purchased more recently remain on hand - Assumes the earliest units purchased are the first units sold
Weighted average cost method
- Averages the cost of purchases so that units are valued at an average, with each unit valued at the same cost - New purchases cause a re-averaging of unit costs
Internal control for cash
- Because cash is so easily taken, concealed, or otherwise misappropriated, most companies have developed elaborate internal controls to safeguard their cash - Controls for cash involve: 1. Mailroom or retail sales area for receipt 2. Treasurer for custody 3. Controller for recording 4. Internal audit
Losses from accounts receivable
- Businesses extend credit in order to increase their volume of sales relative to a cash-only policy - Businesses understand, however, that they will likely not collect 100 percent of all of their outstanding accounts receivable - Credit losses are considered an operating expense and are debited to bad debt expense
Accounting for cash
- Cash includes coins, currency, checks, money orders, checking accounts, and savings accounts - Cash is often reported combined with cash equivalents consisting of such items as certificates of deposit, Treasury bills, and money market accounts - Cash that is restricted in its use must be reported separately
Lower-of-Cost-or-Net Realizable Value Method
- Companies must ensure that the recorded cost of ending inventory (cost) does not exceed the net realizable value (an item's estimated selling price less the expected cost of the eventual sale or disposal) - If net realizable value is less than recorded book value, write down inventory to the lower net realizable value - If net realizable value is greater than recorded book value, inventory value remains at its cost
Control activities
- Control activities are the specific policies and procedures designed to reduce risk - Can be either a prevention control or a detection control - Prevention controls are intended to deter a problem before it occurs, whereas detection controls are designed to uncover problems after they occur - Prevention is much more desirable that detection - It is almost always less expensive to prevent a problem than it is to recover from one
Types of fraud
- Embezzlement of cash - Theft of assets - Filing of false insurance claims - Financial statement fraud
Elements that a company should incorporate for control activities:
- Establish clear lines of authority and responsibility - Implement segregation of duties - Hire competent personnel - Use control numbers on all business documents - Develop plans and budgets - Maintain adequate accounting records - Provide physical and electronic controls
Percentage of sales method
- Estimates bad debt expense as a percentage of credit sales for a given period - Percentage used is usually based on historical past credit losses
Accounts receivable aging method
- Estimates the allowance for doubtful accounts as a percentage of the outstanding accounts receivable - Bad debts expense is then determined as the amount necessary to achieve the proper balance in the allowance account - The allowance for doubtful accounts balance is computed by computing an aging schedule on outstanding accounts receivable partitioned by age of the receivable
Control failures
- Even the best internal controls may fail at times - An employee may forget to lock a door - Collusion among employees can circumvent prescribed internal controls such as segregation of duties - Difficult to prevent or detect - Best approach is hiring high-quality employees, paying them adequately, and maintaining an ethical environment - Insurance is often purchased to compensate the company when control failures occur
Factoring and discounting
- Factoring- a company can speed up the collection of cash on accounts and notes receivable by selling the receivables - The company will receive cash, less a fee (discount), from the buyer - If the receivables are sold without recourse, the buyer may not request reimbursement for amount ultimately not collected - If the receivables are sold with recourse, the buyer has the right to return the uncollected receivables to the seller
Allowance method
- GAAP requires an estimate be made of bad debt expenses at the time of the revenue recognition even though the actual accounts to be written off are unknown at this time - This is an example of the matching principle - This process is executed using the allowance method - The estimate results in an adjusting entry to the contra-asset account Allowance for Doubtful Accounts
Inventory ownership
- Goods in transit can cause uncertainty as to who owns the items - Important to know in order to accurately determine inventory amounts
Information and communication
- Individuals must receive a clear message from top management that control responsibilities must be taken seriously - Communication should be continual - An iterative process of providing and sharing information, then obtaining new information
Just-in-case inventory
- Inventory held as a buffer just in case unexpected problems occur - Costly to maintain because of insurance, building usage, and the cost of capital invested, among other holding costs
Periodic system
- Less widely used - Does not update the Inventory account or the Cost of Goods account as merchandise transactions take place - Updates are made at the end of the accounting period when a physical count of inventory is made
Internal controls
- Measures undertaken by a business to ensure the reliability of the accounting data, protect assets from unauthorized use, and ensure employees are following policies and procedures - Reduce the likelihood of errors - Catch any errors that may occur - Responsibility of management
Monitoring activities
- Monitoring activities involve ongoing evaluations, special evaluations, or some combination of each
Recovery of accounts written off
- Occasionally an account written off will be later collected. Assume the previous $200 write off was actually collected - Two entries will be recorded 1. Reverse the original write-off 2. Collect the cash
Financial statement audit
- Performed by an independent external auditor Procedures established by the Public Company Accounting Oversight Board (PCAOB) - The audit report expresses an "opinion" on the financial statements
Risk assessment
- Risk is the possibility that an event will occur that will have a negative impact on the organization - Risk assessment involves identifying and analyzing relevant risks - Risk assessment is an ongoing dynamic and iterative process
Net sales
- Sales returns and allowances is a contra account with a normal debit balance - Along with any sales discounts given, these amounts are subtracted from sales revenue to yield net sales
Just-in-time manufacturing
- Seeks to eliminate, or at least minimize, the amount of inventory on hand - Very difficult to obtain full just-in-time inventory
Errors in inventory count
- Since the sum of ending inventory plus cost of goods sold equals goods available for sale, an error in ending inventory will cause an error of equal size but opposite direction in cost of goods sold - Since the value of ending inventory carries over to become beginning inventory the following year, both beginning inventory and goods available for sale will be incorrect. This will also cause cost of goods sold to be incorrect
Impacts of cost flow methods
- Specific identification most closely identifies the actual cost of goods sold and ending inventory - FIFO approximates the physical goods flow for most firms - LIFO is popular because of potential tax savings - Weighted-average cost is somewhere in-between FIFO and LIFO
Reporting allowance for doubtful accounts
- The allowance for doubtful accounts is a contra-asset account with a normal credit balance - The allowance account is subtracted from gross accounts receivable to yield a net amount
Writing off specific receivables
- The company will write off a receivable when it is determined the amount will not be collected - The write-off will not affect either expense or total assets, rather the entry simply cleans up the accounts receivable account (the expense occurred at the time of the estimate, not at the time of the write off)
Control environment
- The control environment sets the tone for the organization - Provides the foundation for all other internal control components - The control environment includes: 1. Management philosophy and style 2. Assignment of authority and responsibility 3. Process for attracting and developing competent employees 4. Reward system
Perpetual system
- The cost of merchandise sold is calculated after every sale - Inventory balance is kept "perpetually" up to date - Provides greatest control over inventory - Better able to determine theft or spoilage
Bank reconciliation
- The internal audit department reconciles the amount of cash appearing on the bank statement with the amount of cash showing in the company's books - Items such as outstanding checks, deposits in transit, interest earned, and bank fees can result in reconciling items
Conduct internal audits
- The internal audit function provides appraisals of a company's internal control and financial records - The internal auditor must determine if adequate controls are in place - And also whether the controls in place are functioning as they should
Credit card sales
- The seller collects cash from the credit card company, and the customer pays cash to the credit card company when billed at a later date - The issuer of the credit card will charge the seller a fee each time a card is used - Businesses incur this fee because credit cards provide considerable benefits to the seller
Direct write-off method
- Under the direct write-off method, doubtful accounts are charged to bad debt expense in the period they are determined to be uncollectible - No estimate is made for bed debts in the period of the revenue recognition, therefore no allowance for doubtful accounts is used - Because this violates the matching principle, GAAP does not allow the direct write-off method unless the amounts of bad debts are immaterial
Accounts for the sales of merchandise
- Under the perpetual system, two entries (or a compound entry) are needed to record a sale - The first entry records the sales revenue with a credit (and a debit to either cash or accounts receivable) - The second entry records the reduction of inventory - The Inventory account is removed from the balance sheet with a credit - This amount becomes an expense on the income statement with a debit to the Cost of Goods Sold account
Specific identification method
- Used by manufacturers producing high-value products that can be easily identified separately - The cost of the specific item sold becomes the cost of goods sold amount when an item is sold - The cost on the balance sheet is the cost of the specific items still on hand
Operating cycle of a service firm
1. Perform a service (accounts receivable, no inventory) 2. Payment from customer (cash)
Reasons actual inventory may differ from the accounting records
1. Periodic inventory method is used 2. Theft 3. Spoilage 4. Errors
Operating cycle of a merchandising firm
1. Purchase of merchandise (inventory) 2. Sale of merchandise (accounts receivable) 3. Payment from customer (cash)
Methods of costing inventory
1. Specific identification 2. First in, first out (FIFO) 3. Last in, first out (LIFO) 4. Weighted-average cost (WAC)
The Committee On Sponsoring Organizations' (COSO) framework identifies five internal control components:
1. The control environment 2. Risk assessment 3. Control activities 4. Information and communication 5. Monitoring activities
Beginning inventory
A certain amount of inventory that a company begins the year with
Physical count of inventory
A physical count is taken to determine or verify the amount of inventory on hand
Faster payments
A purchase discount may be given for faster payment. This is often stated as the discount amount and discount period (For example, a 2% discount if paid in 10 days is stated as 2/10)
Transportation costs
All costs necessary to get the merchandise ready for resale become part of the inventory cost
Accounting cost flow assumption—Cost flow
An assumed flow of the cost of goods from acquisition to sale
Fraud
Any act by management or employees of a business involving an intentional deception for personal gain (punishable crime)
LIFO Conformity Rule
Any company that chooses LIFO for tax reporting must also use LIFO for financial reporting
Cost of goods available for sale
Beginning inventory + cost of goods purchased
Merchandising firms
Buy finished products for resale to a customer (they do not manufacture the products)
Wholesalers
Buy finished products in large volumes from manufacturers and sell the product in smaller quantities to retailers
F.O.B. (free on board) shipping point
Buyer assumes ownership at the time the carrier accepts the item from the seller
Sarbanes-Oxley Act of 2002
Congress has legislated that public companies must maintain an adequate system of internal controls. External auditors must attest to the adequacy of these controls
Manufacturers
Convert raw materials and components into finished products
Ending inventory
Cost of goods available for sale - cost of goods sold
Comparing methods
FIFO: Gross profit is larger using FIFO when prices are rising (looks better for reporting to shareholders) LIFO: Gross profit is smaller using LIFO when prices are rising (better for reporting on the company's income tax return)
End of period adjustments
In subsequent periods the following accounts will be analyzed: - Allowance for sales discounts - Sales refunds payable - Estimated inventory return Management will adjust these accounts upward or downward as needed
Credit period
Maximum time given for payment, often stated in net terms as n/ (For example, 30 day terms will be stated as n/30)
Inventory categories
Merchandising companies generally only have one type of inventory—inventory that is finished and ready for sale. Manufacturers have three categories of inventory: 1. Raw materials inventory—items to be used in the production of products 2. Work-in-process inventory—items partially completed 3. Finished goods inventory—items fully manufactured and ready for sale
Effective cash management
Monitoring cash - Statement of cash flows identifies inflows and outflows - Statement of cash flows also identifies whether cash is increasing or decreasing Cash on hand - Sufficient cash on hand is needed to pay day-to-day costs such as wages and suppliers, however too much cash on hand is wasteful Important activities - Manage receivables - Manage inventory levels - Manage payables - Invest excess cash
Fraud triangle
Pressure - Nearly all frauds committed by individuals under either financial or vice pressure - Financial statement fraud often associated with pressure to "make the numbers. Rationalization - Most fraudsters come up with rationalizations to overcome the feeling of guilt Opportunity - Fraud only attempted if there is a chance to get away with it
Interest calculation
Principal x Interest rate x Interest time
Notes receivable
Promissory notes receivable are often used in sale transactions when the credit period is longer than the 30-60 day period common for accounts receivable
Purchase allowances
Represent a reduction in the purchase price given to the buyer, often to induce the buyer to keep merchandise that is otherwise going to be returned
Purchase returns
Represent the return of merchandise that is not wanted by the buyer
F.O.B. (free on board) destination
Seller maintains ownership until the buyer takes possession
Purchase discounts
Sellers often provide buyers with credit in order to increase sales. One cost to the seller is the time it takes before receiving cash
Physical flow of goods—Goods flow
The actual flow of goods from acquisition to sale (order of what sells first)
Accounts receivable
The current asset resulting from a sale or service executed on a credit basis
Retailers
Typically buy products from wholesalers for sale to the general public
Accounting for purchases of merchandise
When the perpetual inventory system is used, a company debits the Inventory account for the acquisition cost. If the purchase is for cash, then the Cash account is credited. If the acquisition is on credit, Accounts Payable is credited
