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