ACCT Exam 2 (chapters 5-8) Textbook Review Cards
specific identification
assigns the actual costs of acquisition to items of inventory. in some circumstances, it is not practical to do this.
weighted average
assigns the same unit cost to all units available for sale during the period
FIFO method
assumes that the first units purchased are the first units sold
LIFO method
assumes that the last units purchased are the first units sold
what can be derived from the inventory turnover ratio
average length of time that it takes to sell inventory
the purchase price of inventory items may
change frequently, and several alternatives are available to assign costs to the goods sold and those that remain in ending inventory
important accounting controls are
concerned with safeguarding assets and producing accurate and timely financial statements. they include: -proper authorizations=only certain personnel may authorize transactions -segregation of duties=physical custody of assets must not be combined with the ability to account for those assets -independent verification=for example, an inventory count -safeguarding of assets and records=both must be adequately protected -independent review and appraisal=done primarily by internal audit -design and use of business documents=source document control
the documents used to record purchase transactions are instrumental in
controlling both cash and inventory
bad debts are estimated under the allowance method by one of two approaches
percentage of net credit sales (income statement method) ; percentage of AR (balance sheet method)
what would a company theoretically want to use for tax purposes (LIFO or FIFO)
LIFO
Brown Corp. ended the year with balances in Accounts Receivable of $60,000 and in Allowance for Doubtful Accounts of $800 (credit balance before adjustment). Net sales for the year amounted to $200,000. Prepare the necessary journal entry at the end of the year assuming: -Estimated percentage of net sales uncollectible is 1%. -Estimated percentage of year-end accounts receivable uncollectible is 4%.
-debit BDE 2,000; credit ADA 2,000 (to record bad debts: 1% x 200,000) -debit DBE 1,600; credit ADA 1,600 (to record bad debts: (4% x 60,000)-800)
Hawkeye recorded sales of $240,000 for the year. Accounts receivable amounted to $40,000 at the beginning of the year and $20,000 at the end of the year. Compute the company's accounts receivable turnover for the year.
240,000/(40,000+20,000)/2=8 times
What does the term LIFO liquidation mean? How can it lead to poor buying habits?
A LIFO liquidation occurs when a company using the LIFO inventory method sells more units during the period than it purchases. A liquidation of some or all of the older, relatively lower-priced units (assuming rising prices) will result in a low cost of goods sold amount and a correspondingly higher gross margin. If the company sells the lower-priced units, its net income will improve, but higher taxes will have to be paid. To avoid facing this situation, a company might buy inventory at the end of the year to avoid these consequences of a liquidation. Unfortunately, the somewhat forced purchase of inventory to avoid the liquidation may not be in the best interests of the company.
Why does the purchase of an item classified as a cash equivalent not appear on the statement of cash flows as an investing activity?
A cash equivalent is convertible to a known amount of cash. Therefore, the purchase of a cash equivalent is not considered a significant investing activity to be reported on the statement of cash flows. Cash equivalents are included with cash on the balance sheet, and thus the company is merely trading one cash item for another when it writes a check and uses the proceeds to invest in a cash equivalent.
What is the purpose of comparing a purchase invoice with a purchase order? of comparing a receiving report with a purchase invoice?
A purchase invoice is compared with a purchase order to ensure that the goods were in fact ordered. The comparison of a receiving report with an invoice ensures that all goods that a company is being billed for were in fact received.
What is the relationship between the valuation of inventory as an asset on the balance sheet and the measurement of income?
According to the cost of goods sold model, beginning inventory plus purchases minus ending inventory equals cost of goods sold. Therefore, the amount assigned to inventory on the balance sheet has a direct effect on the measurement of cost of goods sold on the income statement. Any errors in valuing inventory will flow through to cost of goods sold and thus have an impact on the measurement of net income.
Why is an increase in Accounts Payable added to net income when the indirect method is used to prepare the statement of cash flows?
An increase in accounts payable is an indication that during the period a company increased the amount it owes suppliers and therefore conserved its cash. Therefore, the increase in the account is added on the statement of cash flows.
Why is it likely that the result from applying the lower-of-cost-or-market rule using a total approach (i.e., by comparing total cost to total market value) and the result from applying the rule on an item-by-item basis will differ?
Application of the lower-of-cost-or-market rule on a total basis, compared with an item-by-item basis, will usually yield a different result. The reason is that with the total approach, increases in market value above cost are allowed to offset decreases in value. Alternatively, when the item-by-item approach is used, any increases in value are essentially ignored and it is the declines in value for each item that are recognized.
the COGS includes
any costs necessary to acquire the goods less any purchase discounts, returns, and allowances
Using Y for yes and N for no, indicate whether each of the following items should or should not be included with cash and cash equivalents on the balance sheet. Cash in a checking account Coin and currency in a cash register drawer A six-month certificate of deposit Postage stamps An amount owed by an employee for a travel advance A three-month Treasury bill Y Cash in a money market account Y
Cash in a checking account Y Coin and currency in a cash register drawer Y A six-month certificate of deposit N Postage stamps N An amount owed by an employee for a travel advance N A three-month Treasury bill Y Cash in a money market account Y
For the following items, indicate whether each should be included (I) or excluded (E) from the line item titled Cash and cash equivalents on the balance sheet. Certificate of deposit maturing in 60 days Checking account Certificate of deposit maturing in six months Savings account Shares of GM stock Petty cash Corporate bonds maturing in 30 days Certified check
Certificate of deposit maturing in 60 days I Checking account I Certificate of deposit maturing in six months E Savings account I Shares of GM stock E Petty cash I Corporate bonds maturing in 30 days E Certified check I
Two companies each recorded $10 million in cost of goods sold for the year. Company A had average inventory of $100,000 on hand during the year. Company B's average inventory was $1 million. One company is a car dealer, and the other is a wholesaler of fresh fruits and vegetables. Which company sells cars, and which company sells fruits and vegetables? Explain your answer.
Company A's inventory turnover is $10,000,000/$100,000, or 100 times. Company B's turnover is $10,000,000/$1,000,000, or 10 times. Company A with the much higher turnover is the wholesaler of fresh fruits and vegetables. Company B is the car dealer because its inventory would not turn over nearly as often given the nature of its products.
A company currently uses the LIFO method to value its inventory. For each of the following items, indicate whether it would be higher (H) or lower (L) if the company changed to the FIFO method. Assume a period of rising prices. Cost of goods sold Gross profit Income before taxes Income taxes Cash outflow
Cost of goods sold L Gross profit H Income before taxes H Income taxes H Cash outflow
Indicate whether each of the following items is an adjustment to the balance per books (BK) or to the balance per bank statement (BS) on a reconciliation that adjusts the bank balance and the bank statement to the correct balance. Customer's NSF check Service charge for a lockbox Outstanding checks Interest earned on an account for the month Check written on the account but recorded on the books at the wrong amount Deposits in transit
Customer's NSF check BK Service charge for a lockbox BK Outstanding checks BS Interest earned on an account for the month BK Check written on the account but recorded on the books at the wrong amount BK Deposits in transit BS
control procedures
are actions that company personnel take to make sure that policies set forth by management are followed
Delevan Corp. uses a periodic inventory system and is counting its year-end inventory. Due to a lack of communication, two different teams count the same section of the warehouse. What effect will this error have on net income?
Ending inventory will be overstated. According to the cost of goods sold model, ending inventory is subtracted from cost of goods available to sell to arrive at cost of goods sold expense. Therefore, an overstatement of ending inventory will lead to an understatement of cost of goods sold expense. An understatement of an expense results in an overstatement of net income for the period.
Baxter operates a chain of electronics stores and buys its products from a number of manufacturers around the world. Give at least three examples of costs that Baxter might incur that should be added to the purchase price of its inventory.
Examples of costs that should be added to the purchase price of inventory are freight costs on purchases, insurance during the time inventory is in transit, storage costs before inventory is ready to be sold, and various taxes such as excise and sales taxes.
3 inventory costing methods
FIFO, LIFO, and weighted average; can all be used in combo with a perpetual inventory system
What two basic procedures are essential to an effective system of internal control over cash?
First, all cash receipts should be deposited intact in a bank on a daily basis. That is, no disbursements should be made from any amounts received prior to their deposit in the bank. Second, all cash disbursements should be made by check. The use of serially numbered checks results in a clear record of all payments.
Due to a clerical error, a company overstated by $50,000 the amount of inventory on hand at the end of the year. Will net income for the year be overstated or understated? Identify the two accounts on the year-end balance sheet that will be in error and indicate whether they will be understated or overstated.
If ending inventory is overstated by $50,000, then cost of goods sold will be understated by $50,000 and gross profit will overstated by $50,000. Net income will be overstated, resulting in an overstatement of retained earnings on the balance sheet. Inventory on the balance sheet will also be overstated. This ignores the effect of taxes.
Why are shipping terms such as FOB shipping point or FOB destination point important in deciding ownership of inventory at the end of the year?
For inventory in transit at the end of the year, the terms of shipment dictate whether the buyer should record the purchase of the inventory. FOB shipping point means that the goods belong to the buyer as soon as they are shipped, and the purchases should be recorded at this point in time. Alternatively, FOB destination point means that the goods do not belong to the buyer until they are received and therefore should not be recorded if they are in transit at year-end.
How is a company's gross profit determined? What does the gross profit ratio tell you about a company's performance during the year?
Gross profit is computed by deducting cost of goods sold from net sales. The gross profit ratio indicates how well the company controlled its product costs during the year. For example, a 30% gross profit ratio indicates that for every dollar of net sales, the company has a gross profit of 30 cents. That is, after deducting 70 cents on every dollar for the cost of the inventory that is sold, the company has 30 cents to cover its operating costs and earn a profit.
Which inventory costing method should a company use if it wants to minimize taxes? Does your response depend on whether prices are rising or falling? Explain your answers. Answer In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the most recent purchases are charged to cost of goods sold under LIFO, in a period of rising prices, these units will be higher-priced. Thus, the result will be lower gross margin as well as lower net income before tax. Lower net income will result in a lower amount of tax to pay. If prices are declining during the period, FIFO will result in a lower tax bill.
In a period of rising prices, the use of LIFO will result in a lower tax bill. Because the most recent purchases are charged to cost of goods sold under LIFO, in a period of rising prices, these units will be higher-priced. Thus, the result will be lower gross margin as well as lower net income before tax. Lower net income will result in a lower amount of tax to pay. If prices are declining during the period, FIFO will result in a lower tax bill.
Ralston Corp.'s cost of goods sold has remained steady over the last two years. During this same time period, however, its inventory has increased considerably. What does this information tell you about the company's inventory turnover?
Inventory turnover equals cost of goods sold divided by average inventory. If the cost of goods sold remains constant while the denominator (average inventory) increases, inventory turnover will decrease. This indicates that inventory is staying on the shelf for a longer time. The company should probably evaluate the salability of its inventory.
Who is responsible for establishing and maintaining an adequate internal control structure for a company?
Management is responsible for establishing and maintaining an adequate internal control structure.
List the internal control procedures discussed in the text.
Proper authorizations Segregation of duties Independent verification Safeguarding of assets and records Independent review and appraisal Design and use of business documents
Number each of the following documents to indicate the order in which each document would be used. Purchase order Invoice approval form Check and remittance advice Purchase requisition Invoice Receiving report
Purchase order 2 Invoice approval form 5 Check and remittance advice 6 Purchase requisition 1 Invoice 3 Receiving report 4
under the perpetual method, the inventory acct is updated after
after each sale or purchase of merchandise
What circumstances led to the passage of the Sarbanes-Oxley Act in 2002?
The Sarbanes-Oxley Act was passed in the wake of a number of high-profile cases involving questionable accounting practices. Congress decided that action by the federal government was needed to protect the interests of various parties that rely on corporate financial statements in making decisions.
Why do accountants prefer the allowance method of accounting for bad debts?
The allowance method of accounting for bad debts tries to match one of the costs associated with granting credit, i.e., uncollectible accounts, with the revenue of the period. Under the matching principle, an estimate of bad debts is made on the basis of either the sales of the period or the accounts receivable at the end of the period. The allowance method properly matches the revenue for the period against an expense for the same period.
Which committee of the board of directors provides direct contact between stockholders and the independent accounting firm?
The audit committee provides direct contact between stockholders and the independent accounting firm.
Grogan's inventory increased by $50,000 during the year, and its accounts payable increased by $35,000. Indicate how each of those changes would be reflected on a statement of cash flows prepared using the indirect method.
The increase in inventory would be deducted from net income on the statement of cash flows prepared using the indirect method since the buildup of inventory required cash outflow. The increase in accounts payable conserves cash and is therefore added to net income.
Who provides an independent opinion as to whether management has maintained effective internal control over financial reporting?
The independent auditor provides an opinion as to whether management has maintained effective internal control over financial reporting.
To whom should the independent auditors' report be directed?
The independent auditors' report should be directed to the board of directors and the stockholders.
What is the rationale for valuing inventory at the lower of cost or market?
The lower-of-cost-or-market rule is invoked when the utility of inventory is less than its cost to the company. It is a departure from the historical cost principle and is justified on the basis of conservatism. The rule is a reaction to uncertainty by anticipating a decline in the value of inventory and writing down the asset before it is sold.
A friend says to you: ''I'm confused. I have a memo included with my bank statement indicating a $20 service charge for printing new checks. If the bank is deducting this amount from my account, why do they call it a 'debit memoranda'? I thought a decrease in a Cash account would be a credit, not a debit.'' How can you explain this?
The meaning of a debit or a credit depends on which company is concerned. To the bank, a company's checking account is a liability. Therefore, when a bank deducts a service charge from a company's account, it is reducing its liability to the company. A liability is decreased with a debit. Thus, banks refer to charges to a company's account as debit memoranda.
When computing the accounts receivable turnover ratio, why is the average of accounts receivable for the period used in the denominator of the ratio?
The numerator of the ratio is net credit sales for the entire period, so an average of accounts receivable for that period is used in the denominator.
What are three distinct types of costs that manufacturers incur? Describe each of them.
The three distinct types of costs incurred by a manufacturer are direct materials, direct labor, and manufacturing overhead. Direct, or raw, materials are the ingredients used in making a product. Direct labor consists of the amounts paid to factory workers to manufacture the product. Manufacturing overhead includes all the other costs that are related to the manufacturing process but cannot be directly matched to specific units of output.
What is the difference between a periodic inventory system and a perpetual inventory system?
The two inventory systems differ with respect to how often the Inventory account is updated. Under the perpetual system, the Merchandise Inventory account is updated each time a sale or purchase is made. With the periodic system, the Inventory account is updated only at the end of the period. A temporary account, called Purchases, is used to keep track of the acquisitions of inventory during the period. The periodic method relies on a count of the inventory on hand at the end of the period to determine the amount to assign to ending inventory on the balance sheet and to cost of goods sold expense on the income statement.
What is the significance of the adjective weighted in the weighted average cost method? Use an example to illustrate your answer.
The weighted average cost method assigns more weight to unit costs at which more units were purchased. For example, assume that beginning inventory consists of 100 units with a unit cost of $10 per unit. Assume that during the period, 100 units were purchased at $15 per unit and 200 units were purchased at $20 per unit. The arithmetic average unit cost for the period would be (10+15+20)/3=15 . However, the weighted average unit cost would be [100($10) + 100($15) + 200($20)]/400 units, or $16.25. The acquisition of twice as many units at $20 as opposed to those purchased at $10 and $15 drives the weighted average up to $16.25.
An order clerk fills out a purchase requisition for an expensive item of inventory and the receiving report when the merchandise arrives. The clerk takes the inventory home, then sends the invoice to the accounting department so that the supplier will be paid. What basic internal control procedure could have prevented this misuse of company assets?
This misuse of corporate assets could have been prevented by having a procedure in place for segregation of duties. A single employee should not be allowed to order merchandise, receive it, and approve payment for it.
Will the dollar amount assigned to inventory differ when a company uses the LIFO method depending on whether a periodic or perpetual inventory system is used? Explain your answer.
When LIFO is applied on a perpetual basis, a gap is created. This situation arises because LIFO is applied every time a sale is made rather than only at the end of the period. Therefore, the amount assigned to inventory will be different than it would be if LIFO was applied only at the end of the period, that is using a periodic system.
Why is the weighted average cost method called a moving average when a company uses a perpetual inventory system?
When a perpetual inventory system is used, the dollar amount of inventory is calculated after each sale. Thus, when it is used in conjunction with the weighted average cost method, a new average cost is calculated after each sale. The weighted average changes each time a sale is made; therefore, the unit cost is called a moving average.
When bad debts are estimated, why is the balance in the Allowance for Doubtful Accounts considered when the percentage of receivables approach is used, but not when the percentage of sales approach is used?
When bad debts expense is estimated by using the percentage of receivables approach, the balance already in the allowance account must be considered. For example, if the estimate of the accounts receivable that will prove to be uncollectible is $20,000 and the allowance account has a credit balance of $3,000 before adjustment, only $17,000 has to be added to it. Under the percentage of sales approach, however, the emphasis is on the debit to Bad Debts Expense. The balance in the allowance account before adjustment is ignored.
inventory is a ________; the nature of inventory held depends on ________
a current asset held for resale in the normal course of business; the nature of inventory held depends on whether a business is a reseller of goods (wholesaler or retailer) or a manufacturer
with inventory, resellers incur
a single cost to purchase inventory held for sale
because not all customers pay their outstanding bills,
an estimate of the AR less any doubtful accounts must be presented on the balance sheet
overstatement of ending inventory results in
an understatement of the cost of goods sold and therefore an overstatement of net income
with a perpetual inventory system, the inventory costing method is applied
after each sale of merchandise to update the inventory acct
under the periodic method, the inventory acct is updated
only at the end of the period
the COGS in any one period is equal to
beginning inventory+purchases-ending inventory
under the indirect method of calculating cash flows from operating activities, both the _____ and _____ must be taken into consideration
both the inventory acct and accounts payable acct
inventory turnover ratio
cost of goods sold/average inventory
with inventory, manufacturers incur
costs that can be classified as raw materials, direct labor, and manufacturing overhead
sales discounts are given to
customers who pay their bills promptly
Glendive reports its inventory on a FIFO basis and has inventory with a cost of $78,000 on December 31. The cost to replace the inventory on this date would be only $71,000. Prepare the appropriate journal entry on December 31. Answer
debit "loss on decline in value of inventory" 7,000 and credit "inventory" 7,000
Badger recorded $500,000 of net sales for the year of which 2% is estimated to be uncollectible. Prepare the journal entry at the end of the year to record bad debts.
debit BDE (expense) 10,000; credit ADA (asset) 10,000
the COGS represents
goods sold, as opposed to the inventory purchased during the year. COGS is matched with the sales of the period
the gross profit ratio is the relationship between
gross profit and net sales. managers, investors, and creditors use this important ratio to measure one aspect of profitability
gross profit ratio formula
gross profit/net sales
inventory turnover is a measure of
how efficiently inventory is managed. the ratio measures how quickly inventory is sold
after SOX, auditors must also
increase their documentation and understanding of the internal controls of their clients
Sidney began the year with $130,000 in merchandise inventory and ended the year with $190,000. Sales and cost of goods sold for the year were $900,000 and $640,000, respectively. Turnover ratio=? # of days' sales in inventory=?
inventory ratio=4 times; # days sales in inventory=90 days
cash equivalents
investments that are readily convertible to a known amount of cash. readily meaning 3 months or less
cash management means
managing the need to have enough cash on hand to ensure cash flow needs but not so much that excess funds earn little return and may be vulnerable to misappropriation
petty cash funds are an effective way to
minimize access to large cash accounts to pay for relatively small expenditures
number of days' sales in inventory
number of days in the period/inventory turnover ratio
the effects of errors in inventory may
offset themselves over time. these are known as counterbalancing errors
the SOX of 2002 required
publicly traded companies to improve the documentation and functioning of their internal controls
For each of the following items, indicate whether it increases (I) or decreases (D) cost of goods sold.Purchases Beginning inventory Transportation-in Ending inventory
purchases increase; beg inventory increases; transp-in I; ending inventory decreases
after SOX, management must now
render an opinion on the efficiency of the company's internal control system. a strong control envt is a must for companies
net sales represents
sales less deductions for discounts and merchandise returned (returns and allowances) and is a key figure on the income statement
accounts receivable arise from
sales on credit. companies with many customers may keep detailed records of accounts receivable in a separate subsidiary ledger
examples of things that aren't cash equivalents
stock, corporate bonds, postage stamps, an amount owed by an employee for a travel advance
what should be the driving force behind selecting an inventory costing method
the ability to measure net income accurately for a period
key attribute to the asset cash
the asset is readily available to pay debts
inventory costing methods impact
the cost of goods sold and, therefore, net income
inventory costs ultimately become
the cost of goods sold reflected in the income statement
transportation-in is
the cost to ship goods to a company and is typically classified as part of the cost of goods purchased
the link between the balance sheet and income statement can be seen through
the effect of errors in inventory evaluation
under LCM,
the historical cost of inventory is compared with its replacement cost. if the replacement cost is lower, the inventory account is reduced and a loss is recognized
the higher the inventory turnover ratio,
the less time inventory resides in storage (i.e., the more quickly it turns over)
notes receivable ultimately result in
the receipt of both interest and principal to the holder of the notes
returns and allowances have the same effect on sales as
the same effect on sales that sales discounts do; that is, they reduce sales
bank reconciliations use
third-party documents (bank statements) to reconcile differences between the amount in the bank and on the books. done by an independent party, bank reconciliations are effective control procedures
since inventory is not expenses as the cost of goods sold until
until merchandise is sold, determining which costs belong in inventory affects the timing of when these expenses are reflected in net income
the liquidity of cash makes controls over it
very important to have in place
the principle of conservatism in accounting may
warrant a departure from historical cost. this departure is known as the lower-of-cost-or-market rule (LCM)
3 other methods involving making assumptions about the cost of inventory
weighted average; FIFO; LIFO
the results from using LIFO differ depending on
whether a periodic or perpetual system is used. the same is true with weighted average, which is called moving average in a perpetual system
