A201 Chapter 4, 5, 6 Notes PDF

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Chapter 4, 5, 6 Book summaries...

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Chapter 4: Accounting for merchandising businesses Merchandising businesses generate revenue by selling goods at prices higher than the cost they paid for the goods. Buy merchandise from Suppliers. Goods purchased for resale are called merchandise inventory. - Merchandising businesses include retail companies (sell goods to final consumer) and wholesale companies (sell to other businesses). Sears, JCPenney, Target, and Sam’s Club are merchandising businesses - Report Inventory costs on balance sheet in Assets account (Merchandise Inventory). All costs incurred to acquire merchandise and ready it for sale are included in inventory account. Inventory costs (product costs) examples include price of goods purchased, shipping and handling costs, transit insurance, and storage costs. - Inventory items are referred to as products, inventory costs are frequently called product costs - Product costs are first accumulated in an inventory account (balance sheet asset) and then recognized as CGS (income statement expense) - Costs that aren’t included in inventory are usually called selling and administrative costs (ex: advertising, administrative salaries, sales commissions and insurance). Selling and administrative costs are recognized as expenses in the period in which they are incurred, they’re called period costs. - Product costs are expensed when inventory is sold regardless of when it was purchased. So product costs are matched directly with sales revenue, while S&A costs are matched with the period in which they are incurred. - Cost of goods available for sale = beginning inventory balance + inventory purchased in the period  COG available for sale is allocated between the asset account Merchandise Inventory (cost of inventory items that haven’t been sold) and an expense account CGS (cost of items sold). Merchandise inventory is reported as an asset on balance sheet. CGS is reported on income statement as expense. - Gross margin/gross profit = Sales Revenue – CGS - Net Income = Gross Margin – S&A (period costs) - Perpetual inventory system: how companies maintain their inventory records. Because inventory account is adjusted perpetually (continually) throughout the accounting period. Each time merchandise is purchased, inventory account is increased. Each time it’s sold, inventory account is decreased - Beginning inventory + Inventory Purchased = Goods avail. – Ending inventory = CGS - Purchasing inventory often involves: incurring transportation costs, returning inventory or receiving purchase allowances (cost reductions) and taking cash discounts (cost reductions) - Dissatisfied buyers agree to keep goods instead of returning them if the seller reduces the price (called allowances). Purchase allowances affect financial statements same way as purchase returns. On financial statements, these 2 are combined and called purchase returns and allowances. Purchase returns and allowances reduce product cost - To encourage buyers to pay promptly, sellers offer cash discounts. Purchase discount is when a cash discount is applied to a purchase. A sales discount is when it’s applied to a sale. - A purchase discount reduces cost of inventory and associated account payable on balance sheet. It doesn’t affect income statement or statement of cash flows. - Credit terms: 2/10 n/30  Seller allows a 2% cash discount if purchaser pays cash within 10 days from the date of purchase. The amount not paid within the first 10 days is due at the end of 30 days. - Cost of inventory = List price - Purchase returns and allowances – Purchase Discounts + Transportation-in - Cost of financing inventory: to finance purchase of inventory is to buy it on account and withhold payment until the last day of the term for the account payable so you can collect enough money from inventory you sell to pay for inventory you purchased. Refusing the discount allows you time needed to generate cash necessary to pay off the liability (account payable). But it’s expensive. -

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For credit terms 2/10, n/30. You can pay on the 10th day and still receive the discount. So you obtain financing for only 20 days (30-day full credit term – 10-day discount term. So you forgo a 2% discount for a loan with a 20-day term. What’s the size of discount in annual terms? Annual rate = Discount rate * (365 / Term of loan)  Annual rate = 36.5%  If you don’t have the money to pay account payable, but can borrow money from a bank at less than 36.5% annual interest, should borrow money and pay off account payable within the discount period FOB shipping point: buyer is responsible for shipping (transportation-in) vs. FOB destination: seller is responsible (transportation-out). Transportation out is an expense FOB shipping point increases asset account (Merchandise Inventory) and decreases Cash, affects Cash Flow. Income statement isn’t affected because transportation-in costs aren’t expensed. FOB destination’s account title is Transportation-out, an expense and affects retained earnings Inventory shrinkage: decreases in inventory for reasons other than sales to customers (stolen inventory, damaged, etc.) If experience shrinkage, make an adjusting entry to write off the inventory shrinkage. This decreases both assets (inventory and S.E (ret. Earnings). This increases expenses and decreases net income. Cash flow isn’t affected. Gross margin: when merchandise inventory is sold for more than it costs. Gain: profit resulting from transactions that aren’t likely to regularly recur. (Gain on sale of land vs. Loss on sale of land). Gain on sale of land increases ret. Earnings on balance sheet. Gains and losses are reported on income statement. Operating income: amount of income generated from normal recurring operations of a business Operating income = Operating expenses – Gross Margin Items that aren’t expected to recur on a regular basis are subtracted from operating income to determine Net Income. Interest is reported as nonoperating items in Income Statement, but it’s shown in operating activities in Cash flow (GAAP requirement) Sales discounts: price reductions offered by sellers to encourage buyers to pay promptly. Net sales = Sales – Sales Returns and Allowances – Sales Discounts Net sales is reported on income statement Common size financial statements: how good is a 1 million increase in net income? May be meaningful to a small company but not a big one. Analysts use this to prepare meaningful comparisons. It displays information in percentages as well as absolute dollar amounts. Computed by Net Sales is base, or 100%. Other amounts on the statements are shown as a percentage of Net sales. (ex: CGS percentage = dollar amount of CGS / dollar amount of net sales) Ratio Analysis: Gross margin percentage and net income percentage are commonly used to make comparisons within a specific company or between 2 or more different companies. Gross margin percentage provides insight about a company’s pricing strategy. A high gross margin percentage means that it’s charging high prices in relation to its CGS Gross margin percentage = Gross Margin / Net Sales; Net Income Percentage = NI / Net Sales Net Income percentage is called return on sales ratio. It tells how much of each sales dollar remains as net income after all expenses are paid. Companies with high ratios are better at controlling expenses If gross margin percentage and return on sales increase, strategy is successful. Comparison between companies: If Gross margin percentage of company A is higher than company B, it means company B is charging higher prices Ratios for companies in the same industry are more similar than those in a different industry Multistep income statement: reports product costs separately from S&A costs. Financing cost of carrying inventory: cost of carrying inventory is an opportunity cost. To minimize this, should minimize the amount of inventory, length of time it holds inventory and time requires to collect accounts receivable after inventory is sold

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Periodic system: advantage is recording efficiency, less effort than perpetual system. Used in high volume transactions businesses (restaurant, grocery stores, etc.). But perpetual system provides control advantages. With perpetual records, book balance in Inventory account agrees with amount of inventory in stock every time. Management can determine amount of lost, damaged, destroyed or stolen inventory. Perpetual also allows more timely and accurate reorder decisions and profitability assessments. With periodic inventory system, lost, damaged or stolen merchandise is included in CGS. So amount of any inventory shrinkage is unknown.

Chapter 5: Accounting for Inventories -

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4 methods to determine amount of product costs flow from Inventory account to CGS account: specific identification, FIFO, LIFO, weighted average  Specific Identification:  Tag each item to identify which one is sold at the time of sale. 1st purchase cost $100 and 2nd cost $150. If 1st item is sold, CGS would be $100 and $150 if 2nd item is sold  When inventory consists of low-priced, high-turnover goods, SI isn’t practical. Another disadvantage is opportunity for managers to manipulate income statement (can report lower CGS by selling the 1st instead of 2nd item  Usually used for high-priced, low-turnover inventory like automobiles. Volume is low to manage recordkeeping  Average cost of inventory is reported on both income statement and balance sheet  FIFO:  Cost of items purchased first be assigned to CGS. So CGS is $100 since it’s the 1st purchase  1st cost is reported to income statement (CGS), last cost on balance sheet (ending inventory)  LIFO:  Cost of items purchased last be assigned as CGS. So CGS is $150 since it’s the 2nd(last) purchase  Last cost is reported on income statement (CGS), 1st cost on balance sheet (Ending inventory)  Weighted average:  Average cost per unit = Total cost of inventory available / Total number of units available  CGS = Cost per unit * Number of units sold Physical flow is not the same as costs flow Cost flow method used affects Gross margin reported in income statement, affect Ending Inventory on balance sheet. FIFO > LIFO > Weighted Average, these 3 are frequently used inventory cost flow methods Assets are reported on balance sheet in order of liquidity (how quickly they’re expected to be converted to cash). Since companies frequently sell inventory on account, inventory is less liquid than accounts receivable. So inventory is reported below accounts receivable on balance sheet. Impact of income tax: pay more money in taxes leaves less money in the company  Lower tax payments is more attractive to investors since it allows the company to keep more value in business. Investors make decisions based on economic substance regardless of financial statements High inflation environment uses LIFO for tax advantages vs. Low inflation uses FIFO Rising prices at each purchase means inflation. During high inflation, LIFO leads to higher CGS Computer industry (deflationary) uses FIFO, while medical supplies (inflationary) uses LIFO GAAP principle of full disclosure: financial statements disclose the method chosen GAAP principle of consistency: use the same cost flow method each period With perpetual inventory records (when sales and purchases occur intermittently), use FIFO since weighted average or LIFO leads to timing difficulties. Regardless of which method is used, GAAP requires that the cost be compared with the end of period market value and that the inventory be reported at lower of cost or market Market: amount company would have to pay to replace the merchandise

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If replacement cost is less than actual cost, regardless of whether the decline in market value is due to physical damage, deterioration, etc., the loss must be recognized in the current period Lower-of-cost-or-market rule: can be applied to (1) each individual inventory item, (2) major classes or categories of inventory, (3) entire stock of inventory in the aggregate. Most common is individualized application. If market value at the end falls compared to historical cost, company has to take a loss. This is reported as an operating expense on income statement. Inventory is largest single asset and CGS is largest single expense Inventory and CGS are targets for fraud by understating expenses (less likely to be detected), or by overstating inventory Understatement of CGS results in overstatement of gross margin, leading to overstatement of net earnings, overstatement of assets (inventory) and Stockholders’ Equity (ret. Earnings) Defer this by assigning task of recording inventory transaction to different employees. Gross margin method of estimating the ending inventory balance is a tool to detect financial statement manipulation. Gross margin method: assumes that the percentage of gross margin remains stable. Gross margin ratio from prior periods can estimate current period’s ending inventory. If book balance or physical count is significantly higher than estimated inventory balance, there’s manipulation. Can also detect fraud by comparing current year’s gross margin ratio and last year’s. If CGS is understated (ending inventory overstated), gross margin ratio will be inflated Also, significant growth in inventory that isn’t explained by accompanying sales growth Average number of days to sell inventory: determine how fast inventory is selling Inventory turnover = CGS / Inventory = No. of times the balance in Inventory is sold each year Average number of days in inventory = 365 / Inventory turnover Overall profitability depends on gross margin and inventory turnover. The most profitable combination is carry high margin inventory that turns over rapidly. However, companies often concentrate on one element (Costco offer lower prices to stimulate greater sales, Saks charge higher prices to compensate for slower inventory turnover). Upscale stores justify higher prices by offering superior style, quality, convenience, etc., So effective choices is a marketing and an accounting decision by understanding interaction between gross margin percentage and inventory turnover Gross margin and inventory turnover ratios are also affected by cost flow method used. CGS affects Net income and retained earnings, many other ratios are also affected by inventory cost flow method

Chapter 6: Internal control and accounting for cash -

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Internal controls: policies and procedures used to provide reasonable assurance that the objective of an enterprise will be accomplished. Accounting controls: safeguard company’s assets and reliable accounting records. Administrative controls: evaluating performance and assessing the degree of compliance with company policies and public laws Sarbanes-Oxley Act (SOX): requires public companies to evaluate internal control and to publish those findings with SEC filings Committee of Sponsoring Organizations of the Treadway Commission (COSO): the framework which is the standard by which SOX compliance is judged COSO’s framework titled Internal Control-an integrated Framework, recognizes 5 interrelated components:  Control Environment: Integrity and ethical values of the company, including code of conduct, involvement of board of directors and other actions that set the tone of the organization  Risk Assessment: Management’s process of identifying potential risks that could result in misstated financial statements and developing actions to address those risks

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Control Activities: usually refer to as “internal control”, including segregation of duties, account reconciliations, information processing controls to safeguard assets and enable a timely and reliable financial statements  Information and Communication: Internal and external reporting process, including assessment of technology environment  Monitoring: Assessing quality of a company’s internal control over time and taking actions as necessary to ensure it continues to address the risk of the organization ERM (Enterprise Risk Management): COSO’s updated framework. ERM introduces an enterprisewide approach to risk management and concepts like risk appetite, risk tolerance, portfolio view. SOX applies only to US public companies vs. ERM used by public, private organiza. worldwide. ERM doesn’t replace the internal control framework. It incorporates internal control framework within it. So companies can look to ERM to satisfy internal control needs and move toward a fuller risk management process 9 features of internal control system:  Segregation of Duties: Deterrent to corruption or fraud. One employee’s work can check on the work of another’s. Authorization, recording and custody of assets are assigned to different staffs  Quality of Employees: Train employees to perform a variety of tasks so they can substitute  Bonded Employees: hire people with high levels of personal integrity. Screening is important. Fidelity bond provides insurance that protects a company from losses caused by dishonesty  Required Absences: require employees to take regular vacations and their duties should be rotated periodically. Their replacements can discover errors or fraud  Procedures Manual: Appropriate accounting procedures should be documented in a procedures manual. It should be routinely updated with periodic reviews  Authority and Responsibility: Business should prepare authority manual that establishes a definitive chain of command. This manual should guide both specific and general authorizations. Specific authorizations apply to specific positions within the organization. General authority applies across different levels of management.  Prenumbered Documents: prenumbered forms for all important documents such as purchase orders, receiving reports, invoices and checks. Requires authority signatures.  Physical Control: establish physical control over valuable assets. Access to these should be limited to authorized personnel. There should be physical control over accounting records  Performance Evaluations: independent verification of employee performance through internal and external audits Limitations of internal control system: collusion among employees. A good system minimizes illegal or unethical activities by reducing temptation and increasing the likelihood of early detection Notes to Financial Statements: explains some of the estimates that were made as well as which reporting options were used. Read the notes to understand the financial statements Management’s discussion and analysis (MD&A): located at the beginning of annual report, explaining the company’s past performance with future plans. It compares current year earnings with past periods and explains reasons for significant changes. It includes plans for significant acquisitions of assets or other business, and plans to discontinue part of the existing business 5 primary roles of independent auditor (CPA):  Conducts a financial audit (a detailed examination of a company’s financial statements and underlying accounting records)  Assumes both legal and professional responsibilities to the public as well as to the company paying the auditor  Determines if financial statements are materially correct rather than absolutely correct  Presents conclusions in an audit report that includes an opinion as to whether statements are prepared in conformity with GAAP and issues a disclaimer in rare cases  Maintains professional confidentiality of client records. Auditor is NOT exempt from legal obligations such as testifying in courts

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Financial statements audit: a detailed examination of a company’s financial statements and the documents that support those statements. It also tests the reliability of the accounting system used to produce the financial reports. This is conducted by an independent auditor (CPA) Materiality: auditors don’t guarantee that financial statements are absolutely correct, only materially correct. Ma...