Accounting Exam 2 Review PDF

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Shaista Dhanesar ACCOUNTING 2610 EXAM 2 REVIEW Reporting and Interpreting Sales Revenue, Receivables, and Cash - Revenue Principle: recognize revenue when: o Delivery has occurred or services have been rendered o There is evidence of an arrangement for customer payment o The price is fixed or determinable o Collection is reasonable assured - FOB Shipping Point: title of goods change hands at shipment; buyer normally pays for shipping o Revenue is recognized when the goods leave the seller’s loading dock - FOB Destination: title of goods change hands on delivery; seller normally pays for shipping o Revenue recognized when goods arrive at customers’ receiving dock - 3 things that reduce revenue (contra revenue) o Credit cards o Sales returns o Sales discounts Credit Card Sales - Benefits to accepting credit cards: o Increasing customer traffic o Avoiding the costs of providing credit directly to the customer o Lowering the losses due to bad checks o Avoid losses from fraudulent credit card sales o Receiving money faster Sales discounts - Sales discount: a cash discount that is offered to encourage prompt payment of an account receivable - Why do companies give sales discounts? o To encourage customers to pay early o To collect cash faster - 3/15,n/45 o discount%, days in discount period, net(total sales-returns), max credit period Sales Returns and Allowances - represents a reduction of sales revenues for return of or allowances for unsatisfactory goods Reporting Net Sales - companies record sales discounts, sales returns, and credit card discounts separately in contra accounts to allow management to better monitor these transactions - Net sales (reported in income statement) = sales revenue – sales returns and allowances – sales discounts – credit card discounts Receivables

Shaista Dhanesar Account receivable: open accounts owed to the company by customers (i.e. trade receivables) - Notes receivable: written promises that require another party to pay the business under specified conditions (amount, time, interest) - Receivables are categorized on the balance sheet into current and noncurrent assets o Depends on when the cash is expected to be collected o Current asset if collection is < 1 year Bad Debt Expense - Expense associated with estimated uncollectible accounts receivable - When customers pay with credit, the company later ascertains that the customer will not pay the amount they owe regardless of collection efforts - BDE recognized on the income statement in the same period in which the sales are recognized  application of the matching principle - Problem: much of the time, the company does not know which customers will not be paying until the next period - BDE is normally classified as a selling expense and is closed at year end - Contra asset = Allowance for Doubtful Accounts (XA) Bad Debt Estimation - Two man ways: o Percentage of credit sales method  Based on historical percentage of credit sales that result in bad debts (bad debt loss rate)  Bad Debt Loss Rate = Previous Bad Debt Losses/ Previous Credit Sales  Focus on determining the amount to record on the income statement as bad debt expense  Credit sales x bad debt loss rate = bad debt expense o Aging of accounts receivable  Estimate uncollectible accounts based on the age (days outstanding) of each account receivable  As accounts receivable become older and more overdue, it is less likely they will be collectible  Divide accounts receivables into categories based on the number of days the receivable is outstanding, then apply a bad debt loss rate to each category  Focus on determining the ending balance in the ADA on the balance sheet Write-Offs - When it is clear that a specific customer’s account receivable will be uncollectible, the amount should be removed from the accounts receivable account and the ADA balances - Why is BDE not debited when the account is written off? o We previously estimated the percentage of accounts receivable that will be uncollectible and was expensed through the bad debt expense account - How is the income statement affected by the write-off? o Unchanged -

Shaista Dhanesar How are total assets affected by the write-off? o Unchanged Reporting Accounts Receivable - Net Realizable Value of Accounts Receivable = accounts receivable – ADA Ratios - Gross Profit (Margin) Ratio = Gross Profit/ Net Sales - Receivables Turnover = Net Sales/ Avg Net Trade Accounts Receivables - Average Collection Period = 365/ Receivables Turnover Cash - Cash: money or any instrument that banks will accept for deposit and immediate credit to a company’s account - Examples: o Currency o Coins o Balances in savings and checking accounts o Checks received but not yet cashed o Bank draft o Money order - Cash equivalent: short-term investments that have a maturity date no longer than 3 months from the date of purchase - Examples: o Treasury bills that the U.S. government issues o Bank certificates of deposits o Money market accounts Internal Controls - Policies and procedures designed to: o Properly account for assets o Safeguard assets o Ensure the accuracy of financial accounts - Internal control procedures extend to all assets (cash, receivables, investments, plant and equipment, etc.) o Cash is most susceptible to fraud and theft - Internal controls for cash: o Separation of duties  Recording, custody, authorization o Prescribed policies and procedures  Bank reconciliations, purchase approval, check signatures, pre-numbered checks, payment approval, daily deposits Bank Reconciliation - Purpose: to reconcile the company’s cash balance with the bank’s cash balance - Timing differences can create discrepancies between the cash balance listed on the bank’s statement and the company’s records - Unless we reconcile the two cash balances we wont know if we have any errors -

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Common causes for differences between ending bank balance and ending book balance o Outstanding checks o NSF checks o Deposits in transit o Interest o Bank service charges o Errors From the company’s perspective (require adjusting entry to cash account) o + interest paid by bank o – NSF checks/ service charges o +/- company errors From bank’s perspective: o + Deposits in transit o – Outstanding checks o +/- Bank errors Steps in bank reconciliation o Identify outstanding checks o Identify deposits in transit o Record charges and credits o Determine impact of errors

Reporting and Interpreting Cost of Goods Sold and Inventory Types of Inventory - Merchandising (retail) inventory consists of inventory - Manufacturing inventory consists of o raw material inventory: items acquired for processing into finished goods (i.e. direct materials) o work in progress inventory: goods in the process of being manufactured but not yet complete o finished goods inventory: manufactured goods that are complete and ready for sale - Merchandise inventory: beg bal + purchases – COGS = end bal - Manufacturing inventory: COSTS Example Raw materials inventory Purchased raw materials Plastic and metal Work in progress inventory Direct labor incurred Wages of individuals who work on the product Finished goods inventory Factory overhead incurred Factor supervisors, utility costs, maintenance Manufacturing Process

Shaista Dhanesar Direct labor: the earnings of employees who work directly on the products being manufactured - Factory overhead: manufacturing costs that are not raw material or direct labor costs o Ex. Supervisor’s salary, utility costs to operate factory - NOT part of operating expenses, part of COGS (inventory) Tracking Inventory - Perpetual method: detailed inventory maintained by the company that records each purchase and sale during the accounting period in real time - Periodic method: ending inventory and COGS are determined at the end of the accounting period based on physical account o Uses multiple temporary accounts which are closed into inventory at the end of the reporting period o Temporary accounts: purchases, freight-in, purchase discounts, purchase returns - Inventory is second most susceptible to theft/ fraud Inventory Costs - All costs that are incurred to get the inventory ready for sale o Ex. Freight charges, inspection, and preparation costs, COGS, F.O.B. Shipping point - Costs not included in inventory: costs that are not directly related to manufacturing or getting the inventory ready for sale o Ex. Marketing department salaries, administration expenses, F.O.B. Destination Closing Temporary Accounts - Close out freight in, purchase discounts, and purchase returns to purchases - Close out purchases account to inventory - Calculate cost of goods sold in inventory account Perpetual vs. Periodic - Companies that sell high dollar value items would use perpetual o E.g. jeweler, computer company, car company - Companies that have homogenous inventory that is not likely to be highly valuable in small quantities would use periodic method o E.g. aluminum manufacturer, gravel pit Ratios - Inventory Turnover Ratio = COGS/ Avg Inventory o how many times the avg inventory was produced and sold during the period - Average Days to Sell Inventory = 365/ Inventory Turnover o The average time it takes the company to produce and deliver inventory to customers Selling Inventory - Cost flows assumptions o Specific identification: identifies the cost of the specific item that was sold o First in first out: assumes the first goods purchased are the first goods sold  Good for shareholders o Last in first out: assumes the most recently purchased units are sold first -

Shaista Dhanesar  Smaller gross profit, less taxes  If prices are increasing, LIFO COGS are highest o Average cost - No requirement that a firm’s cost flow assumption match the physical flow of goods - FASB requires that companies applies their accounting methods on a consistent basis over time - LIFO not allowed under IFRS - If prices stayed the same, COGS would be the same for all methods - Total Cost to Acquire Inventory = purchase price + shipping costs – returns – discounts - Inv (end) = Inv (beg) + purchases – COGS - Depreciation, Prices increase o LIFO end inv < FIFO end inv  LIFO inv + LIFO reserve = FIFO end inv o LIFO COGS > FIFO COGS  LIFO COGS – change in LIFO reserve = FIFO COGS LIFO Issues - LIFO conformity rule: requires a company that uses LIFO for tax reporting to also use LIFO for financial reporting - If LIFO is used, companies also have to report beginning and ending inventory on a FIFO basis - The LIFO reserve is the excess of FIFO over LIFO inventory - FIFO Inventory value (high) – LIFO inventory value (low) = LIFO reserve (disclosed in footnotes) - LIFO reserve only needs to be calculated if company keeps track of inventory using FIFO but reports inventory using LIFO Carrying Value - If value of inventory increases, only record profit when you sell inventory - If value of inventory decreases, apply lower of cost or market value rule and write the inventory down to its market value if: o Market value < original cost o Market value defined as “replacement cost” Reporting and Interpreting PP&E, Natural Resources, & Intangibles Long- Lived Assets - Tangible and intangible resources owned by a business and used in its operations over several years o Intangible long-lived assets: non-physical items that confer specific rights on their owner  Ex. Patents, copyrights, trademarks, franchises, goodwill, licenses o Tangible long-lived assets: physical items that are classified as property, plant, and equipment or fixed assets  Land, buildings, fixtures, and equipment, and natural resources Acquisition

Shaista Dhanesar What costs associated with the acquisition of a long-lived asset are capitalized (put on BS as asset rather than expensed)? o All reasonable and necessary expenditures made in acquiring and preparing an asset for use should be recorded as the cost of the asset and capitalized o Special discounts are subtracted from the acquisition cost of long-lived assets - Choice dependent on what period you get the benefit, if you get benefit in one period, expense it, but if multiple periods, capitalize it - Capitalize things that have long term benefit - Expenditures capitalized as long lived assets: o Improvements o Sales taxes o Legal fees o Installation costs o Transportation fees o Purchase price - Why capitalize an expenditure rather than expense it? o Increases current period net income o Allows the company to spread the expense over a longer period of time rather than recognize it all during the current period - Long-lived assets can be purchased with cash, debt, equity, other non-cash considerations - Long-lived assets can also be constructed o All expenditures associated with the construction of the asset are capitalized  E.g. labor, materials, interest incurred during the construction period Post-Acquisition Expenditures - Ordinary repairs and maintenance o Expenditures for the normal maintenance and upkeep of long-lived assets, recurring in nature, do not directly lengthen the useful life of the asset  Usually expensed - Additions and improvements o Expenditures that increase the productive life, operating efficiency, or capacity of the asset, increase the efficiency or life of asset  Ex. Additions, major overhauls, reconditioning, major replacements, improvements  Usually capitalized - General rule: o Expense the cost if it only benefits the current period o Capitalize the cost if it increases future benefits Use of Tangible Assets - Depreciation: the process of allocating the cost of a tangible asset over its productive life using a systematic and rational method - What assets do we depreciate? o Tangible assets with a limited useful life -

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Represent the prepaid cost of a bundle of future services or benefits Matching principle requires that a portion of the asset’s cost be allocated as an expense in the same period that revenues are generate generated by its use o Tangible assets with unlimited useful lives are not depreciated e.g. land - Natural resources are depleted - Intangible assets are amortized - Depreciation is a process of cost allocation NOT a process of determining an asset’s current market value or worth - After an asset is depreciated, the remaining balance sheet amount does not necessarily represent its current market value - After acquisition, the asset is not measured at fair market value (what the item could be sold for today) on the balance sheet - Depreciation expense: amount reported on income statement for each period - Accumulated depreciation: the accumulation of depreciation expense recorded since the acquisition date of the asset o Accumulated deprecation is a contra-asset account; companion account = property, plant, and equipment - Net Book (Carrying) Value = Acquisition Cost – Accumulated Depreciation o Reported on the BS and titled PP&E - To calculate depreciation expense you need: o Acquisition cost o Estimated useful life to the company: management’s estimate to the asset’s useful economic life to the company rather than its total economic life to all users o Estimated residual (salvage) value at the end of the asset’s useful life: management’s estimate of the amount the company expects to recover upon disposal of the asset at the end of its useful life Cost Allocation Methods - Straight-line o Depreciation expense = (Cost - Residual value) x 1/ (Useful Life) o Allocates the cost of the asset in equal periodic amounts over its useful life o Most common depreciation method - Units-of-production o Depreciation expense = (Cost – Residual value)/ Estimate Total Production x Actual Production - Declining-balance o Depreciation Expense = (Cost – Accumulated Depreciation) x Rate/ Useful Life o The rate can be whatever number the manager chooses o Double declining balance is the most frequently used accelerated method of depreciation  Rate = 2 for double declining balance  Rate = 15 for one and a half declining balance

Shaista Dhanesar Asset Impairment - Long-lived assets are recorded at historical cost unless the net book value becomes greater than the asset’s estimated future cash flows o Similar to the lower-of-cost of market value rule applied to inventory - If the net book value of the asset becomes greater than the estimated future cash flows of the asset, we must record an asset impairment loss to decrease the net book value of the asset to its fair market value - Companies review assets for possible impairments using a 2-step process: o Step 1: Test the asset for impairment  If net book value > estimated future cash flows, asset is impaired o Step 2: Computation of impairment loss  Impairment loss = Net Book Value – Fair Value  Net Book Value = cost – Accumulated Depreciation Asset Disposals - The disposal of an asset requires 2 journal entries o An adjusting entry to update the depreciation expense and accumulated depreciation (required because disposal of an asset seldom occurs on the last day of the accounting period) o An entry to record the disposal of the asset  Both the cost of the asset and any accumulated depreciation must be removed from the financial statements - Because the book value of the asset does not generally reflect its fair market value, a gain or loss may result from the sale of the asset - Gain/ Loss on Sale of Asset = Assets Received Upon Disposal (e.g. cash) – Net Book Value o Gain/ loss on sale of assets is NOT part of operating income on income statement Natural Resources - Some companies harvest or mine natural resources (e.g. gold, iron, oil) - Depletion expense of natural resources is calculated very similarly to how it is calculated using the units of production method o Depreciation Expense = (Cost – Residual Value) / Estimate Total Depletion x Actual Depletion Intangible Assets - Non-physical items that confer specific rights on their owner (e.g. patents, copyrights, licenses) - We record intangible assets at historical cost only when they have been purchased - We do not capitalize internally generated intangible assets o Internally generated intangible assets are expensed when incurred - Intangible asset with definite lives are amortized o Amortization expense typically calculated using straight line method - Intangible assets with indefinite lives are tested annually for impairments Goodwill - Goodwill: the excess of the purchase price of a business over the fair value of the business assets and liabilities

Shaista Dhanesar Typically, goodwill can only be recorded as an intangible asset when purchasing another company - Indefinite life and is tested for impairment on an annual basis - Goodwill = Purchase Price – Fair Market Value of Net Assets Other Intangibles - Trademarks: an exclusive legal right to use a special name, image, or slogan - Copyrights: an exclusive right to publish, use and sell literary, musical, or artistic work - Patents: granted by the federal government for an invention; exclusive right given to the owner to use, manufacture, and sell the subject of the patent - License and Operating Rights: obtained through the agreements with governmental units or agencies, permit owners to use public property in performing their services - Research and Development: the cost of developing an intangible asset internally o Research and development expenditures typically do not possess sufficient probability of resulting in measurable cash flows -

Accounts Receivable (end) = Accounts Receivable (Beg) + Credit Sales–Cash Collection – W/ Offs ADA (end) = ADA (beg) + BDE – Write Offs Net Accounts Receivable (end) – Accounts Receivable (end) Gross – ADA (end)...