Accounting Test 2 Study Guide - Ch. 4-6 PDF

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Study guide for financial accounting test 2. Includes chapters 4, 5, and 6. Has chapter summaries, class notes, and examples. Will help you pass!...

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ACCOUNTING CHAPTERS 4-6 Chapter 4: Reporting and Analyzing Merchandising Operations 

Merchandising (retail) companies sell products / goods to customers rather than providing services. Merchandising companies do not manufacture the product they sell.

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Operating Cycle for a Merchandiser:  

A merchandising company’s operating cycle begins with purchasing merchandise and ends with collecting cash from selling merchandise. Operating cycle length varies – company’s try to keep them short because assets tied up in inventories and receivables are not productive.

o Inventory 

Inventory – aka Merchandise Inventory – products a company owns and intends to sell. This is an asset for the company. The cost of the asset is the cost incurred to buy the goods, ship them, and make them ready for sale.

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Issues affecting inventory are important because: o Sales of Inventory to customers often represent the primary source of revenue for the organization. o Inventory issues affect both the income statement and the balance sheet.

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Costs Included in Inventory: Inventories are recorded at historical cost when acquired. Historical cost in terms of inventory acquisition includes all expenditures necessary to acquire the goods and convert them to a saleable condition (or get them ready for sale).

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Service companies provide services to their customers in order to generate revenues. (like chapters 1 – 3)

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Beginning Inventory + Net Purchases = Merchandise Available for Sale. o This merchandise available for sale either becomes cost of goods sold or is in ending inventory.

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Inventory Costs (assets on balance sheet)  COGS (expense on income statement) at point of sale. o Under the revenue recognition principle, revenues are recognized in the period they are earned (when the goods are exchanged and title transfers). The expense

incurred to generate this revenue is called cost of merchandise/goods sold (COGS). Under the expense recognition or matching principle COGS is expensed on the income statement in the same period that the revenue from the sale is recognized/recorded. o Period Costs: costs that cannot be traced directly to products, or to their acquisition. Period costs are expensed immediately in the period in which they are incurred. Typical examples include selling expenses (costs to ship or deliver goods to customers), and other administrative type of expenses. Your text calls these OPERATING EXPENSES (sometimes they are also referred to as Selling, General and Administrative Costs, SG&A Expenses). 

Inventories can be accounted for (or kept track of) under two methods: o Perpetual Inventory Method: in the perpetual method, the balance in the inventory account is adjusted during the period. The Inventory account is increased when inventory is purchased and decreased when inventory is sold. Inventory transactions are recorded continuously in the inventory account, and data is available in the accounting records anytime relative to the quantity of material or type of merchandise on hand. A physical count of inventory is taken at the end of the year and compared to the general ledger balance. Any differences between the physical inventory count and the general ledger balance are investigated immediately, and an adjustment is recorded to reflect the difference. There is good internal control with the perpetual method. o Periodic Inventory Method: Under the periodic method, the inventory account is updated or changed only at the end of the period. (The inventory account is not updated when inventory is purchased or sold.) The ending inventory balance and the COGS balance is a computation made at the end of the period under the periodic method. Internal control is not as effective under this method since there is no ending balance in the general ledger to compare the physical inventory count to. In practice, the period method is not used by many companies anymore due to the lack of internal control. (NOTE: This method will not be tested in this course in either chapter 4 or 5)

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A

= L +

[Cash + A/R +Merchandise Inventory]

A/P

E [CC + RE] [REEOY=REBOY – DIV +NI] [NI = REV – EXP]

[Net Sales = Sales – Sales Discount* – Sales returns and allowances*]

[COGS]

* = contra revenue accounts ~ make revenue go down. Normal Balance is debits From the viewpoint of the Buyer: 

Product Costs: costs which are directly traced to the products and include all costs necessary to acquire goods and make them ready for sale. Product costs are held as assets and included in the inventory accounts until the product is sold. o Company purchases inventory with cash Dr. Merchandise Inventory Cr. Cash o Company purchases inventory on credit Merchandise Inventory Accounts Payable

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Purchase Discounts - To motivate buyers to pay promptly (or early), purchase discounts are given. This incentive is good for both the buyer (via cheaper prices) and the seller (via a shortened operating cycle since the cash is collected more quickly). o Credit Terms – amounts and timing of payments from a buyer to a seller n/# of days for credit period n/30 = net 30 days; EOM = end of month o A seller can grant a cash discount, which they call a sales discount. Buyers call this cash discount a purchase discount. Discount %/# of days discount available 2/10 = 2% discount if payed in the next 10 days o 2/15, n/30 = 2% discount if payed in the next 15 days otherwise all of it is due in 30 days. o

Date of Invoice I------------------------------Credit Period------------------------------I I-----Discount Period-----I

I-Due: Invoice Price minus discount-II----------Due: Invoice Price-----------I o Buyer purchases Inventory with terms 2/10, n/30 Merchandise Inventory Accounts Payable Purchased merchandise on credit, terms 2/10, n/30 o Buyer pays within 10 days Accounts Payable

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Amount of Purchase

Merchandise Inventory

2% of A/P

Cash

A/P – 2%

Purchase Returns and Allowances: if a buyer or purchaser is dissatisfied with the items purchased, the buyer may return the goods (known as a purchase return), or keep the goods & receive an additional mark-down (or price reduction known as a purchase allowance). (Note: The journal entry for the buyer/purchaser is the same for both a purchase return & a purchase allowance.) If the goods are returned or an allowance is made, the original entry is reversed (for a return) or reduced (for an allowance or price adjustment / mark-down), by the following entry: A/P or Cash Merchandise Inventory

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Transportation Costs and Ownership Transfer: The buyer pays freight only when the terms of shipping are FOB shipping point. Freight paid by the buyer is considered a product cost and is therefore included the inventory account. When the goods are sold it becomes part of the COGS balance on the income statement. If the terms of shipping are FOB shipping, the buyer pays the transportation costs and the ownership of the goods transfer when goods are passed to the carrier. To record this entry: Merchandise Inventory Cash

 From viewpoint of the Seller: 

Each sales transaction for a seller of merchandise involves two parts: o 1. Revenue received in the form of an asset from the customer o 2. Cost recognized for the merchandise sold to the customer

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Sales of Inventory: We must show the change in our inventory and our incoming revenue. o Sold on Cash: Cash Sales Cost of Goods Sold Inventory o Sold on credit: Accounts Receivable Sales Cost of Goods Sold Inventory

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Trade Discounts: Sometimes firms give “Trade Discounts” that offer special discounts to certain customers. The term list price, manufacturers suggested price, or catalog price is used to specify the full or gross price before the trade discount is taken. Sales involving trade discounts are always recorded net of (or after subtracting) any trade discounts. An example is buying a car. You negotiate the price before. This discount is taken before anything else.

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Sale Discounts: To motivate buyers to pay promptly (or early), the seller may offer sales discounts. This incentive is good for both the buyer (via cheaper prices) and the seller (via a shortened operating cycle since the cash is collected more quickly). 

Do not confuse a sales discount (e.g. 1/15, n/45) with a trade discount.

o If the customer pays within the discount window:

Cash Sales Discount A/R o If the customer does not pay within the discount window: Cash A/R 

Sales Returns: if a customer returns a good Sales Returns and Allowances Accounts Receivable Merchandise Inventory Cost of Goods Sold **if the good is defective, you must return it to inventory at its estimated value, not cost. If the good was original worth 600 but is defective and valued at 150, you record the inventory at 150, while still keeping the Sales Return and Allowances and A/R transaction at 600 *Note: Sales Returns & Allowances is a contra-sales/revenue account. Its normal balance is a debit balance.

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Sales Allowances: If merchandise is defective, the buyer can keep it and the seller will give a sales allowance. The allowance will be for an agreed upon price reduction, not the full value Sales Returns and Allowances Accounts Receivable *Note: Sales Returns & Allowances is a contra-sales/revenue account. Its normal balance is a debit balance.

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Freight Costs: If the shipping terms are FOB destination, the seller pays the transportation costs and the ownership of the goods is not transferred until the goods are passed to the buyer. Delivery Expense Cash

Ownership or Title to Inventory: Ownership of the goods is referred to as title. Title passes: 

In a point of sale transaction (~ in a store) when the buyer physically obtains the goods (takes possession of the goods) from the seller.

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In a transaction where goods are shipped, the shipping terms determine when title passes. If the goods are shipped: o FOB shipping: buyer owns the goods (title transfers) when they leave seller’s shipping point (buyer owns goods while goods are in the hands of the common carrier in transit). Buyer is also responsible for paying the freight costs. (Since the freight is a cost of obtaining the inventory, it is considered a product cost & is included in COGS on the income statement.) o FOB destination: seller owns the goods until they reach the buyer’s place of business (called the destination point). Since the seller owns the goods while they are in transit, title is said to transfer at destination point ~ the buyer’s place of business. The seller owns the goods while in transit, the seller is responsible for paying the freight costs. (Since the freight is a cost of getting goods to a customer, it is considered a period cost in SG&A (or Operating) Expenses on the income statement.)

Physical Goods to be included in Inventory: In order to achieve proper cut-off between periods we must examine closely all goods in transit at the end of the period. 

Inventory out on consignment belongs to the consignor's inventory.

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Damaged Goods – do not include as inventory since items aren’t saleable (can’t sell them to customers). Record as shrinkage (See below.)

Internal Control and Physical Inventory Counts: Internal control procedures are the procedures in place to safeguard a company’s assets and to ensure that the accounting records are accurate and

reliable. Under GAAP all companies must take a physical count of inventory at the end of the period at least once a year. Subsidiary Ledgers or Sub-Ledgers: a separate book/record (~ part of the company’s accounting records) where more detailed information is kept about certain types of accounts (e.g. The A/R, A/P, and Inventory accounts in the G/L have subsidiary ledgers). Details on specific things rather than overall. 

The inventory subsidiary ledger (or subledger) contains detailed records indicating the number of units on hand and the cost paid for each item.

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The A/R subsidiary ledger (or subledger) contains information about individual customers (what the individual customer purchased on account, what the individual customer paid on account and what the individual customer still owes the company.)

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The A/P subsidiary ledger (or subledger) contains information about what the company owes particular vendors or suppliers (what the company purchased on account from the individual supplier, what the company has paid on account and the company still owes the individual vendor or supplier).

Completing the Accounting Cycle: 

Adjusting Entries for Merchandisers: o Generally, the same as service companies. However, there are some differences: 

Inventory Shrinkage: If the physical count of inventory does not equal the perpetual inventory accounting records, shrinkage has occurred. Inventory shrinkage (inventory shortage) is caused by inventory damage, waste, theft, or spoilage that occurred during the period. If the shrinkage is not material (not significant) it is considered a normal cost of operations. If the company uses the perpetual method, they adjust the accounting records with the following entry: Cost of Goods Sold Inventory 

After recording the entry above, the company would report the inventory on hand that is based on the physical count in its balance sheet

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Closing Entries:

o Step 1: Close Credit Balances in Temporary Accounts to Income Summary Sales Income Summary o Step 2: Close Debit Balances in Temporary Accounts to Income Summary Income Summary Sales Discounts Sales Returns and Allowances Cost of Goods Sold Depreciation Expense Salaries Expense Insurance Expense Rent Expense Supplies Expense Advertising Expense o Step 3: Close Income Summary to Retained Earnings Income Summary Retained Earnings o Step 4: Close Dividends Account to Retained Earnings Retained Earnings Dividends 

Financial Statements: o Multiple-Step Income Statement: Net income is determined by performing multiple computations. Both merchandising companies and manufacturing companies commonly use the multi-step format. The multi-step income statement also contains the line “Gross Profit” (or Gross Margin). 

Gross Profit = Net Sales – Cost of Goods Sold Company Income Statement For ____ended______

Sales

XXX Sales Discounts

XXX

Sales Returns and Allowances

XXX_______

Net Sales

XXX

Cost of Goods Sold

XXX

Gross Profit

XXX

Expenses Selling Expenses Sales Salaries Expense

XXX

Rent Expense – selling space

XXX

Store Supplies Expense

XXX

Total Selling Expenses

XXX

General and Administrative Expenses Office Salaries Expense

XXX

Rent Expense

XXX

Office Supplies Expense

XXX

Total General and Administrative Expense Total Expenses

XXX XXX

Net Income

XXX

 o Single-Step Income Statement: Net income is determined in one single computation. Service companies often use this presentation. Company Income Statement For ____ended______ Net Sales Expenses

XXX

COGS

XXX

Selling Expenses

XXX

General and Administrative Expenses

XXX

Total Expenses Net Income

XXX XXX

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o In a Classified Balance Sheet, a merchandiser reports merchandise inventory as a current asset. Chapter 5: Reporting and Analyzing Inventories 

Determining Inventory Items: The Company should physically count all inventory at its stores and warehouses at year-end. In order to achieve proper cut-off between periods we must examine closely all goods in transit, consigned goods & damaged goods at the end of the period. o Goods in transit: are goods purchased and shipped (by the seller) but not received by the buyer by the end of the period. 

Goods in transit at the end of the period shipped FOB shipping should be included in the buyers' ending inventory, since legal title has passed to the buyer when the goods were delivered to the common carrier for shipment.

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Goods in transit at the end of the period shipped FOB destination belong to the seller until the buyer receives the goods at the buyer’s place of business (~ the destination point). Since legal title to the goods does not pass until the goods reach their destination, these goods should be included in the seller's inventory while in transit.

o Goods on Consignment: belongs to the consignor's (separate party from seller or receiver) inventory. Only include in the physical count if you are the consignor. Consignee excludes them. o Damaged Goods: exclude items from physical count since items aren’t saleable (~ can’t sell to customers). Record damaged inventory as shrinkage. You do record this in inventory if they can be sold at a reduced price. 

Some Accounting Principles cannot be neglected when determining inventory costs: o Consistency principle: requires businesses to use the same accounting method from period to period. if the inventory method is changed, the change and the effect of the change must be disclosed in the financial statements. o full disclosure principle: must report enough information for outsiders to make knowledgeable decisions. inventory methods used must be disclosed in the financial statements. o materiality concept: must adhere to GAAP only for items and transactions that are significant to the financial statements. o conservatism concept: when in doubt about how to record, do not overstate asset and net income, or understate liabilities.

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Inventory Cost Flow Assumptions: Inventories are asset items held for sale in the ordinary course of business. Inventory represents a primary source of revenue as well as a significant portion of the assets on the balance sheet. Issues affecting inventory affect both the income statement and the balance sheet. When inventory purchases are made at different prices / costs the company needs to decide which cost to send to the income statement as cost of goods sold and which costs to leave on the balance sheet as inventory. GAAP has four different cost flow assumptions to solve this issue. The 4 assumptions are:

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Specific Identification: method keeps track exactly which goods are sold (in COGS) and which goods are left on hand in ending inventory.

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FIFO: method assumes the first (earliest) goods purchased are the first sold (COGS). FIFO therefore approximates the actual physical flow of goods. Ending inventory consists of goods from the most recent purchases.

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LIFO: method assumes that the latest (most recent) goods purchased are the first sold (COGS). Ending inventory consists of goods purchased the earliest (oldest)

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Weighted average cost: method assigns an average cost to both goods sold (COGS) and goods in ending inventory.

o All four of these methods are acceptable cost flow methods for valuing inventory under GAAP! 

Cost flow assumptions can be applied to both the perpetual and the periodic methods. (NOTE: We will only cover the perpetual method in CH. 5)

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Reme...