Exam II Chapters 6 - 9 Review
Exam II Chapters 6 - 9 Review ACIS 2115
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Date Created: 04/02/16
Chapter 6 – 9 Test II Review See Chapters 6 – 9 notes for in-class journalizing/posting entries, etc. Chapter 6: Merchandisers need only one inventory classification, merchandise inventory. Manufacturing companies classify inventory into three categories: finished goods inventory, work in process, and raw materials. Finished goods inventory – manufactured items that are completed and ready for sale. Work in progress – the portion of manufactured inventory that has begun the production process but is not yet complete. Raw materials – basic goods that will be used in production but have not yet been placed into production. Just-in-time (JIT) inventory – inventory system in which companies manufacture of purchase goods only when needed. Many have significantly lowered inventory levels and costs using this method. Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods. 1. Taking a physical inventory: At the end of an accounting period; involves actually counting, weighing, or measuring each kind of inventory on hand. 2. Determining the ownership of goods: Two questions must be answered. a. Do all of the goods included in the count belong to the company? b. Does the company own any goods that were not included in the count? A complication of determining ownership is goods in transit (on board a truck, train, ship, and plane). Goods in transit should be included in the inventory of the company that has legal title to the goods. a. When the terms are free on board shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. b. When the terms are free on board destination, ownership of the goods remains with the seller until the goods reach the buyer. In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods (consigned goods). Specific identification method – an actual physical-flow costing method in which particular items sold and items still in inventory are specifically costed to arrive at cost of goods sold and ending inventory; a relatively rare practice. Cost flow assumptions: Because specific identification is often impractical, other cost flow methods are permitted. They assume flows of costs that may be unrelated to the actual physical flow of goods. First-in, first-out (FIFO) These are OKAY! There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Last-in, first-out (LIFO) Average-cost ***Reminder: Cost of goods sold = (beginning inventory + purchases) – ending inventory 1. FIFO method – an inventory costing method that assumes that the earliest goods purchased are the first to be sold; costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold, regardless of which units were actually sold. Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. 2. LIFO method – an inventory costing method that assumes that the latest units purchased are the first to be sold; costs of the latest goods purchased are the first to be recognized in determining cost of goods sold, regardless of which units were actually sold. Companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. to analyze a company’s financial statements over successive time period.ory costing method that uses the weighted-average unit cost to Consistent applallocate the cost of goods available for sale to ending inventory and cost of goods sold. Cost of goods available for sale / total units available for sale = weighted-average unit cost. The reasons companies adopt different inventory cost flow methods: Income statement effects o In a period of inflation, FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue. o In a period of inflation, LIFO produces a lower net income because lower unit costs of the last goods purchased are matched against revenue. o If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest. o Regardless of whether prices are rising or falling, average-cost produces net income between FIFO and LIFO. Balance sheet effects o In a period of inflation, the costs allocated to ending inventory will approximate their current cost. o In a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost. Tax effects o During a time of rising prices, LIFO results in the lowest income taxes (because of lower net income). Lower-of-cost-or-market (LCM) – a basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost. Current replacement cost – the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities. Inventory turnover – a ratio that indicates the liquidity of inventory by measuring the number of times average inventory is sold during the period. Inventory turnover = Cost of goods sold / Average inventory during the period Days in inventory – measure of the average number of days inventory is held. Days in inventory = 365 / inventory turnover Companies using LIFO are required to report the difference between inventories reported using LIFO and using FIFO. This amount is referred to as the LIFO reserve. This enables analysts to make adjustments to compare companies that use different cost flow methods. Chapter 7: Fraud – a dishonest act by an employee that results in personal benefit to the employee at a cost to the employer. Fraud triangle – the three factors that contribute to fraudulent activity by employees: opportunity, financial pressure, and rationalization. -xley Act (1. Opportunity: the most important element. Opportunities occur when the workplace lacks this, Congress passufficient controls to deter and detect fraud. 2. Financial pressure: employees commit fraud because of personal financial problems or the Sarbanes desire to live a lifestyle not affordable on their salary. 3. Rationalization – employees justify their fraud with excuses that they are underpaid, etc. To address Sarbanes Oxley Act (SOX) – laws that requires publicly traded companies to maintain adequate systems of internal control. Internal control – a process designed to provide reasonable assurance regarding the achievement of company objectives related to operations, reporting, and compliance. Internal control systems have five primary components: A control environment. It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. Risk assessment. Companies must identify and analyze the various factors that create risk for the business and must determine how to manage these risks. Control activities. Management must design policies and procedures to address the specific risks faced by the company. The six principles of control activities are as follows. 1. Establishment of responsibility 2. Segregation of duties 3. Documentation procedures 4. Physical controls 5. Independent internal verification 6. Human resource controls Information and communication. Must capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties. Monitoring. The adequacy of internal control systems must be monitored periodically. Internal auditors – company employees who continuously evaluate the effectiveness of the company’s internal control systems. Bonding – obtaining insurance protection against theft by employees. Cash receipt controls include over-the-counter receipts and mail receipts. Over-the-counter receipts – standard retail, cash register receipt. The clerk/cashier has access to the money but not the register tape. The supervisor has access to register tape but not the cash. Mail receipts – should be opened in the presence of at least two mail clerks; generally in the form of checks. Mail clerks prepare a list of the checks received each day and signs the list, assuming responsibility. TO FRACash disbursements controls include voucher system controls and petty cash funds. CASH IS THE ASETVoucher system – a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper. o Voucher – an authorization form prepared for each expenditure in a voucher system. Petty cash fund – a cash fund used to pay relatively small amounts. Two essential steps in establishing a petty cash fund are (1) appointing a petty cash custodian who will be responsible for the fund, and (2) determining the size of the fund. Bank reconciliation – the process of comparing the bank’s balance with the company’s balance, and explaining the differences to make them agree. Electronic funds transfers (EFTs) – a disbursement system that uses wire, telephone, or computer to transfer cash from one location to another. Bank statement – a statement received monthly from the bank that shows the depositor’s bank transactions and balances. REMEMBER, bank statements are prepared from the bank’s perspective; every deposit the bank receives is an increase in the bank’s liabilities (an account payable to the depositor). NSF check (not sufficient funds) – a check that is not paid by a bank because of insufficient funds in a bank account. The need for reconciliation has two causes: 1) time lags that prevent one of the parties from recording the transaction in the same period, 2) errors by either party in recording transactions. Reconciliation procedure: 1. Reconciling items per bank. a. Deposits in transit (+) – deposits recorded by the depositor that have not been recorded by the bank. b. Outstanding checks (-) – issued checks recorded by the company that have not been paid by the bank. c. Bank errors (+/-). 2. Reconciling items per books. a. Other deposits (+). b. Other payments (-). c. Book errors (+/-). Cash equivalents – short term, highly liquid investments that are both readily convertible to known amounts of cash and so near maturity that their market value is relatively insensitive to changes in interest rates. Restricted cash – cash that is not available for general use but rather is restricted for a special purpose. Treasurer – employee responsible for the management of a company’s cash. Basic principles of cash management: 1. Increase the speed of receivables collection. The more quickly a company’s customers pay, the sooner the funds can be used. 2. Keep inventory levels low. Maintaining a large inventory of supplies and finished product ties up large amounts of cash and warehouse space. 3. Monitor payment of liabilities. Using the full payment period (but not paying late) and taking advantages of cash discounts provides the best use of money. 4. Plan the timing of major expenditures. Companies should make any major expenditures when they normally have excess cash. In addition, they should plan ahead to receive prime outside financing. 5. Invest idle cash. Cash on hand does nothing—invest it! Cash budget – a projection of anticipated Chapter 8: salreceivable that result from Receivables – amounts due from individuals and companies; claims that are expected to be collected in called cash. Notes and accounts Accounts receivable – amounts customers owe on account; result from the sale of goods and trade receivables services, and are usually expected for collection within 30 to 60 days. Notes receivable – a written promise for amounts to be received; normally requires the collection of interest and extends for time period of 60 to 90 days or longer. Other receivables – nontrade receivables such as interest receivable, loans to company officers, . advances to employees, and income taxes refundable; do not generally result from operations of the business. Bad Debt Expense/Uncollectible Accounts Expense – an expense account to record losses from extending credit (when receivables become uncollectible). Two methods are used in accounting for uncollectible accounts: (1) the direct write-off method and (2) the allowance method. 1. Direct write-off method: a method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible. UNLESS A COMPANY EXPECTS BAD DEBT LOSSES TO INSIGNIFICANT, THE DIRECT WRITE-OFF METHOD IS NOT ACCEPTABLE FOR FINANCIAL REPORTING PURPOSES. 2. Allowance method: a method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. Cash (net) realizable value – the net amount a company expects to receive in cash from receivables. COMPANIES MUST USE THE ALLOWANCE METHOD FOR FINANCIAL REPORTING PURPOSES WHEN BAD DEBTS ARE MATERIAL IN AMOUNT. The allowance method has three essential features: 1. Companies estimate uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded. 2. Companies record estimated uncollectibles as an increase (a debit) to Bad Debt Expense and an increase (a credit) to Allowance for Doubtful Accounts through an adjusting entry at the end of each period. Allowance for Doubtful Accounts is a contra account to Accounts Receivable. 3. Companies debit actual uncollectibles to Allowance for Doubtful Accounts and credit them to Accounts Receivable at the time the specific account is written off as uncollectible. Under the allowance method, a company debits every bad debt write-off to the allowance account and not to Bad Debt Expense. Occasionally, a company collects from a customer after the account has been written off as uncollectible. The company must make two entries to record the recovery of a bad debt: 1) Reverse the entry made in writing off the account, and 2) journalize the collection in the usual manner. Percentage-of-receivables basis – a method of estimating the amount of bad debt expense whereby management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts. Aging the accounts receivable – a schedule of customer balances classified by the length of time they have been unpaid. Factor – a finance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. Three parties are involved when national credit cards are used in making retail sales: 1. The credit card issuer; who is independent of the retailer 2. The retailer 3. The customer Promissory note – a written promise to pay a specified amount of money on demand or at a definite time; may be used (1) when individuals and companies lend or borrow money, (2) when the amount of the transaction and the credit period exceed normal limits, and (3) in settlement of accounts receivable. Maker – the party in a promissory note who is making the promise to pay. Payee – the party to whom payment of a promissory note is to be made. Determining the maturity date: omit the date the note is issued but include the due date. Computing interest: face value of note x annual interest rate x time in terms of one year = interest Dishonored (defaulted) note – a note that is not paid in full at maturity. Managing accounts receivable involves five steps: 1. Determine to whom to extend credit. Require risky customers to provide letters of credit or bank guarantees. Ask potential customers for references from banks and suppliers, to determine their payments history. 2. Establish a payment period. It is important that the payment period is consistent with that of competitors. 3. Monitor collections. Companies should prepare an accounts receivable aging schedule at least monthly. If a company has significant concentrations of credit risk, it must discuss this risk in the notes to its financial statements. A concentration of credit risk is a threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company. 4. Evaluate the liquidity of receivables. Accounts receivable turnover – a measure of the liquidity of accounts receivable. Accounts receivable turnover = net credit sales/average net accounts receivable Average collection period – the average amount of time that a receivable is outstanding. Average collection period = 365/accounts receivable turnover 5. Accelerate cash receipts from receivables when necessary. Companies may sell receivables because: i. They do not necessarily want to hold large amounts of receivables. ii. They may be the only reasonable source of cash. iii. Billing and collection are often time-consuming and costly. Chapter 9: Plant assets – resources that have physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. It is important for a company to: 1. Keep assets in good operation condition 2. Replace worn-out or outdated asserts 3. Expand its productive assets as needed Revenue expenditures – expenditures that are immediately charged against revenues as an expense; costs not included in a plant asset account. Capital expenditures – expenditures that increase the company’s investment in plant assets; not expensed immediately. Cash equivalent price – an amount equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. The cost of LAND includes: (1) the cash purchase price, (2) closing costs such as title and attorney’s fees, (3) real estate brokers’ commissions, and (4) accrued property taxes and other liens on the land assumed by the purchaser. Companies often use land as a building sit for a manufacturing plant or office site. The cost of LAND IMPROVEMENTS includes all expenditures necessary to make the improvements ready for the intended use. Land improvements are structural additions with limited lives that are made to land, such as driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of BUILDINGS are all necessary expenditures relating to the purchase or construction of a building. Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Plant/property/equipment costs The cost of EQUIPMENT consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. Equipment includes assets used in operations, such as store check-out counters, office furniture, factor machinery, and delivery trucks. Ordinary repairs – expenditures to maintain the operating efficiency and expected productive life of the unit. Additions and improvements – costs incurred to increase the operating efficiency, productive capacity, or expected useful life of a plant asset. Lessor – a party that has agreed contractually to let another party use its asset for a period at an agreed price. Lessee – a party that has made contractual arrangements to use another party’s asset for a period at an agreed price. Perks of leasing: Reduced risk of obsolescence. Lease terms may allow exchanges if the asset becomes outdated. Little or no down payment. Shared tax advantages. Lessor gets the tax advantage because it owns the asset. It will often pass these savings on to the lessee in the form of lower lease payments. Assets and liabilities not reported. Reporting lower assets and liabilities has advantages. o Operating lease – a contractual agreement allowing one party (the lessee) to use the asset of another party (the lessor); accounted for as rental by the lessee; allows for neither liability nor asset to be recorded. Capital lease – a contractual agreement allowing one party (the lessee) to use another party’s asset (the lessor); accounted for like a debt-financed purchase by the lessee. Depreciation – the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner; applies to land improvements, buildings, and equipment NOT LAND! Three factors that affect the computation of depreciation: 1. Cost. All expenditures necessary to acquire the asset and make it ready for intended use. 2. Useful life. Estimate of the expected life based on need for repair, service life, and vulnerability to obsolescence. 3. Salvage value. Estimate of the asset’s value at the end of its useful life. Depreciable cost – the cost of a plant asset less its salvage value. Depreciation methods: Straight-line method – o Companies expense an equal amount of depreciation each year of the asset’s useful life. o Used for some or all of the depreciation taken by more than 95% of U.S. companies. (COST – SALVAGE VALUE) / USEFUL LIFE = DEPRECIATION EXPENSE Declining-balance method – o Applies a constant rate applied to a declining book value of the asset (called an accelerated-depreciation method) and produces a decreasing annual depreciation ds are acceptable underense over the asset’s useful life. Units-of-activity method – o Useful life is expressed in terms of the total units of production or use expected from the asset. o Ideally suited to factory machinery: in term of units of output or in terms of machine Allgenerally accepted accounting principles. It is also possible to use the method for such items as delivery equipment (miles driven) and airplanes (hours in use). Not suitable for buildings or furniture. Impairment – a permanent decline in the fair value of an asset.
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