Part 1 Study Unit 2
SU 2.1 Accounts Receivable Overview Recording receivables, which coincides with revenue recognition, is consistent with the accrual method of accounting. Current Receivables will be collected in 1 year or less and reported at net realizable value (NRV), which means net of allowance for doubtful accounts, allowance for sales return, and billing adjustments. Non-current Receivables are carried at net present value of future cash flows (consequently you have to discount the receivable). Direct write-off method, writes off receivables when they are deemed uncollectible, and is not acceptable under GAAP since it does not follow the matching principle but may be used for tax.
SU 2.1 Accounts Receivable Allowances for sales returns Due to product defects, customer dissatisfaction, etc. Must follow the matching principle and therefore has to be estimated in the period that sales are recorded. See example shown on page 48
SU 2.1 Accounts Receivable Allowances for Uncollectible Accounts and Bad Debt Expense Collection in full unlikely, therefore bad debt needs to be matched with the related revenue. Issue/challenge is the estimation of bad debt both for balance sheet purposes and income statement purposes. Balance sheet Increases allowance, contra account, decreases net receivables Income statement Increases expenses Most common methods Percentage-of-sales method Percentage-of-receivables method continued
SU 2.1 Accounts Receivable Allowances for Uncollectible Accounts and Bad Debt Expense Percentage of Sales (Income Statement approach) Based on percentage of credit sales. See example on page 49 Percentage of Receivables (Balance Sheet approach) Based on ending gross accounts receivables. Could be based on total A/R account balance, but more likely to be based on an Aging Schedule See aging schedule on page 49 continued
SU 2.1 Accounts Receivable Allowances for Uncollectible Accounts and Bad Debt Expense Write-off of bad debt has no effect on expenses/income statement Write-off has no effect on carrying amount of net accounts receivable or working capital Recovery of written-off bad debt has no effect on expenses See reconciliation of allowance for uncollectible accounts page 50
SU 2.1 Accounts Receivable Factoring of Accounts Receivables Transfer of receivables to a third party (factor) who accepts responsibility of collections. They are more than just servicing the collection process, they have rights to the funds. Factoring can be done: With recourse Transferor may be required to make payments for receivables that can t be collected. Without recourse Transferee assumes the risks of collection Example on bottom of page 50 Transferor receives immediate cash as opposed to having to wait on payment, but pays a high price to the factor.
SU 2.1 Accounts Receivable Practice question 1 The measurement basis most often used to report a long-term payable representing a commitment to pay money at a determinable future date is A Historical cost. B Current cost. C Net realizable value. D Present value of future cash flows.
Correct Answer: D SU 2.1 Accounts Receivable Practice question 1 answer The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. However, it is usually combined with other measurement bases (attributes). The attribute used to measure a long-term receivable or payable is the present or discounted value of its future cash flows. Incorrect Answers: A. Historical cost is used to measure property, plant, and equipment and most inventories. B. Some inventories are measured at current (replacement) cost. C. Short-term receivables and some inventories are reported at net realizable value.
SU 2.1 Accounts Receivable Practice question 2 An analysis of an entity s $150,000 accounts receivable at year end resulted in a $5,000 ending balance for its allowance for uncollectible accounts and a bad debt expense of $2,000. During the past year, recoveries on bad debts previously written off were correctly recorded at $500. If the beginning balance in the allowance for uncollectible accounts was $4,700, what was the amount of accounts receivable written off as uncollectible during the year? A $1,200 B $1,800 C $2,200 D $2,800
SU 2.1 Accounts Receivable Practice question 2 answer Under the allowance method, uncollectible accounts are written off by a debit to the allowance and a credit to accounts receivable. The $500 of recovered bad debts is accounted for by a debit to accounts receivable and a credit to the allowance. The $2,000 bad debt expense is also credited to the allowance. The amount of accounts receivable written off can be calculated as follows: Beginning allowance $4,700 Bad debt expense 2,000 Recoveries 500 Ending allowance (5,000) A/R written off $2,200
SU 2.1 Accounts Receivable Practice question 3 The following information has been compiled by Able Manufacturing Company: Sale of company products for the period to customers with net 30-day terms amounting to $150,000. Sale of company products for the period to a customer, supported by a note for $25,000, with special terms of net 180 days. Balance of trade receivables at the end of the last period was $300,000. Collections of open trade receivables during the period was $200,000. Rental income for the period, both earned and accrued but not yet collected, from the Able Employees Credit Union for use of company facilities was $2,000. The open trade receivables balance to be shown on the statement of financial position for the period is A $250,000 B $252,000 C $275,000 D $277,000
SU 2.1 Accounts Receivable Practice question 3 answer Correct Answer: A The open trade receivables balance is calculated as follows: Previous ending balance $300,000 Add: sales to customers (terms net 30) 150,000 Minus: collections during period (200,000) Open trade receivables reported $250,000
SU 2.2 Inventory Inventory Inventory are not supplies, they are used in the ordinary course of business. Could be raw materials, work-in-process or finished goods Categorized as current assets Used in the calculation toward Gross Profit Net Sales COGS = Gross Profit Cost of Inventory includes all cost incurred in bringing the inventory to company and get ready-to-use condition, and includes: Inventory trade discounts, rebates, etc. Handling, insurance, freight-in continued
SU 2.2 Inventory Inventory Cost of manufactured inventories includes: Direct labor costs, and Manufacturing overhead costs Accounting systems include Perpetual inventory system Probably most common today, which updates inventory accounts after each purchase or sale. Important when inventory expensive and heterogeneous items. Purchases charged to inventory and COGS are adjusted as sales occur. Benefits include that the amount of inventory is always available, but can be more complex to implement continued
SU 2.2 Inventory Inventory Periodic inventory system Inventory and COGS sold are updated at specific intervals, based on a physical count. Purchases are booked to a temporary account like Purchases. Changes in inventory of cost of goods sold are recorded only at the end of the period, based on the physical count at the end of the period. See example on bottom of page XX and the difference between periodic and perpetual on the top of page 53 continued
SU 2.2 Inventory Inventory Annual period-end inventory physical count is necessary under both the inventory methods. Helps detect theft, misstatements, which are recognized as a separate line item in the current period income statement. Also helps determine shortages and overages. continued
SU 2.2 Inventory Annual period-end inventory Goods in transit are items that inventories that are not on the premises, and whose legal title is held by the entity. FOB shipping point title passes to buyer at the sellers docks. FOB destination title passes to buyer at buyers docks. Consignment Goods Item transferred to an agent for sale Included in consignor s inventory Consignee never considers them to be their assets
SU 2.2 Inventory Inventory Estimation Used for interim reporting purposes or when inventory records have been destroyed. Gross profit margin (gross profit percentage) equals gross profit divided by sales. Gross profit margin (%) = Gross profit / Sales See example on the bottom of page 54 continued
SU 2.2 Inventory Inventory Errors may affect: Current Assets, working capital, COGS, Net Income and Equity. Common error is inappropriate timing of recognition of transaction. Understand the effects of overstating and understanding inventory. Will have no effect in the long-term but can cause two years to be incorrect.
SU 2.2 - Inventory Practice question 1 A physical inventory count showed an entity had inventory costing $1,000,000 on hand at December 31, Year 1. Excluded from this amount were the following: Goods costing $82,000, shipped to a customer free on board (FOB) shipping point on December 28, Year 1. They were expected to be received by the customer on January 4, Year 2. Goods costing $122,000, shipped to a customer free on board (FOB) destination December 30, Year 1. They were expected to be received by the customer on January 5, Year 2. Compute the correct ending inventory to be reported on the shipper s statement of financial position at December 31, Year 1. A $1,000,000 B $1,082,000 C $1,122,000 D $1,204,000
SU 2.2 - Inventory Practice question 1 answer Correct Answer: C The goods shipped FOB shipping point should be counted in the buyer s, not the seller s, inventory because title and risk of loss pass at the time and place of shipment. These goods were properly excluded from ending inventory. The goods shipped FOB destination were improperly excluded from the seller s ending inventory. The title and risk of loss did not pass until the time and place where the goods reached their destination and were duly tendered. Thus, the correct ending inventory is $1,122,000 ($1,000,000 beginning balance + $122,000 goods shipped FOB destination). Incorrect Answers: A B D The amount of $1,000,000 results from excluding the goods shipped FOB destination. The amount of $1,082,000 results from excluding the goods shipped FOB destination and from including the goods shipped FOB shipping point. The amount of $1,204,000 results from including the goods shipped FOB shipping point.
SU 2.2 - Inventory Practice question 2 An internal auditor performs an analytical procedure to compare the gross margins of various divisional operations with those of other divisions and with the individual division s performance in previous years. The internal auditor notes a significant increase in the gross margin at one division. The internal auditor does some preliminary investigation and also notes that there were no changes in products, production methods, or divisional management during the year. The most likely cause of the increase in gross margin is A B C D An increase in the number of competitors selling similar products. A decrease in the number of suppliers of the material used in manufacturing the product. An overstatement of year-end inventory. An understatement of year-end accounts receivable.
SU 2.2 - Inventory Practice question 2 answer Correct Answer: C An overstatement of year-end inventory results in an understatement of cost of goods sold, which overstates gross margin.
SU 2.3 Inventory Cost Flow Methods Specific Identification used when you can specifically (i.e. unique identification number) identify the inventory (e.g. car) Most accurate but requires detailed records and is more expensive Average method Moving-average method is used under the perpetual inventory method. See example on page 56 Weighted-average method is used under the periodic inventory method. See example on page 56 & 57
SU 2.3 Inventory Cost Flow Methods First-in, First-out (FIFO) Ending inventory consists of latest purchases and therefore will result in the highest inventory balance and the lowest COGS. Year-end inventory and COGS for the period are the same, regardless of perpetual or periodic inventory accounting. See example on page 57 Last-in, First-out (LIFO) Newest items are sold first and ending inventory is the oldest and usually lowest cost inventory, which will create lowest inventory balance and highest COGS. Calculation of inventory and COGS are made at the end of the period for the Periodic Inventory method. continued
SU 2.3 Inventory Cost Flow Methods Cost Flow Methods Comparison\ Objective is to most clearly reflect periodic income. FIFO better approximates replacement costs, but matches old cost against current revenues. Management can affect Net Income under LIFO with an end-of-period purchase which alters COGS. In times of rising prices (large inflation), LIFO results in the Lowest ending inventory (lower Balance Sheet) Highest COGS (lower Net Income) See comparison chart on page 58
SU 2.3 - Concepts in Financial Accounting Practice question 1 Which of the following changes in accounting policies resulting from a significant change in the expected pattern of economic benefit will increase profit? A B C D A change from FIFO to LIFO inventory valuation when costs are rising. A change from FIFO to weighted-average inventory valuation when costs are falling. A change from accelerated to straight-line depreciation in the later years of the depreciable lives of the assets. A change from straight-line to accelerated depreciation in the early years of the depreciable lives of the assets.
SU 1.3 - Concepts in Financial Accounting Practice question 1 answer Correct Answer: B In a period of falling costs, FIFO results in higher cost of goods sold than the weighted-average method. FIFO includes the higher, earlier costs in cost of goods sold, and the weighted-average method averages the later, lower costs with the higher, earlier costs. Thus, a change from FIFO to weighted-average costing reduces cost of goods sold and increases reported profit.
SU 1.3 - Concepts in Financial Accounting Practice question 2 The inventory method yielding the same inventory measurement and cost of goods sold whether a perpetual or periodic system is used is A B C D Average cost. First-in, first-out. Last-in, first-out. Either first-in, first-out or last-in, first-out.
SU 1.3 - Concepts in Financial Accounting Practice question 2 answer Correct Answer: B A perpetual inventory system will result in the same dollar amount of ending inventory as a periodic inventory system assuming a FIFO cost flow. Under both perpetual and periodic systems, the same units are deemed to be in ending inventory.
SU 1.3 - Concepts in Financial Accounting Practice question 3 An entity has 8,000 units in inventory on January 1, valued at $10 per unit. During the year, the entity sold 25,000 units and purchased inventory as follows Date Quantity Purchased Unit Price 1 Apr 15,000 units $8 1 Jul 10,000 units $9 1 Oct 12,500 units $10
SU 1.3 - Concepts in Financial Accounting Practice question 3 continued If the entity uses the weighted-average method of inventory valuation, cost of goods sold for the period will be A $186,978 B $197,000 C $228,023 D $235,000
SU 2.3 - Concepts in Financial Accounting Practice question 3 answer Correct Answer: C Under the weighted-average method, the weighted-average cost per unit is multiplied by the number of units sold to determine the cost of goods sold for the period. The total units available for sale equaled 45,500 (8,000 + 15,000 + 10,000 + 12,500). The total cost of all units available for sale was $415,000 [(8,000 $10) + (15,000 $8) + (10,000 $9) + (12,500 $10)]. Thus, the weighted-average cost per unit of inventory was $9.1209 ($415,000 45,500), and cost of goods sold was $228,023 (25,000 $9.1209).