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Chapter 5 & 6
Concepts & Definitions
82
Accounting
Undergraduate 1
03/05/2010

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Term
A merchandising operation earns revenue by selling products called ...
Definition
inventory
Term
Merchandising have a few different balance sheet and income statement accounts, what are they?
Definition
balance sheet: inventory or merchandise inventory
income statement: revenue: sales revenue or sales, expense: cost of goods sold
Term
What is a merchandise companies Operating Cycle?
Definition
The length of time that is required for a business to purchase inventory, sell the inventory and collect the cash from the sale so that the cycle can begin again.
Term
Explain the periodic system of inventory management.
Definition
Used by businesses that sell relatively inexpensive goods and/or cannot afford a computerized inventory systems. Inventory is counted at regular intervals but is not maintained in between. Less popular as more businesses keep inventory records on computers.
Term
Explain perpetual inventory management systems.
Definition
Maintains a real-time running count of the amount of inventory on hand. Physical count happens at least once a year. Integrated inventory system. Most companies use this now because technology advances.
Term
What is a purchase invoice?
Definition
the suppliers request for payment from the purchaser.
Term
How is the purchase of inventory recorded?
Definition
Increase to assets (inventory) and an increase to liabilities (accounts payable)
Term
Explain how purchase discounts work.
Definition
Granted by the seller for early payment of an invoice. Terms of payment specify how much the discount is and when the invoice must be paid. The discount is recorded if the payment is made within the discount period.
Term
How would a discount term of 3/15 n/30 work?
Definition
The purchaser that a 3% discount is paid if the invoice is paid within 15 days, or the full amount of invoice is due in 30 days.
Term
What is merchandise returns & allowances?
Definition
Merchandise returned to the seller and allowances granted to the purchaser for damaged goods. Reduces accounts payable and reduces the cost of inventory.
Term
How do you record returns & allowances
Definition
accounts payable decreases and inventory decreases
Term
How are shipping costs accounted for?
Definition
Transportation costs are part of the cost of inventory.
Term
total cost of inventory is equal to
Definition
all fo the costs to acquire the inventory and get it ready for sale
Term
What does FOB stand for?
Definition
Free on board or freight on board
Term
What are the terms of FOB shipping point?
Definition
indicates that the buyer bears the shipping costs. Title passes to the buyer upon shipment. This is the most common method.
Term
What are the terms of FOB destination?
Definition
indicates that the seller bears the shipping costs. Title passes to the buyer when the goods reach the destination.
Term
Define: Freight in
Definition
Transportation cost on purchased goods. Debit inventory
Term
Define: Freight Out
Definition
Transportation cost on goods sold. Debit an expense (delivery expense)
Term
HOw are freight in transportation costs accounted for?
Definition
freight in is added to the cost of the inventory and are not subject to the purchase discount. Inventory is increased and cash is decreased.
Term
How is Freight Out accounted for?
Definition
Freight out on inventory sold is not added to the inventory but is considered an operating expense.
Term
the sale of inventory requires two entries, what are they?
Definition
revenue entry and COGS entry
Term
define sales revenue ...
Definition
amount earned from selling inventory. Revenue account
Term
Cost of Goods sold: define.
Definition
Cost of inventory that has been sold to customers. Expense account
Term
The sale of inventory requires two entries. what are they?
Definition
the entry to update the inventory and record the cost of the goods sold. Teh entry to record the sale and cash receipts.
Term
sales returns are recorded in what account?
Definition
the contra account, sales returns and allowances. discounts are not taken on returned merchandise.
Term
What is the reason for purchase discounts?
Definition
Incentive granted to the customer to encourage prompt payment.
Term
Sales discounts are recorded ...
Definition
in the contra account, Sales Discounts, when the accounts receivable is collected.
Term
net sales revenue =
Definition
sales revenue - sales discounts - sales returns and allowances
Term
gross profit =
Definition
revenue - COGS
Term
Define: Gross Profit
Definition
also called sales profit or gross operation profit is the difference between revenue and the cost of making a product or providing a service, before deducting overheads, payroll, taxation, and interest payments.
Term
If physical account of inventory is different from the amount on the books is ...
Definition
inventory shrinkage
Term
how is inventory shrinkage recorded?
Definition
debit cost of goods sold, credit inventory
Term
How do you adjust the ledger balance of inventory to the physical count?
Definition
Any difference between the phyisical count and the ledger balance is adjusted through Cost of Goods Sold and Inventory. This reduces inventory to its physical count or to increase inventory to its physical count
Term
What are the added accounts for closing entries?
Definition
sales discounts, sales returns and allowances, cost of goods sold
Term
How do you close income accounts?
Definition
debit all income statemnt accounts with a credit balance. Credit Income Summary for the total. Credit all income statement accounts with a debit balance. Debit income summary for the total. If income summary has a credit balance, debit income summary to close it and credit retained earnings. Credit withdrawals to close it and debit capital.
Term
What are the two ways to calculate net income for income statements?
Definition
Capital maintanence approach also called the change in equity approach. Difference in capital values at two points in time. Transaction approach: focus is on components of changes and revenue, expense, loss and gain accounts
Term
Gross Profit Percentage
Definition
Gross Profit / Net Sales
Percentage of dollar sales available to cover expenses and provide a profit
Term
Rate of inventory turnover
Definition
Indicates how rapidly inventory is sold. A business desires to sell its inventory as quickly as possible.
Average Inventory = (beginning inventory + ending inventory) / 2
Term
Define the rate of inventory turnover.
Definition
The rate of inventory turnover is the ratio of cost of goods sold to average inventory. This ratio measures the number of times a company sells its average level of inventory during a year.The faster the sales, the higher the potential income.
Term
how do you calculate cost of goods sold for a periodic inventory system?
Definition
beginning inventory + purchases = goods available for sale - ending inventory = cost of goods sold
Term
Outline the key points of a multi-step income statement
Definition
sales discounts and returns are contra accounts to sales revenue, these will be combined to create net value. Operating expenses need to be shown separately
Term
How is the income statement formatted?
Definition

net sales

- Cost of goods sold

gross profit

- operating expenses:

     selling expenses - related to selling and marketing the inventory

     general expense- office expenses

Operating income

+ other revenue and expense

net income

Term
Where are freight-in, purchase returns and allowances and purchase discounts recorded?
Definition
They are debited to Inventory
Term
How is Cost of Goods Sold recognized for each sale?
Definition
By debiting Cost of Goods Sold and crediting Inventory
Term
Purchases of merchandise for resale or raw materials for production are recorded how?
Definition
By debiting Inventory rather than purchases
Term
Inventory is a control account that is supported by a subsidiary ledger of individual inventory records. What do the subsidiary records show?
Definition
The quantity and cost of each type of inventory on hand.
Term
List each of the inventory costing methods.
Definition
Specific Unit Cost, FIFO, LIFO, Average Cost
Term
How does Specific Unit Cost work and when is it used?
Definition
assigns a specific invoice cost to each item in the inventory. Used for items that differ from unit to unit, such as real estate and automobiles but is seldom used in practice.
Term
Explain the Average Cost Method and it's pro's and con's
Definition
assigns an average cost to the units on hand and sold. Justified on practical rather than conceptual reasons. Simple to apply, objective, not subject to income manipulation. Particularly persuasive when the inventory involved is relatively homogeneous.
Term
Explain the moving average method.
Definition
assigns a new average unit cost each time a purchase is made.
Term
Explain FIFO.
Definition
Under the first-in, first-out cost method, the first goods purchased are the first used or sold. Inventory represents the most recent purchases. Oldest costs are assigned to cost of goods sold. Consistant with the physical flow of goods.
Term
What are the advantages of FIFO?
Definition
Ending inventory is close to current cost because it is composed of most recent purchases. Provides most reasonable approximation of replaement cost on the balance sheet when price changes have not occurred since the most recent purchases.
Term
What are the disadvantages of FIFO?
Definition
Current costs are not matched against current revenue on the income statement. Oldest costs are charged. Leads to a distortion in gross profit and net income.
Term
Explain LIFO.
Definition
Last-in, First-Out cost method, the most recent costs are assigned to cost of goods sold. Matches the cost of the last goods purchased against revenue. LIFO is favored by many companies because it often results in highest cost of goods sold and lowest income tax.
Term
What are the advantages of LIFO?
Definition
Actually approximates the phyisical flow of the goods in and out of the inventory. Matching - the most recent costs are matched against current revenues to provide a better picture of current earnings. The tax benefits - as long as price levels increase and inventory levels do not decrease, a deferral of income taxes occurs.
Term
What is the LIFO conformity rule?
Definition
Tax law requires a company to use LIFO for both tax and financial reporting.
Term
What is the future earnings hedge associated with LIFO?
Definition
future reported earnings are not affected by future price declines. Eliminates or reduces write-downs to market as a result of price decreases. Since most of the recent inventory is sold first, there isn't much ending inventory sitting around at high prices vulnurable to a price decline. Inventory costed under FIFO is more vulnerable to price declines, which can reduce net income substantially.
Term
What are the disadvantages of LIFO?
Definition
Reduced earnings - lower profits reported under LIFO in inflationary times for managers who would rather have higher reported profits than lower taxes. Misleading to investors and the stock might fall although non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street. Also leads to understated inventory creating a distorting effect on a company's balance sheet because the understatement of oldest costs remaining in inventory makes the working capital position the company appear worse than it really is.
Current costs income not measured. Involuntary liquidation - if the base layers of old costs are eliminated, old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result as well as consequences that are detrimental from an income tax point of view.
Term
Explain LIFO liquidation.
Definition
Results when there is a decline in inventory quantities meaning you sold more than you purchased. The older costs in the LIFO layer liquidation are matched with current sales dollars. This results in inflated or illusory profit margins.
Term
How is LIFO liquidation profit calculated?
Definition
(current cost - LIFO layer cost) x Quantity liquidated.
When LIFO liquidation profits are material, the SEC requires that its income effect be reported. Results in an unssustainable increase in the gross margin percentage.
Term
When does LIFO liquidation occur?
Definition
When current sales are higher than current purchases. The result is that any inventory not sold in previous periods is liquidated.
Term
What does a LIFO liquidation mean for taxes?
Definition
The expected tax advantage of LIFO is turned into a disadvantage because older, lower costs are matched with current revenues. The cost is a higher tax liability if prices have risen since LIFO was adopted. Another cost may be lost sales.
Term
Explain LIFO Reserve
Definition
The LIFO reserve is a mandated disclosure that shows the dollar magnitude of the difference between LIFO and FIFO inventory costs. By adding the reported LIFO reserve to the balance sheet LIFO inventory number, one can estimate FIFO inventory. The LIFO reserve disclosure also allows the analyst to convert reported LIFO cost of goods sold amount to FIFO amounts.
Term
What are the disadvantages of LIFO?
Definition
Poor buying habits - A company may purchase more goods and matche these goods against revenue to ensure that the old costs are not charged to expense. A company could attempt to manipulate net income at the end of the year by altering purchase patterns. Because of prices rising, LIFO has provided a tax advantage over FIFO.
Term
What are some internal controls for inventory?
Definition
Pre-numbered inventory tickets, counters have no inventory responsibility, counts confirm existence, amount and quality of inventory item, second count is taken, manager confirms all items counted.
Term
Explain how management can exploit the LIFO accounting structure to artificially inflate earnings.
Definition
By liquidating old LIFO layers. The older and presumably lower costs in the LIFO layers are matched against sales amounts that are stated at higher current prices resulting in an artifical rise in the profit margin.
Term
Which inventory method is used most in practice?
Definition
FIFO
Term
Explain the Consistancy Principle
Definition
A company should use the same accounting methods from period to period so that financial statments are comparable. Methods can be changed, but the change and the effect of the change must be disclosed.
Term
Explain Disclosure Principle.
Definition
Report enough information for outsiders to make wise decisions about the company. Info should be relevant, reliable and comparable. Methods must be disclosed.
Term
Explain the Materiality Concept.
Definition
The materiality concept states that a company must adhere to GAAP only for items and transactions that are significant to the business's financial statements. Information is significant or material when its presentation int he financial statments would cause someone to change a decision.
Term
Explain accounting conservatism.
Definition
Means reporting items in the financial statements at amounts that lead to the most cautious immediate results. The goal is not to overstate net income or assets, and not to understate liabilities.
Term
Define Lower-orCost-or-Market rule.
Definition
Example of accounting conservatism. Inventory is reported at whichever is lower. Historic cost or market value. If market is lowe than cost -- write inventory down by debiting cost of goods sold and crediting inventory
Term
What is the effect of inventory errors?
Definition
Ending inventory becomes next years beginning inventory and results in misstatement of income over two years.
Term
If ending inventory is overstated ...
Definition
so is net income and gross profit. Cost of Goods sold is understated.
Term
If ending inventory is understated ...
Definition
so is net income and gross profit. Cost of goods sold is overstated.
Term
When are the effects of inventory errors reversed?
Definition
In year two.
Term
How might companies try to mislead readers of financial statements by manipulating inventory?
Definition
Management increases inventory values and conceal shortages. Some have gone so far as to mix hundreds of empty boxes with boxes of real merchandise in roder to exaggerate their inventory.
Term
How can you spot inventory fraud?
Definition
A company committing inventory fraud will often not have sales increase as fast as its inventory even as inventory increases shopping costs are falling or remaining the same as the goods sold are not inline with companies filed tax returns.
Term
List a few symptoms of inventory fraud.
Definition
missing documents, second endorsements on checks, unexplained adjustments to inventory, customer complaints, unusual patterns in dopeosits in transit, employees who exceed the scope of their responsibilties, an unusual reduction in a regular customers business, open-ended contracts with suppliers
Term
explain the gross profit method.
Definition
Estimate ending inventory by applying the gross profit ratio to net sales. Useful when inventory has been destroyed, lost or stolen
Term
How do you compute gross profit?
Definition
sales - cost of goods sold
Term
How do you compute gross profit percent?
Definition
gross profit/net sales
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