Accounting exam 2

Chapter 5
Net revenues (net sales)- a companys total revenue
minus any amounts for discounts, returns, and
allowances.
o Total sales sales discounts- sales returnsallowances= net revenues
Sales return- if a customer returns a product
o Full refund
Sales allowances- seller reduces the customers
balance owed partially
o Customer does not return the product
Sales discounts, returns, and allowances are all contra
revenue accounts. (offsets assets)
Sales discount- represents a reduction of the amount
to be paid by a credit customer if payment is made
within a certain time.
o Discount terms: 2/10, n/30 (customer will
receive a 2% discount if paid in 10 days, if not paid
in 10 days the full amount is due within 30 days.
Current asset- receives cash within 1 year.
Long-term- not within 1 year
Net realizable value- amount of money the firm
expects to collect
Uncollectible accounts (bad debts)- customers
accounts that we no longer consider collectible.
o Account for uncollectible accounts by using the
allowance method.
Under the method, companies are required to
estimate future uncollectible accounts and
record them in the current year.
Operating expense
Decreases net income

 Percentage of receivables method (balance sheet

method)- based on percentage of receivables
expected not to be collected
Bad debt expense- uncollectible accounts expense or
provision for doubtful accounts
Allowance for uncollectible accounts- contra asset
account representing the amount of accounts
receivable that we do not expect to collect.
Writing off accounts receivable
o Has no effect on the total amounts reported in the
balance sheet or in the income statement
o The negative effects were already recorded in the
previous year
o Collecting cash on a previously written off account
has no effect on total assets or net income
Direct write off method- records bad debt expense
when uncollectible account is known
o Used:
When uncollectible accounts are not
anticipated or are immaterial
When its not possible to reliably estimate
uncollectible accounts
For tax purposes only
Notes receivable
o Similar to accounts receivable but more formal
o Classified as either current or noncurrent asset
o Typically arise from loans
Interest calculation
o Interest = face value x annual interest rate x
fraction of the year
o Example: 10,000 6 month, 12 % promissory note:
10,000 x 12% x 6/12 = 600
Collection of notes receivable
o Debit cash
o Credit notes receivable & interest revenue
Receivables turnover ratio

o Number of times the average accounts receivable

balance is collected
o Net credit sales/ average accounts receivable =
turnover ratio
o A higher ratio is more favorable.
o Higher ratios mean that companies are collecting
their receivables more frequently throughout the
year
The average collection period
o Number of days the average accounts receivable
balance is outstanding
o 365 days/ receivables turnover ratio= avg
collection period
o A lower ratio is more favorable
o Lower rations indicate that a company is turning
their receivables into cash more quickly.

Chapter 6
Inventory
o Current asset
o Includes good and materials a company holds w/
intention of selling the goods to third parties
o Also includes not finished products
o Company reports the cost of the inventory it sold
as cost of goods sold.
o Represents the inventory not sold
Merchandising companies
o Purchase inventories that are primarily I finished
form for resale
o Wholesaler, retailer
Manufacturing companies
o Manufacture the inventories they sell
o Classify inputs in 3 categories
Raw material
Work in progress
Finished goods
Costs of goods sold

o An expense
o Inventory thats been sold
Multiple-step income statement
o Reports multiple levels of income
o Separates revenue and expenses into investors &
creditors
Gross profit- inventory transactions (net
sales - cost of goods sold)
Operating expenses (operating income)gross profit these expenses (rent,
insurance, etc.)
Combining operating income with
nonoperating revenues and expenses yields
income before taxes.
Subtract income tax expense to find net
income
Inventory cost methods
1. Specific identification
Matches each unit of inventory w/ its actual
cost
Usually used by businesses that have low unit
volume of merchandise w/ high prices
2. FIRST-IN, FIRST-OUT (FIFO)
Assume that the first items purchased are the
first items sold
Balance sheet focus
Ending inventory reflects todays costs
3. LAST-IN, FIRST-OUT (LIFO)
Assume that the last units purchased are the
first ones sold
Income statement focus
Cost of goods sold reflects todays costs
Companies that choose LIFO must report the
difference if it used FIFO instead of LIFO
4. Weighted-average cost
Assume that both cost of goods sold and
ending inventory consist of random mixture
of all the goods available for sale

Weighted-average unit cost= cost of goods

available for sale/ number of units available
for sale.
Perpetual inventory system
o Maintains a record track of inventory transactions
on a continual/ daily basis
o Helps company better manage inventory levels
Periodic inventory system
o Calculates the balance of inventory once per
period, at the end, based on physical count of
inventory
o Not continual
LIFO adjustment
o Used to convert a companys own inventory
records maintained on a FIFO basis to LIFO basis
for preparing financial statements
Additional inventory transactions
o Freight charges
Includes cost of shipment from suppliers, as
well as cost of shipment to customers
FOB shipping point- record purchase when
supplier leaves the warehouse
FOB destination-record purchase when
inventory arrives
Freight-out
The cost of freight on shipments to
customers
Freight-in: charges on incoming shipments
from suppliers
Add the cost of freight-in to balance of
inventory
When the inventory is sold-the freight
charges become part of the cost of
goods sold.
o Purchase discounts
Ex. 2/10 n/30
o Purchase returns

Sometimes inventory is damaged

In this case, the company returns the items
to the supplier and records the purchase
return as a reduction in both inventory and
accounts payable
Lower-of-cost-or-market (LCM)
o When the market value of inventory falls below its
original cost, companies are required to report
inventory at the lower market value
o Market value of inventory is called replacement
cost
Inventory turnover ratio
o Shows the number of times the firm sells its
average inventory balance during a reporting
period
o Cost of goods sold/ average inventory
o Higher ratio- means company is more effective
Average days in inventory
o Indicates the approximate number of days the
average inventory is held
o 365/inventory turnover ratio
Gross profit ratio
o Indicator of the companys successful
management of inventory
o Measures the amount by which the sale price of
inventory exceeds its cost per dollar of sales
o Gross profit/net sales

Chapter 7
Long term assets:
o Tangible assets- land, land improvements,
o

buildings, equipment, natural resources

Intangible assets- patents, trademarks,
copyrights, franchises, goodwill

Tangible assets

 Property, plant, equipment

o Long term asset (tangible)
o Record asset at its cost + all expenditures
necessary to get it ready for use
o Capitalize- recording an expenditure as an asset
Land and land improvements
o Land- includes land used for operations
o Costs include: title search, unpaid real estate
taxes, clearing land, ECT.
Land improvements
o Parking lots, sidewalks, fences, etc.
o Depreciate land improvements but not land
Equipment
o Cost of machinery + all other costs necessary to
prepare the asset for use (sales tax, shipping,
assemply)
o Recurring costs are not included as cost of
equiptment
Basket purchases
o Purchase of more than one asset for one purchase
price
o Allocate total purchase price based on individual
fair values
Natural resources
o Oil, salt, gas, timber
o Physically use up or deplete
o Depletion- allocation of the cost of a natural
resource over its service life

Intangible assets
-No physical substance

-Acquired in 2 ways: purchase & create internally

-Record purchased assets at their cost + all other
costs necessary to get them ready for use
-Expense the costs for internally developed intangible
assets.

 Patent
o Exclusive right to manufacture a product or to use
a process
o 20 years
o When purchased
Capitalized for purchase price plus legal and
filing fees
o When internally developed
Capitalized for legal and filing fees
Copyright
o Exclusive right of protection given to the creator of
a published work
o Life of creator + 70 years
o Identical to patents when recording
Trademarks
o Word, slogan, or symbol
o Renewed for indefinite number of 10 year periods
o Capitalized for legal, registration, and design fees
o Advertising costs are recorded as advertising
expense
Franchises
o Local outlets that pay for exclusive right to use the
franchisors name and sell its products
W/ in specified geographical area
o Capitalize for initial fee
o Additional periodic payments usually expensed
Goodwill
o Represents value of a company as a whole, over &
above the value of its identifiable net assets
o Record: purchase price- fair value of the net assets
acquired
Expenditures after acquisition
o Repairs and maintenance
o Additions
o Improvements
o Capitalize if it increases future benefits
o Expense if it benefits only current period

 Materiality
o Item said to be material if it is large enough to
influence a decision
Depreciation
o The process of allocating to an expense the cost of
an asset over its service life
Accumulated depreciation
o Contra asset account
Book value
o Original cost of asset current balance in
accumulated depreciation
Residual value
o Salvage value or amount company expects to
receive from selling the asset at the end of its
service life
Straight-line method
o Takes equal amount of depreciation each year
o Depreciation expense = assets cost-residual
value/service life
Declining-balance method
Activity-based depreciation
o Depreciation rate per unit= depreciable cost/total
units expected to be produced
o Multiply depreciation rate by amount of units used
that year to get depreciation expense
Tax depreciation
o Accelerated methods reduce taxable income more
in the earlier years of an assets life
Companies use straight line method for
financial reporting
Accelerated method for income tax
Amortization of intangible assets
o Allocating the cost of intangible assets to an
expense
o Intangible assets with finite useful life: patents,
copyrights, trademarks, franchises
Intangible assets not subject to amortization

o Those w/ indefinite useful life: goodwill,

trademarks
3 methods of asset disposal
1. Sale
Most common
Can result in gain (if sold for more than book
value) or loss (if sold for less)
2. Retirement
When a long-term asset is no longer useful
but cannot be sold
3. Exchange
When two companies trade assets
Return on assets
o Indicates the amount of net income generated for
each dollar invested in assets
o Net income/average total assets= return on assets
Profit margin and asset turnover
o Profit margin indicates the earnings per dollar of
sales
Net income / net sales
o Asset turnover measures the sales per dollar of
assets invested
Net sales/ average total assets
Asset impairment
o Impairment- occurs when the future cash flows
(future benefits) generated for a long-term asset
fall below its book value
o Impairment loss = assets book value- fair value

Chapter 8
Current liabilities
o Liability: a present responsibility to sacrifice
assets in the future due to a transaction or other
event that happened in the past
o Liabilities represent future sacrifices
Current liabilities
o Payable w/in one year or an operating cycle

o Some companies take longer than a year to

perform the activities that produce revenue, we
call the time it takes to produce revenue the
operating cycle
o Examples of common ones: notes payable,
accounts payable, payroll liabilities
Long-term liabilities
o Payable more than one year or an operating cycle
Notes payable
o Note signed by firm promising to repay the
amount borrowed (bank loan) plus interest
o Interest = face value x annual interest rate x
fraction of the year
Accounts payable
o Amounts the companies owe to suppliers of
merchandise or services
o Sometimes called trade accounts payable
Line of credit
o Informal agreement
o Permits a company to borrow up to a prearranged
limit
o No formal loan procedures and paperwork
Commercial paper
o Company borrows from another company rather
than from a bank
o Sold w/ maturities normally ranging from 30 to 270
days
o Interest rate is usually lower than on a bank loan
Payroll liabilities
o Employee costs
Federal and state income taxes
FICA taxes (7.65 %)
Social security (6.2%) and Medicare
taxes (1.45%)
Employees may opt to have additional
amounts withheld from their paychecks

Employer records the amounts deducted and

pays them to the appropriate organizations
Employer costs
o Must pay same amount if FICA tax as employee
o Employers also pay federal and state
unemployment taxes on behalf o its employees
o FUTA (federal unemployment tax) & SUTA (state
unemployment tax)
o Fringe benefits: additional employee benefits
paid for by the employer
Unearned revenue
o Current liability account used to record cash
received in advance of the sale or service
o Credit this when cash is received
o Debit when service is actually given
Sales tax payable
o Collected from customers by the seller
o Sales tax payable= total cash paid- (total cash
paid/ 1+sales tax rate)
Current portion of long-term debt
o Debt that will be paid w/in the next year
o Provides information about a companys
bankruptcy risk
Contingent liabilities
o The existence and amount depend on uncertain
events
o An example is a lawsuit against the company
o If the company wins, no payment made
o If the company loses, payment is made
o Contingent liabilities are recorded if payment is
probable and the amount is known or
reasonably estimated.
o Contingent liabilities are disclosed if the payment
is reasonably possible.
o Contingent liabilities are not disclosed if
payment is remote.

 Warranties
o Most common example of contingent liabilities
o Helps increase sales
o Warrant expense is recorded in the same
accounting period as the sale
o It should be probable and the amount can be
reasonably estimated
Contingent gains
o An existing uncertain situation that might result in
gain
o Not recorded until the gain is certain
o Conservative reasoning
o Firms sometimes disclose them in notes to the
financial statements
Liquidity analysis
o Liquidity- refers to having sufficient cash or other
current assets to pay currently maturing debts
o Lack of liquidity can result in financial difficulties
or even bankruptcy
o 3 liquidity measures:
1. Working capital
A large positive working capital is an indicator
of liquidity
Not the best measure of liquidity when
comparing it with another company bc of
relative size

 Working capital = current assets

current liabilities
2. Current ratio
Ratio of 1 or higher often reflects an
acceptable level of liquidity (more current
assets than current liabilities)
Higher the current raio- greater the
companys liquidity
Ex. if ratio is 1.5 it means for every dollar of
current liabilities, the company has 1.50 of
current asset
Current ratio = current assets/ current
liabilities
3. Acid- test ratio or quick ratio
Based on a more conservative measure
Quick assets are readily convertible into cash
Quick assets include only: cash, current
investments, and A/R
Acid-test ratio= (cash + current inv. +
Accounts rec.) / (current liabilities)