Financial Accounting Exam 2 Study Guide: Receivables, Inventory, Plant Assets, and Investments

Chapter 5: Receivables and Revenue Recognition

Revenue Recognition Criteria

Revenue is recognized when a company satisfies its performance obligation to a customer, typically when goods or services are transferred.

• Performance Obligation: A promise to deliver a good or service to a customer.

• Revenue Recognition: Occurs when control of the good or service passes to the customer.

• Example: If a company ships goods FOB shipping point, revenue is recognized when goods leave the seller's premises.

Shipping Terms

• FOB Shipping Point: Buyer takes ownership when goods leave the seller.

• FOB Destination: Buyer takes ownership when goods arrive at their location.

Sales Discounts, Returns, and Allowances

• Sales Discounts: Reductions in price for early payment (e.g., 2/10, n/30 means 2% discount if paid within 10 days).

• Sales Returns & Allowances: Reductions in revenue for returned goods or price adjustments.

• Net Revenue Calculation: $\text{Net Revenue} = \text{Gross Sales} - \text{Sales Discounts} - \text{Sales Returns and Allowances}$

• Example: If gross sales are $10,000, discounts are $200, and returns are $300, net revenue is $9,500.

Types of Receivables

• Trade Receivables: Amounts owed by customers from sales of goods/services.

• Non-Trade Receivables: Amounts owed from sources other than customers (e.g., interest receivable).

Accounting for Accounts Receivable

• Increase: Sales on account.

• Decrease: Collections, write-offs, sales returns, and discounts.

Allowance Method for Uncollectible Accounts

• Allowance for Doubtful Accounts: Contra-asset account used to estimate uncollectible receivables.

• Journal Entry: To record estimated uncollectibles: $\text{Bad Debt Expense} \quad \text{Dr.}\quad XXX$ $\text{Allowance for Doubtful Accounts} \quad \text{Cr.}\quad XXX$

Net Realizable Value (NRV) of Accounts Receivable

• Definition: The amount expected to be collected.

• Formula: $\text{NRV} = \text{Accounts Receivable} - \text{Allowance for Doubtful Accounts}$

Methods for Estimating Uncollectibles

• Percent-of-Sales Method: Bad debt expense is a percentage of credit sales.

• Aging-of-Receivables Method: Estimates uncollectibles based on the age of each receivable.

• Example: If $100,000$ in credit sales and 2% is estimated uncollectible, bad debt expense is $2,000$.

Writing Off Uncollectible Accounts

• Journal Entry: $\text{Allowance for Doubtful Accounts} \quad \text{Dr.}\quad XXX$ $\text{Accounts Receivable} \quad \text{Cr.}\quad XXX$

• Effect: No impact on NRV; both AR and Allowance decrease by the same amount.

Notes Receivable

• Interest Calculation: $\text{Interest} = \text{Principal} \times \text{Rate} \times \text{Time}$

• Maturity Value: $\text{Maturity Value} = \text{Principal} + \text{Interest}$

• Accruing Interest: At period-end, accrue interest earned but not yet received.

Quick (Acid-Test) Ratio and Days' Sales Outstanding

• Quick Ratio: $\text{Quick Ratio} = \frac{\text{Cash} + \text{Short-term Investments} + \text{Net Receivables}}{\text{Current Liabilities}}$

• Days' Sales Outstanding: $\text{DSO} = \frac{\text{Average Accounts Receivable}}{\text{Net Credit Sales}} \times 365$

• Interpretation: Lower DSO and higher Quick Ratio generally indicate better liquidity.

Pivot Tables in Excel for AR Analysis

• Purpose: Summarize and analyze collectability of accounts receivable by customer, age, or region.

• Benefit: Helps identify trends and overdue accounts efficiently.

Chapter 6: Inventory and Cost of Goods Sold

Inventory Cost

• Includes: Purchase price, freight-in, taxes, and any costs to prepare inventory for sale.

Special Inventory Arrangements

• Consignment: Goods held for sale by one party (consignee) but owned by another (consignor).

Cost of Goods Sold (CoGS)

• Definition: Expense representing the cost of inventory sold during the period.

• Reported on: Income Statement.

• Account Type: Expense.

Perpetual Inventory System

• Characteristics: Inventory records updated continuously with each purchase and sale.

Periodic Inventory System (CoGS Calculation)

• Formula: $\text{CoGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

Inventory Costing Methods

• FIFO (First-In, First-Out): Oldest inventory costs assigned to CoGS first.

• LIFO (Last-In, First-Out): Newest inventory costs assigned to CoGS first.

• Average Cost: Weighted average cost per unit assigned to CoGS and ending inventory.

Effect of Costing Methods

• Net Income & Ending Inventory: In periods of rising prices, FIFO yields higher net income and ending inventory; LIFO yields lower net income and ending inventory.

Lower-of-Cost-or-Market (LCM) Rule

• Purpose: Inventory reported at the lower of its historical cost or market value.

Gross Profit and Gross Profit Percent

• Gross Profit: $\text{Gross Profit} = \text{Net Sales} - \text{CoGS}$

• Gross Profit Percent: $\text{Gross Profit Percent} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100$

• Interpretation: Higher gross profit percent indicates better profitability.

Inventory Turnover

• Formula: $\text{Inventory Turnover} = \frac{\text{CoGS}}{\text{Average Inventory}}$

• Interpretation: Higher turnover means inventory is sold more quickly.

Chapter 7: Plant Assets, Natural Resources, and Intangibles

Capitalizing Costs

• To Capitalize: Record a cost as an asset rather than an expense.

• Criteria: Costs that provide future economic benefit are capitalized.

Characteristics of Plant Assets

• Long-lived, tangible assets used in operations (e.g., land, buildings, equipment).

Costs to Capitalize for Plant Assets

• Land: Purchase price, closing costs, clearing, grading, demolition.

• Land Improvements: Fencing, paving, lighting (depreciable).

• Building: Purchase/construction cost, permits, architect fees.

• Equipment: Purchase price, shipping, installation, testing.

Lump-Sum (Basket) Purchases

• Definition: Purchase of multiple assets for one price; allocate cost based on relative fair values.

Capital Expenditure vs. Immediate Expense

• Capital Expenditure: Increases asset's value or extends useful life; capitalized.

• Immediate Expense: Maintains asset's current condition; expensed immediately.

Depreciation

• Definition: Systematic allocation of asset's cost over its useful life.

• Required Information: Cost, estimated useful life, residual value.

Accumulated Depreciation

• Contra-asset account showing total depreciation taken to date.

Depreciation Methods

• Straight-Line: $\text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$

• Units-of-Production: $\text{Depreciation per Unit} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Units}}$

• Double-Declining Balance (First Year): $\text{Depreciation} = \text{Book Value at Beginning of Year} \times \frac{2}{\text{Useful Life}}$

• Difference: Double-declining is an accelerated method; more depreciation in early years.

Book Value

• Formula: $\text{Book Value} = \text{Cost} - \text{Accumulated Depreciation}$

Sale of Plant Assets

• Journal Entry: Remove asset and accumulated depreciation; record cash received and gain/loss.

• Gain/Loss: $\text{Gain or Loss} = \text{Cash Received} - \text{Book Value}$

Intangible Assets

• Characteristics: Non-physical assets (e.g., patents, copyrights, trademarks).

• Amortization: Systematic allocation of cost over useful life (similar to depreciation).

Goodwill

• Definition: Excess of purchase price over fair value of net assets acquired in a business combination.

• Amortization: Not amortized; tested for impairment.

Impairment

• Definition: Permanent decline in value of an asset; asset written down to fair value.

Return on Assets (ROA)

• Formula: $\text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}$

• Interpretation: Higher ROA indicates more efficient use of assets.

Excel Functions for Depreciation

• SLN: Calculates straight-line depreciation.

• DDB: Calculates double-declining balance depreciation.

• SYD: Calculates sum-of-years-digits depreciation.

ESG and Plant Assets

• ESG Issues: Environmental, social, and governance factors may affect asset valuation, useful life, and impairment decisions.

Appendix E: Investments

Original Reporting Basis for Investments

• All investments are initially recorded at cost on the date of purchase.

Subsequent Reporting Basis for Investments

• Depends on type of investment and level of influence or control.

Accounting for Stock (Equity) Investments

Type	Ownership %	Term	Accounting Method	Valuation	Income Statement Effect	Unrealized Gain/Loss
Insignificant Influence	Less than 20%	Short-Term	Fair Value	Fair Value	Dividend Revenue	Reported in Income Statement
Significant Influence	20% - 50%	Long-Term	Equity Method	Adjusted Cost	% of Investee's Income	None
Controlling Influence	More than 50%	Long-Term	Consolidation	Consolidated Statements	N/A	N/A

• Fair Value Method: For insignificant influence, investments adjusted to fair value at period-end; unrealized gains/losses recognized in income.

• Equity Method: For significant influence, investment adjusted for share of investee's income and dividends; not at fair value.

• Consolidation: For controlling influence, combine all assets, liabilities, income, and expenses of parent and subsidiary.

Accounting for Debt Securities (Held-to-Maturity)

• Valuation: Amortized cost (cost plus/minus amortized premium or discount).

• Income Statement: Interest revenue recognized.

• Unrealized Gains/Losses: Not recognized for held-to-maturity securities.