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

Receivables and Revenue Recognition

Revenue Recognition Criteria

Revenue is recognized when the performance obligation is satisfied, typically when goods or services are delivered to the customer.

• Key Point: Revenue is earned when the customer obtains control (e.g., shipment is made, not when cash is received).

• Example: FOB Shipping Point – sales are recognized when goods are shipped.

Sales Discounts, Returns, and Allowances

Sales discounts, returns, and allowances are contra-revenue accounts that reduce total sales to arrive at net sales.

• Sales Discounts: Discounts offered to customers for early payment (e.g., 2/10, net 30 terms).

• Sales Returns & Allowances: Reductions in sales due to returned goods or allowances for defective goods.

• Example: If a customer returns goods, the sales revenue is reduced and a sales returns account is credited.

Net Sales Calculation

Net sales is calculated by subtracting sales discounts, returns, and allowances from gross sales.

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

Accounts Receivable and Bad Debts

Trade Receivables

Trade receivables arise from sales of goods or services on credit.

• Accounts Receivable: Amounts owed by customers for credit sales.

• Notes Receivable: Written promises to pay a specified amount at a future date.

Allowance for Uncollectible Accounts

The allowance method estimates uncollectible accounts and matches bad debt expense to the period of sale.

• Net Realizable Value (NRV): The amount expected to be collected from accounts receivable.

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

• Example: If $10,000$ is owed and $500$is estimated uncollectible, NRV is $9,500$.

Estimating Bad Debts

Bad debts can be estimated using the percentage of sales method or the aging of receivables method.

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

• Aging of Receivables Method: Estimates uncollectible accounts based on the age of receivables.

• Formula: $\text{Bad Debt Expense} = \text{Estimated %} \times \text{Credit Sales}$

Write-Offs and Recovery

When an account is deemed uncollectible, it is written off against the allowance account. If later collected, the account is reinstated and cash is received.

• Journal Entry for Write-Off: Debit Allowance for Uncollectible Accounts, Credit Accounts Receivable.

• Recovery: Reverse the write-off, then record the cash collection.

Interest on Notes Receivable

Interest revenue is recognized on notes receivable over time.

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

• Maturity Value: The sum of principal and interest earned.

Receivables Turnover and Days Sales Outstanding

These ratios measure the efficiency of receivables collection.

• Receivables Turnover: $\text{Receivables Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

• Days Sales Outstanding: $\text{DSO} = \frac{365}{\text{Receivables Turnover}}$

• Interpretation: Lower DSO indicates faster collection.

Inventory Accounting

Inventory Cost and Valuation

Inventory is valued at cost, including purchase price, freight, and other costs necessary to bring inventory to saleable condition.

• Inventory Cost: Includes purchase price, freight-in, and discounts.

• Consignment Inventory: Inventory held by another party but owned by the consignor.

Inventory Systems

There are two main inventory systems: perpetual and periodic.

• Perpetual System: Inventory records are updated continuously.

• Periodic System: Inventory records are updated at the end of the period.

Cost of Goods Sold (COGS)

COGS represents the cost of inventory sold during the period and is reported on the income statement.

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

Inventory Cost Flow Assumptions

Methods for assigning costs to inventory and COGS include FIFO, LIFO, and weighted average.

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

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

• Weighted Average: Average cost per unit is assigned to COGS.

• Example: In periods of rising prices, FIFO results in lower COGS and higher net income; LIFO results in higher COGS and lower net income.

Gross Profit and Gross Profit Percent

Gross profit measures the profitability of sales after deducting COGS.

• Formula: $\text{Gross Profit} = \text{Sales} - \text{COGS}$

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

Depreciation and Plant Assets

Capitalization of Plant Assets

Plant assets are capitalized at cost, including all expenditures necessary to acquire and prepare the asset for use.

• Capitalized Cost: Purchase price plus installation, delivery, and testing costs.

• Example: Equipment purchase price plus shipping and installation.

Depreciation Methods

Depreciation allocates the cost of plant assets over their useful lives.

• Straight-Line Method: Equal expense each year.

• Units-of-Production Method: Expense based on usage.

• Formula (Straight-Line): $\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$

Book Value and Accumulated Depreciation

Book value is the asset's cost minus accumulated depreciation.

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

Disposal of Plant Assets

When an asset is sold or disposed, the difference between proceeds and book value is recognized as a gain or loss.

• Journal Entry: Remove asset and accumulated depreciation, record cash received, and recognize gain or loss.

Intangible Assets and Amortization

Intangible Assets

Intangible assets lack physical substance and include patents, copyrights, trademarks, and goodwill.

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

• Example: Patent amortized over its legal life.

Goodwill

Goodwill is recorded only when a business is purchased for more than the fair value of its net assets.

• Impairment: Goodwill is tested for impairment, not amortized.

Investments and Reporting

Investments in Debt and Equity Securities

Investments are recorded at cost on the date of purchase. Subsequent reporting depends on the type of security.

• Trading Securities: Reported at fair value, with unrealized gains/losses in net income.

• Available-for-Sale Securities: Reported at fair value, with unrealized gains/losses in other comprehensive income.

• Held-to-Maturity Securities: Reported at amortized cost.

Bond Investments

When purchasing a bond, record the investment at cost. Know the journal entry for bond purchase.

• Example: Debit Investment in Bonds, Credit Cash.

Summary Table: Key Financial Accounting Concepts

Concept	Definition	Key Formula
Net Sales	Sales after deducting returns, allowances, and discounts	$\text{Net Sales} = \text{Gross Sales} - \text{Returns} - \text{Allowances} - \text{Discounts}$
Net Realizable Value (NRV)	Expected cash collection from receivables	$\text{NRV} = \text{Accounts Receivable} - \text{Allowance for Uncollectible Accounts}$
COGS	Cost of inventory sold during the period	$\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$
Gross Profit Percent	Profitability ratio for sales	$\text{Gross Profit Percent} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100$
Depreciation Expense (SL)	Annual expense for asset use (straight-line)	$\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$
Receivables Turnover	Efficiency of receivables collection	$\text{Receivables Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

Additional info: Academic context and formulas have been expanded for clarity and completeness. Examples and definitions have been added to ensure the notes are self-contained and suitable for exam preparation.