Financial Accounting Final Exam Review: Comprehensive Study Notes

Inventory and Cost of Goods Sold

Inventory Valuation Methods

Inventory valuation is crucial for determining the cost of goods sold (COGS) and ending inventory. The main methods are:

• Specific Identification: Tracks the actual cost of each specific item sold and remaining in inventory. Used for unique, high-value items.

• Weighted Average: Calculates a new average cost per unit after each purchase. COGS and ending inventory are based on this average.

• FIFO (First-In, First-Out): Assumes the earliest goods purchased are the first to be sold. Ending inventory consists of the most recently purchased items.

• LIFO (Last-In, First-Out): Assumes the latest goods purchased are the first to be sold. Ending inventory consists of the oldest items.

Example Calculation (Weighted Average):

• Weighted Average Cost per Unit: $\frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}$

Application: The choice of inventory method affects gross profit, net income, and taxes.

The Accounting Information System

Journal Entries

Journal entries are the foundation of the accounting system, recording all business transactions in a double-entry format (debits and credits).

• Revenue Recognition: Record revenue when earned, not necessarily when cash is received.

• Expense Recognition (Matching Principle): Record expenses in the period they help generate revenue.

• Examples: Recording cash received, supplies purchased, equipment bought, insurance paid, and services performed.

Format:

Account Title and Description	Debit	Credit
Cash	10,000
Accounts Receivable	20,000
Service Revenue		30,000

Additional info: Journal entries must always balance (total debits = total credits).

The Financial Reporting Process

Preparation of Financial Statements

Financial statements summarize the financial performance and position of a company:

• Income Statement: Reports revenues and expenses to show net income for a period.

• Balance Sheet: Shows assets, liabilities, and equity at a specific date.

• Statement of Retained Earnings: Explains changes in retained earnings over the period.

• Closing Entries: Transfer balances from temporary accounts (revenues, expenses, dividends) to permanent accounts (retained earnings).

Cash and Internal Controls

Statement of Cash Flows

The statement of cash flows classifies cash transactions into three activities:

• Operating Activities: Cash flows from core business operations (e.g., paying employees, collecting from customers).

• Investing Activities: Cash flows from buying/selling long-term assets (e.g., equipment, investments).

• Financing Activities: Cash flows from borrowing, repaying debt, or issuing stock.

Example: Paying dividends is a financing activity; purchasing equipment is an investing activity.

Receivables and Sales

Bad Debts and Uncollectible Accounts

Companies must estimate and record bad debts to match expenses with revenues:

• Allowance Method: Estimates uncollectible accounts at period-end, creating an allowance for doubtful accounts.

• Direct Write-Off Method: Bad debts are recorded only when specific accounts are deemed uncollectible.

Aging Category	Amount	Estimated Uncollectible %
Not Yet Due	210,000	2%
1-30 Days Past Due	70,000	10%
Over 30 Days	20,000	35%

Calculation: Multiply each category by its percentage to estimate total uncollectible accounts.

Long-term Assets and Depreciation

Depreciation Methods

Depreciation allocates the cost of long-term assets over their useful lives:

• Straight-Line Method: Equal expense each year. $\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$

• Double-Declining Balance: Accelerated method. $\text{Depreciation Expense} = 2 \times \text{Straight-Line Rate} \times \text{Book Value at Beginning of Year}$

• Units of Production: Based on usage. $\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Units}} \times \text{Units Produced in Period}$

Example: A truck costing $75,000, 5-year life, $7,500 residual value, double-declining method.

Current and Long-term Liabilities

Understanding Liabilities

Liabilities are obligations to pay cash or provide services in the future. They are classified as:

• Current Liabilities: Due within one year (e.g., accounts payable, short-term loans).

• Long-term Liabilities: Due after one year (e.g., bonds payable, long-term loans).

Example Table: Current Liabilities

Account Title	Amount
Accounts Payable	50,000
Notes Payable	100,000
Accrued Expenses	20,000
Total Current Liabilities	170,000

Stockholders' Equity

Issuing Stock and Dividends

Stockholders' equity represents owners' claims on the business. Key transactions include:

• Issuing Common Stock: Increases cash and equity.

• Paying Dividends: Reduces retained earnings and cash.

Statement of Cash Flows

Classification of Cash Flows

Each cash transaction must be classified as operating, investing, or financing. For example:

• Borrowing money: Financing

• Paying employees: Operating

• Purchasing equipment: Investing

Financial Statement Analysis

Key Ratios and Their Interpretation

Financial ratios help assess a company's performance and financial health:

• Earnings Per Share (EPS): $\frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}$

• Return on Assets (ROA): $\frac{\text{Net Income}}{\text{Average Total Assets}}$

• Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$

• Asset Turnover: $\frac{\text{Net Sales}}{\text{Average Total Assets}}$

• Gross Profit Percentage: $\frac{\text{Gross Profit}}{\text{Net Sales}}$

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

Application: Ratios are used to compare performance over time or against industry benchmarks.

The Accounting Process

Steps in the Accounting Cycle

The accounting cycle consists of the following steps:

1. Analyze transactions

2. Journalize transactions

3. Post to ledger accounts

4. Prepare a trial balance

5. Make adjusting entries

6. Prepare adjusted trial balance

7. Prepare financial statements

8. Make closing entries

9. Prepare post-closing trial balance

Temporary vs. Permanent Accounts: Temporary accounts (revenues, expenses, dividends) are closed at period-end; permanent accounts (assets, liabilities, equity) carry balances forward.

Miscellaneous Key Concepts

• GAAP: Generally Accepted Accounting Principles, the standard framework for accounting in the U.S.

• Matching Principle: Expenses are matched with related revenues in the same period.

• Accrual vs. Cash Basis: Accrual recognizes revenues/expenses when earned/incurred; cash basis recognizes when cash is received/paid.

• Debit and Credit Accounts: Assets and expenses increase with debits; liabilities, equity, and revenues increase with credits.

Example Table: Debit vs. Credit Accounts

Account Type	Normal Balance
Assets	Debit
Liabilities	Credit
Equity	Credit
Revenue	Credit
Expenses	Debit

Additional info: These notes are structured to cover all major topics relevant to a college-level Financial Accounting course, as reflected in the provided exam review materials.