Principles of Accounting: Exam #3 Study Guide (Chapters 5–7)

Chapter 5: Merchandising Operations

Purchase of Merchandise Inventory

This section covers the accounting for purchasing inventory, including returns, allowances, discounts, and freight costs.

• Journal Entry for Merchandise Returns or Allowances (Buyer’s Perspective): When merchandise is returned or an allowance is granted, the buyer reduces the Merchandise Inventory account and records the return or allowance.

• Calculating Cash Payment with Credit Terms: Credit terms (e.g., 2/10, n/30) specify the discount available and the payment period. To determine the cash payment, subtract any applicable discounts from the invoice price.

• Net Cost of Inventory Purchased: The net cost includes the purchase price, plus freight-in, minus returns, allowances, and discounts.

Example: A company purchases inventory for $5,000, with terms 2/10, n/30, and pays $200 freight-in. If $500 is returned and payment is made within the discount period:

• Gross purchase: $5,000

• Less returns: $500

• Net purchases: $4,500

• Less 2% discount: $90

• Plus freight-in: $200

• Net cost: $4,610

Sale of Merchandise Inventory

Sales of inventory require compound journal entries to record both the revenue and the cost of goods sold.

• Journal Entry for Merchandise Sales: Record the sale (debit Cash or Accounts Receivable, credit Sales Revenue) and the cost (debit Cost of Goods Sold, credit Merchandise Inventory).

• Journal Entry for Merchandise Returns (Seller’s Perspective): Reverse the revenue and cost entries for the returned goods.

• Sales Discounts: When a customer pays within the discount period, record the cash received and the sales discount taken.

• Gross Profit Calculation: Gross Profit = Net Sales Revenue – Cost of Goods Sold.

Example: Sold goods for $2,000 (cost $1,200), customer pays within discount period (2%):

• Net sales revenue: $2,000 – $40 (discount) = $1,960

• Gross profit: $1,960 – $1,200 = $760

Credit Terms, Freight Costs, and Shrinkage

• Credit Terms: Indicate the timing and amount of discounts (e.g., 2/10, n/30 means 2% discount if paid within 10 days, net due in 30 days).

• Freight Costs:

  • FOB Shipping Point: Buyer pays freight-in (debit Merchandise Inventory).

  • FOB Destination: Seller pays freight-out (debit Delivery Expense or Freight-Out).

• Inventory Shrinkage: Shrinkage is the loss of inventory due to theft, damage, or errors. Calculate by comparing physical count to book balance. Record with a journal entry debiting Cost of Goods Sold and crediting Merchandise Inventory.

Chapter 6: Merchandise Inventory

Key Accounting Principles

• Materiality Concept: Only information that would influence a decision needs to be disclosed.

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

• Conservatism: When in doubt, report lower assets or income and higher liabilities or expenses.

• Disclosure Principle: All relevant information must be disclosed in the financial statements.

Inventory Costing Methods

• Weighted Average Cost per Unit:

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

• Cost of Goods Sold (Weighted Average): Multiply units sold by weighted average cost per unit.

• FIFO Method: First-In, First-Out assumes earliest goods purchased are sold first. Calculate CoGS using the cost of the oldest inventory layers.

Example: Beginning inventory: 10 units @ $5; Purchase: 20 units @ $6. Sold: 15 units.

• FIFO CoGS: 10 x $5 + 5 x $6 = $80

• Weighted Average Cost per Unit: $(10 x 5 + 20 x 6)/30 = $5.67$

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

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

• If market value drops below cost, write down inventory to market value.

Inventory Errors and Financial Statement Effects

• If ending inventory is overstated: CoGS is understated, Gross Profit is overstated.

• If ending inventory is understated: CoGS is overstated, Gross Profit is understated.

Chapter 7: Internal Control and Cash

Bank Reconciliation

• Bank-side Adjustments: Items known to the company but not yet recorded by the bank (e.g., deposits in transit, outstanding checks).

• Book-side Adjustments: Items known to the bank but not yet recorded by the company (e.g., bank fees, NSF checks, interest earned).

• Adjusted Cash Balance: After all adjustments, the bank and book balances should agree.

• Journal Entries: Only book-side adjustments require journal entries.

Petty Cash

• Definition: A small fund used for minor expenditures where writing a check is impractical.

• Purpose: To facilitate small, routine payments.

• Cash Over/Short: If the petty cash replenishment does not match receipts, record the difference in the Cash Short & Over account.

• Debit or Credit: Cash Short & Over is debited for shortages and credited for overages.

Chapter 8: Receivables

Allowance for Bad Debts

• Nature: A contra-asset account that estimates uncollectible accounts receivable.

• Percent-of-Sales Method: Bad Debts Expense is estimated as a percentage of credit sales.

• Adjusting Entry:

  • Debit Bad Debts Expense, Credit Allowance for Bad Debts.

• Write-off Entry: Debit Allowance for Bad Debts, Credit Accounts Receivable.

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

Aging of Receivables Method

• Classify accounts by age, estimate uncollectible amounts for each category, sum to get target Allowance for Bad Debts balance.

• Bad Debts Expense = Target Allowance – Current Allowance balance.

Accounts Receivable, Net

• Formula: $\text{Accounts Receivable, Net} = \text{Accounts Receivable} - \text{Allowance for Bad Debts}$

Notes Receivable

• Maturity Date: Add the term (in days) to the issue date to find the maturity date.

• Interest Revenue:

  • Formula: $\text{Interest} = \text{Principal} \times \text{Rate} \times \frac{\text{Time (in days)}}{360}$

• Collection at Maturity: Debit Cash, Credit Notes Receivable and Interest Revenue (or Interest Receivable if accrued across periods).

Exam Preparation Tips

• Review textbook chapters and lecture notes thoroughly.

• Memorize key journal entries and formulas.

• Practice with homework problems and sample multiple-choice questions.

• Understand definitions, applications, and effects of errors on financial statements.