Chapter 7 Part A: Cash and Cash Equivalents

I. What Is Included? (T7-1) A. Cash includes currency and coins, balances in checking accounts, and items acceptable in these accounts, such as checks and money orders received from customers. B. Cash equivalents include such items as money market funds, treasury bills, and commercial paper. C. Companies typically classify investments with maturity dates of three months or less when purchased as cash equivalents. The company's policy must be described in a disclosure note. II. Internal Control of Cash (T7-2) A. Internal control refers to a company's plan to (a) encourage adherence to company policies and procedures, (b) promote operational efficiency, (c) minimize errors and theft, and (d) enhance the reliability and accuracy of accounting data. Section 404 of the Sarbanes-Oxley Act requires a company to document and assess its internal controls. The companys auditors must provide an opinion on managements assessment. The Public Company Accounting Oversight Boards Auditing Standard No. 2 further requires the auditor to express its own opinion on whether the company has maintained effective internal control over financial reporting C. A critical aspect of an internal control system is the separation of duties. D. In the cash receipt process, the employee who opens the mail should not also deposit the checks nor be involved in recordkeeping. E. In the cash disbursement process, responsibilities for check signing, check writing, check mailing, cash disbursement documentation, and recordkeeping should be separated whenever possible. III. Restricted Cash and Compensating Balances A. Only cash available for current operations or to pay current liabilities should be classified as a current asset. B. Restrictions on cash can be informal, arising from management intent or might be contractually imposed. 1. Cash that is restricted and not available for current use usually is reported as investments and funds or other assets. 2. An example of a contractual restriction on cash is a lender-imposed compensating balance requirement.

B.

Part B: Current Receivables

I. Initial Valuation of Accounts Receivable A. Receivables resulting from the sale of goods or services on account are called accounts receivable.

B. Accounts receivable are current assets because, by definition, they will be converted to cash within the normal operating cycle. C. The typical account receivable is valued at the amount expected to be received, called the net realizable value. D. A trade discount reduces the actual price to a customer and is recognized indirectly by recording the sale at the net of discount price. E. Cash discounts reduce the amount to be paid if remittance is made within a specified short period of time. (T7-3) 1. Using the gross method, we record the receivable and sales revenue at the gross, before discount price. Discounts taken are recorded as sales discounts (reductions to gross sales revenue). 2. Using the net method, we record the receivable and sales revenue at the net of discount price. Discounts not taken are recorded as interest revenue. 3. The effect on the financial statements of the difference between the two methods usually is not material. II. Subsequent Valuation of Accounts Receivable A. Possible returns and customer nonpayment could cause subsequent accounts receivable to be less than initial valuation. B. If sales returns are material, they should be estimated and recorded in the same period as the related sale. (T7-4) C. If bad debts are material, the allowance method should be used. The method estimates future bad debts and matches that expense with the related sales revenue. 1. There are two approaches to estimating bad debts, the income statement approach and the balance sheet approach. (T7-5) a. With the income statement approach, bad debt expense is a percentage of the period's net credit sales. The amount recorded ignores any prior balance in the allowance account. b. With the balance sheet approach, the net realizable value of receivables is determined, often using an aging schedule. Bad debt expense is equal to the required adjustment to the allowance account to bring net receivables to realizable value. 2. With either approach, accounts receivable is reduced to net realizable value indirectly by an adjusting entry in which bad debt expense is debited and an allowance account is credited. 3. Actual bad debt write-offs reduce both accounts receivable and the allowance account. (T7-6) 4. When previously written-off accounts are collected, the receivable and the allowance are reinstated and the cash collection is recorded as usual. D. Direct write-off method 1. This is a method not generally permitted by GAAP. 2. Bad debt expense is simply the actual bad debt write-offs during the period. III. Measuring and Reporting Accounts ReceivableA Summary (T7-7) IV. Notes Receivable

A. Notes receivable are formal credit arrangements between a creditor (lender) and a debtor (borrower). B. The typical note receivable requires the payment of a specified face amount, also called principal, at a specified maturity date, along with interest at a specified percentage of the face amount. (T7-8) C. Sometimes a receivable assumes the form of a so-called noninterest-bearing note. 1. Noninterest-bearing notes actually do bear interest, but the interest is deducted at the onset (or discounted) from the face amount to determine the cash proceeds made available to the borrower. (T7-9) 2. When interest is discounted from the face amount of a note, the effective interest rate is higher than the stated discount rate. D. Similar to accounts receivable, if a company anticipates bad debts on shortterm notes receivable, it uses an allowance account to reduce the receivable to net realizable value. V. Financing with Receivables A. Financial institutions have developed a wide variety of methods that allow companies to use their receivables to obtain immediate cash. B. These methods can be described as either: 1. A secured borrowing. 2. A sale of receivables. C. If the transferor surrenders control over the assets transferred, the arrangement is accounted for as a sale; otherwise, it is accounted for as a borrowing. D. An assignment involves the pledging of specific accounts receivable as collateral for a loan. (T7-10) E. The pledging of accounts receivable involves the assigning of accounts receivable in general rather than specific receivables. No specific accounting treatment is needed other than the disclosure of the pledging arrangement. F. Two popular arrangements used for the sale of accounts receivable are factoring and securitization. The sale of accounts receivable can be made without recourse or with recourse. 1. The buyer assumes the risk of uncollectibility when accounts receivable are sold without recourse, and the transfer is accounted for as a sale. The typical factoring arrangement is made without recourse. (T7-11) 2. The seller retains the risk of uncollectibility when accounts receivable are sold with recourse. If certain criteria are met, factoring with recourse is accounted for as a sale; otherwise, its accounted for as a borrowing. (T712)

G. The

transfer of a note receivable to a financial institution is called discounting. (T7-13) H. Financing with Receivables A Summary (T7-14) Decision Makers Perspective

A. A company's investment in receivables is influenced by several variables, including the level of sales, the nature of the product or service sold, and credit and collection policies. B. Management's choice of credit and collection policies often involves trade-offs. Management must evaluate the costs and benefits of any change in credit and collection policies. C. The ability to use receivables as a method of financing also offers management alternatives. D. Investors and creditors can gain insights by monitoring a company's investment in receivables. (T7-15) 1. The receivables turnover ratio is calculated by dividing net sales by the average accounts receivable. 2. The average collection period is calculated by dividing 365 days by the receivables turnover ratio. E. Bad debt expense is one of a variety of discretionary accruals that provide management with the opportunity to manipulate income.

Appendix 7: Cash Controls

A. One of the most important tools used in the control of cash is the bank reconciliation. B. Differences between the book and bank balances for cash occur due to (1) differences in the timing of recognition of certain transactions, and (2) errors. (T7-16) C. Step one in a bank reconciliation adjusts the bank balance to the corrected cash balance. In addition to bank errors, adjustments include: 1. Checks outstanding. 2. Deposits outstanding. D. Step two adjusts the book balance to the corrected cash balance. 1. In addition to company errors, these adjustments typically include service charges, charges for NSF checks, and collections made by the bank on the company's behalf. 2. Each of these adjustments requires a journal entry to correct the book balance. (T7-17) E. Companies often keep a small amount of cash on hand to pay for low cost items such as postage, office supplies, delivery charges, and entertainment expenses. A petty cash fund provides an efficient way to handle these payments. F. The petty cash fund always should have a combination of cash and receipts that together equal the amount of the fund. G. The fund is established by writing a check to the custodian, and the appropriate expense accounts are debited when the petty cash fund is reimbursed. (T7-18)

Chapter 8

Part A: Recording and Measuring Inventory

I. Types of Inventory A. Inventory for a wholesale or retail company consists of goods purchased in finished form for resale. Inventory for a manufacturing company includes raw materials, work in process, and finished goods. (T8-1) B. For a manufacturing company, the costs of raw materials, direct labor, and manufacturing overhead flow into work in process, then to finished goods when the manufacturing process is completed, and finally to cost of goods sold when goods are sold. (T8-2)

II. Perpetual Inventory System (T8-3) A. A perpetual inventory system continuously tracks both changes in inventory quantity and inventory cost. B. Inventory is debited when merchandise is purchased or returned by a customer, and credited when merchandise is sold or returned to a supplier. C. An important control feature of a perpetual system is that it is designed to track inventory quantities from their acquisition to their sale. III. Periodic Inventory System (T8-4) A. A periodic inventory system adjusts inventory and records cost of goods sold only at the end of each reporting period. B. Merchandise purchases, purchase returns, purchase discounts, and freight-in are recorded in temporary accounts. C. Purchases plus freight-in less returns and discounts equals net purchases. D. The period's cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account:
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold

IV. A Comparison of the Perpetual and Periodic Inventory Systems A. The impact on the financial statements of choosing one system over the other generally is not significant. B. The perpetual system provides more timely information but is more costly to implement. C. The periodic inventory system is less costly to implement during the period but usually requires a physical count before ending inventory and cost of goods sold can be determined. V. What Is Included in Inventory? A. Generally, physical quantities included in inventory consist of items in the possession of the company. (T8-5) 1. For goods in transit, ownership depends on whether the merchandise is shipped f.o.b. shipping point, or f.o.b. destination. 2. Goods held on consignment are included in the inventory of the consignor until sold by the consignee.

3. A company includes in inventory the cost of merchandise it anticipates will be returned. B. Expenditures necessary to bring inventory to its condition and location for sale (or use for raw materials) are included in inventory cost. (T8-6) 1. Shipping charges on outgoing goods are related to the selling activity and are reported as a selling expense when incurred, not as part of inventory cost. 2. Freight-in paid by the purchaser is included in inventory cost. 3. Purchase returns represent reductions in net purchases. 4. Purchase discounts represent reductions in the amount to be paid if remittance is made within a designated period of time. The purchaser can record purchase discounts using either the gross method or the net method (T8-7) C. Comprehensive example comparing perpetual and periodic systems. (T8-8)

VI. Inventory Cost Flow Assumptions A. Regardless of the system used, it's necessary to assign dollar amounts to physical quantities of goods sold and goods remaining in ending inventory. (T8-9) 1. The specific identification method matches each unit sold or each unit on hand at the end of the period with its actual cost. The method is not feasible for most inventories. 2. Most companies use cost flow assumptions to determine cost of goods sold and ending inventory. (T8-10) a. The average cost method assumes that items sold and items in ending inventory come from a mixture of all the goods available for sale. (T8-11) b. The first-in, first-out (FIFO) method assumes that items sold are those that were acquired first. Ending inventory consists of the most recently acquired items. (T8-12) c. The last-in, first-out (LIFO) method assumes that items sold are those that were most recently acquired. Ending inventory consists of the items acquired first. (T8-13) B. The financial statement effect of using the different methods depends on the direction of any change in the unit cost of goods. (T8-14) C. There are a number of factors that motivate company management to choose one method over another. 1. A company is not required to choose an inventory method that approximates actual physical flow. 2. Many companies choose LIFO to reduce income taxes in periods when prices are rising. a. The IRS LIFO conformity rule requires that if a company uses LIFO to measure its taxable income, LIFO also must be used to measure income reported to investors and creditors. b. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures that report in a note the effect of using another method on inventory valuation rather than LIFO. (T8-15) 3. Proponents of LIFO argue that it results in a better match of revenues and expenses. a. However, the use of LIFO could result in an unrealistic ending inventory balance. b. A decline in inventory quantity results in LIFO liquidation profit in periods of rising costs. (T8-16)

Decision Makers PerspectiveFinancial Analysis A. A company should maintain sufficient inventory quantities to meet customer demand while at the same time minimizing inventory ordering and carrying costs. B. Analysts should make adjustments when evaluating companies that use different inventory methods. Supplemental LIFO disclosures can be used to convert LIFO inventory and cost of goods sold amounts. (T8-17) C. Two important ratios used by analysts in assessing profitability are: (T8-18) 1. The gross profit or gross margin ratio, computed by dividing gross profit (sales less cost of goods sold) by net sales, indicates the percentage of each sales dollar available to cover other expenses and provide a profit. 2. The inventory turnover ratio, computed by dividing cost of goods sold by average inventory, is designed to evaluate a company's effectiveness in managing its investment in inventory.

Part B: Methods of Simplifying LIFO

I. LIFO Inventory Pools A. Unit LIFO can be costly to implement and can lead to LIFO liquidations. B. The objectives of using LIFO inventory pools is to (1) simplify recordkeeping by grouping inventory units into pools based on physical similarities and (2) to reduce the risk of LIFO layer liquidation. C. The average cost for all of the pool purchases during the period is applied to the current year's LIFO layer.

II. Dollar-Value LIFO A. The dollar-value LIFO (DVL) method extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Most LIFO applications are based on this approach. (T8-19) B. Inventory is viewed as a quantity of value instead of a physical quantity of goods. Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years. C. A DVL pool is made up of items that are likely to face the same price change pressures, not items with physical similarities. D. Under DVL, we determine whether a new LIFO layer was added by comparing the ending dollar amount with the beginning dollar amount after deflating inventory amounts to base year with the aid of a cost index. (T8-20) E. The starting point in DVL is determining the current year's ending inventory valued at year-end costs. The DVL estimation technique then employs three steps: (T8-21) 1. Step 1 converts ending inventory valued at year-end cost to base year cost. 2. Step 2 identifies the layers of ending inventory and the years they were created. 3. Step 3 converts each layer's base year cost to layer year cost using the cost index for the year it was acquired.

Chapter 9
Part A: ReportingLower of Cost or Market
I. Determining Market Value (T9-1) A. Inventories are reported at the lower of cost or market (LCM). B. The LCM approach to valuing inventory recognizes losses in the period when the value of inventory declines below cost. C. Market value for LCM purposes is the inventory's current replacement cost (RC) except that market should: 1. Not exceed the net realizable value (that is, estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal). 2. Not be less than net realizable value (NRV) reduced by an allowance for an approximately normal profit margin D. NRV provides a ceiling and NRV less a normal profit margin (NRV-NP) a floor between which market must fall. This means that the designated market value is the number that falls in the middle of the three possibilities: RC, NRV, and NRV-NP. E. Replacement cost usually is a good indicator of the direction of change in selling price. The upper and lower limits placed on replacement cost prevent certain types of profit distortion.

II. Applying Lower of Cost or Market A. The LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. (T9-2) B. Applying LCM to groups of inventory items usually will cause a higher inventory valuation than if applied item-by-item because group application permits decreases in the market value of some items to be offset by increases in others. C. Each approach is acceptable but should be applied consistently from one period to another. III. Adjusting Cost to Market A. The preferable way to report a loss from an inventory write-down is as a separate item in the income statement. B. A less desirable approach is to include the loss in cost of goods sold.

Part B: Inventory Estimation Techniques

I. The Gross Profit Method (T9-3) A. The gross profit method is useful in situations where estimates of inventory are desirable:

1. In determining the cost of inventory that has been lost, stolen, or destroyed. 2. In estimating inventory and cost of goods sold for interim periods. 3. In auditors' testing of the overall reasonableness of inventory amounts reported by clients. 4. In budgeting and forecasting. B. The gross profit method provides only an approximation of inventory and is not acceptable for the presentation of annual financial statements. C. The technique estimates cost of goods sold by multiplying net sales for the period by a historical gross profit percentage and then subtracting this amount from net sales. (T9-4) D. An estimate of ending inventory is then obtained by subtracting estimated cost of goods sold from cost of goods available for sale. II. The Retail Inventory Method (T9-5) A. The retail inventory method estimation technique is similar to the gross profit method in that it relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold, thus avoiding the necessity to take a physical count of inventory. B. The retail inventory method tends to provide more accurate estimates than the gross profit method because it's based on the current cost-to-retail percentage (the reciprocal of the gross profit ratio) rather than a historical gross profit ratio. C. The technique requires a company to maintain records of inventory and purchases not only at cost but also at current selling price (retail). D. In its simplest form, the retail inventory method estimates the amount of ending inventory (at retail) by subtracting sales (at retail) from goods available for sale (at retail). This estimated ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage. This ratio is found by dividing goods available for sale at cost by goods available for sale at retail. (T9-6) E. The retail inventory method can be used for financial reporting and for income tax purposes. F. Changes in selling prices must be included in the determination of ending inventory at retail. Net markups and net markdowns are included in the retail column to determine ending inventory at retail. (T9-7) G. An advantage of the retail inventory method is that the various cost flow assumptions (in particular average cost and LIFO) can be explicitly incorporated into the estimation technique. We can even incorporate an approximation of the lower of cost or market. (T9-8) 1. To approximate average cost, the cost-to-retail percentage is determined for all goods available for sale. Net markups and net markdowns both are included in the retail column before the cost-to-retail percentage is determined. (T9-9) 2. The most commonly used variation of the retail method often is referred to as the conventional retail method. This variation approximates average

LCM by excluding markdowns from the calculation of the cost-to-retail percentage. (T9-10) a. By not subtracting net markdowns from the denominator, the cost-toretail percentage is lower. b. The logic for using this approximation is that a markdown is evidence of a reduction in the utility of inventory. c. The LCM variation also could be applied to the FIFO method but is not generally used in combination with LIFO. 3. To approximate LIFO cost in its simplest form, we assume that the retail prices of goods remained stable during the period. With this assumption, we can compare beginning and ending inventory at retail to determine what happened to inventory quantity. (T9-11) a. If inventory at retail increases during the year, a new layer is added. b. If inventory at retail decreases, LIFO layer(s) are liquidated. c. Each period's LIFO layer will carry its own cost-to-retail percentage. Therefore, beginning inventory is not included in the calculation of the current year's cost-to-retail percentage. H. Other issues pertaining to the retail method 1. Freight-in is added only to the cost side in determining net purchases. 2. Purchase returns are deduced from purchases on both the cost and retail side (at different amounts). 3. If the gross method is used to record purchases, purchase discounts taken is deducted in determining the cost of net purchases. 4. If sales are recorded net of employee discounts, the discounts are added to sales. 5. Normal shortage is deducted in the retail column after the calculation of the cost-to-retail percentage. Abnormal shortage is deducted in both the cost and retail columns before the calculation of the cost-to-retail percentage.

Part C: Dollar-Value LIFO Retail

A. Using the LIFO retail method in combination with dollar-value LIFO (DVL) is referred to as the dollar-value LIFO retail method. B. DVL retail improves on LIFO retail by first determining if there has been a real increase in inventory quantity by eliminating any price changes before comparing beginning and ending inventory at retail. C. After determining year-end inventory at current retail prices, DVL retail employs a three-step approach. (T9-12)

1. In step 1, the ending inventory at current retail prices is converted to base year retail by dividing by the current year's price index (relative to the base year). 2. In step 2, ending inventory at base year retail is then apportioned into layers, each at base year retail. 3. In step 3, each layer is then converted to layer year cost using the layer year's price index and cost-to-retail percentage.

Part D: Change in Inventory Method and Inventory Errors

I. Change in Accounting Principle A. Changes in inventory method, other than a change to LIFO, are accounted for retrospectively. This means reporting all previous periods financial statements as if the new inventory method had been used in all prior periods. (T9-13) 1. The first step is to revise prior years financial statements. 2. The second step is to create a journal entry to adjust book balances from their current amounts to what those balances would have been using the new inventory method. 3. In addition, a disclosure note describes the change and justification for the change. The note also would indicate the effects of the change on items not reported on the face of the primary statements, as well as any per share amounts affected for the current period and all prior periods presented. B. For changes to the LIFO method, accounting records usually are inadequate for a company to calculate the income effect on prior years. (T9-14) 1. The LIFO method is used from that point on. 2. A disclosure note explains the nature of the change and justification for it, the effect of the change on current year's income and earnings per share, and why retrospective application was impracticable.

II. Inventory Errors A. If an inventory error is discovered in the same accounting period that it occurred, the original erroneous entry should simply be reversed and the appropriate entry recorded. B. If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, any previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. (T9-15) 1. Incorrect balances are corrected. 2. A correction of retained earnings is reported as a prior period adjustment. 3. A disclosure note describes the nature and the impact of the error on income amounts.

Appendix 9: Purchase Commitments (T9-16)

A. Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates.

B. Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. C. If the contract period is contained within a single fiscal year: 1. If market price is equal to or greater than the contract price, the purchase is recorded at the contract price. 2. If market price is less than the contract price, the purchase is recorded at the market price. D. If the contract period extends beyond the fiscal year: 1. If the market price at year-end is less than the contract price for outstanding purchase commitments, a loss and corresponding liability are recorded for the difference. 2. If market price on purchase date has not declined from year-end price, the purchase is recorded at the year-end market price. 3. If market price on purchase date declines from year-end price, the purchase is recorded at the market price.