Accounting for Service and Merchandising Companies

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Questions and Answers

What method does Lee Company use to manage its accounts receivable?

Aging of accounts receivable method

Allowance method (correct)

Direct write-off method

Percentage of sales method

When recording the acceptance of a note receivable, what is the initial journal entry made by Danica Company?

Debit Accounts Receivable and Credit Notes Payable

Debit Notes Receivable and Credit Accounts Receivable (correct)

Debit Cash and Credit Notes Receivable

Debit Notes Payable and Credit Cash

Which of the following could be considered a potential issue with the direct write-off method?

It requires a detailed analysis of accounts receivable.

It may overstate accounts receivable during the period. (correct)

It accurately matches bad debts with the associated sales.

It results in a less accurate representation of profit in the financial statements. (correct)

What impact does the adjustment for accrued interest have on financial statements?

Increases assets and affects net income positively Signup and view all the answers

What is an appropriate journal entry to record bad debts expense at year-end for Lee Company?

Debit Bad Debts Expense and Credit Allowance for Doubtful Accounts Signup and view all the answers

What is the formula for the Acid Test Ratio?

Quick Assets / Current Liabilities Signup and view all the answers

What is deemed the minimum acceptable value for the Acid Test Ratio to avoid liquidity problems?

1.0 Signup and view all the answers

Which of the following methods is NOT used to assign costs to inventory?

Patent Method Signup and view all the answers

Which of the following statements about Gross Margin Ratio is correct?

It shows the percentage of sales available to cover expenses. Signup and view all the answers

In determining inventory, which item is NOT considered when assessing goods in transit?

Out for delivery to the end customer Signup and view all the answers

What method uses the cost of the most recently purchased inventory for cost of goods sold?

LIFO Signup and view all the answers

Which financial statement format separates operating revenues and expenses from non-operating revenues and expenses?

Multiple-step income statement Signup and view all the answers

What is the primary impact of merchandise shrinkage on a merchandising company's financial statements?

Reduces inventory value Signup and view all the answers

In the context of inventory accounting, what does LCM stand for?

Lower of Cost or Market Signup and view all the answers

When a merchandising company returns defective merchandise, what is the effect on inventory?

Increase in inventory value Signup and view all the answers

Which of the following is considered a key ratio for assessing merchandise inventory management?

Gross margin ratio Signup and view all the answers

What occurs if a business overstates its ending inventory?

Cost of goods sold is understated Signup and view all the answers

If Dollar Store uses the perpetual inventory system, which is true regarding the transaction of selling merchandise?

Inventory is reduced at the time of sale. Signup and view all the answers

What is the correct formula for calculating net income for a merchandiser?

Net sales - Cost of goods sold - expenses Signup and view all the answers

In the operating cycle for a merchandiser, what is the starting point?

Purchase of merchandise Signup and view all the answers

If a company sells 13 bikes for $5 each, what is the cost of goods sold (COGS) if the total value is used?

$65 Signup and view all the answers

What happens when payment for inventory is made after the cash discount period?

The company pays the full amount Signup and view all the answers

Which of the following is NOT included in itemized costs of purchases?

Inventory theft Signup and view all the answers

What is the ending inventory if a merchandiser starts with 25 units and sells 13 units?

12 units Signup and view all the answers

Which of the following statements accurately describes perpetual inventory systems?

They continuously update inventory records after each transaction Signup and view all the answers

What does gross profit represent in the income calculation for a merchandiser?

Net sales minus cost of goods sold Signup and view all the answers

What method is primarily used to estimate bad debts based on revenue?

Percent of Sales Method Signup and view all the answers

Which equation represents the Percent of Receivables Method for calculating Bad Debts Expense?

Bad Debts Expense = AR * Bad Debt % Signup and view all the answers

In the Aging of Receivables Method, what is adjusted when there is a debit balance in the allowance account?

Bad Debts Expense Signup and view all the answers

Which method requires a detailed review of accounts before estimating bad debts?

Aging of Accounts Receivable Method Signup and view all the answers

What primarily affects the Accounts Receivable Turnover ratio?

Sales and collections efficiency Signup and view all the answers

When a note is dishonored, what is typically recorded?

An increase in Accounts Receivable Signup and view all the answers

What is the primary objective of estimating Bad Debts Expense?

To provide an accurate view of net accounts receivable Signup and view all the answers

What is an important factor in computing interest on Notes Receivable?

The length of the repayment period Signup and view all the answers

Study Notes

Reporting Income for a Service Company

Service companies sell a service to earn revenue
Service companies do not have inventory
Service companies have only one cost of goods sold: expenses

Reporting Income for a Merchandiser

Merchandising companies sell products to earn revenue
Examples of a merchandiser: clothing, shoes, sporting goods
Net sales - cost of goods sold = gross profit - expenses = net income
Example: Nordstrom sells $1000 worth of shoes, the cost to buy the shoes from Nike is $200, so gross profit is $800, then subtract $100 in wage expenses for a net income of $700

Operating Cycle for a Merchandiser

Begins with the purchase of merchandise and ends with the collection of cash for the sale of merchandise

Inventory Systems

Perpetual system keeps a running count of inventory
Periodic system counts up inventory at the end of the period

Perpetual Inventory Systems

Tracks the cost of each purchase and sale of inventory
Information is readily available for determining the amount of inventory on hand at any time
Purchases
- Debits inventory when purchasing goods
- Credits cash or accounts payable based on method of payment
Sales
- Debits cash or accounts receivable
- Credits sales revenue
- Debits cost of goods sold and credits inventory for the amount the goods are sold

Transactions for Merchandise Purchases

Purchases without Cash Discounts:: When inventory is bought
Purchases with Cash Discounts:: Discount is offered for paying within a specified period

Purchases with Cash Discounts: Gross Method

Cash discount is recorded when payment is made
Example: Inventory cost $1000, cash discount is 2/10, n/30
- Paid within 10 days:
  - Debit Inventory - $20
  - Credit Cash - $980
- Paid after 10 days:
  - Debit Inventory - $0
  - Credit Cash - $1000

Payment within Discount Period: Journal Entry

Debit inventory for the amount of the discount
Credit cash for the net purchase price

Payment after Discount Period

No discount is recorded
Debit Inventory for the full cost of the goods
Credit cash for the full purchase price

Allowances

Seller allows a customer to return goods or may reduce the price for damaged goods
Purchase Allowances:
- Debit Accounts Payable or Cash
- Credit Inventory
Sales Allowances:
- Debit Sales Returns and Allowances
- Credit Accounts Receivable or Cash

Shipping Terms

FOB Shipping Point: Buyer pays for the transportation costs
- Example: If you buy a car from a dealership in California and are picking it up in New York, the shipping costs from California to New York are your responsibility
FOB Destination: Seller pays for the transportation costs
- Example: If you order a rug online, the seller is most likely going to pay for the cost of having the rug shipped to your home

Itemized Costs of Purchases

Inventory is debited for everything that increases the cost of inventory
Inventory is credited for everything that decreases the cost of inventory
Example of costs that are added to inventory:
- Freight (freight paid by the buyer)
Example of costs that are subtracted from inventory:
- Purchase returns
- Purchase allowances

Acid-Test Ratio

A measure of a company's ability to pay its current liabilities with its most liquid assets
Formula: Quick Assets (Cash + Short-Term Investments + Receivables) / Current Liabilities
A value of at least 1.0 indicates that a company should be able to pay its current liabilities

Gross Margin Ratio

Measures the percentage of sales available to cover expenses and provide a profit
Formula: Net Sales - Cost of Goods Sold / Net Sales
Example: A gross margin ratio of 40% means that 40% of sales are available to cover expenses and provide a profit

Determining Inventory Items

Merchandise Inventory: Goods held for sale
Raw Materials Inventory: Goods used in the manufacturing process
Goods in Process Inventory: Goods that are partially completed in the manufacturing process
Finished Goods Inventory: Goods that are completed and waiting to be sold

Goods in Transit

Goods that are being shipped from the seller to the buyer
FOB shipping point:
- Goods are owned by the buyer once shipped
FOB destination:
- Goods are owned by the seller until they reach the buyer

Goods on Consignment

Goods that are held by a consignee for sale
The consignor owns the goods and the consignee sells the goods for them
The consignee does not take ownership of the goods but they receive a commission for their sale

Goods Damaged or Obsolete

These items are not included in inventory because they are considered to have no value or minimal value
Any value they do have will be classified as a loss

Determining Inventory Costs

Specific Identification Method:
- This method is used when it is easy to identify the goods that were sold
**FIFO (First-In, First-Out): **
- This method assumes that the oldest inventory is the first to be sold
**LIFO (Last-In, First-Out): **
- This method assumes that the newest inventory is the first to be sold
Weighted-Average Method:
- This method uses a weighted average to calculate the cost of goods sold

Taking a Physical Count

Inventory is physically counted to verify the quantity and quality of goods on hand
This is done periodically based on the company's needs

Inventory Costing Methods: Perpetual System

Specific Identification Method:
- This method is used when it is easy to identify the goods that were sold
**FIFO (First-In, First-Out): **
- This method assumes that the oldest inventory is the first to be sold
**LIFO (Last-In, First-Out): **
- This method assumes that the newest inventory is the first to be sold
Weighted-Average Method:
- This method uses a weighted average to calculate the cost of goods sold
- This method is a compromise between FIFO and LIFO

Lower of Cost or Market (LCM)

The market value of inventory is compared to its cost
The lower of the two values is used for inventory valuation and cost of goods sold
This ensures that inventory is not overvalued and protects the company from potential losses

Effects of Inventory Methods for Financial and Tax Reporting

FIFO:
- This method results in the highest net income and the highest ending inventory balance during periods of rising prices
LIFO:
- This method results in the lowest net income and the lowest ending inventory balance during periods of rising prices
Weighted-Average:
- This method results in a net income and ending inventory balance that is between FIFO and LIFO

Effects of Inventory Error on Financial Statements

An error in inventory can have a significant impact on the financial statements
Examples of errors:
- Incorrect counts of inventory
- Incorrect costing methods
- Overstating or understating inventory

Inventory Turnover and Days' Sales in Inventory Ratios

These ratios measure how efficiently a company is managing its inventory
Inventory Turnover Ratio:
- measures how quickly a company is selling its inventory
- Formula: Cost of Goods Sold / Average Inventory
Days' Sales in Inventory:
- measures the average number of days that inventory is held before it is sold
- Formula: (Average Inventory / Cost of Goods Sold) * 365

Accounts Receivables

Cash balances owed by customers
Direct Write-Off Method:
- Records the amount of bad debts when it is determined that a customer will not pay
- This method is not allowed under GAAP because it does not match the expense to revenue
Allowance Method:
- Estimates the amount of bad debts that is expected to be uncollectible
- This is a more common method than the direct write-off method because it matches the expense to revenue

Allowance Methods

Percentage of Sales Method:
- Estimates bad debts as a percentage of sales
- This method is easier to use but less accurate than the other methods
Percentage of Receivables Method:
- Estimates bad debts as a percentage of accounts receivable
- This method is more accurate than the percentage of sales method but more complex
Aging of Receivables Method:
- Estimates bad debts by aging the accounts receivable to determine how long they have been outstanding
- This method is the most accurate method but also the most complex method

Aging of Accounts Receivable

This method groups accounts receivable by the date of the transaction
The older the account, the less likely it is to be collected

Notes Receivables

A written promise to pay a specific sum of money on a specified date
They usually bear interest
Honoring a note: When the maker pays the Note at maturity
Dishonoring a note: When the maker fails to pay the Note at maturity

Recording Notes Receivable

When a company accepts a Note, a journal entry is made to record the Note Receivable
Debit Notes Receivable for the face value of the Note
Credit Accounts Receivable for the amount of the accounts receivable that is being converted into a Note

Notes Receivable in Acceptance of Past-Due Accounts Receivable

This is used when a customer is unable to pay an account receivable and a Note is given to the company in exchange
Debit Notes Receivable and Credit Accounts Receivable in a journal entry

Honoring and Dishonoring of a Note and Adjustments for Interest

A journal entry is made to remove the Note when it is paid at maturity
To record an honored note:
- Debit Cash for the amount of the note and the interest for the note
- Credit Notes Receivable for the face value of the note
- Credit Interest Revenue for the amount of interest earned
To record a dishonored note:
- Debit Accounts Receivable for the amount of the note and the interest earned
- Credit Notes Receivable for the face value of the note
- Credit Interest Revenue for the amount of interest earned

Recording End-of-Period Interest Adjustments

Under the accrual basis of accounting, interest earned on Notes Receivable is recognized in the accounting period in which it is earned
To record accrued interest:
- Debit Interest Receivable and Credit Interest Revenue
- Interest Receivable represents the interest that has been earned but not yet received

Disposal of Receivables

Factoring: Selling accounts receivable to a finance company
Assigning: Transferring accounts receivable to a bank, but the original company remains responsible for the account

Accounts Receivable Turnover

Measures how quickly a company is collecting its accounts receivable
Formula: Net Sales / Average Accounts Receivable
A higher turnover rate of accounts receivable is generally better than a low turnover rate
Higher accounts receivable turnover generally represents:
- A faster collection process
- Better management of credit and collections
Lower accounts receivable turnover generally represents:
- Slower cash collection process
- Poor management of credit and collections

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Description

This quiz covers the key concepts of reporting income for service and merchandising companies. It explores their differences, income calculation methods, operating cycles, and inventory systems. Test your understanding of these essential accounting principles.