Unit 3 & 4 Reviewer PDF

**UNIT 3.1 ESTIMATION OF DOUBTFUL ACCOUNTS** **Methods of estimating doubtful accounts** 1. 2. 3\. Percent of sales or \"income statement approach" **Aging of accounts receivable** The aging of accounts receivable involves an analysis where the accounts are classified into not due or past du...

**UNIT 3.1 ESTIMATION OF DOUBTFUL ACCOUNTS** **Methods of estimating doubtful accounts** 1. 2. 3\. Percent of sales or \"income statement approach" **Aging of accounts receivable** The aging of accounts receivable involves an analysis where the accounts are classified into not due or past due. a\. Not due b\. 1 to 30 days past due c.31 to 60 days past due d\. 61 to 90 days past due e\. 91 to 120 days past due f\. 121 to 180 days past due g\. 181 to 365 days past due h\. More than 1 year past due The allowance is then determined by multiplying the total of each classification by the rate or percent of loss experienced by the entity for each category. The major argument for the use of this method is the more accurate and scientific computation of the allowance for doubtful accounts. This method has the advantage of presenting fairly the accounts receivable in the statement of financial position at net realizable value. The objection to the aging method is that it violates the matching process. Moreover, this method could become prohibitively time consuming if a large number of accounts are involved **Percent of Accounts Receivable** A certain rate is multiplied by the open accounts at the end of the period in order to get the required allowance balance. The rate used is usually determined from past experience of the entity. This procedure has the advantage of presenting the accounts receivable at estimated net realizable value. The approach is also simple to apply. However, the application of this approach violates the principle of matching bad debt loss against the sales revenue. Moreover, the loss experience rate may be difficult to obtain and may not be reliable.  **Percent of sales** The amount of sales for the year is multiplied by a certain rate to get the doubtful accounts expense. The rate may be applied on credit sales or total sales. Theoretically, the rate to be used is computed by dividing the bad debt losses in prior years by the charge sales of prior years. The rate thus obtained is multiplied by the current year\'s charge sales to arrive at the doubtful accounts expense. Practically, however, there is no substantial difference if in the computation of the rate, the basis is total sales of the prior periods. In such a case, the rate thus obtained is multiplied by the current year\'s total sales to get the doubtful accounts expense. This procedure of determining the rate has the advantage of eliminating the extra work of making a record of cash sales and credit sales. However, this approach may prove unsatisfactory when there is a considerable fluctuation in the proportion of cash and credit sales periodically. **Argument for percent of sales method** When the "percent of sales" method is used in computing doubtful accounts, proper matching of cost against revenue is achieved. This is so because the bad debt loss is directly related to sales and reported in the year of sale. Thus, this method is an income statement approach because it favors the income statement. **Argument against percent of sales method** The main argument against this method is that the accounts receivable may not be shown at estimated realizable value because the allowance for doubtful accounts may prove excessive or inadequate. Thus, it becomes necessary that from time to time the accounts should be \"aged\" to ascertain the probable loss. As a consequence, the rate applied on sales should be revised accordingly. **UNIT 4. INVENTORIES** **INVENTORIES** "INVENTORIES are assets held for sale in the ordinary course of business, in the process of production for such sale or in the form of materials or supplies to be consumed in the production process or in the rendering of services." **CLASSES OF INVENTORIES** 1. TRADING CONCERN -- one that buys and sells goods in the same form purchased. The term use is "MERCHANDISE INVENTORY". 2. MANUFACTURING CONCERN -- one that buys goods which are altered or converted into another form before they are made available for sale. a\. Finished Goods b\. Goods in Process c\. Raw Materials d\. Factory or Manufacturing Supplies - **Finished Goods** -- completed products which are ready for sale. - **Goods in Process** -- work in process are partially completed products which are require further process or work before they can be sold. - **Raw Materials** -- goods that are to be used in production process. "Direct Materials" - **Factory or Manufacturing Supplies** -- similar to raw materials but their relationship to end product is indirect. "Indirect Materials" **GOODS INCLUDIBLE IN THE INVENTORY** As a rule, all goods to which the entity has title shall be included in the inventory, regardless of location. The phrase \"passing of title\" is a legal language which means \"the point of time at which ownership changes.\" **LEGAL TEST** **Is the entity the owner of the goods to be inventoried?** If the answer is in the [affirmative,] the goods shall *be included in the inventory*. If the answer is in the [negative,] the goods shall be *excluded from the inventor*y. Applying the legal test, the following items are included in inventory: a\. Goods owned and on hand b\. Goods in transit and sold FOB destination c\. Goods in transit and purchased FOB shipping point d\. Goods out on consignment to consignee e\. Goods in the hands of salesmen or agents f\. Goods held by customers on approval or on trial **EXCEPTION TO THE LEGAL TEST** Installment contracts may provide for retention of title by the seller until the selling price is fully collected. Following the legal test, the goods sold on installment basis are still the property of the seller and therefore normally includible in his inventory. However, in such a case, it is an accepted accounting procedure to record the installment sale as a regular sale on the part of the seller and as a regular purchase on the part of the buyer. Thus, the goods sold on installment are included in the inventory of the buyer and excluded from that of the seller, the legal test to the contrary notwithstanding. This is a clear example of economic substance prevailing over legal form. **WHO IS THE OWNER OF GOODS IN TRANSIT?** **FOB destination** - ownership of goods purchased is transferred only upon receipt of the goods by the buyer at the point of destination. \- the goods in transit are still the property of the seller. \- the seller shall legally be responsible for freight charges and other expenses up to the point of destination. **FOB shipping point** -- ownership is transferred upon shipment of the goods and therefore, the goods in transit are the property of the buyer. \- the buyer shall legally be responsible for freight charges and other expenses from the point of shipment to the point of destination. **FREIGHT TERMS** **Freight collect** - freight charge on the goods shipped is not yet paid. The common carrier shall collect the same from the buyer. Thus, the freight charge is actually paid by the buyer if the term is freight collect. **Freight prepaid** - freight charge on the goods shipped is already paid by the seller. **\"FOB destination\" and \"FOB shipping point"** - determine ownership of the goods in transit and the party who is supposed to pay the freight charge and other expenses from the point of shipment to the point of destination. **\"freight collect\"** and **\"freight prepaid\" -** determine the party who actually paid the freight charge but not the party who is supposed to legally pay the freight charge. **MARITIME SHIPPING TERMS** **FAS or free alongside** - A seller who ships FAS must bear all expenses and risk involved in delivering the goods to the dock next to or alongside the vessel on which the goods are to be shipped. The buyer bears the cost of loading and shipment and thus, title passes to the buyer when the carrier takes possession of the goods. **CIF or Cost, insurance and freight** - Under this shipping contract, the buyer agrees to pay in a lump sum the cost of the goods, insurance cost and freight charge. The shipping contract may be modified as CF which means that the buyer agrees to pay in a lump sum the cost of the goods and freight charge only. In either case, the seller must pay for the cost of loading. Thus, title and risk of loss shall pass to the buyer upon delivery of the goods to the carrier. **Ex-ship** - A seller who delivers the goods ex-ship bears all expenses and risk of loss until the goods are unloaded at which time title and risk of loss shall pass to the buyer. **CONSIGNED GOODS** - "A consignment is a method of marketing goods in which the owner called the consignor transfers physical possession of certain goods to an agent called the consignee who sells them on the owner\'s behalf." - Consigned goods shall be included in the consignor\'s inventory and excluded from the consignee\'s inventory. - Freight and other handling charges on goods out on consignment are part of the cost of goods consigned. - When consigned goods are sold by the consignee, a report is made to the consignor together with a cash remittance for the amount of sales minus commission and other expenses chargeable to the consignor.  **STATEMENT PRESENTATION** Inventories are generally classified as current assets. The inventories shall be presented as one line item in the statement of financial position but the details of the inventories shall be disclosed in the notes to financial statements. For example, the note shall disclose the composition of the inventories of a manufacturing entity as finished goods, goods in process, raw materials and manufacturing supplies. **ACCOUNTING FOR INVENTORIES** 1. **Periodic System** - calls for the physical counting of goods on hand at the end of the accounting period to determine quantities. The quantities are then multiplied by the corresponding unit costs to get the inventory value for balance sheet purposes. \- gives actual or physical inventories. \- generally used when the individual inventory items have small peso investment, such as groceries, hardware and auto parts. **4.1 ILLUSTRATION -- PERIODIC SYSTEM**  2. **Perpetual System** - requires the maintenance of records called stock cards that usually offer a running summary of the inventory inflow and outflow. \- Inventory increases and decreases are reflected in the stock cards and the resulting balance represents the inventory. This approach gives book or perpetual inventories. \- Commonly used where the inventory items treated individually represent a relatively large peso investment such as jewelry and cars. \- In an ideal perpetual system, the stock cards are kept to reflect and control both units and costs. \- When the perpetual system is used, a physical count of the units on hand should at least be made once a year to confirm the balances appearing on the stock cards. **4.2 ILLUSTRATION -- PERPETUAL SYSTEM**  **INVENTORY SHORTAGE OR OVERAGE** In the illustration, the merchandise inventory account has debit balance of P65,000. If at the end of the accounting period, a physical count indicates a different amount, an adjustment is necessary to recognize any inventory shortage or overage. For example, if the physical count shows inventory on hand of P55,000, the following adjustment is necessary: Inventory shortage 10,000 Merchandise inventory 10,000 Actual count 55,000 Ledger Balance 65,000 Deduction(Credit) 10,000 The inventory shortage is usually closed to cost of goods sold because this is often the result of normal shrinkage and breakage in inventory. However, abnormal and material shortage shall be separately classified and presented as other expense. **TRADE DISCOUNTS AND CASH DISCOUNTS** - **Trade discounts** are deductions from the list or catalouge price in order to arrive at the invoice price which is the amount actually charged to the buyer. Thus, trade discounts are not recorded. The purpose of trade discounts is to encourage trading or increase sales. Trade discounts also suggest to the buyer the price at which the goods may be resold. - **Cash discounts** are deductions from the invoice price when payment is made within the discount period. The purpose of cash discounts is to encourage prompt payment. Cash discounts are recorded as purchase discount by the buyer and sales discount by the seller. - **Purchase discount** is deducted from purchases to arrive at net purchases and sales discount is deducted from sales to arrive at net sales revenue. **4.3 ILLUSTRATION -- TRADE AND CASH DISCOUNTS**  **METHODS OF RECORDING PURCHASES** 1. **Gross method** - Purchases and accounts payable are recorded at gross amount of invoice. 2\. **Net method** - Purchases and accounts payable are recorded at net amount of the invoice. **4.4 ILLUSTRATION -- GROSS METHOD** **GROSS METHOD VS NET METHOD** The cost measured under the net method represents the cash equivalent price on the date of payment and therefore the theoretically correct historical cost. However, in practice, most entities record purchases at gross invoice amount. Technically, the gross method violates the matching principle because discounts are recorded only when taken or when cash is paid rather than when purchases that give rise to the discounts are made. Moreover, this procedure does not allocate discounts taken between goods sold and goods on hand. Despite its theoretical shortcomings, the gross method is supported on practical grounds. The gross method is more convenient than the net method from a bookkeeping standpoint. Moreover, if applied consistently over time, the gross method usually produces no material errors in the financial statements. **COST OF INVENTORIES** The cost of inventories shall comprise: a\. Cost of purchase b\. Cost of conversion c\. Directly attributable cost incurred in bringing the inventories to their present location and condition **COST OF PURCHASE** The [cost of purchase] of inventories comprises the purchase price, import duties and irrecoverable taxes, freight, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the cost of purchase. The cost of purchase [shall not] include foreign exchange differences which arise directly from the recent acquisition of inventories involving a foreign currency. Moreover, when inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as [interest expense over the period of financing.] **COST OF CONVERSION** The [cost of conversion of inventories] includes cost directly related to the units of production such as direct labor. The [cost of conversion] also includes a systematic allocation of fixed and variable production overhead that is incurred in converting materials into finished goods. [Fixed production overhead] is the indirect cost of production that remains relatively constant regardless of the volume of production. Examples are depreciation and maintenance of factory building and equipment, and the cost of factory management and administration. [Variable production overhead] is the indirect cost of production that varies directly with the volume of production. Examples are indirect labor and indirect materials. **ALLOCATION OF FIXED PRODUCTION OVERHEAD** The [allocation of fixed production overhead] to the cost of conversion is based on the normal capacity of the production facilities. [Normal capacity] is the production expected to be achieved on circumstances taking into account the loss of capacity resulting average over a number of periods or seasons under normal from planned maintenance. The amount of fixed overhead allocated to each unit of production is not increased as consequence of low production or idle plant. Unallocated fixed overhead is recognized as expense in the period in which it is incurred. **ALLOCATION OF VARIABLE PRODUCTION OVERHEAD** [Variable production overhead] is allocated to each unit of production on the basis of the actual use of the production facilities. A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or where there is a main product and a by-product. When the costs of conversion are [not separately identifiable,] they are allocated between the products on a rational and consistent basis, for example, on the basis of the relative sales value of each product. Most by-products by their nature are [not material.] By-products are measured at net realizable value and this value is [deducted] from the cost of the main product. **DIRECTLY ATTRIBUTABLE COST** **[Directly attributable cost]** is the cost of inventories incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include the cost of designing product for specific customers in the cost of inventories. However, the following costs are excluded from the cost of inventories and recognized as **[expenses]** in the period when incurred: a. Abnormal amounts of wasted materials, labor and other production costs. b. Storage costs, unless necessary in the production process prior to a further production stage. Thus, storage c[osts on goods in process] are [capitalized] but storage costs on [finished goods are expensed.] c. Administrative overheads that do not contribute to bringing inventories to their present location and condition. d\. Distribution or selling costs **COST OF INVENTORIES OF A SERVICE PROVIDER** The cost of inventories of a service provider consists primarily of the following: a\. Labor and other costs of personnel directly engaged in providing the service, including supervisory personnel b\. Directly attributable overhead. Labor and other costs relating to sales and general administrative personnel are not included but are recognized as expenses in the period incurred. **UNIT 4.1 INVENTORY COST FLOW** COST FORMULAS - PAS 2, paragraph 25, expressly provided that the cost of inventories shall be determined by using either: a. First in, First out b. Weighted average - The standard does not permit anymore the use of last in, first out (LIFO) as an alternative formula in measuring cost of inventories. FIRST IN, FIRST OUT (FIFO) - The FIFO method assumes that the goods of first purchase are first sold and consequently the goods remaining at the inventory at the end of the period are those most recently purchased or produced. - In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods are sold in the order they are purchase. - The rule is "first come, first sold" - The inventory is thud expressed in terms of recent or new prices while the cost of goods sold is representative of earlier or old prices - This method favors the statement of financial position in that the inventory is stated at current replacement cost. - The objection to the method is that there is improper matching of cost against revenue because the good sold are stated at earlier or older prices resulting in understatement of cost of sales. - Accordingly in a period of inflation or rising prices the FIFO method would result to the highest net income. - However in a period of deflation or declining prices the fifo method would result to the lowest net income.    WEIGHTED AVERAGE- PERIODIC - The cost of the beginning inventory plus the total cost of purchases during the period is divided by the total units purchase plus those in the beginning inventory to get a weighted average unit cost - Such weighted average unit cost is done multiplied by the units on hand to derive the inventory value - In other words the average unit cost is computed by dividing the total cost of goods available for sale by the total number of units available for sale for the period - The preceding illustrative data are used.