Section A.2 Recognition, Measurement, Valuation, and Disclosure Flashcards
a. Identify issues related to the valuation of accounts receivable, including timing of recognition and estimation of uncollectible accounts
-GAAP requires that accounts receivable be carried on the balance sheet at net realizable value (NRV)
-NRV -
is gross A/R less allowance for uncollectible accounts, returns and allowances, and discounts
b. Determine the financial statement effect of using the percentage-of-sales (I/S) approach as opposed to the percentage-of-receivables (B/S) approach in calculating the allowance for uncollectible accounts
-GAAP allows either approach for the determination of uncollectible expense and the allowance for uncollectible accounts.
-%-of-sales calculates the uncollectible expense and credits the allowance to determine the balance in the allowance account
-%-of receivables method calculates the ending balance in the allowance account and “backs” into the uncollectible expense
c. Distinguish between receivables sold (factoring) on a with-recourse basis and those sold on a without-recourse basis, and determine the effect on the balance sheet
- Factoring without recourse transfers the ownership of the receivable to the factor and removes it from the balance sheet
- When factoring with recourse, rights of owners remain with the original owner of the receivable and are not transferred to the factor. The receivable then remains on the original owner’s balance sheet.
d. Identify issues in inventory valuation, including which goods to include, what costs to include, and which cost assumption to use.
-All goods available for sale and still owned by the company are included in the inventory
This would include goods out on consignment, goods in-transit shipped FOB destination (title transfers at destination) as well as owned goods on hand
-it’s up to management to decide which of the three inventory cost assumptions to use
e. Identify and compare cost flow assumptions used in accounting for inventories
1) FIFO
2) LIFO
3) Average cost (weighted average for periodic inventory or moving average for perpetual inventory)
FIFO values the ending inventory at the newest (current) costs and the COGS at the oldest costs
LIFO values the ending inventory at the oldest costs and COGS at the newest (current) costs.
Weighted average cost values both the ending inventory and COGS at the weighted average cost of the goods for the period
The moving average method recomputes the average cost of the inventory whenever the shipment is received and uses the recomputed average to determine the cost of the next sale
f. Demonstrate an understanding of the lower of cost or market rule for inventories
GAAP requires that inventory be valued and carried at lower of cost or market (LCM)
Cost may be: FIFO, LIFO, average cost, or specific identification
Market is defined as replacement cost.
There’s a ceiling and a floor on replacement cost
The ceiling is NRV (replacement cost less costs to complete and dispose of).
The floor is NRV reduced by the normal profit margin.
g. Calculate the effect on income and on assets of using different inventory methods
When inventory costs are consistently rising, FIFO results in the highest net income due to the lowest cost of sales and the highest inventory value on the balance sheet.
LIFO results in the lowest net income due to the highest cost of sales and lowest inventory value on the balance sheet
Average cost results would be between FIFO and LIFO. When inventory costs are consistently falling, FIFO and LIFO would be reversed; an average cost would still be in between. The relationships of the three methods would be indeterminable if inventory costs are fluctuating up and down
h. Analyze the effects of inventory errors
An error in the end-of-period inventory will affect the cost of sales for the period, net income for the period, ending retained earnings for the period, beginning inventory for the next period, cost of sales for the next period, and net income for the next period.
The cost of sales and net income errors in the next period would be in the opposite direction from those in the first period. The retained earnings at the end of the next period would be correct.
For example: a dollar overstatement in this period’s inventory will understate this period’s cost of sales by a dollar, overstate its net income by a dollar, and overstate its retained earnings by a dollar.
The error will overstate the next period’s beginning inventory by a dollar, overstate its cost of sales by a dollar, understate its net income by a dollar, and restore retained earnings to where it would have been had the error not occurred.
i. Identify the advantages and disadvantages of the different inventory methods
FIFO generates an ending inventory valuation close to current (replacement) cost. It minimizes income taxes when prices are consistently falling.
One disadvantage of FIFO is that it matches older costs in cost of sales to revenue in income determination.
Second, it results in higher income taxes than either LIFO or average cost when inventory costs are consistently rising.
B) LIFO matches the most current costs (through cost of sales) to revenue in income determination. It minimizes income taxes when inventory costs are consistently rising.
It’s main disadvantage is that the inventory valuation on the balance sheet could be many years out of date. Since LIFO become available prior to WWII, the inventory valuation could be over 70 years old. Last, it’s an extremely complex system when used for perpetual inventory valuation.
C) Average costing is an easy-to-use and understand method. It is relatively easily programmed when used for perpetual inventory valuation. It provides little tax advantage when costs are consistently rising or falling.
j. Recommend the inventory method and cost flow assumption that should be used for a firm given a set of facts
LIFO is the recommended system when prices are consistently rising and inventory level is constant or rising
FIFO would be best when prices are consistently falling or the inventory is being depleted
Average cost is recommended when the inventory level fluctuates materially and/or the prices fluctuate.
Average cost is the best for commodities and fungible goods
