ACC202

Financial and Managerial Accounting

Seminar 2

1
Financial and Managerial
Accounting
STUDY UNIT 2
INVENTORY, CASH AND RECEIVABLES

2
 Learning Outcomes
 By the end of this unit, you should be able
to:
◦ Compute inventory using the specific
identification, FIFO, and Weighted average cost
in a perpetual system.
◦ Discuss internal controls for cash receipts and
payments.
◦ Compute and analyse liquidity and profitability
ratios.
◦ Describe accounts receivable, estimate and
account for uncollectibles using the allowance 3
Chapter 1
Inventory system

4
Statement of Comprehensive Income
Comparison
Can you spot the differences in
Service Business the SCI?
• Cost of goods sold are the cost
Fees earned $150,000 of inventory kept and sold by the
Operating expenses (120,000) merchandishing company.
• Inventory: products that a
Net profit $ 30,000 company owns and intends to
sell.
Merchandishing Business • Inventory must be accounted for
periodically or perpetually
Sales revenue $600,000 • In this course, only perpetual
Cost of goods sold (450,000) method is considered.
Gross profit $150,000
Operating expenses (120,000)
Net profit $ 30,000
What costs should be included in
Inventory?

 Inventory cost include

 its purchase price
 less any purchases discounts
 other cost related to bringing in inventory such as
transportation, import duties, and insurance
against losses in transit.
 Why are these other costs included?
 These other costs are all incidental costs
that are necessary to bring the inventory
item to a saleable condition and location.
FOB
 FOB Shipping Point: Title
passes to the buyer when the
seller delivers the goods to the
common carrier Included in
customer’s inventory
 FOB Destination Point: Title Buyer's
Seller's Sales Goods in transit
passes to the buyer when the Inventory
(incl. freight in)
buyer receives the goods
Included in Sellers’ inventory
 Question. If Skechers sells
goods to Target with terms
FOB shipping point, which Seller's
Goods in transit Seller's Sales
company reports these goods in Inventory
(freight out-
its inventory while they are in expense)

transit?
Answer: Target reports these goods in its inventory.
Activity 2 Q1

8
Cost of goods sold
• Cost of goods sold = Qty sold x Cost price per unit
• To compute the COGS and the cost of ending inventory, there are
three common cost flow assumptions used in business.
Cost Flow Assumption Inventory Costing Method

Specific identification Each unit should have the

specific cost and the sales
records should exactly identify
when and which items were
sold.
Cost flow is in the order
in which the costs were First-in, first-out (FIFO)
incurred.

Cost flow is a weighted

average of the costs. Weighted Average cost
Inventory costing illustration
(FIFO)
Item 127B Units Cost
Jan. 1 Balance 320 $6.00
9 Purchase 85 6.40
25 Purchase 110 6.60
26 Sale 360

What is the cost of the 155 units that remain in ending

inventory at January 31, assuming costs are assigned
based on a perpetual inventory system and use of FIFO?
 FIFO Perpetual Inventory Account
Item 127B
In Out Balance

Unit Total Unit Total Unit Total

Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
Jan. 1 320 $6.00 $1,920
 FIFO Perpetual Inventory Account
Item 127B
In Out Balance

Unit Total Unit Total Unit Total

Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
Jan. 1 320 $6.00 $1,920
9 85 $6.40 $544 85 6.40 544

The purchase price of $6.40 is different from the cost of the

previous 320 units on hand; therefore, the inventory balance
of 85 units is accounted for separately even though the total
inventory is 405 units.
 FIFO Perpetual Inventory Account
Item 127B
In Out Balance

Unit Total Unit Total Unit Total

Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
Jan. 1 320 $6.00 $1,920
9 85 $6.40 $544 85 6.40 544
25 110 6.60 726 110 6.60 726

The purchase price of $6.60 is different from the cost of the

earlier units on hand; therefore, the inventory balance of 110
units is accounted for separately. The total inventory balance
and total cost is 515 units and $3,190 respectively
 FIFO Perpetual Inventory Account
Item 127B
In Out Balance

Unit Total Unit Total Unit Total

Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost
Jan. 1 320 $6.00 $1,920
9 85 $6.40 $544 FIFO 85 6.40 544
25 110 6.60 726 110 6.60 726
26 320 $6.00 $1,920
40 6.40 256 45 6.40 288
110 6.60 726

Of the 360 units sold, 320 come from the opening balance at a cost of $6
and the balance 40 units from the next earliest purchase at a cost of
$6.40. Total cost = $2,176.
The ending inventory 155 units is make up of 45 units bought at
$6.40/unit and 110 units bought at $6.60/unit (i.e. total cost = $1,014)
FIFO perpetual inventory entries
Date Description Debit Credit

Jan. 9 Inventory 544

Cash/AP 544
To record purchase of 85 units of item 127B.
Jan. 25 Inventory 726
Cash/AP 726
To record purchase of 85 units of item 127B.
Jan. 26 Cost of Goods Sold 2,176
Inventory 2,176
To record cost of sales of item 127B.
Inventory costing illustration
(WAC)
Item 127B Units Cost
Jan. 1 Balance 320 $6.00
9 Purchase 85 6.40
25 Purchase 110 6.60
26 Sale 360

What is the cost of the 155 units that remain in ending inventory
at January 31, assuming costs are assigned based on a
perpetual inventory system and use of weighted average?
 Weighted Average Cost Method

Product 127B Perpetual Inventory Account (Weighted average cost method)

In Out Balance
Total Total Total
Date Quantity Unit cost Quantity Unit cost Quantity Unit cost
cost cost cost
Jan. 1 320 6.000 1,920
9 85 6.40 544 405 6.084 (a) 2,464
25 110 6.60 726 515 6.194 (b) 3,190
26 360 6.194 2,230 155 6.194 960

When the WAC method is

used in a perpetual (a) ($1,920 + $544)/(320 + 85) = $2,464/405 = $6.084
inventory system, a (b) ($2,464 + $726)/(405 + 110) = $3,190/515 = $6.194
weighted average unit cost
for each type of item is
computed each time a
purchase is made.

This unit cost is then used to determine the cost of each sale until
another purchase is made and a new average is computed.
WA perpetual inventory entries
Date Description Debit Credit

Jan. 9 Inventory 544

Cash/AP 544
To record purchase of 85 units of item 127B.
Jan. 25 Inventory 726
Cash/AP 726
To record purchase of 85 units of item 127B.
Jan. 26 Cost of Goods Sold 2,230
Inventory 2,230
To record cost of sales of item 127B.
Activity 2 Q2 and Q3

19
 Financial Statement Effects of
Inventory Errors
Opening
+ Purchases
inventory

Period 1 What will

happen if error
Inventories available for sale
in computation
or a change in
cost flow
Ending inventory COGS
assumption
lead to a need
Opening to restate the
+ Purchases
inventory ending
Period 2 inventory for
period 1?
Inventories available for sale

Ending inventory COGS

 Financial Statement Effects of
Inventory Errors
Opening • If ending inventory
+ Purchases for period 1
inventory
increased by
Period 1 $10,000
Inventories available for sale • Period 1
Profit = +$10,000
• Period 2
Ending inventory Profit = -$10,000
COGS (-$10,000)
(+$10,000) • Total profit for Period
Opening 1 & 2, unchanged.
Purchases
inventory(+$10,000) +
Period 2
Inventories available for sale
(+$10,000)

Ending inventory COGS (+$10,000)

 Financial Statement Effects of
Inventory Errors
Opening • If ending inventory
+ Purchases for period 1
inventory
decreased by
Period 1 $10,000
Inventories available for sale • Period 1
Profit = -$10,000
• Period 2
Ending inventory Profit = +$10,000
(-$10,000)
COGS (+$10,000)
• Total profit for Period
Opening 1 & 2, unchanged.
inventory (- + Purchases
$10,000)
Period 2
Inventories available for
sale (-$10,000)

Ending inventory COGS (-$10,000)

Activity 2 Q4

23
Chapter 2
Cash and Receivables

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CASH & CASH EQUIVALENTS
 Cash includes
 Money
 deposit in bank accounts
 Negotiable instruments
 cheque
 postal note
that a financial institution will accept
 Cash equivalents
 short-term, highly liquid investment assets that are
readily convertible into cash and subject to insignificant
risk of changes in value

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CONTROL OF CASH
 Cash is the asset most subject to theft
 Need a good internal control system for
handling cash and recording cash
transactions
 3 important principles
1. Separation of responsibility for handling and
custodianship of cash from maintaining records for
cash
2. Banking intact each day’s cash receipts
3. Making all payments by electronic transfer or by
cheque
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TYPES OF RECEIVABLES
 A receivable is an amount due from another
party.
◦ Accounts Receivable (also known as trade
debtor) are amounts due from customers for
credit sales.
◦ Notes Receivable are promissory note i.e.
written promise to pay a specified amount of
money, usually with interest
 sellers generally prefer to receive notes when the credit period
is long and when the receivable is for a large amount.
◦ Other Receivables are receivables not related
to goods or services
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Accounts Receivable & Credit
Sales
 On July 1, A Co. had a credit sale of $950 to
B Co. and a collection of $720 from C Co.
from a prior credit sale.
◦ Entries
 July 1
Dr Accounts Receivable – B Co. $950
Cr Sales $950
To record credit sales
 July 1
Dr Cash $720
Cr Accounts Receivable – C Co. $720
To record collection of credit sales

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BAD AND DOUBTFUL DEBTS
 Not all amounts owing will be collected
 Need to account for Impairment or Bad Debts
 Risk of doing business on credit
 Minimised through credit checks
 Uncollectible amounts (known as bad debt)
represent a business expense (expected reduction
is economic benefits)
 Written off periodically
 Two methods to account for bad debts
◦ Allowance method (for this course)
◦ Direct write-off method

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ALLOWANCE METHOD OF
ACCOUNTING FOR DOUBTFUL DEBTS
 Estimate of doubtful debts made at the end of the
period using either one of the 2 methods:
1. The percent of accounts receivable method and
2. Aging of Receivables Method
 Pass adjusting entry to recognise expense and an
allowance (contra-asset)
 This allowance will be deducted from accounts
receivable on the statement of financial position

30
Providing & Recording Bad Debts
Expense
◦ A Co. had credit sales General Journal
of $300,000 during its 31 Bad Debts Expense 1,500
first year of Dec
operations. Allowance for Doubtful Debts 1,500
◦ At the end of the first (contra asset account)
year, $20,000 of credit (to record estimated bad debt)
A LTD
sales remained Statement of financial position (partial)
uncollected. as at 31 December 20X1
◦ Based on the CURRENT ASSETS
experience of similar Cash at bank $ 20,500
businesses, A Co.
Accounts Receivable $20,000
estimated that $1,500
Less: Allowance for 1,500 18,500
of its accounts doubtful debts
receivable would be
Inventory 50,000
uncollectible.
TOTAL CURRENT $89,000
ASSETS
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WRITING OFF BAD DEBTS
 When debts turned bad it is written off
against the allowance.
◦ A Co. decides that D Co.’s $520 account is
uncollectible.
General Journal
Jan 25 Allowance for Doubtful Debts 520
Accounts Receivable – D Co 520
(To write off an uncollectible account)

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Estimating bad debt – Percent of Receivables
Method
 The percent of accounts receivable method assumes that
a given percent of a company’s receivables is
uncollectible.
◦ This percent is based on past experience and is impacted by
current conditions such as economic trends and customer
difficulties.
 Musicland has $50,000 of accounts receivable on December 31,
2015. Experience suggests 5% of its receivables is uncollectible. This
means that after the adjusting entry is posted, we want the Allowance
for Doubtful Accounts to show a $2,500 credit balance (5% of
$50,000).
◦ If the Allowance for Doubtful
General Journal
Accounts Why? has a credit
Account
balance of $200 just before December 31, Balance
2015,required: Cr $2,500
the adjusting
31 Bad Debts
entry Expense
to give 2,300
the estimated balance wouldCurrent
be: balance: Cr $200
Dec Add. Allowance : Cr $2,300
Allowance for Doubtful Debts 2,300
(contra asset account)
(to record estimated bad debt)
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Estimating bad debt – Aging of Receivables
Method
 Aging of Receivables
Method
◦ assuming that the longer an
amount is past due, the more
likely it is to be uncollectible.
• This means that after the
adjusting entry is posted,
the Allowance for Doubtful
Accounts must show a
$2,270 credit balance.
• If the Allowance for
Doubtful Accounts Account General Journal
has a debit balance of 31 Bad Debts Expense 2,
$150 just before December Dec 420
31, 2015, the adjusting Allowance for Doubtful Debts 2,420
entry to give the estimated (contra asset account)
balance would be:Why? (to record estimated bad debt)
Balance required: Cr $2,270
Current balance: Dr $150
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Add. Allowance : Cr $2,420
Note Receivables
 A promissory note is a written promise to pay a specified amount of
money, with interest, either on demand or at a definite future date.
 Promissory notes are used in many transactions, including paying for
products and services, and lending and borrowing money.

Note Payable
Interest Expense

Note Receivable
Interest Revenue

Principal Annual Time expressed

x x = Interest
of the note interest rate in fraction of year

Even for maturities less than one If the note is expressed in days, base a
year, the rate is annualized. year on 360 days.
Notes Receivables -illustration
 On Dec. 13, A Co. Dec. 13
accepted a $10,000, 45- Notes Receivable—B Co
day, 8% note dated 10,000
December 13 in granting Accounts Receivable –B Co.
10,000
B company a time To record receipt of note on
extension on her past-due account.
• account
On Dec.receivable.
31, A Co. •Dec. 31
Interest Receivable 40
prepared an adjusting
entry to record the Interest Revenue 40
accrued interest To record interest earned
expense on the B Co.’s [$10,000 x .08 x 18/360].
note.
Activity 2 Q5 and Q6

37
Working Capital management
2. Sell products on credit
1. Buy products on credit Dr AR Cr Revenue
Dr Inventory Cr AP 3. Reduce inventory
Dr CGS Cr Inventory
Economic buying Sell faster/cash; reduce
inventory
Supplier A Co. Customer

4. Pay cash to supplier 5. Receive cash from

Dr AP Cr Cash customer
Delay payment Dr faster
Collect Cash Cr AR

Effective management of AR, inventory, payables

1. 2,5 AR turnover, days’ sales uncollectible(time AR convert to cash)
2. 2,3 Inventory turnover, days’ sales in inventory (time inventory
convert to cash/AR)
3. 1,4 Days’ purchase outstanding, AP turnover (time to pay suppliers)

38
Working Capital

Working capital represents current

assets financed from long-term capital
sources that do not require near-term
repayment.
Current assets
– Current liabilities
= Working capital

More working capital suggests a strong liquidity

position and an ability to meet current obligations.
Current Ratio
Current Assets
Current Ratio =
Current Liabilities

This ratio measures the short-term debt-

paying ability of the company. A higher current
ratio suggests a strong liquidity position.
 Acid-Test Ratio

Cash + Short-term investments + Current

Acid-test ratio = receivables
Current Liabilities
Referred to as Quick Assets

This ratio is like the current ratio but excludes current assets
such as inventories and prepaid expenses that may be
difficult to quickly convert into cash.
Activity 2 Q7
Inventory Turnover
Cost of goods sold
Inventory turnover =
Average inventory

Average inventory = (Beginning inventory + Ending inventory)

2

• Measure
• how quickly it sells its merchandise inventory.
• how many times a company sells its inventory.
• A low ratio indicates inefficient use of assets i.e. holding more
inventory than it needs.
• a high ratio is preferable provided inventory is adequate to meet
demand
DAYS’ SALES IN INVENTORY

Day's sales in = Ending inventory

× 365
Inventory Cost of goods sold

This ratio is a useful measure in evaluating

inventory liquidity. If a product is demanded
by customers, this formula estimates how
long it takes to sell the inventory.
Activity 2 Q8

© 2018 Singapore University of

Social Sciences. All rights
reserved.
Accounts Receivable Turnover

Net sales
Accounts receivable =
Average accounts receivable,
turnover
net
(Beginning acct. rec. + Ending acct. rec.)
Average accounts receivable =
2

• This ratio measures how many times a company

converts its receivables into cash each year.
• Indicates the likelihood of collection
DAYS’ SALES UNCOLLECTED

Day's sales = Accounts receivable, net

× 365
uncollected Net sales

Provides insight into how frequently a

company collects its accounts receivable.
Accounts Payable Turnover
Cost of goods sold
Accounts payable turnover =
Average accounts payable
(Beginning accounts payable +
Average accounts
Ending accounts payable)
payable =
2

A short-term liquidity measure used to

quantify the rate at which a company pays
off its suppliers.
DAYS’ PURCHASES IN ACCOUNTS
PAYABLE

Accounts = Accounts payable

× 365
Payable Cost of goods sold

This ratio is a useful measure in evaluating

how long the business takes to pay its credit
suppliers.
Activity 2 Q9
 Both companies
appear reasonable
efficient in collecting
accounts receivable,
but Puma collects
them over a longer
period of time in both
years compared to
Adidas. Puma
showed a slightly
more favorable trend
with a shorter
collection time for
year 2013 compared
with 2012
Activity 2 Q10

51