Mastering Financial Accounting: Sales, Inventory, and Fraud Prevention

Posted on Jan 22, 2025 in Naval Architecture

Chapter 5: Sales Revenue and Gross Profit

Sales Revenue – Cost of Goods Sold (COGS) = Gross Profit

Gross Profit – Operating Expenses = Net Loss

Gross Profit / Net Sales = Gross Profit Rate

Sales Revenue – Sales Returns and Allowances = Net Sales

COGS is an expense account.

  • Perpetual System: Constantly keeps inventory data up to date.
  • Periodic System: Does not maintain detailed, continuous inventory records.

Cost of inventory includes purchase price and shipping charges.

  • FOB Shipping Point: Free for the seller; the buyer pays for shipping.
  • FOB Destination: The seller pays for shipping.

Credit terms permit the buyer to claim a cash discount for prompt payment.

Example: 2/10, n/30 means you get a 2% discount within 10 days, or the outstanding balance is due in 30 days.

Merchandise companies have two journal entries:

  1. Cash (Debit), Sales Revenue (Credit) = Selling Price
  2. COGS (Debit), Inventory (Credit) = Cost

Sales Returns and Allowances is a contra-revenue account with a normal debit balance.

Purchase discounts get recorded as a credit to inventory.

The cost of goods sold is determined and recorded each time a sale occurs in a perpetual account only.

A multi-step income statement shows several steps in determining net income and distinguishes between operating and non-operating activities.

Example: Interest revenue

Steps:

  1. Calculation of Gross Profit
  2. Calculation of Income from Operations
  3. Results of Non-Operating Activities = Net Income

Chapter 6: Inventory Management

Merchandising companies produce their own inventory.

Manufacturing companies have three classes of inventory:

  1. Raw Materials
  2. Work in Process
  3. Finished Goods

All companies report all inventories in current assets on the balance sheet.

Physical inventory is taken for two reasons in a perpetual system:

  1. To check accuracy
  2. To determine the amount of inventory lost

In a periodic system, physical inventory is taken to:

  1. Determine inventory on hand
  2. Determine the cost of goods sold for the period

Goods in Transit: Inventory items that have not arrived and are currently being shipped. The party who pays the shipping charges has legal title.

Specific Identification Method: Used only by companies that sell unique inventory.

Cost Flow Assumptions: Used by companies that sell homogenous products, but only truly applicable if inflation is in place.

FIFO (First-In, First-Out) Method

Assumes the oldest purchases are sold first.

  • Ending inventory consists of the most recent purchases.
  • To calculate COGS, start with the oldest inventory (top of the account).
  • To calculate ending inventory, start with the most recent inventory.

LIFO (Last-In, First-Out) Method

Assumes the most recent purchases are sold first.

  • Ending inventory consists of the oldest purchases.
  • To calculate COGS, start at the bottom of the chart.
  • To calculate ending inventory, start at the top of the chart.

Average Cost Method

Assumes each unit costs the average cost of all unit purchases.

Calculate: Total Cost / Total Units

Ending Inventory = # of Units in Ending Inventory x Average Cost

COGS = # of Units Sold x Average Cost

Balance Sheet Effects

During inflation, FIFO will be close to cost, while LIFO will be understated.

Net income and inventory are higher under FIFO and lower under LIFO.

LIFO has a lower income tax expense, while FIFO has a higher income tax expense.

COGS = Beginning Inventory + Purchases – Ending Inventory

Income Statement Effects of Inventory Errors

  1. Understated Beginning Inventory: COGS is understated, Net Income is overstated.
  2. Overstated Beginning Inventory: COGS is overstated, Net Income is understated.
  3. Understated Ending Inventory: COGS is overstated, Net Income is understated.
  4. Overstated Ending Inventory: COGS is understated, Net Income is overstated.

Lower of Cost or Market (LCM): The best choice among accounting alternatives is the method that is least likely to overstate assets and net income.

Balance Sheet Effects of Ending Inventory Errors

Ending Inventory ErrorAssetsLiabilitiesStockholders’ Equity
OverstatedOverstatedNo EffectOverstated
UnderstatedUnderstatedNo EffectUnderstated

Presentation

  • Balance Sheet: Inventory is classified as a current asset.
  • Income Statement: The cost of goods is subtracted from sales.

There should also be a disclosure of the major inventory classifications, the basis of accounting (cost of LCM), and the cost method.

Chapter 7: Fraud and Internal Control

Three factors that contribute to fraudulent activity:

  1. Opportunity
  2. Financial Pressure
  3. Rationalization

Fraud is a dishonest act by an employee that results in personal benefit to the employee at the cost of the employer.

The Sarbanes-Oxley Act: Requires companies to have internal control.

Internal Control: Implements safeguards to protect assets, enhance the reliability of accounting records, increase the efficiency of operations, and ensure compliance with laws and regulations.

Six Principles of Internal Controls

  1. Establishment of Responsibility: Control is most effective when one person is given responsibility for one task.
  2. Segregation of Duties: Different employees should be in charge of related activities.
  3. Documentation Procedures
  4. Physical Controls
  5. Independent Internal Verification
  6. Human Resources Control

Limitations of Internal Control

  • Cost should not exceed benefit.
  • Human element
  • Size of business

Cash receipt controls are like the internal control principles.

Cash disbursement controls: Generally, internal control is more effective when cash is paid by check or electronic funds transfer (EFT) rather than cash.

Petty Cash Fund: Used to pay small amounts.