Accounting Prelim #2 (Chapters 6-8)

Internal Control of Cash

"Internal controls" refers to the process by which a company: 1. Safeguards its assets 2. Provides reasonable assurance regarding:• The reliability of the company's financial reporting • The effectiveness and efficiency of its operations • Compliance with laws and regulations *Controls are designed to prevent inadvertent errors and outright fraud. Internal control is reviewed by the outside independent auditor. *Cash is the asset most vulnerable to theft and fraud

Accounting for Bade Debts

* Companies may not learn which particular customers will not pay until the next accounting period - Therefore, companies use the allowance method to measure bad debt expense. The allowance method is based on estimates of the expected amount of bad debts with two steps:

Trademarks

- A special name, image or slogan identified with a product or company. - Rarely seen on balance sheets because they are only recorded if purchased -infinite life no amortization

Impact of Alternative Depreciation Methods

- Accelerated depreciation methods report higher depreciation and, therefore, lower net income during the early years of an asset's life. As the age of the asset increases, this effect reverses

Measuring and Reporting Receivables

- Accounts receivable: (created by a credit sale on an open account) - Trade receivable: (created in the normal course of business when a credit sale of merchandise or services occurs - Notes receivable: (a written promise to pay principal and interest at one or more future dates) - Non-trade receivables: (arise from transactions other than the normal sale of merchandise or services)

Cash Management Procedures

- Accurate accounting so that reports of cash flows and balances may be prepared. - Controls to ensure that enough cash is available to meet current operating needs, maturing liabilities, and unexpected emergencies. - Prevention of the accumulation of excess amounts of idle cash.

Measuring and Recording Acquisition Cost

- Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use. This does not include financing charges associated with the purchase. - Acquisition Costs •Purchase price •Sales taxes •Legal fees •Transportation costs •Installation and preparation costs -Interest expenses if paid on credit not included Note - We say that the expenditures are capitalized when they are recorded as an asset

Sales Discounts to Businesses

- Companies often sell to other businesses on open account (without a formal written promissory note). - Companies may offer a sales discount as an early payment incentive.

LIFO and Conflicts between Managers' and Owners' Interests

- Company managers may have an incentive to select a method that is not consistent with the owners' objectives. - A well‐designed compensation plan should reward managers for acting in the best interest of the owners. - A manager who selects an accounting method that is not optimal for the company solely to increase his or her compensation is engaging in questionable ethical behavior.

Sales to customers in which the customers pay within 30 days are referred to as

- Credit sales or -Sales on Account

Sales Returns and Allowances

- Customers have a right to return unsatisfactory or damaged merchandise and receive a refund or an adjustment to their bill. These returns are accumulated in a separate account called Sales Returns and Allowances.

Depreciation Concepts

- Depreciation is the process of allocating the cost of buildings and equipment over their productive lives using a systematic and rational method. - The remaining balance sheet amount probably does not represent the asset's current market value. - The undepreciated cost is not measured on a market or fair value basis

Differences in Estimated Lives within a Single Industry

- Differences in estimated lives of assets may be attributable to a number of factors such as the type of aircraft used by each company, equipment replacement plans, operational differences, and the degree of management's conservatism. - This can alter comparisons of profitability

Perpetual Inventory Systems and Cost Flow Assumptions in Practice

- FIFO inventory and cost of goods sold are the same whether computed on a perpetual or periodic basis. - Accounting systems that keep track of the costs of individual items normally do so on a FIFO or average cost basis, regardless of the cost flow assumption used for financial reporting. - As a consequence, companies that wish to report under LIFO convert the outputs of their perpetual inventory system to LIFO with an adjusting entry at the end of each period.

Increased Profitability Due to an Accounting Adjustment?

- Financial analysts are particularly interested in changes in accounting estimates because they can have a large impact on a company's before-tax operating income.

Accounting for Net Sales Revenue (2)

- For sellers of goods, sales revenue is recorded when title and risks of ownership transfer to the buyer. -

Goodwill

- Goodwill: •Only recorded as an asset when one company buys another business. •Equals the purchase price of the company less the fair market value of the net assets (assets minus liabilities). •Not amortized but reviewed annually for impairment. (indefinite)

Declining-Balance Method - an accelerated depreciation method (Dep. Method 3)

- If an asset is more efficient or productive when it is newer, managers might choose the declining-balance depreciation method to match a higher depreciation expense with higher revenues in the early years of an asset's life and a lower depreciation expense with lower revenues in the later years.

Actual Write-offs Compared with Estimates

- If uncollectible accounts actually written off differ from the estimated amount previously recorded, a higher or lower amount of bad debt expense is recorded in the next period to make up for the previous period's error in estimate. - When estimates are found to be incorrect, financial statement values for prior annual accounting periods are not corrected.

Internal Control of Inventory

- Maintaining perpetual inventory records. *Separation of responsibilities for inventory accounting and physical handling of inventory. - Storage of inventory in a manner that protects it from theft and damage. - Comparing perpetual inventory records to periodic physical counts of inventory. *Limiting access to inventory to authorized employees.

How Managers Choose

- Managers determine which depreciation method provides the best matching of revenues and expenses. Financial Reporting (GAAP) - provide economic information: -Choose the straight-line method (the most common and easy to use) if the asset provides benefits evenly over time. During the early years of an asset's life, the straight-line method reports higher income than the accelerated methods do. - Choose an accelerated method if assets produce more revenue in their early lives. Tax Reporting (IRC): When given a choice managers will apply the least and latest rule. All taxpayers want to pay the lowest amount of tax that is legally permitted and at the latest possible date.

Items Included in Inventory

- Merchandisers: Merchandise Inventory - Manufacturers: Raw materials inventory Work in process inventory Finished Goods Inventory

Periodic Inventory Systems

- No up‐to‐date record of inventory is maintained during the year. - Sales require one entry to record the sale. Cost of goods sold is calculated at the end of each period.

FIFO uses the ______ cost for Cost of Goods Sold on the income statement and the ______ cost for Inventory on the balance sheet.

- Oldest; Newest - Reason: FIFO assumes the older items are sold first as Cost of Goods Sold and the newer items remain in Inventory.

FIFO and LIFO Cost of Goods Sold under Periodic versus Perpetual Inventory Systems

- Perpetual LIFO is complex and costly to maintain in practice. - In periods of rising prices, periodic LIFO has higher COGS and lower amount for income before taxes. - Companies keep perpetual inventory records on a FIFO basis and then make an end‐of‐period adjusting entry to convert inventory on the balance sheet and cost of goods sold on the income statement to a LIFO basis.

In a perpetual inventory system, Inventory is reduced by ______.

- Purchase discounts, purchase returns and allowances *In general the company should cease accumulating purchase costs when the good is ready for use

Additional Issues in Measuring Purchases

- Purchase returns and allowances require a reduction in the cost of inventory purchases and a refund to the vendor.

Perpetual Inventory Systems

- Purchase transactions are recorded directly in an inventory account. - Sales require two entries to record: (1) the sale and (2) the cost of goods sold.

Franchises

- Rights granted by the government or a company to provide a product or service. - The investment made by the franchisee is accounted for as an intangible asset. - The life of the franchise agreement depends on the contract and can be for a single year or indefinite period.

The Book Value as an Approximation of Remaining Life

- Some analysts compare the book value of assets to their original cost as an approximation of their remaining life. - Example: If book value of an asset is 100 percent of its cost, it is a new asset. If book value of an asset is 25 percent of its cost, it only has around 25 percent of its life remaining.

When are each used?

- The percentage of credit sales method is simpler to apply, but the aging method is generally more accurate. - Many companies use the simpler method on a weekly or monthly basis and use the more accurate method on a monthly or quarterly basis to check the accuracy of the earlier estimates.

Units of Production Method (Dep. Method 2)

- The units-of-production depreciation method relates depreciable cost to total estimated productive output. - Varying amounts of Dep. Expense based on production level - Note - the ending Net Book Value is equal to the estimated residual value at the end of the useful life

Inventory Sold

- This is just the cost of goods sold (Income statement)

Primary Goals of Inventory Management

- To have sufficient quantities of high‐quality inventory available to serve customers' needs -To minimize the costs of carrying inventory (production, storage, obsolescence, and financing)

*net realizable value

- Under lower of cost or net realizable value, companies recognize a "holding" loss in the period in which the net realizable value of an item drops below original cost, rather than recording the loss in the period the item is sold - If the net realizable value of the inventory is lower than original cost, the company would make a "write‐ down" entry to reduce the inventory balance to net realizable value - No write‐down is necessary if the net realizable value is higher than the original cost. Recognition of holding gains on inventory is not permitted by GAAP

Managers' Choice of Inventory Methods

- What motivates companies to choose different inventory costing methods? Most managers choose accounting methods based on two factors - Managers prefer to pay the least amount of taxes allowed by law as late as possible. -Any conflict between the two motives is normally resolved by choosing one accounting method for external financial statements and a different method for preparing tax returns.

LIFO Liquidation

- When a company using LIFO sells more inventory than it purchases or manufactures, items from beginning inventory become part of cost of goods sold. This is called a LIFO liquidation. - Many companies avoid LIFO liquidations by purchasing sufficient quantities of inventory at year‐end to ensure that ending inventory quantities are greater than or equal to beginning inventory quantities.

To Take or Not to Take the Discount, That Is the Question?

- With discount terms of 2/10, n/30, a customer saves $2 on a $100 purchase by paying on the 10th day instead of the 30th day. This amounts to substantial savings! Amount Saved Amount Paid = Interest Rate for 20 Days $2/$98= 2.04% savings for 20 Days 365 Days/20days × 2.04% = 37.23% annual interest rate *** As long as the bank's interest rate is less than the annual interest rate the customer will save by taking the cash discount.

Errors in Measuring Ending Inventory

- You can compute the effects of inventory errors on both the current year's and the next year's income before taxes using the cost of goods sold equation. - Assume that ending inventory was overstated by $10,000 due to a clerical error that was not discovered. This would effect the current year and next year. - This means COGS for the current year was understated

Inventory Remaining

- this is just the ending inventory (balance statement)

Component Allocation

- •Under IFRS, the cost of an individual asset's components is allocated among each significant component and then depreciated separately over that component's useful life. - Ex. Different parts of an aircraft differ in depreciation lives

Valuation at Lower of Cost or Net Realizable Value

-Inventories should be measured initially at their purchase cost. When the net realizable value of goods in ending inventory falls below cost, these goods must be assigned a unit cost equal to their net realizable value. *This rule is known as measuring inventories at the lower of cost or net realizable value (lower of cost or market).

Comparison of two methods (BDE)

1. Aging of Accounts Receivable: Compute the estimated ending balance in the Allowance for Doubtful Accounts on the balance sheet after making the necessary adjusting entry. The difference between the current balance in the account and the estimated balance is recorded as the adjusting entry for Bad Debt Expense. 2. Percentage of credit sales: Directly compute the amount of Bad Debt Expense on the income statement for the period.

Methods for Motivating Sales and Collections

1. Allowing consumers to use credit cards to pay for purchases. 2. Providing business customers direct credit and discounts for early payment. 3. Allowing returns from all customers under certain circumstances.

Financial Statement Effects of Bad Debt

1. Estimated Bad debt Expense: - Net income (decreases) - Assets (A/R) (decreases) 2. When actual bad debts are written off - Net Income (no effect) - Assets (A/R ) (no effect)

The point at which title changes hands is determined by these shipping terms: FOB Destination and FOB Shipping point (FOB means "free on board")

1. FOB Destination - the title of the goods changes hands on delivery. 2. FOB Shipping point - the title of the goods changes hands at the shipping date.

Revenue Recognition for Bundled Goods and Services (5 step process)

1. Identify the contract between the company and the customer. Ex: Bundled: iPad and related future upgrade services 2. Identify the performance obligations (promised goods and services). #1 Hardware with essential software #2 Future software upgrades 3. Determine the transaction price. Ex. 500$ 4. Allocate the transaction price to the performance obligations. Ex -> #1 Hardware with software $450 #2 Future software upgrades $50 5. Recognize revenue when each performance obligation is satisfied (or over time if a service is provided over software) Ex: - 450 in Y1 - Future software upgrades $50/5 = $10each year for 5

Costs included in Inventory Purchases

1. Inventory is initially recorded at cost. - Inventory cost includes the costs to bring an article to usable or salable condition and location. 2. Items added to inventory cost - Invoice Price - Freight‐in (freight charges to deliver items to company's warehouse) - Inspection Costs - Preparation Cost 3. Items Subtracted from Inventory Cost - Purchase Returns and Allowances - Purchase Discounts * This ^ all equals total inventory cost - Companies should cease accumulating purchase costs when the raw materials are ready for use or when the merchandise inventory is ready for shipment. - Selling costs included in selling, general, and administrative expenses

Accounting for Bad Debts (2)

1. Make end-of-period adjusting entry to record bad debt expense. 2. Write off specific accounts determined to be uncollectible during the period *Allowance for doubtful Accounts credited and Bad debt expense debited

Practices That Can Help Minimize Bad Debts

1. Require approval of customers' credit history by a person independent of the sales and collections functions. 2. Reward both sales and collections personnel for speedy collections so they work as a team. 3. Age accounts receivable periodically and contact customers with overdue payments.

Effective Internal Control of Cash

1. Separation of Duties - Separate jobs of receiving cash and disbursing cash. - Separate procedures of accounting for cash receipts and cash disbursements. -Separate the physical handling of cash and all phases of the accounting function. 2. Prescribed Policies and Procedures - Require that all cash receipts be deposited in a bank daily. Keep cash on hand under strict control. - Require separate approval of the purchases and the actual cash payments. - Assign responsibilities for cash payment approval and check-signing to different individuals. - Require monthly reconciliation of bank accounts with the cash accounts on the company's books.

Inventory Costing Methods

1.Specific Identification: the cost of each item sold is individually identified and recorded as cost of goods sold. This method requires keeping track of the purchase cost of each item. *Efficient for unique items (houses, jewelry) 2.First in, first‐out (FIFO) -oldest inventory sold first 3.Last‐in, first‐out (LIFO) -Most recent purchases/additions to inventory sold first 4.Average cost *alternative ways to assign the total dollar amount of goods available for sale between ending inventory and cost of goods sold. *Total dollar amounts of goods available for sale is assigned to ending inv. and COGS

bank reconciliation (the need for it)

A bank reconciliation explains the differences between the ending cash balance reported on the bank statement and the ending cash balance in the company's records. Differences exist for two possible reasons: 1. Transactions affecting cash were recorded on the books of the company (the accounting records) or the bank statement, but not both. 2. Errors in recording transactions.

Measuring and Recording Acquisition Cost Acquisition by Construction

Asset cost includes: - All materials and labor traceable to the construction. - A reasonable amount of over head. - Interest on debt incurred during the construction.

Costs of goods sold for merchandise Inventory

Beg. Inv. + Purchases = Goods available for sale

Cash and Cash Equivalents

Cash: - Money, Checks, Money Orders, Bank Drafts Cash Equivalents (investments with original maturities of 3 months or less): - Certificates of Deposit, T-Bills

Reporting Net Sales

Companies record credit card discounts, sales discounts, and sales returns and allowances separately to allow management to monitor the magnitude of these transactions.

Inventory Methods and Financial Statement Analysis:

Ending inventory will be different under the alternative methods, and, because last year's ending inventory is this year's beginning inventory, beginning inventory also will be different *It does not effect the recording of purchases

Improvements

Identifying Characteristics: 1. Increase the productive life, operating efficiency, or capacity of the asset 2. Occur infrequently 3. Involve large amounts of money. Treatment: Add to asset account (capitalize) *To avoid spending too much time classifying additions and improvements and repair expenses, some companies record all expenditures below a certain dollar amount as expenses.

Ordinary Repairs and Maintenance

Identifying Characteristics: 1. Maintains the productive capacity of the asset during the current accounting period only 2.Recurring in nature 3.Involves small amounts 4.Do not increase the productive life, operating efficiency, or capacity of the asset Treatment: Expense in the period incurred

LIFO conformity rule

If last‐in, first‐out is used to compute taxable income, it must also be used to calculate inventory and cost of goods sold for financial statements. This is called the LIFO Conformity Rule.

Applying the Materiality Constraint in Practice

Incidental costs, such as inspection and preparation costs, do not have to be assigned to the inventory cost if they are not material. Therefore, many companies record inspection and preparation costs as an expense.

LIFO Reserve or "Excess of FIFO over LIFO"

LIFO reserve (or "Excess of FIFO over LIFO) refers to the differences between LIFO and FIFO values for beginning and ending inventory. LIFO Reserve is a contra‐asset for the excess of FIFO over LIFO Inventory. - You can adjust the inventory amounts on the balance sheet to FIFO by substituting the FIFO values in the note for the LIFO values. - Alternatively, you can add the LIFO reserve to the LIFO value on the balance sheet to arrive at the same numbers.

Conservatism Constraint

Lower of Cost or Net Realizable Value is based on the conservatism constraint, which requires companies to avoid overstating assets and income. This is particularly important for two types of companies: 1) High‐technology companies 2)Companies that sell seasonal goods

Receivables turnover ratio

Measures how many times average trade receivables are recorded and collected for the year. - Can get average average days in accounts receivable by dividing the ratio by 365 *Measures how many days on average are the accounts receivable outstanding

Service Companies...

Most often record sales revenue when they have provided services to the buyer.

LIFO and Inventory Turnover

Note that the major difference between the two ratios is in the denominator. FIFO inventory values are roughly 40 percent higher than the LIFO values. The LIFO beginning and ending inventory numbers are artificially small because they reflect older lower costs. (in the example given)

Straight Line Method (Depreciation Method 1)

Notice that: - Depreciation expense is a constant amount each year. - Accumulated depreciation increases by an equal amount each year. - Net book value decreases by the same amount each year until it equals the estimated residual value.

Which inventory system requires that the Inventory account be updated when merchandise is purchased?

Periodic system: Purchases are recorded as increases in the purchases account.

Credit Card Sales to Consumers

Retailers accept credit cards for several reasons: - To increase customer traffic. - To avoid the costs of providing credit directly to customers. - To lower risks due to bad checks. - To avoid losses due to fraudulent credit card sales. - To receive payment quicker.

Flow of Inventory Costs

STAGE 1: PURCHASING/ PRODUCTION ACTIVITIES - Merchandiser: Merchandise purchased -Manufacturer: Raw materials purchased Direct labor incurred Factory overhead incurred STAGE 2: ADDITIONS TO INVENTORY ON THE BALANCE SHEET - Merchandiser: Merchandise Inventory -Manufacturer: Raw materials inventory Work in process inventory Finished goods inventory STAGE 3: SALE‐ COST OF GOODS SOLD ON INCOME STATEMENT (Same for each)

Accounts Receivable Effect on cashflows (indirect method)

Start with Net income and adjusted for: - Add any decrease in Accounts Receivable -Subtract any increase in Accounts Receivable *You haven't received the cash yet

Measuring Asset Impairment

Step 1: Test for Impairment; Impairment occurs when events or changed circumstances cause the estimated future cash flows (future benefits) of these assets to fall below their book value. *If net book value > Estimated future cash flows, then the asset is impaired Step 2: : Computation of Impairment Loss; For any asset considered to be impaired, companies recognize a loss for the difference between the asset's book value and its fair value (a market concept). The asset is written down to fair value.

Classifying Long-Lived Assets

Tangible: Physical Substance Intangible: No Physical Substance

Technology

Technology: •Website development: Capitalize the costs of acquiring a domain name and developing graphics. •Software: Capitalize the direct costs of developing software (coding and testing) after the software is technologically feasible. Costs incurred during the preliminary concept phase should be expensed. Amortize as a general expense or as cost of goods sold if the software is to be sold to customers.

Estimating Bad Debts—Aging of Accounts Receivable

The Aging method estimates uncollectible accounts based on the age of each - Applies percentage to each time period (I.E 2% not yet due, 90 past due (12%), etc.) then - These estimates are added up then the write offs are later applied to adjust the amount properly

Estimating Bad Debt Expense

The bad debt expense amount recorded in the end-of-period adjusting entry often is estimated based on either: 1. A percentage of total credit sales for the period or 2. An aging of accounts receivable. - Both methods are acceptable under GAAP and are widely used.

Cost Flow Assumptions

The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves. That is why they are called cost flow assumptions.

Estimating Bad Debts—Percentage of Credit Sales Method

The percentage of credit sales method bases bad debt expense on the historical percentage of credit sales that result in bad debts. Will use this % to calculate bad debt expense, then credit Allowance for Doubtful Accounts (+XA, -A)

Inventory Turnover Ratio

The ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly through the production process to the customer, thus reducing storage and obsolescence costs.

Accounting for Net Sales Revenue

The revenue recognition principle requires that revenues be recorded: -when the company transfers goods and services to customers. - in the amount the company expects to be entitled to receive.

The estimated amount of credit sales that customers will likely fail to pay is recorded as bad debt expense in which period?

The same period as credit sales (expense rec. principle.)

Fixed Asset Turnover

This ratio measures the sales dollars generated by each dollar of fixed assets used. A high rate suggests effective management

Average Days to Sell Inventory

This ratio reflects the average time in days it takes a company to produce and deliver inventory to its customers.

Write off Specific Uncollectible Accounts

Throughout the year,when it is determined that a customer will not pay its debts (e.g., due to bankruptcy), the write-off of that individual bad debt is recorded through a journal entry.

If a company records a transaction before the bank records the same transaction, this is called a/an ______ difference.

Timing

Depreciation Concepts (2)

To calculate depreciation expense, three pieces of information are required for each asset: 1.Acquisition cost 2.Estimated useful life 3.Estimated residual (or salvage) value at the end of the assets' useful life

Bank Reconciliation (2)

Two Major Objectives: 1. It checks the accuracy of the bank balance and the company cash records, which involves developing the correct cash balance to be reported on the balance sheet. 2.It identifies any previously unrecorded transactions or changes that are necessary to cause the company's Cash account(s) to show the correct cash balance. *Any transactions or changes on the company's books side of the bank reconciliation need journal entries.

Amortization of Intangible Assets

Upon acquisition of intangible assets, managers determine whether they have definite or indefinite lives: Definite Life: - Amortized over the shorter of the assets' economic life or legal life. - Straight-line method used. - Most companies doe not estimate a residual value Indefinite Life: - Not amortized. - Reviewed at least annually for possible impairment of value. If impaired, the carrying value is reduced to fair market value - Amortization is a cost allocation process similar to depreciation and depletion. *. Decreases: - Total SE on the balance sheet -Total assets on BS -Net income on the income statement

Bad Debt Recoveries

When a company receives a payment on an account that has already been written off, the journal entry to write off the account is reversed to put the receivable back on the books and then the collection of cash is recorded. *these entries, like the original write-off, do not affect total assets or net income. Only the estimate of bad debts affects these amounts.

Credit Card Discount

When credit card sales are made, the company must pay the credit card company a fee for the service it provides. This fee is called a Credit Card Discount.

The journal entry to record the return of merchandise previously purchased on account was recorded by debiting Inventory and crediting Accounts payable. As a result of this entry, ______.

assets will be overstated liabilities will be overstated

To ensure the accuracy of inventory accounted for using a perpetual system, physical counts ______. (Check all that apply.)

detect shrinkage detect theft detect bookkeeping errors

A check that you have written has cleared the bank when

funds have been withdrawn from your bank account to cover the check

Patents

•Exclusive right granted by the federal government for 20 years for inventions and new processes. •Owner can use, manufacture, and sell both the subject of the patent and the patent itself. •Only registration fees and legal costs are capitalized if developed internally. Research and development costs are expensed.

Two Sets of books

•Most public companies, maintains two sets of accounting records. •It is both legal and ethical to maintain separate records for tax and financial reporting purposes. However, these records must reflect the same transactions. *By maintaining two sets of books, corporations can defer (delay) paying millions and sometimes billions of dollars in taxes.

Nature of Intangible Assets

•Non-current assets without physical substance (patents, trademarks, etc.) •Has value because of certain rights and privileges conferred by law •Usually evidenced by a legal document *Intangible assets are recorded at historical cost only if they have been purchased. If these assets are developed internally by the company, they are expensed when incurred. * An intangible asset may be recorded if it pays more than the net assets of the company purchased

Copyrights

•The exclusive right to publish, use, and sell a literary, musical, or artistic work. •Legal life is the life of the creator plus 70 years.

Fraud in expense reporting

•When expenditures that should be recorded as current period expenses are improperly capitalized as part of the cost of the asset, the effects on the financial statements can be enormous.