Ch 5-8 Reviews and Definitions

What are the 5 components of internal control? Briefly Explain each.

5 Components of Internal Control: 1. Control Procedures-designed to ensure that the business's goals are achieved. 2. Risk Assessment-the company business risk, as well as the risk over individual accounts, must be assessed. The higher the risk, the more controls must be in place to safeguard the company assets. 3. Information System-controls must be in place to ensure appropriate authorizations and approvals are used and that accurate information is produced. 4. Monitoring of Controls-performed by both internal and external auditors to determine whether the company and employees are following company policies and that operations are running efficiently. 5. Environment-"tone at the top" of the business. Members of management must behave honorably to set a good example for company employees.

Materiality Concept

A Company must perform strictly proper accounting only for items that are significant to the business's financial situation. (Pg. 326)

When dealing with receivables, give an example of a subsidiary account.

A business must maintain a separate accounts receivable account for each customer in order to account for payments received from the customer and amounts still owed. All sales and collections from that customer are tracked in that account, along with the balance.

Conservatism

A business should report the least favorable figures in the financial statements when two or more possible options are presented. (Pg. 326)

Consistency Principle

A business should use the same accounting methods and procedures from period to period. (Pg. 325)

What occurs when a business pledges its receivables?

A business uses its receivables as security for a loan. The business borrows money from a bank and offers its receivables as collateral. The business still is responsible for collecting on the receivables and uses the money collected to pay off the loan along with interest. In pledging, if the loan is not paid, the bank can collect on the receivables.

Disclosure Principle

A business's financial statements must report enough information for outsiders to make knowledgeable decisions about the company. (Pg. 325)

What is a merchandiser, and what is the name of the merchandise that it sells?

A merchandiser is a business that sells merchandise, or goods, to customers. The merchandise that these types of businesses sell is called merchandise inventory.

Describe the multi-step income statement.

A multi-step income statement lists several important subtotals. IN addition to net income (the bottom line), it also reports subtotals for gross profit and income from operations.

What is a purchase return? How does a purchase allowance differ from a purchase return?

A purchase return is when businesses allow purchasers to return merchandise that is defective, damaged, or otherwise unsuitable. Purchase allowances are granted to the purchaser as an incentive to keep goods that are not "as ordered." Together, purchase returns and allowances decrease the buyer's cost of the inventory.

What is the difference between accounts receivable and notes receivable?

Accounts receivable represent the right to receive cash in the future from customers for goods sold or for services performed. Accounts receivable are usually collected within a short period of time such as 30 or 60 days. Notes receivable are usually longer in term than accounts receivable. Notes receivable represent a written promise that a borrower will pay a fixed amount of principal plus interest by a certain date in the future.

What does the days' sales in receivables indicate, and how is it calculated?

Also called the collection period, indicates how many days it takes to collect the average level of accounts receivable. The number of days' sales in receivables should be close to the number of days customers are allowed to pay when credit is extended. The shorter the collection period, the more quickly the organization can use its cash. The longer the collection period, the less cash is available for operations. 365 days/accounts receivable turnover ratio

What is the formula to compute interest on a note receivable?

Amount of interest=Principal x Interest Rate x Time

Specific Identification Method

An inventory costing method based on the specific cost of particular units of inventory. (Pg. 329)

Weighted-Average Method

An inventory costing method based on the weighted-average cost per unit of inventory that is calculated after each purchase. Weighted-average cost per unit is determined by dividing the cost of goods available for sale by the number of units available. (Pg. 333) Weighted-Average Cost per Unit= Cost of Goods Avail. for Sale/# Units Avail.

First-In, First-Out (FIFO) Method

An inventory costing method in which the first costs into inventory are the first costs out to cost of goods sold. Ending inventory is based on the costs of the most recent purchases. (Pg. 330)

Last-In, Last-Out (LIFO) Method

An inventory costing method in which the last costs into inventory are the first costs out to cost of goods sold. The method leaves the oldest costs-those of beginning inventory and the earliest purchases of the period-in ending inventory. (Pg. 331)

What is an invoice?

An invoice is the seller's request for payment from the buyer. It is also called a bill.

What is the expense account associated with the cost of uncollectible receivables called?

Bad Debts Expense

How do you calculate Cost of Goods Sold?

Beginning Inventory + Purchases -Purchase Returns/Allowances -Purchase Discounts +Freight In -Ending Inventory =COGS

How is the acid-test ratio calculated, and what does it signify?

Cash + Cash Equivalents + Short-term investments + net current receivables to total current liabilities. The acid-test ratio reveals whether the entity could pay all its current liabilities if they were to become due immediately.

Cash Ratio

Cash Ratio=(Cash + Cash Equivalents)/Total Current Liabilities helps determine a company's ability to meet its short-term obligations.

How do businesses control cash receipts over the counter?

Cash Register. The cash register only opens after the clerk enters a transaction and it is recorded. A receipt is given to the customer. The cash register report of cash sales at the end of the day is compared to the cash in the drawer. All cash is deposited in the bank at the end of the day. These measures, coupled with oversight by a manager, discourage theft.

Bank Reconciliation

Compares and explains the difference between cash on the company's books and cash according to the bank's records on a specific date.

What is the goal of conservatism?

Conservatism in accounting means exercising caution in reporting items in the financial statements. A company should report the least favorable figures in the financial statements when two or more possible options are presented. The goal of conservatism is to report realistic figures and to never overstate assets or net income.

What are some limitations of internal controls?

Cost and Benefit. The better the controls, the more they can cost, so a company needs to determine the best balance of cost and benefit. It can also be difficult for a business to prevent collusion-when two or more people work together to circumvent internal controls and defraud the company.

What is Cost of Goods Sold (COGS), and where is it reported?

Cost of Goods Sold is the cost of merchandise that has been sold to the customer. It is shown on the income statement as an expense.

How do you calculate Days' Sales in Inventory?

Days' Sales in Inventory= Days/Inventory Turnover

What are the controls needed to secure the petty cash fund?

Designate a custodian of the fund. Designate a specific amount of cash to be kept in the fund. Support all petty cash fund payments with a petty cash ticket.

List some common examples of other receivables, besides accounts receivable and notes receivable.

Dividends Receivable Interest Receivable Taxes Receivable

List internal control procedures related to e-commerce.

Encryption and Firewalls

List some examples of timing differences, and for each difference, determine if it would affect the book side of the reconciliation or the bank side of the reconciliation.

Examples of timing differences: A. Deposits in transit-affect bank side B. Outstanding Cks- affect bank side C. Electronic Funds transfer-book side

Describe FOB shipping point and FOB destination. When does the buyer take ownership of the goods, and who typically pays the freight?

FOB shipping point means the buyer takes ownership (title) to the goods after the goods leave the seller's place of business (shipping point). In this case, the buyer (owner of the goods while in transit also pays the freight. FOB destination means the buyer takes ownership (title) to the goods at the delivery destination point. In this case, the seller (owner of the goods while in transit) usually pays the freight.

What are the two journal entries involved when recording the sale of inventory when using the perpetual inventory system?

First: Debit to Cash or Accts Receivable Credit to Sales Revenue Second: Debit Cost of Goods Sold Credit Merchandise Inventory

What is freight out, and how is it recorded by the seller?

Freight out expense is one in which the seller pays freight charges to ship goods to customers. Freight out is a delivery expense to the seller.

How do you calculate Gross Profit Percentage?

Gross Profit/Net Sales Revenue=GP%

How is gross profit calculated, and what does it represent?

Gross profit is calculated as net Sales Revenue minus Cost of Goods Sold and it represents the mark-up on the merchandise inventory. It is the extra amount the company receives from the customer over what the company paid to the vendor. Gross Profit=Net Sales Revenue - COGS

What is the effect on cost of goods sold, gross profit, and net income if ending merchandise inventory is understated?

If ending merchandise inventory is understated, cost of goods sold is overstated, gross profit is understated, and net income is understated.

How do the percent-of-receivables and aging-of-receivables methods compute bad debts expense? What is the difference between the two methods?

In both, the business determines the target balance of the allowance for bad debts account based on a percentage of accounts receivable. This target balance is then used to determine the amount of bad debts expense after considering the previous balance in the allowance for bad debts. In the percent-of-receivables method, the business uses only one percentage to determine the balance of the allowance for bad debts account. In the aging-of-receivables method, the business groups' individual accounts according to how long the receivable has been outstanding. They then apply a different percentage to each aging category.

What account is debited when recording the adjusting entry to write down merchandise inventory under the LCM rule?

In the adjusting entry to write down merchandise inventory, Cost of Goods Sold is debited (and Merchandise Inventory is credited).

Internal Auditor Vs. External Auditor

Internal Auditors are employees who ensure that the company's employees are following company policies, that the company is meeting legal requirements, and that operations are running efficiently. External Auditors are outside accountants, completely independent of the business, who monitor the controls to ensure the financial statements are presented fairly in accordance with GAAP.

How do you calculate Inventory Turnover?

Inventory Turnover= COGS/Avg. Merchandise Inventory

What is inventory shrinkage? Describe the adjusting entry that would be recorded to account for inventory shrinkage.

Inventory shrinkage is the loss of inventory that occurs because of theft, damage, errors. The adjusting entry for shrinkage: Debit to Cost of Goods Sold Credit to Merchandise Inventory

What does inventory turnover measure?

Inventory turnover measures how rapidly merchandise inventory is sold during a period (the number of times a company sells its average level of merchandise inventory during a period). Inventory Turnover= COGS/Avg. Inventory (where Avg. merchandise Inventory = Beginning merchandise inventory + Ending merchandise inventory/2).

How does Sarbanes-Oxley Act relate to internal controls?

It requires public companies to issue an internal control report, which is a report by management describing its responsibility for and the adequacy of internal controls over financial reporting. Additionally, an outside auditor must evaluate the client's internal controls and report on the internal controls as part of the audit report.

What occurs when a business factors its receivables?

It sells its receivables to a finance company or bank (often called a factor). The business receives cash less an applicable fee from the factor for the receivables. The factor, instead of the business, now collects the cash on the receivables. The business no longer has to deal with the record-keeping and collection of the receivables.

What are some limitations of using the direct write-off method?

It violates the matching principle and is not preferred by GAAP. The matching principle requires that the expense of uncollectible accounts be matched with the related revenue. Under the direct write-off method the expense can occur in future months or years. In addition, the accounts receivable (asset) are overstated on the balance sheet.

Separation of Duties

Limits fraud and promotes the accuracy of the accounting records by dividing responsibility between two or more people. The two main areas of separation are separating operations from accounting and separating the custody of assets from accounting.

Discuss some measures that should be taken to maintain control over merchandise inventory.

Maintaining good controls over merchandise inventory is very important for a merchandiser. Good controls ensure that inventory purchases and sales are properly authorized and accounted for by the accounting system. This can be accomplished by taking the following measures: -Ensure merchandise inventory is not purchased without proper authorization, including purchasing only from approved vendors and within acceptable dollar ranges. -After inventory is purchased, the order should be tracked and properly documented when received. At time of delivery, a count of inventory received should be completed and each item should be examined for damage. -Damaged inventory should be properly recorded and then should be used, disposed of, or returned to the vendor. -A physical count of inventory should be completed once a year to track inventory shrinkage due to theft, damage, and errors. -When sales are made, the inventory sold should be properly recorded and removed from the inventory count. This will reduce the likelihood of stockouts.

Days' Sales in Inventory

Measures the average number of days that inventory is held by a company. (Pg. 365) Days' Sales in Inventory= Days/Inventory Turnover

Inventory Turnover

Measures the number of times a company sells its average level of merchandise inventory during a period. (Pg. 344) Inventory Turnover= COGS/Avg. Merchandise Inventory

What financial statement is merchandise inventory reported on, and in what section?

Merchandise inventory is shown as current asset on the Balance Sheet.

What are the two types of merchandisers? How do they differ?

Merchandisers are often identified as either wholesalers or retailers. A wholesaler is a merchandiser that buys goods from a manufacturer and then sells them to retailers. A retailer buys merchandise either from a manufacturer or a wholesaler and then sells those goods to customers.

Trick for calculating affect of rising and declining prices for LIFO/FIFO.

Name List # in order EI/CGS/NI For Name EI & NI Same X-signifies crossed out EXAMPLE for Rising Prices: FIFO 1X 2X 3 EI-Up/CGS-Dwn/NI-UP 4 5 LIFO 1 EI-Dwn/CGS-Up/NI-Dwn 2 3 4X 5X

How do you calculate Gross Profit?

Net Sales Revenue -COGS =Gross Profit

Why is it necessary to record journal entries after the bank reconciliation has been prepared? Which side of the bank reconciliation requires journal entries?

Once the bank reconciliation is complete, all items that affect the book side of the reconciliation need to be recorded with journal entries. This ensures the cash balance agrees with the reconciled amount.

When does an inventory error cancel out, and why?

One period's ending merchandise inventory becomes the next period's beginning merchandise inventory. As a result, an error in ending merchandise inventory carries over into the next period. Ending merchandise inventory is subtracted from the cost of goods available for sale in one period and the same amount is added as beginning merchandise inventory in the next period. Therefore, an inventory error cancels out after two periods.

Perpetual Vs. Periodic

Perpetual Periodic DR CR DR CR Inv A/P Purchase Purc A/P A/P Inv Return A/P Purc Inv AP/Csh Freight FrtIn AP/Csh A/P Csh Pay Bill A/P Csh AR/Cs Sales Sales AR/Cs Sales Cogs Inv *COGS Manual

How is the net cost of inventory calculated?

Purchase Cost of Inventory -Purchase returns/allowances -purchase discounts + Freight in =Net Cost of Inventory

Sales Discounts

Reduction in the amount of cash received from a customer for early payment. (Pg.259)

Lower-of-Cost-or-Market (LCM) Rule

Rule that merchandise inventory should be reported in the financial statements at whichever is lower-its historical cost or its market value. (Pg. 339)

How do you calculate Net Sales Revenue?

Sales Revenue -Sales Returns/Allowances -Sales Discounts =Net Sales Revenues

How do businesses control cash receipts by mail?

Separating the check and the remittance advice in the mail room. The checks are given to the treasurer to deposit in the bank, and the remittance advice is used by the accounting department to record the payment to the customer's account. The controller will compare the debit to cash and the bank deposit receipt to ensure they agree. Some companies may also use a lock-box system, where cash receipts are sent directly to a post office box managed by a bank's employee.

What is a critical element of internal control in the handling of receivables by a business? Explain how this element is accomplished.

Separation of cash-handling and cash-accounting duties. For good internal control over cash collections from receivables, separation of duties must be maintained and the credit department should have no access to cash. Additionally, those who handle cash should not be in a position to grant credit to customers.

FOB Shipping Point

Situation in which the buyer takes ownership (title) to the goods after the goods leave the seller's place of business (Shipping Point) and the buyer typically pays the freight. (Pg. 255)

FOB Destination

Situation in which the buyer takes ownership (title) to the goods at the delivery destination point and the seller typically pays the freight. (Pg. 255)

During periods of rising costs, which inventory costing method produces the highest gross profit?

The FIFO inventory costing method produces the highest gross profit.

What account is debited when recording a purchase inventory when using the perpetual inventory system?

The Merchandise Inventory account is debited when recording the purchase of inventory using the perpetual inventory system.

What are two common methods used when accepting deposits for credit card and debit card transactions?

The Net Method-total sale less the processing fee assessed equals the net amount of cash deposited by the processor, usually within a few days of the sale date. The Gross Method-total sale is deposited daily, within a few days of the actual sale date. The processing fees for all transactions processed for the month are deducted from the company's bank account by the processor, often on the last day of the month.

When using the allowance method, how are accounts receivable shown on the balance sheet?

The Realizable Value. Net realizable value is the net value that the company expects to collect from its receivables (accounts receivables less allowance for bad debts.)

What are some benefits to a business in accepting credit cards and debit cards?

The ability to attract more customers, not having to check each customer's credit rating, and not having to keep accounts receivable records or make collections from the customer.

What does the accounts receivable turnover ratio measure, and how is it calculated?

The accounts receivable turnover ratio measures the number of times the company collects the average accounts receivable balance in a year. The higher the ratio, the faster the cash collections. Net credit sales/Avg net accounts receivables

What type of account must the sum of all subsidiary accounts be equal to?

The balance in all the subsidiary accounts receivable accounts must equal the total balance of the control account, Accounts Receivable.

What are the steps taken to ensure control over purchases and payments by check?

The buyer sends a purchase order to the supplier that contains the quantity and type of goods needed. The supplier ships the item and sends the buyer an invoice; once the item is received a receiving report is prepared. Once all the documents are matched and approved, a check is sent to the supplier.

What would the credit terms of "2/10, n/EOM" mean?

The credit terms "2/10, n/EOM" means that the purchaser can deduct 2% from the total bill excluding freight if the company pays within 10 days of the invoice date. Otherwise the full amount is due by the end of the month.

Under a perpetual inventory system, what are the four inventory costing methods and how does each method determine ending inventory and cost of goods sold?

The four inventory costing methods are: -Specific Identification-uses the specific cost of each unit of inventory to determine cost of goods sold and ending merchandise inventory. -FIFO-assumes that the first costs into merchandise inventory are the first costs out to COGS. Ending inventory is based on the costs of the most recent purchases. -LIFO-assumes that the last costs into merchandise inventory are the first costs out to COGS. This method leaves the oldest costs-those of beginning inventory and the earliest purchases of the period-in ending merchandise inventory. -Weighted-Average-based on the weighted average cost of inventory that is calculated after each purchase of inventory. After each purchase, weighted average cost per unit is determined by dividing the cost of goods available for sale by the number of units available. When using a perpetual inventory system and the weighted-average inventory costing method, a new weighted average cost per unit is computed after each purchase. Cost of goods sold and ending merchandise inventory are based on the same weighted average cost per unit.

What are the four steps involved in the closing process for a merchandising company?

The four-step closing process for a merchandising company are: Step 1: Make the revenue accounts equal zero via the Income Summary account. Step 2: Make the expense accounts and other temporary accounts with a debit balance (Sales Returns/Allowances/Sales Discounts) equal zero via the Income Summary account. Step 3: Make the Income Summary account equal zero via the Retained Earnings account. Step 4: Make the Dividends account equal zero via the Retained Earnings Account.

What does the gross profit percentage measure, and how is it calculated?

The gross profit percentage measures the profitability of each sales dollar above the cost of goods sold. Gross Profit/Net Sales Revenue=GP%

Why must companies record accrued interest revenue at the end of the accounting period?

The interest revenue earned on the note up to year-end is part of that year's earnings. Interest revenue is earned over time, not just when cash is received. Because of the revenue recognition principle, a business must record the earnings from the note in the year in which they were earned.

Discuss the materiality concept. Is the dollar amount that is material the same for a company that has annual sales of $10,000 compared with a company that has annual sales of $1,000,000?

The materiality concept states that a company must perform strictly proper accounting only for significant items. Information is significant-or, in accounting terms, material-when it would cause someone to change a decision. The amount that is material for a company with annual sales of $10,000 is not the same as the amount that is material for a company with annual sales of $1,000,000. For example, $1,000 is 10% of $10,000 but is only 0.1% of $1,000,000. Thus, $1,000 is material for a company with annual sales of $10,000 but not for a company with annual sales of $1,000,000.

Describe the operating cycle of a merchandiser.

The operating cycle of a merchandiser is as follows: It begins when the company purchases inventory from a vendor, the company then sells the inventory to a customer, and finally, the company collects cash from customers.

Internal Control

The organizational plan and all the related measures adopted by an entity to safeguard assets, encourage employees to follow company policies, promote operational efficiency, and ensure accurate and reliable accounting records.

Describe the single-step income statement.

The single-step income statement is the income statement format that groups all revenues together and all expense together without calculating other subtotals.

What are the two types of inventory accounting systems? Briefly describe each.

The two types of inventory accounting systems are the periodic inventory system and the perpetual inventory system. The periodic inventory system requires businesses to obtain a physical count of inventory to determine the quantities on hand. It is normally used for relatively inexpensive goods. The perpetual inventory system keeps a running computerized record of merchandise inventory, including inventory units and dollars amounts.

When a receivable is written off under the allowance method, how does it affect the net realizable value shown on the balance sheet?

There is no change in the net realizable value shown on the balance sheet.

When granting a sales allowance, is there a return of merchandise inventory from the customer? Describe the journal entry(ies) that would be recorded.

There is not a return of merchandise when a sales allowance is granted. Debit Sales Returns Debit Allowances Credit Accounts Receivable

When is bad debts expense recorded when using the allowance method?

Under the allowance method, bad debts expense is estimated and recorded in the same period as the sales revenue as an adjusting entry at the end of the accounting period.

When is bad debts expense recorded when using the direct write-off method?

Under the direct write-off method, accounts receivables are written off and bad debts expense is recorded when the business determines that it will never collect from a specific customer.

What are some common controls used with a bank account?

Use of a Signature Card Deposit Tickets Checks Bank Statements Bank Reconciliations

When using the periodic inventory system, which inventory costing method(s) always produces the same result as when using the perpetual inventory system?

When using a periodic inventory system, the specific identification and FIFO inventory costing methods produce the same results as when using a perpetual inventory system.

When using a perpetual inventory system and the weighted-average inventory costing method, when does the business compute a new weighted-average cost per unit?

When using a perpetual inventory system and the weighted-average inventory costing method, a new weighted average cost per unit is computed after each purchase.

When using the allowance method, what account is debited when writing off uncollectible accounts? How does this differ from the direct write-off method?

When using the allowance method, the allowance for bad debts account is debited when writing off uncollectible accounts. This is different than the direct write-off method, which would debit bad debts expense. The allowance method does not affect net income when an account is written off.

When using the periodic inventory system and weighted-average inventory costing method, when is the weighted-average cost per unit computed?

When using the periodic inventory system and weighted-average inventory costing method, the weighted average cost per unit is computed at the end of the period (a single weighted average cost per unit is computed for the entire period).

How does the percent-of-sales method compute bad debts expense?

as a percentage of net credit sales