Accounting 1; Exam 2 ~ Chapters 5, 6, 7, 8

Principle: Human resource controls

1. Bond employees who handle cash - Bonding involves obtaining insurance protection against theft by employees. 2. Rotate employees' duties and require employees to take vacations. 3. Conduct through background checks

Principle: Independent internal verification

1. Companies should verify records periodically or on a surprise basis. 2. An employee who is independent of the personnel responsible for the information should make the verification. 3. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action.

Managing receivables

1. Determine to whom to extend credit 2. Establish a payment period 3. Monitoring collections -A concentration of credit risk: a threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company 4. Evaluate the liquidity of receivables

Principles of internal control activities

1. Establishment of Responsibility 2. Segregation of duties 3. Documentation procedures 4. Physical controls 5. Independent internal verification 6. Human resource controls

Income statement effects

1. In a period of inflation, FIFO produces a higher net income because lower unit costs of the first units purchased are matched against revenue. 2. In a period of inflation, LIFO produces a lower net income because higher unit costs of the last goods purchased are matched against revenue. 3. If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the lowest net income and LIFO the highest. 4. Regardless of whether prices are rising or falling, average cost produces net income between FIFO and LIFO.

Basic principles of cash management

1. Increase the speed of receivables collection 2. Keep inventory levels low 3. Monitor payment of liabilities 4. Plan the timing of major expenditures 5. Invest idle cash - A liquid investment is one with a market in which someone is always willing to buy or sell the investment - A risk-free investment means that there is no concern that the party will default on its promise to pay its principal and interest

Lower-of-cost-or-market (LCM)

A basis whereby inventory is stated at the lower of either its cost or its market value as determined by current replacement cost An example of the accounting convention of CONSERVATISM Under the LCM basis, market is defined as current replacement cost, not selling price. Applied to items in inventory after the company has used one of the cost flow methods to determine cost Companies must "write down" the inventory to its market value in the period in which the price decline occurs.

Purchase discounts

A cash discount claimed by a buyer for a prompt payment of a balance due Advantages: - The purchaser saves money - The seller is able to shorten the operating cycle by converting the accounts receivable into cash earlier The credit terms specify the amount of the cash discount and time period during which it is offered. Also indicate the length of time in which the purchaser is expected to pay the full invoice price Passing up the discount may be viewed as paying interest for use of the money.

Purchase allowance

A deduction made to the selling price of merchandise, granted by the seller, so that the buyer will keep the merchandise

Fraud

A dishonest act by an employee that results in personal benefit to the employee at a cost to the employer Why does fraud occur? 1. Opportunity - Opportunities occur when the workplace lacks sufficient controls to deter and detect fraud. 2. Financial pressure - Employees want/need more money. 3. Rationalization - Employees rationalize their dishonest actions. Sarbanes - Oxley Act reduces fraud. - Applies to publicly traded U.S. corporations - Required to maintain a system of internal control - Corporate executives and boards of directors must ensure that these controls are reliable and effective. - Independent outside auditors must attest to the adequacy of the internal control system -SOX created the Public Company Accounting Oversight Board (PCAOB)

Purchase invoice

A document that indicates the total purchase price and other relevant information Each purchase should be supported by this The purchaser uses the copy of the sales invoice sent by the seller as a purchase invoice.

Factor

A finance company or bank that buys receivables from business for a fee and then collect the payments directly from the customers

Balance sheet effects

A major advantage of the FIFO method is that in a period of inflation, the cost allocated to ending inventory will approximate their current cost.

Accounts receivable turnover

A measure of the liquidity of accounts receivable computed by dividing net credit sales by average net accounts receivable

Direct write-off method

A method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible Unless a company expects bad losses to be insignificant, the direct write-off method is not acceptable for financial reporting purposes. Debit bad debt expense every time Overstate assets Don't match expenses and revenues

Allowance method

A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period Ensures that receivables are stated at their cash (net) realizable value on the balance sheet Companies must use the allowance method for financial reporting purposes when bad debts are material in amount. Three features: 1. Companies estimate uncollectible accounts receivable and match them against revenues in the same accounting period in which the revenues are recorded. 2. Companies record estimated uncollectibles as an increase (a debit) to bad debit expense and an increase (a credit) to allowance for doubtful accounts through an adjusting entry at the end of each period. Allowance for doubtful accounts is a control account to accounts receivable. 3. Companies debit actual uncollectibles to allowance for doubtful accounts and credit them to accounts receivable at the time the specific account is written off at uncollectible. Debit bad dept expense once a year

Percentage-of-receivables basis

A method of estimating the amount of bad debt expense whereby management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts

Internal control

A process designed to provide reasonable assurance regarding the achievement of company objectives related to operations, reporting, and compliance Purposes of internal control are to safeguard assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure compliance. Five primary components of internal control systems: 1. A control environment 2. Risk assessment 3. Control activities 4. Information and communication 5. Monitoring Limitations of internal control: - The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their benefit. - Human element: A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. - The size of the business also may impose limitations on internal control. + Small companies find it difficult to separate duties or to provide for independent internal verification.

Cash budget

A projection of anticipated cash flows, usually over a one to two year period (illustration 7.14 and 7.15)

Sales discounts

A reduction given by a seller for prompt payment of a credit sale

Purchase return

A return of goods from the buyer to the seller for cash or credit

Aging the accounts receivable

A schedule of customer balances classified by the length of time they have been unpaid

Bank statements

A statement received monthly from the bank that shows the depositor's bank transactions and balances Bank statements are prepared from the bank's perspective, so a deposit is called a credit. When a check clears, they call it a debit. A paid check is sometimes referred to as a cancelled check. NSF (not sufficient funds) check: A check that is not paid by a bank because of insufficient funds in a bank account.

Comprehensive income statement

A statement that presents items that are not included in the determination of net income referred to as other comprehensive income

Notes receivable

A written promise (as evidence by a formal instrument) for amounts to be received Normally requires the collection of interest and extends for time periods of 60-90 days or longer

Promissory note

A written promise to pay a specified amount of money on demand or at a definite time May be used when individuals and companies lend or borrow money, when the amount of the transaction and the credit period exceed normal limits, and in settlement of accounts receivable The maker is the party making the promise to pay. The party to whom payment is to be made is called the payee.

Single step income statement

All data are classified into two categories 1. Revenues, which include both operating and non operating revenues and gains 2. Expenses, which include cost of goods sold, operating expenses, and non operating expenses and losses Reasons to use single step 1. A company does not realize any type of profit or income until total revenues exceed total expenses, so it makes sense to divide the statement into these 2 categories 2. Simple and easy to read

Average cost method

Allocates the cost of goods available for sale on the basis of the weighted average unit cost incurred Total cost / units = Ending inventory

Accounts receivable

Amounts customers owe on account Result from sale of goods and services Generally expected to collect accounts receivable within 30 to 60 days

Contra revenue account

An account that is offset against a revenue account on the income statement Ex: Sales Returns and Allowances; Sales Discounts

Specific identification method

An actual physical-flow costing method in which particular items sold and items still in inventory are specifically costed to arrive at cost of goods sold and ending inventory Requires that companies keep records of the original cost of each individual inventory item

Bad debt expense

An expense account to record losses from extending credit Such losses are a normal and necessary risk of doing business on a credit basis.

Principle: Establishment of responsibility

Assign responsibility to specific employees Control is most effective when only one person is responsible for a given task. Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel.

First-in, first-out (FIFO)

Assumes that the earliest goods purchased are the first to be sold Often parallels actual physical flow of merchandise The cost of the earliest goods purchased are the first to be recognized in determining cost of goods sold, regardless of which units were actually sold. Ending inventory is based on the prices of the most recent units purchased. Companies determine the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all unit of inventory have been costed.

Last-in, first-out (LIFO)

Assumes that the latest goods purchased are the first to be sold Seldom coincides with the actual physical flow of inventory The costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. Under the periodic system, which we are using here, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase. Has the highest net cash provided by operating activities because it results in the lowest tax payments. Also impacts the quality of earnings ratio. In times of rising prices, LIFO will give the lowest ending inventory, lowest gross profits, lowest income taxes, and the lowest net income.

Weight average unit cost

Average cost that is weighted by the number of units purchased at each unit cost

Flow of costs

Beginning inventory + cost of goods purchased = cost of goods available for sale As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of the account period represent ending inventory.

Inventory turnover

Calculated as cost of goods sold divided by average inventory --> Inventory turnover ratio: Cost of goods sold / Average inventory High inventory turnover indicates the company has minimal funds tied up in inventory; that it has a minimal amount of inventory on hand at any one time Days in inventory = 365 / Inventory turnover ratio

Restricted cash

Cash that is not available for general use, but rather is restricted for a special purpose

Periodic inventory system

Companies determine the cost of goods sold only at the end of the accounting period (periodically). Steps to determine the cost of goods sold using this system: 1. Determine the cost of goods on hand at the beginning of the accounting period. 2. Add to it the cost of goods purchased. 3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period. In other words: Beginning inventory + Cost of goods purchased _________________________________ Cost of goods available for sale - Ending inventory _________________________________ Cost of goods sold

Perpetual inventory system

Companies maintain detailed records of the cost of each inventory purchase and sale. These records continually show the inventory that should be on hand for every item. Under this system, a company determines the cost of goods sold each time a sale occurs. Advantages of the perpetual system: - provides better control over inventories than a periodic system - if shortages are uncovered, companies can investigate immediately

Determining inventory quantities

Companies using a periodic inventory system must take physical inventory for two different purposes: 1. To determine the inventory on hand at the balance sheet date 2. To determine the cost of goods sold for the period Involves 2 steps: 1. Taking a physical inventory of goods on hand 2. Determining the ownership of goods

Internal auditors

Company employees who continuously evaluate the effectiveness of the company's internal control systems

Multiple step income statement

Considered more useful because it highlights the components of net income Three important line items 1. Subtract cost of goods sold from net sales to determine gross profit 2. Deduct operating expenses from gross profit to determine income from operations 3. Add or subtract the results of activities not related to operations to determine net income Includes: - net sales (sales less sales returns and allowances and sales discounts) - gross profit: the excess of net sales over the cost of goods sold or the profit on your inventory + determined by deducting cost of goods sold from net sales + represents the merchandising profit of a company, not the measure of the overall profit of a company + comparisons of current gross profit with past amounts and rates and with those in the industry indicate the effectiveness of a company's purchasing and pricing policies - operating expenses - non operating activities (consist of various revenues and expenses and gains and losses that are unrelated to the company's main line of operations)

Cash

Consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository

Merchandise inventory

Describes the many different items that make up the total inventory Two common characteristics: 1. They are owned by the company. 2. They are in a form ready for sale to customers in the ordinary course of business.

Electronic funds transfer (EFT) system

Disbursement systems that use wire, telephone, or computers to transfer cash from one location to another Ensures that no cash or checks are handled by company employees Use is quite common

Principle: Documentation procedures

Documents provide evidence that transactions and events have occurred. Documents used in the business should always be prenumbered.

Paper or phantom profits

Earnings that do not really exist

Operating cycles

For a service company: Cash --> perform services --> accounts receivable --> receive cash --> back to cash For a merchandising company: Cash --> buy inventory --> inventory --> sell inventory --> accounts receivable --> receive cash --> back to cash

FOB

Free on board

Cash disbursements controls

Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. Voucher system controls: - A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper. - A voucher is an authorization form prepared for each expenditure in a voucher system. Petty cash fund: - A cash fund used to pay relatively small amounts

Gross profit rate

Gross profit may be expressed as a percentage by dividing the amount of gross profit by net sales More informative than gross profit amount

Other receivables

Include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable Do not generally result from the operations of the business

Cost

Includes all expenditures necessary to acquire goods and place them in a condition ready for sale

Cash receipts section

Includes expected receipts from the company's principal source of cash, such as cash sales and collections from customers on credit sales Also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investment, plant assets, and the company's capital stock

Manufacturing company inventory

Inventory classified in 3 categories: - finished goods inventory: manufactured items that are completed and ready for sale - work in process: that portion of manufactured inventory that has begun the production - raw materials: the basic goods that will be used in production but have not yet been placed into production By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management's production plans.

Just in time (JIT) inventory methods

Inventory system in which companies manufacture or purchase goods only when needed

Taking a physical inventory

Involves actually counting, weighing, or measuring each kind of inventory on hand

Adjustments for LIFO reserve

LIFO reserve: For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO

Tax effects

LIFO results in the lowest income taxes during times of rising prices.

Determining the ownership of goods

Making sure a company owns the inventory *Goods in transit - The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. - Should be included in the inventory of the company that has legal title to the goods + Legal title is determined by the terms of the sale *Consigned goods - Goods held for sale by the party although ownership of the goods is retained by another party - Avoids the risk of purchasing an item that they will not be able to sell

Finished goods inventory

Manufactured items that are completed and ready for sale

Profit margin

Measures the percentage of each dollar of sales that results in net income Measures the extent by which selling price covers all expenses Net income / net sales = profit margin

Internal decision making

Merchandising companies may use more than one sales account. By doing this, company management can monitor sales trends more closely and respond to changes in sales patterns more strategically.

Retailers

Merchandising companies that purchase and sell directly to consumers

Wholesalers

Merchandising companies that sell to retailers

Cost flow assumptions

Necessary because specific identification is often impractical Assume flow of costs that may be unrelated to the actual physical flow of goods Three assumed cost flow methods: 1. First-in, first-out (FIFO) 2. Last-in, first-out (LIFO) 3. Average cost There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. To determine the 3 cost flow methods, use a periodic inventory system Companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average cost and adjust cost of goods sold to this recalculated number.

Reconciling the bank account

Necessary to make the balance per books and the balance per bank agree with the correct or true amount Two causes: 1. Time lags that prevent one of the parties from recording the transaction in the same period 2. Errors by either party in recording transactions

Trade receivables

Notes and accounts receivable that result from sales transactions

Cash receipt controls

Over the counter receipts - Visibility of the cash sale to the customers prevents the cashier from entering a lower amount and pocketing the difference. - Illustration 7.5 - Involves segregation of recordkeeping from physical custody Mail receipts - All mail receipts should be opened in the presence of at least two mail clerks

Sales revenue

Primary source of revenue for a merchandising company

Principle: Physical controls

Related to the safeguarding of assets and enhance the accuracy and reliability of the accounting records

Cash equivalents

Short term, highly liquid investments that are both 1. readily convertible to known amounts of cash, and 2. so near their maturity that their market value is relatively insensitive to changes in interest rates

Financing section

Shows expected borrowings and repayments of borrowed funds plus interest

Cash disbursements section

Shows expected payments for inventory, labor, overhead, and selling and administrative expenses Also includes projected expenses for income taxes, dividends, investments, and plant assets Does not include depreciation since depreciation expense does not use cash

Work in process

That portion of manufactured inventory that has begun the production

Conservatism

The approach adopted among accounting alternatives is the method that is least likely to overstate assets and net income

Average collection period

The average amount of time that a receivable is outstanding, calculated by dividing 365 days by the accounts receivable turnover

Raw materials

The basic goods that will be used in production but have not yet been placed into production

Current replacement cost

The cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities

Cash (net) realizable value

The net amount a company expects to receive in cash from receivables Excludes amounts that the company estimates it will not collect

Bank reconciliation

The process of comparing the bank's balance with the company's balance, and explaining the differences to make them agree

FOB shipping point

The seller places the goods free on board the carrier, and the buyer pays the freight costs. When the buyer pays the transportation costs, these costs are considered part of the cost of purchasing inventory. Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.

FOB destination

The seller places the goods free on board to the buyer's place of business, and the seller pays the freight. Freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. When the seller pays the freight charges, the seller will usually establish a higher invoice price for the goods, to cover the expense of shipping. Ownership of the goods remains with the seller until the goods reach the buyer.

Cost of goods sold

The total cost of merchandise sold during the period This expense is directly related to the revenue recognized from the sale of goods.

Principle: Segregation of duties

The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. 1. Segregation of related activities - making one individual responsible for related activities increases the potential for errors and irregularities + Purchasing activities: companies should assign related purchasing activities to diff. individuals. + Sales activities: companies should assign related sales activities to diff. individuals. 2. Segregation of recordkeeping from physical custody - The custodian of the asset is not likely to convert the asset to personal use when one employee maintains the record of an asset, and an different employee has physical custody of the asset

Reconciliation procedure

To obtain maximum benefit from a bank reconciliation, an employee who has no other responsibilities related to cash should prepare the reconciliation. Reconciling items per bank 1. Deposits in transit (+) - Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit. 2. Outstanding checks (-) - Issues checks recorded by the company that have not been paid by the bank represent outstanding checks. 3. Bank errors (+/-) - All errors made by the bank are reconciling items in determining the adjusted cash balance per bank. Reconciling items per book 1. Other deposits (+) 2. Other payments (-) 3. Book errors (+/-)

Sales returns

Transactions where the seller accepts goods back from a purchaser

Sales allowances

Transactions where the seller grants a reduction in the purchase price (allowance) so that the buyer will keep the goods