ACCT 2110 Exam 2

Step 5: Adjusting the Accounts

Every adjusting entry that you make involves a revenue or an expense. Result of timing differences between when an expense or revenue is recognized and cash is received or paid. Adjustments are made at the end of the period, before making financial statements. All Adjusting entries will affect at least one income statement account and one balance sheet account. Note that cash is NEVER affected by adjustments.

FOB Shipping Point

Everything is free to the buyer until the good is shipped.

Interest Calculation

Face Value X Rate X Time

Interest Rates

Face Value X Rate X Time (Usually out of 12 for months) (Can be out of 360 for daily)

Cash Management Options

Factory Receivables (The factoring company collects receivables and charges percentage). Asset-based lending arrangement. Acceptance of credit/debit cards.

Service Charges

Fees charged by the bank for checking account services. The amount of the fee is not known to the business (and therefore cannot be recorded) until the bank statement is received.

FOB

Free on Board (Risk, Title, and Money)

Gross Profit Margin

Gross Profit ÷ Net Sales

Disposition of Notes Receivable

Honored: Paid in full at maturity. Dishonored: Not paid in full. Eliminate carrying value of note it honored. Write off if dishonored and no hope of repayment.

Cash Equivalents

Include "all highly liquid investments with an original maturity of 3 months or less at date of inception."

Short-Term Investments

Keep bank cash balances to a minimum since most bank accounts earn relatively small amounts of interest. Accordingly, these are purchased with temporary cash surpluses. The value and composition of these portfolios change continually in response to seasonal factors and other shift in the business environment.

Deferred (Unearned) Revenues

Liabilities arising from the receipt of cash for which revenue has not yet been earned. A type of adjusting entry.

Promissory Note

Maker: Promises to pay. Payee: Receives payment (records N/R). Recorded at face value. Stronger legal claim/requires interest.

Section 404 (SOX)

Requires publicly traded companies to include in their annual report to stockholders an internal control report containing two items: Statement of management's responsibility to establish and maintain internal controls and an assessment of the effectiveness of its internal controls. Forces management to be engaged with respect to its internal controls. Requires an annual audit of the company's internal control structure and the assessment provided by management.

Committee of Sponsoring Organizations (COSO)

Report that was the culmination of the committee's exhaustive research and deliberation on the elements of sound internal control. This framework has become the standard for understanding what good internal controls look like.

Sales Returns and Allowances

Return of defective product or price allowance for minor defects. Late arrival, or any way that makes a product less valuable may be a reason for an allowance. Contra-revenue account is used to record the merchandise return or price reduction.

Cash-Basis Accounting

Revenue is recorded when cash is received, regardless of when it is actually earned. Expenses recognized when cash is paid. Net income is easier to manipulate. Departure from GAAP because it violates the Revenue Recognition and Matching Principles.

Valuation (Amount of Revenue Recognized)

The appropriate amount of revenue to recognize is generally the cash received or the cash equivalent of the receivable. Three changes to sales revenues include: discounts, returns, and allowances. Two contra-revenue accounts are used to track these: Sales Returns and Allowances (People return goods or do not want to pay full price) and Sales Discounts (entry point terms)

Accumulated Depreciation

A Contra-Account for depreciation, and on the balance sheet it is shown as a negative asset. Will be a credit on the asset T-Chart.

Accrual-Basis

Accounting that recognizes revenue when it is realized, which means that non-cash resources (such as inventory) have been exchanged for cash or near cash (accounts receivable), and earned, which means the earnings process is substantially complete (good amount of certainty that we will be paid).

Time-Period Assumption

Allows company to artificially divide their operations into time periods so they can satisfy users' demands for information. Time difference between cash-basis and accrual.

Accrual-Basis Accounting

An alternative to cash-basis accounting that is required by GAAP. Superior because it links income measurement to selling, the principle activity of the company. Includes Time-Period Assumption and Revenue Recognition Principle. Transactions are recorded in the time periods of the events. Requires adjusting entries.

Deposit in Transit

An amount received and recorded by the business, but which has not been recorded by the bank in time to appear on the current bank statement. Cause the bank balance to be smaller than the business's cash account balance.

Risk Assessment

An element of internal control. Procedures are designed to identify, analyze, and manage strategic risks and business process risks.

Performing a Bank Reconciliation

Bank Balance + Deposits in Transit - Outstanding Checks = Adjusted Bank Balance. Company Cash Balance + Bank Additions (Interest/Collection of Note) - Bank Deductions (Service Charges/NSF Checks) = Adjusted Company Balance.

3 Key Cash Controls

Bank Reconciliation. Cash Over and Short. Petty Cash Funds.

Deferrals ("Prepayments")

Cash exchange happens before revenue/expense is recognized. Adjusting entry always decreases a balance sheet account and increases an income statement account. We have had a cash transaction that has already happened, then revenue and expense transactions happen later.

Accounting and Reporting Cash

Cash is reported on both the balance sheet and the statement of cash flows. The balance sheet typically reports the amount of cash and cash equivalents available at the balance sheet date.

Revenue Recognition Principle

Determines when revenue is recorded and reported. Under this principle, revenue is recognized, or recorded, in the period in which both of the following conditions are met: the revenue has been earned and the collection of cash is reasonable assured.

Trade Receivables

Due from customers purchasing inventory in the ordinary course of business. Recognized in connection with a sale.

Internal Control for Sales

End Goal: Sales (and receivables) are presented fairly according to GAAP. For sales revenues, these typically involve the following documents and procedures: Purchase Order and Shipping Documents and Invoice. A sale and its associated receivables are recorded only when the order, shipping, and billing documents are all present.

Errors

Errors in recording transactions represent yet another source of difference between a business's cash account balance and the bank balance. Errors are inevitable in any accounting system and should be corrected as soon as discovered. In addition, an effort should be made to determine the cause of any error as a basis for corrective action.

Cash Controls

The authority to collect, hold, and pay cash must be clearly assigned to specific individuals. Whenever feasible, cash-handling activities, and cash record-keeping activities should be assigned to different individuals. Cash records should be examined often by an objective party as a basis for evaluating the performance of cash-handling activities. Controls should be supported by an appropriately designed record-keeping system. Cash should be safeguarded in vaults and banks.

Accounts Receivable

Type of receivable. "On Account". "Trade Receivables" result from sale of goods/services.

Other Receivables

Type of receivable. Non-trade receivables (interest receivable, notes to company officers, advances to employees, tax refunds)

Notes Receivable

Type of receivable. Used for less creditable customers. Formal debt instrument, normally requires interest.

Permanent (Real) Accounts

Balances need to be carried forward into future accounting periods.

Outstanding Check

A check issued and recorded by the business that has not been "cashed" by the recipient of the check. These cause the bank balance to be higher than the business's cash account balance.

Non-Sufficient Funds (NSF) Check

A check that has been returned to the depositor because funs int he issuer's account are not sufficient to pay the check (bounced check).

Write-Off

A company recognizes there is a good chance they will not be able to collect a receivable.

Segregation of Duties

A control activity. Accounting and administrative duties should be performed by different individuals, no one person prepares all the documents and records for an activity. Reduces the likelihood that records could be used to conceal irregularities (intentional misstatements, theft, or fraud) and increases the likelihood that irregularities will be discovered. Also reduced the likelihood that unintentional record-keeping errors will remain undiscovered.

Adequate Documents and Records

A control activity. Good paperwork and documentation. Accounting records are the basis for the financial statements and other reports prepared for managers, owners, and other both inside and outside the business. Summary records and their underlying documentation must provide information about specific activities and her in the evaluation of individual performance.

Checks on Recorded Amounts

A control activity. Recorded amounts should be checked by an independent person to determine that amounts are correct and that they correspond to properly authorized activities. These procedures include clerical checks, reconciliations, comparisons of asset inspection reports with recorded amounts, computer-programmed controls, and management review of reports.

Safeguards Over Assets and Records

A control activity. Requires physical protection of the assets through, for example, fireproof vaults, locked storage facilities, keycards, and anti-theft tags. An increasingly important part of this is safeguarding access controls for computers.

Clearly Defined Authority and Responsibility

A control activity. The authority to perform important duties is delegated to specific individuals, and those individuals should be held responsible for the performance of those duties in the evaluation of their performance. Motivates individuals to perform well because they know they are accountable for their actions.

Monitoring Collections

A form of Management of Receivables. Analyzing Receivables - Aging Analysis. Holds on Accounts/Collection Activity.

Screening Customers

A form of Management of Receivables. Credit Policy. Evaluation of Financial Position and Credit History.

Determining Credit Terms and Limits

A form of Management of Receivables. Payment Terms: 2/10, n30. Credit Limits.

Too Loose

A form of credit policy that leads to extending credit to customers who do not pay.

Too Tight

A form of credit policy that leads to loss of customers/market share.

Petty Cash

A fund used to pay for small items such as stamps or a cake for an employee birthday party. The custodian pays for small dollar amounts directly from the fund and reimburses employees who have receipts for items they've bought with their own money. The fund is reconciled and replenished at the end of the period. Accounting transactions only occur when the fund is established and when it is replenished.

Cash

A highly desired asset - easily concealed, taken, or converted into other Assets with only a small change of detection. The asset most likely to be stolen. More liquid, more likely to be stolen.

Control Environment

An element of internal control. The collection of environmental factors that influence the effectiveness of control procedures. Includes: the philosophy and operating style of management and the personnel policies and practices of the business. An important feature is recognizing that an individual employee's goal may differ from the goals of other individuals and the goals of the business. Resolving these conflicting incentives in an ethical manner that promotes organizational objectives is highly dependent on the tone at the top.

Information and Communication

An element of internal controls. An internal control system will be unable to help a company achieve its objective unless good information is gathered on a timely basis. This information must be communicated to the appropriate employees in the organization. If information is not gathered and communicated, then management may not become aware of problems until it it too late and returns and complaints are made by dissatisfied customers.

Monitoring

An element of internal controls. Process of tracking potential/actual problems in the internal control system. Accomplished through normal supervising activities such as when a manager asks a subordinate how things are going. Best practices for larger organizations suggest that an internal audit group help monitor the effectiveness of the internal control system. Monitoring the system of internal controls allows the organization to identify potential and actual weaknesses that could, if uncorrected, produce problems. Sarbanes-Oxley Act requires all publicly-traded corporations to have an internal audit function that reports to the audit committee of the board of directors.

Control Activities

An element of internal controls. The policies and procedures top management establishes to help insure that its objectives are met. The ones most directly related to the accounting system can generally be identified with one of the following five categories: Clearly Defined Authority and Responsibility, Segregation of Duties, Adequate Documents and Records, Safeguards Over Assets and Records, and Checks on Recorded Amounts.

Cash Over and Short

Another important control activity requires that cash receipts be deposited in a bank daily. At the end of the day, the amount of cash received during the day is debited to the cash accounts to which it has been deposited. The amount deposited should equal the total of cash register tapes. If it does not (and differences will occasionally occur even when cash-handling procedures are carefully designed and executed), the discrepancy is recorded in an account called this.

Non-Trade Receivables

Arise from transactions not involving inventory.

Business Process Risks

Arise out of the internal processes of the company - specifically, how the company allocated its resources to meet its objectives.

Deferred (Prepaid) Expenses

Assets arising from the payment of cash which have not been used or consumed by the end of the period. A type of adjusting entry.

Direct Write Off

Bad debt expense is recognized when a specific account is deemed uncollectible. Only actual losses are reflected in bad debt expenses. Expense is often recognized in a different period than the revenue associated with the sale. Violates the "matching principle". FASB does not allow this method unless bad debt expense is "insignificant".

Accounting System

Consists of the methods and records used to identify, measure, record, and communicate financial information about a business. One integrated system with the internal control system designed to meet the needs of a particular business.

Elements of Internal Control

Control Environment. Risk Assessment. Control Activities. Information and Communication. Monitoring.

Credit Memo

Could result if the bank collected note receivable for the business.

Allowance Method

Makes an estimate of uncollectible accounts at the end of each period. Better matching of expenses and revenues. bad debt expense is estimated and matched with the revenues in the same period from which the sales revenues were generated. Contra-Asset Account: Allowance for Doubtful Accounts. Adjusting entry recorded to recognize bad debt expense. Account Receivable are presented at Net Realizable Value. At Write-Off, the uncollectible amount is debited to the Allowance Account and credited to A/R. Running balance in the Allowance account is the estimated amount of A/R that will be uncollectible in the future. The credit balance int he Allowance account will absorb the specific write-offs.

2/10, n30

Means 2% Sales Discount if paid in 10 day, or else due in 30 days.

% of Receivables

Method for Estimating Bad Debts. Calculating Allowance Account. Balance Sheet Approach. Aging analysis of A/R, different rates applied to different age categories. Calculates the required balance in the allowance account.

% of Sales

Method for Estimating Bad Debts. Calculating Bad Debt Transaction. Income Statement Approach. Credit Sales X Estimated Bad Debt %. Calculates the amount of Bad Debt Expense to be recognized.

Debit Memo

Might result if the bank makes a prearranged deduction from the business's account to pay a bill.

Net Profit Margin

Net Income ÷ Net Sales

Allocation Concept

Not an attempt to reflect the actual change in the value of an asset.

Operating Margin

Operating Income ÷ Net Sales

Cash Management

Operating cycle requires cash. This sequence of activities includes a continual process of paying an receiving cash. How can a company manage its cash efficiently? Delaying paying suppliers (so a company can earn as much interest on their cash as possible), speeding up collection from customers (in order to invest the cash sooner), or earning the greatest return on any excess cash.

Transactions Recorded by the Business but Not Yet Recorded by the Bank (Timing Differences)

Outstanding Check or Deposit in Transit

Strategic Risks

Possible threat to the organization's success in accomplishing its objectives and are external to the organization. These risks are often classified around industry forces such as competitors, customers, substitute products or services, suppliers, and threat of new competitors (known as Porter's Five Factors) or macro factors such as political, economic, social, and technological (also known as PEST factors)

Accrued Expenses

Previously unrecorded expenses that have been incurred but not yet paid in cash. A type of adjusting entry. Expenses incurred but not yet paid. Adjusting Entry is a debit to an expense account and a credit to a liability account.

Accrued Revenues

Previously unrecorded revenues that have been earned but for which no cash has yet been received. A type of adjusting entry. Revenues earned but not yet received in cash or recorded. Adjusting Entry results in a debit to an asset account and credit to a revenue account.

Section 302 (SOX)

Principal executive and financial officers must certify that they are responsible for establishing and maintaining the system of internal control over financial reporting.

Analyzing Sales

Profitability ratios are used to try and measure the return the company is making on sales. Operating margin is a key ratio for financial analysts because it tells how much is left from a sales dollar after paying for the product and all its operations.

Accruals

Revenue/Expense recognized before money is exchanged. Adjusting Entries for these always increase both a balance sheet and income statement.

Management of Receivables

Screening Customers. Determining Credit Terms and Limits. Monitoring Collections.

Factoring Receivables

Sell receivables, factor charges a %. Immediate cash is received. Factor assumes rights of collection along with risks of uncollectability.

FOB Destination

Seller is Responsible until the good arrives at the destination.

Transactions Recorded by the Bank, but Not Yet Recorded by the Business (Unknown/Unrecognized by the Business)

Service Charges. Non-Sufficient Funds (NSF) Check. Debit Memo. Credit Memo.

Bank Reconciliation

Since the bank's accounting records and company's accounting records often disagree due to timing differences, these must be "reconciled" to ensure that the accounting records are consistent with the bank's accounting records. A control function by identifying errors and providing an inspection of detailed records that deters theft. A transaction detection function by identifying transactions performed by the bank, so the business can make the necessary entries in its records.

Realized Criteria

The SEC maintains that revenue is realized and earned when the following criteria are met: Persuasive evidence of an arrangement exists (e.g. a contract), Delivery has occurred or services have been provided, The seller's price to the buyers is fixed and determinable, and Collectability is reasonably assured.

Purchase Order

The customers official request from the buyer. This document is necessary for the buyer to be obligated to accept and pay for the ordered goods.

Buying Inventory

The first stage of the operating cycle. Money that is tied up in inventory sitting on shelves is not earning any return. As such, an important aspect of cash management is to keep inventory levels low.

Shipping Documents and Invoice

The invoice documents the terms of the sale.

Expense Recognition (or Matching) Principle

The process of identifying an expense with a particular time period. The key idea is that an expense is recorded when it is incurred, regardless of when cash is paid. Expenses must be recorded and reported in the same period as the revenue that it helped to generate.

Paying for Inventory

The second stage of the operating cycle. As with all payments, a good cash management principle is to delay payments as long as possible while maintaining a good relationship with the payee. The longer a company keeps cash, the more interest it can collect.

Internal Control

The system of policies and procedures that a company puts in place to provide reasonable assurance that: Operations are effective and efficient, compliance with laws and regulations, financial reporting is reliable.

Selling Inventory

The third stage of the operation cycle, often produces receivables. Many companies sell their receivables rather than wait for their customers to pay (Factoring). Of course, they sell the receivables for less than they will receive (which represents interest an return for the buyer), but it also allows the company to receive the cash sooner and avoid hiring employees to service the receivables.

Differences Between the Cash Account Balance and the Bank Statement Balance

These develop from three sources: Transactions recoded by the business, but not yet recorded by the bank in time to appear on the current bank statement (timing differences), transactions recorded by the banks, but not yet recorded by the business (unknown to the business), or errors in recording transactions on either set of records.

Temporary (Nominal) Accounts

Those related only to a given time period. You need to close the balances of these to retained earnings.

Sales Discounts

To encourage prompt payments, businesses may offer these. This is a reduction of the normal selling price and is attractive to both the seller and the buyer. For the buyer, it is a reduction the cost of the goods and services. For the seller, the cash is more quickly available and collection costs are reduced. Sales invoices use a standard notation to state the terms. Recorded in a contra-revenue account.

Sarbanes-Oxley Act (SOX)

Top management of publicly-traded corporations have an increased responsibility for a system of internal controls that ensures the reliability for a system of internal controls that ensures the reliability of the financial statements. Took away the ability of the Executives to act like they did not know what was going on with fraudulent transactions. Requires a separate Financial Statement where the executive and management have to sign their approval.

Adjusted Trial Balance

Trial Balance after the adjusting entries are made. Prepared after all Adjusting Journal Entries are journalized and posted. Financial Statements are prepared from this.

Accounts Receivable (Ch. 3)

When you have performed the revenue on credit.

Incurred

When you use up a resource.