Financial Accounting Exam 2 Study Guide

Sales and Purchase entries-Cash vs. Credit/Debit Cards vs. On Account

-Acceptance of Customer Checks. Whether a customer uses cash or a check to make a purchase, the company records the transaction as a cash sale. -Acceptance of Credit Cards. The acceptance of credit cards provides an additional control by reducing employees' need to directly handle cash. Credit card companies earn revenues primarily in two ways. First, the cardholder has a specified grace period before he or she has to pay the credit card balance in full. If the balance is not paid by the end of the grace period, the issuing company will charge a fee (interest). Second, credit card companies charge the retailer, not the customer, for the use of the credit card. This charge generally ranges from 2% to 4% of the amount of sale. From the seller's perspective, the only difference between a cash sale and a credit card sale is that the seller must pay a fee to the credit card company for allowing the customer to use a credit card. -Acceptance of Debit Cards. Debit cards also provide an additional control for cash receipts. Like credit cards, debit cards offer customers a way to purchase goods and services without a physical exchange of cash. They differ, however, in that most debit cards (sometimes referred to as check cards) work just like a check and withdraw funds directly from the cardholder's bank account at the time of use. (recall that credit cards don't remove cash from the cardholder's account after each transaction.)

Multi-step income statement-format and calculations of various profitability levels

-First step: Revenues (net of returns, allowances, and discounts)-Cost of goods sold=Gross profit -Second step: operating income. operating expenses such as include selling, general, and administrative expenses.Gross profit reduced by these operating expenses is referred to as operating income. -Third step: Income Before Income Taxes. After operating income, a company reports nonoperating revenues and expenses. These could be referred to as 'other income.' Nonoperating revenues and expenses arise from activities that are not part of the company's primary operations. Combirning operating income with nonoperating revenues and expenses yields income before income taxes. Fourth step: Net Income. A company subtracts income tax expense to find it net income. Income tax expense is reported separately because it represents a significant expense.

Sales-entries for Sales on account, Sales Returns & Allowances, and Sales Discounts

-Sales on account transfer products and services to a customer today while bearing the risk of collecting payment from that customer in the future. We would debit accounts receivable and credit service revenue. -If a customer returns a product, we call that a sales return. After a sales return, we reduce the customer's account balance if the sale was on account or we issue a cash refund if the sale was for cash. -In other cases, the customer does not return the product or service, but the seller reduces the customer's balance owed to provide at least a partial adjustment of the amount the customer owes. This adjustment is called a sales allowance. -A sales discount represents a reduction, not in the selling price of a product or service, but in the amount to be paid by a credit customer if payment is made within a specified period of time. It's a discount intended to provide incentive for quick payment.

Bank Reconciliation-preparation, adjustments, entries

-Step 1: Reconcile the bank's cash balance. First, we consider cash transactions recorded by the company, but not yet recorded by its bank. These include deposits outstanding and checks outstanding. Deposits outstanding are cash receipts of the company that have not been added to the bank's record of the company's balance. Checks outstanding are checks the company has written that have not been subtracted from the bank's record of the company's balance. -Step 2: Reconcile the company's cash balance. What are some examples of cash transactions recorded by the bank but not yet recorded by the company? Here are some common items that will increase the company's cash balance once the reconciliation occurs. Bank collections on the company's behalf offer a convenient and safer way for the company to collect cash. With the increase in electronic banking, these types of cash collections are becoming increasingly popular, especially in certain business settings such as recurring payments from customers, real estate transactions, collection agencies, and lending arrangements. Companies may also earn interest based on the average daily balance of their checking or savings account. Other items in the reconciliation will decrease the company's cash balance. NSF checks occur when customers' checks are written on "nonsufficient funds." In other words, the company receives a customer's check and deposits that check, recording an increase in cash. However, the company later find out from the bank statement that the customer's check was 'bad', and the company then needs to decrease its cash balance to undo the initial increase. Employees sometimes use debit cards to make purchases. These purchases are immediately withdrawn from the bank account, but they may not be known by the company's accountant until examination of the bank statement. Electronic funds transfers (EFTs) are automatic transfers from one bank account to another (sometimes referred to as electronic checks or e-checks). For example, a company may pay its mortgage or utility bill by having it automatically withdrawn from its bank account. Banks charge service fees for various activities related to monthly maintenance, overdraft penalties, ATM use, wire transfers, foreign currency exchanges, automatic payments, and other account services. These fees may not be known by the company until examination of the bank statement. -Step 3: Update the company's cash account. As a final step in the reconciliation process, a company must update the balance it its cash account, to adjust for the items used to reconcile the company's cash balance. We record these adjustments once the bank reconciliation is complete. Remember, these are amounts the company didn't know until it received the bank statement.

Cash-definition and components

Among all of the company's assets, cash is the one most susceptible to employee fraud. The amount of cash recorded in a company's balance sheet includes currency, coins, and balances in savings and checking accounts, as well as items acceptable for deposit in these accounts, such as checks received from customers. The balance of cash also includes cash equivalents, which are defined as short-term investments that have a maturity date no longer than three months from the date of purchase. Common examples of such investments are money market funds, Treasury bills, and certificates of deposit.

Bad Debt Expense-when to record, calculation, and entry

Bad debt expense represents the cost of the estimated future bad debts. Bad debt expense is debited and allowance for uncollectible accounts is credited.

Merchandising company-definition and examples

Companies that earn revenue by selling inventory are either manufacturing or merchandising companies. Merchandising companies purchase inventories that are primarily in finished form for resale to customers. These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they do not manufacture it. They simply serve as intermediaries in the process of moving inventory from the manufacturer, the company that actually makes the inventory to the end user. Merchandising companies can be classified as wholesalers or retailers. Wholesalers resell inventory to retail companies or to professional users. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.

Direct write-off vs. accrual method of accounting for bad debts

For tax reporting, companies use an alternative method commonly referred to as the direct write-off method. Under the direct write-off method, we write off bad debts only at the time they actually become uncollectible, unlike the allowance method which requires estimation of uncollectible accounts before they even occur. It is important to emphasize the direct write-off method is not allowed for financial reporting under GAAP. The direct write-off method is primarily used for tax reporting. Under the allowance method, an estimate of the future amount of bad debt is charged to a reserve account as soon as a sale is made. Companies are required to estimate future uncollectible accounts and record those estimates in the current year.

Inventory methods-periodic vs. perpetual-definitions and timing of entries

In a periodic inventory system, companies do not continually record inventory amounts. Instead, it calculates the balance of inventory once per period, at the end, based on a physical count of inventory on hand Most companies on the other case use a perpetual inventory system. This system involves recording inventory purchases and sales on a perpetual (continual) basis. Managers know that to make good decisions they need to keep track each day of which inventory is selling and which is not. This information will affect decisions related to purchase orders, pricing, product development and employment management. Because these decisions need to be made on a daily basis, maintaining inventory records on a continual basis is necessary.

Interest calculation

Interest=face value x annual interest rate x fraction ofthe year

Sarbanes-Oxley Act (SOX)-Reason for passage, purpose, main components

Managers are entrusted with the resources of both the company's lenders (liabilities) and its owners (stockholders' equity). In this sense, managers of the company act as stewards or caretakers of the company's assets. In response to these corporate accounting scandals and to public outrage over seemingly widespread unethical behavior of top executives, Congress passed the Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX. SOX applies to all companies that are required to file financial statements with the SEC and represents of the greatest reforms in business practices in U.S. history.

Net Sales calculation

Net sales or net revenues refer to a company's total revenues less any amount of discounts, returns, and allowances.

Notes receivable vs. Accounts receivable-definition on the financial statements

Notes receivable are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument, or note. Notes receivable typically arise from loans to other entities (including affiliated companies); loans to stockholders and employees; and occasionally the sale of merchandise, other assets, or services. Like accounts receivable, notes receivable are assets and therefore have a normal debit balance. We classify notes receivable as either current or noncurrent, depending on the expected collection date. If the time to maturity is longer than one year, the note receivable is a long-term asset. We record the collection of notes receivable the same way as collection of accounts receivable, except that we also record interest earned as interest revenue in the income statement.

Internal controls-Definition, purpose, examples of controls over cash receipts and disbursements

Opportunity, motivation, and rationalization are the three parts of the fraud triangle. Of the three elements of the fraud triangle, companies have the greatest ability to eliminate opportunity. To eliminate opportunity, companies implement formal procedures known as internal controls. These represent a company's plan to (1) safeguard the company's assets and (2) improve the accuracy and reliability of accounting information. Control activities include a variety of policies and procedures used to protect a company's assets. There are two general types of control activities: preventative and detective. Preventative controls are designed to keep errors or fraud from occurring in the first place. Detective controls are designed to detect errors or fraud that already have occurred. Examples of preventative controls include: -Separation of duties: A set of procedures intended to separate duties among employees for authorizing transactions, recording transactions, and controlling related assets is referred to as separation of duties. Fraud is prevented by not allowing the same person to be responsible for both controlling the asset and accounting for the asset. -Physical controls over assets and accounting records. Each night, money from ticket sales should be placed in the theatre's safe or deposited at the bank. Important documents should be kept in fireproof files, and electronic records should be backed up daily and require user-ID and password for access. Concession supplies should be kept in a locked room with access allowed only to authorized personnel. -Proper authorization to prevent improper use of the company's resources. The theatre should establish formal guidelines on how to handle cash receipts and make purchases. For example, only management should be authorized to make purchases over a certain amount. -Employee management. The company should provide employees with appropriate guidance to ensure they have the knowledge necessary to carry out their job duties. Employees should be made fully aware of the company's internal control procedures, ethical responsibilities, and channels for reporting irregular activities. -E-commerce controls. E-commerce refers to the wide range of electronic activities of a company, such as buying and selling over the Internet, digital information processing, and electronic communication. For example, only authorized personnel should have passwords to conduct electronic business transactions. The company should maintain and systematically check the firewall settings to prevent unauthorized access to accounts and credit card numbers. All employees should update the system's antivirus software periodically. Examples of detective controls include: -Reconciliations. Management should periodically determine whether the amount of physical assets of the company (cash, supplies, inventory, and other property) agree with the accounting records. For example, accounting personnel should routinely reconcile the company's cash records with those of its bank, and any discrepancy should be investigated. -Performance reviews. The actual performance of individuals or processes should be checked against their expected performance. For example, the amount of concessions sold should be compared to the number of tickets sold over a period of time. If concession sales are lower than expected for a given number of tickets, employees could be wasting food, stealing snacks, or giving it to their friends for free. Alternatively, vendors may be supplying lower-quality, driving down sales. Management may also wish to evaluate the overall performance of the theatre by comparing ticket sales for the current year with tickets sales for the previous year. -Audits. many companies, such as those companies listed on a stock exchange are required to have an independent auditor attest to the adequacy of their internal control procedures. Common controls over cash receipts include: 1. Open mail each day, and make a list of checks received, including the amount and payer's name. 2. Designate an employee to deposit cash and checks into the company's bank account each day, different from the person who receives cash and checks. 3. Have another employee record cash receipts in the accounting records as soon as possible. Verify cash receipts by comparing the bank deposit slip with the accounting records. 4. Accept credit cards or debit cards, to limit the amount of cash employees handle.

Net Accounts Receivable calculation

The difference between total accounts receivable and the allowance for uncollectible accounts is referred to as net accounts receivable. A better matching of expenses and revenues results in a more accurate measure of net income for the period. From a balance sheet perspective, though, the percentage-of-receivables method is preferable because assets (net accounts receivable) are reported closer to their net realizable value.

Aging and percentage of receivables methods to estimate uncollectible accounts

Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.