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Exam 1, 2, & 3 Study Notes

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by: Taylor Patterson

Exam 1, 2, & 3 Study Notes ACCT 2001 001

Taylor Patterson

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These notes contain all the information from lectures and the textbook that is important on each exam. They are categorized into packets for each exam. These notes helped me to achieve over a 90 ...
Prin. of Financial Accounting
Richard Kochanek (PI)
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"Almost no time left on the clock and my grade on the line. Where else would I go? Taylor has the best notes period!"
Jermaine Howell Jr.

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This 67 page Bundle was uploaded by Taylor Patterson on Sunday January 31, 2016. The Bundle belongs to ACCT 2001 001 at University of Connecticut taught by Richard Kochanek (PI) in Fall 2015. Since its upload, it has received 66 views. For similar materials see Prin. of Financial Accounting in Accounting at University of Connecticut.

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Date Created: 01/31/16
Accounting Exam 1 Study Guide  Chapters 1-4 th  February 19 , 2015 1. Accounting- an information system, the resources and procedures that turn the effects of economic events into financial information. Collect data, process the data, and communicate information to users. 2. Accounting Cycle a. Journal Entries b. Ledger Accounts c. Unadjusted Trial Balance d. Adjusting Entries e. Adjusted Trial Balance f. Financial Statements g. Closing Entries h. Post-Closing Trial Balance 3. Analysis a. Percentage Change-> Value(new)−Value(old) Value(old) Expenses NetIncome b. Common Size Percentage-> , , Revenues Revenues O wner’sEquity Liabilities , Assets Assets Total Revenues c. Total Asset Turnover Ratio-> AverageTotal Assets Revenue new )−Revenue(old) d. Revenue Growth Percentage-> Revenue(old) netincome e. Return on Assets-> totalaverageassets 4. Assets, Liabilities, and Owner’s Equity a. Assets i. Debit increase ii. Credit decrease b. Liabilities i. Debit decrease ii. Credit increase c. Owner’s Equity i. Debit decrease ii. Credit increase d. Expenses i. Debit increase ii. Credit decrease e. Revenues i. Debit decrease ii. Credit increase f. Contra Accounts i. Opposite 5. Closing Entries: a. Close Revenue to Income Summary i. Debit Revenue ii. Credit Income Summary b. Close Expenses to Income Summary i. Debit Income summary ii. Credit Expenses c. Close Income Summary to Net Income/Net Loss i. Debit Net Loss ii. Credit Income Summary iii. Debit Income Summary iv. Credit Net Income d. Close Dividends to Retained Earnings i. Debit Retained Earnings ii. Credit Dividends 6. Adjusting Entries a. Never use cash in adjusting entry b. Depreciation: (cost-residual value)/years or months c. Interest=cost*interest*(days/360) d. Should always have a temporary account (income statement) and a real account (balance sheet) 7. Examples a. Journal Entries i. b. Ledger Accounts i. c. Unadjusted Trial Balance i. d. Income Statement i. e. Statement of Owner’s Equity i. f. Balance Sheet i. Accounting Notes: st Saturday, February 21 , 2015 Book Notes-Chapter 5  Understanding Business Issues o Merchandising business-> earn revenue by buying goods and reselling them to customers  Ex. Gap Inc., Best Buy, and Wal-Mart o Cost of goods sold-> major cost incurred by merchandising business  Comparisons in income statements for service and merchandising businesses o Service business  Revenue  -Operating Expenses  =Net Income before income taxes  -Income Tax Expense  =Net Income o Merchandising Business  Net Sales Revenue  -Cost of goods sold  =Gross margin on sales  -Operating expenses  =Net operating margin  +Other revenues  -Other expenses  =Net income before income tax  -Income tax expense  =Net Income  Income Calculation for a Merchandising Business o Important differences between calculating income for a service business and for a merchandising business o Net income for the year ended for both is equal to the difference between revenues and expenses  But merchandising business has different types of revenue and expense items on its income statement  Cost of goods sold is the cost to the merchandising firms of the goods sold to customers during a period of time  Gross margin on sales (gross margin)-> difference between cost of goods sold and net sales revenue  Gives info on the ability to sell merchandise at a price greater than its cost  Net operating margin-> gross margin-operating expenses  Measures management’s ability to control expenses such as salaries, supplies, and utilities.  Other revenues and expenses->items that do not relate ti the primary source of revenue o Examples-> rent revenue, interest expense, etc.  Net Sales Revenue o Merchandising businesses maintain three accounts to collect sales transactions data  Sales  Transactions in which goods are exchanged for cash or a promise of cash  Revenue account-> sales  Records total or gross sales of merchandise  Debit cash/accts. Receivable and credit sales account  Asset increases and revenue (gross increase in owner’s equity) increases  Trade Discounts  Businesses often print a catalog with standard price lists of their goods  Discounts allow businesses to offer different prices to various groups of customers o Can depend on class of buyer (wholesaler or retailer) or quantity ordered  Trade discount-> percentage reduction from a list price  Record the transaction at the invoice price  Invoice price-> list price-trade discount  Trade discounts eliminates frequent reprinting of catalogs or printing different price lists for diff. classes of buyers  Chain discount-> more than one discount on a single sale o Apply each discount successively to the declining balance o Multiply list price by the complements of the discounts  Sales Returns and Allowances  Customer can return merchandise because it is defective or broken  Can request a price allowance because the goods are not as ordered  Debit account Sales Returns and Allowances contra account to Sales  Credit cash or accounts receivable  Credit memorandum-> business form issued to inform the customer that they have credited the customer’s account  Sales Discounts  Invoice-> shows the terms of the sale of merchandise on credit  Often a business offers a discount to customers who pay within a stated time period o Cash discount o Businesses do this to speed up cash inflow  Compute cash discounts on the invoice amount  Invoice shows payment terms o Example: 2/10, n/30 o Two ten net thirty o Buyer may deduct 2% if paid in 10 days or net price if paid in 30 days  Discount period-> the period in which the discount is available  n/10 EOM-> net invoice price due 10 days after the end of the month  Discount reduces cash received  Debit discounts to Sales Discounts a contra sales account  Calculating Net Sales Revenue  Credit: Gross Sales Revenue  Debit: Sales Returns and allowances (contra account)  Debit: Sales Discounts (contra account)  =Net sales revenue  Sales Tax Payable  Most states levy a sales tax on certain merchandise  Customer pays and company collects  Record the % of the sale to Sales Payable (credit) o Current liability  Company must file a sales tax return each month o When files will pay tax o Debits Sales Taxes Payable o Credits Cash  Merchandise Inventory Systems o Merchandise Inventory-> Merchandising firms keep stock of goods on hand for sale to customers o Two methods  Periodic Inventory System  Determine the cost of goods sold and the ending inventory balance only at the end of each accounting period  Perpetual Inventory System  Determine the cost of the product sold and the inventory balance on hand at each sale  Produces a continuous record of cost of goods sold and inventory on hand  Cost of Goods Sold Account: Periodic Inventory System o Purchases  Periodic inventory system uses a separate Purchases account to record the cost of all merchandise bought for resale  Do not record the purchases of operating supplies or store equipment in the Purchases account  Purchases-> record the cost of goods purchased during period  Debit o Transportation In  Invoice price of goods may include the cost of transportation from seller to buyer  Don’t record the transportation costs separately then  Otherwise must decide who is responsible for good  Owner of goods during transit is responsible  To decide ownership refer to F.O.B. terms of the transaction (Free on board) o F.O.B. shipping point-> title to goods passes to the buyer when the seller turns the shipment over to a common carrier  Buyer is responsible o F.O.B. destination-> title to goods passes to the buyer at the destination  Seller is responsible  When buyer is responsible  Debit cost to Transportation In  Add cost to purchases in income statement o Purchases Returns and Allowances  Goods bought for resale can be defective/broken/not of quality  Debit Accounts Payable (decreases)  Credit Purchases Returns and Allowances  Contra account to Purchases  Can also credit Purchases directly but less organized o Purchases Discounts  Contra account to Purchases o Net Cost of Purchases  Invoice cost of purchases  + Transportation in  - Purchases returns and allowances  -Purchases discounts  =Net cost of purchases o Merchandise Inventory  Periodic Inventory System records merchandise purchased for resale at invoice cost in the Purchases account  Merchandise Inventory-> shows the cost of merchandise on hand at the end of each accounting period  Edit:  Remove beginning balance by a debit to Income Summary and a credit to Merchandise Inventory  Set up new ending balance by a debit to Merchandise Inventory and a credit to Income Summary o Calculating Cost of Goods Sold  o Gross Margin on Sales  Differences between net sales revenue and cost of goods sold  Gross means that we must still deduct the expenses necessary to operate the business to arrive at the net operating margin  Multi-Step Income Statement o  Operating Expenses o Record the expired costs of goods or services used in operating the business o Ex.-> salaries, postage, computer services, utilities, and insurance o Open an account or each type of operating expense  Allows analyses and comparisons for cost control o Selling Expenses  Packaging, advertising, selling, and delivering the product o General and Administrative Expenses->  Office expenses, computer services, executive salaries, and portion of rent and insurance that applies to administrative functions  Net Operating Margin o Gross Margin on Sales o – Total Operating Expenses o = Net Operating Margin  Other Revenues and Other Expenses o Do not relate to the principal activity of the business o Valuable o Permit calculation of net operating margin w/o being distorted by these non-operating items  Income Tax Expense o Corporations pay income taxes  Single Step Income Statement o Deduct expenses from revenues in one step  Worksheet for a Merchandising Business o Similar to that of a service business o Only difference is that the merchandiser includes a line for merchandise inventory Wednesday, February 25 , 2015 th Book Notes-Chapter 5  Inventory Changes Treated as Closing Entries o Debit the beginning balance in the Income Statement column o Credit the ending balance in the Income Statement column o Debit the Ending balance in Balance Sheet column o Debit the purchases and transportation in in Income Statement o Credit the Purchases Returns and Allowances and Purchases Discounts in Income Statement  Statements Prepared from the Worksheet o o  Closing Entries o Closing entries are essentially the same as in a service business o Only differences is you must close the following accounts:  1:  Debit: o Merchandise Inventory-ending o Sales o Purchases Returns and Allowances o Purchases Discounts o Rent Revenue  Credit: o Income Summary  Closes ending inventory, revenue, and credit balance merchandise accounts  2:  Debit: o Income Summary  Credit: o Merchandise Inventory-beginning o Sales Returns and Allowances o Sales Discounts o Purchases o Transportation In o Sales Salaries Expense o Rent Expense –Warehouse o Advertising Expense o Transportation Out Expense o Office Salaries Expense o Rent Expense – Office Equipment o Utilities Expense o Depreciation Expense-Office Building o Interest Expense o Income Tax Expense  Closes beginning inventory, expenses, and debit balance merchandise accounts  3:  Debit: o Income Summary  Credit: o Retained Earnings  Transfer net income to Retained Earnings  4:  Debit: o Retained Earnings  Credit: o Dividends  Close Dividends to Retained Earnings  Management Control: The Exception Principle o Managers who practice control principle of management by exception devote their energies to activities that differ from expectations o Managers hope to isolate items that identify operating inefficiencies  Net Price Method o Application of management by exception o Purchases Discounts Lost would record all the missed opportunities to decrease cost of goods sold o Record purchases at net invoice (price –discount) o Then record items without discount in Purchases Discounts Lost o Other expenses- Purchases Discounts Lost o Disadvantages:  Doesn’t record the amount of discount separately  Statements from creditors do not match  Increased clerical costs  Requires an adjusting entry  Analyzing Information o Examine Net Sales, Gross Margin, Net Operating Margin, and Expenses Book Notes-Chapter 6  Understanding Business Issues o Management must keep the data that makes up financial statements safe and accurate o To do this management uses internal control structure , safeguards assets and provides accurate data o Cash:  most liquid  easily stolen asset  flexible  very important to businesses  Fraud o Intentional deception made for personal gain or damage to another individual or organization o It is a crime and civil law violation o Internet fraud is fastest growing area o The Sarbanes-Oaxley Act of 2002 (SOX)  Passed by congress  Assists in the prevention and detection of fraud  Companies required to maintain effective systems of internal control  Established the Public Company Accounting Oversight Board (PCAOB)  Auditing standards  Regulate auditor activity  Private sector, non-profit corporation  Internal Control o Control -> to regulate o Internal control -> includes the policies and procedures for protecting assets from improper use and detection and prevention of errors or irregularities in accounting o Different depending on the size of the company and other factors o Consists of all measures within an organization to ensure  Reliability of the accounting records and financial reporting  Effectiveness and efficiency of operations and safeguarding of assets  Compliance with applicable laws and regulations o Committee of Sponsoring Organizations of the Treadway Commission (COSO)  COSO’S Internal Control-Integrated Framework  Control Environment o Establishes the tone of the organization o Guides the consciousness of its people o Provides discipline and structure o Serves as foundation  Risk Assessment process o Process of identifying and responding to business risks which face the organization o Identify risks relevant to the fair presentation of financial statements in conformity with generally accepted accounting principles o Take appropriate action to manage those risks  Control Activities o Reduce the possibility of fraud by designing policies and procedures to address the specific risks  Information and Communication o All relevant info is captured and reported throughout the organization o Communication involves providing an understanding of individual role and responsibilities pertaining to internal control over financial reporting  Monitoring of controls o Process to assess the quality of internal control performance over time o Involves the design and operation of controls on a timely basis and taking necessary corrective actions o Elements of internal Control Activities  Control environment includes ethical behavior standards, formal code of conduct, etc.  Organization control of management affects internal control o The Accounting System  Consists of the methods and records used to identify, assemble, classify, analyze, record, and report a firm’s transactions  Should classify transactions and measure their value  Quality system leads to proper presentation of transactions and disclosure in the firm’s financial statements o The Control Activities  Provide reasonable assurance that the business will safeguard its assets and record its transactions accurately  Basic procedures used to promote effective internal control:  Proper authorization of transaction activities o Only certain people should have the authority to start transactions  Separation of duties o The same person should not authorize, record, and hold assets  Design and use of adequate source documents and records o Reasonable assurance that it is recording all valid transactions  Adequate safeguards over access to and use of assets and records o Only authorized people should have access to assets  Periodic independent review of internal controls  Control Structure for Cash o Cash:  Deposits in checking and savings  Coins  Currency  Cashier’s checks  Money orders  Certain credit card sales invoices o Not cash:  Notes receivable  IOUs  Checks dates in the future o The real problem is to control the large inflows and outflows of cash that occurs throughout the year o Cash Controls  Certain basic controls to prevent misuse of cash  Clearly establish individual responsibility for ach step in cash flow  On receipt, endorse all checks and stamp them for deposit only  Deposit total cash receipts intact daily  Intact-> should not pay bills from cash collected that day  Make all payments by company check and not out of cash receipts  Use automated control devices  Separation of duties  Provision of equipment necessary for cash control  Definite written instructions that control authorization of cash  Organization of flow  Periodic testing  Establish of controls over access to computers and computer programs o Electronic Transfers of Cash  Involve cash receipts and disbursements by computer  One type-> point-of-sale  Cash receipt system that allows customers to transfer cash from personal bank accounts at the time of sale  Employees don’t handle cash  Petty Cash o Should deposit total cash receipts intact daily o Make disbursements by check o Sometimes payment by check is impractical o Petty Cash fund for small payments o Put funds in custody of one person o Petty Cash Voucher-> receipt signed by the person receiving the cash supports each payment  Shows purpose, date, and amount o When it reaches the minimum or the end of each accounting period you replenish the fund o o Method is called imprest petty cash system o An increase or decrease in the fund requires an additional debit or credit to Petty Cash  Cash Over and Short o Cash over-> credit o Cash short-> debit o General and Administrative expense if debit o Other revenue if credit  Bank Checking Account o Check-> written order directing a bank to pay a specified amount of money to the order of a payee o Essential part is that only one person should have authority to sign check o Depositor fills out a deposit ticket  Lists each check deposited, date of deposit, and account number into which deposit was made  Bank Statement o Banks send depositors a monthly statement, cancelled checks, and notices of bank debits and credits o Bank statements list at a minimum  Beginning balance  Deposits received  Checks paid  Other debits and credits to the account  The ending balance o o Common Transactions  Service Charge -> depositors must keep a minimum balance in the bank or they’ll get a service charge  Debit Memo -> bank deduction from depositor’s account  Credit Memo -> describes a bank credit, normally in deposit column  Certified Check -> Depositor requests one, bank immediately deducts the amount of the check from the depositor’s balance  Interest o Reconciliation Procedure  For each entry in depositor’s cash account there should be a counterpart in the bank’s books  The bank entries are made at different times, the bank, an outside organization, is keeping a separate record of cash  The records of the depositor and the bank will not normally agree at the end of the month.  Items will appear on one but not the other, time lag in recording deposits and checks  May be bank charges and credits that the depositor is unaware of, or errors and irregularities  Must reconcile the two balances and determine the adjusted cash balance  Bank reconciliation ->  A statement that shows the items that account for the difference between the Cash account balance and the bank statement balance  4 steps to prepare o Compare debits shown on the bank statements with debits in the Cash account, deposits in transit are too late in the month for bank to credit, deposits in transit in previous month appear on next month o Compare checks paid and returned by the bank (cancelled checks) with the credit entries in the cash account, checks not yet presented by payees to the bank for payment are “outstanding checks,” check previous statement to see if those have been cleared o Compare special debits and credits made by the bank, usually reported in debit or credit memos, with the depositor’s books to see if they have already been recorded o List any errors in the bank’s or depositor’s records that become apparent during completion of steps 1-3   Analyzing Information o Cash and cash equivalents  Cash equivalents -> short-term, highly liquid investments  Be readily convertible into cash  Original maturity of three months or less th Thursday, February 26 , 2015 Book Notes-Chapter 7  Understanding Business Issues o When times are hard attractive credit terms may be the key to business survival o For many companies accounts receivable is one of the largest assets on the balance sheet o Managing the investment in receivables and ensuring prompt collection is critical for business survival  Classifying Receivables o Claims against individuals or companies for the future receipt of cash or other assets o Two broad categories  Trade receivables -> arise from the sale of goods or services to customers  Nontrade receivables -> arise from other sources o Trade receivables are normally collectible within one year or one operating cycle o Shown as current assets on balance sheet o Show nontrade receivables collectible in the current period separately from trade receivables  Classifying Trade Receivables o Three types of trade receivables  Accounts Receivables  Claims against customers for sales made on account with specified credit terms  Notes Receivables  Claims supported by written, formal promises to pay  Credit Card Receivables  Arise non bank credit cards, such as American Express  Allowance Method o Most businesses will lose some money on credit sales o A business much reach a balance between extra sales due to a liberal credit and a reasonable amount of uncollectible accounts o Companies with many sales on account have a credit department that examines the credit history of customers, establishes customer credit limits and follows up on unpaid accounts  Bad Debts Expense o Bad debt-> an account receivable that proves uncollectible o One problem in accounting is determining the accounting period for recognizing bad debt losses o Central goal of accrual basis of accounting is to match revenues with expenses for a period of time o Recognize the bad debts expense during the same period when we recognize the sales revenue o Business doesn’t know which customers will not pay their account at the time of the sale so it must make an estimate of the amount of accounts receivable that will prove uncollectible o This estimate becomes the basis for matching bad debts expense with current sales revenue o Recording estimated bad debts expense at the end of the accounting period is called the allowance method of accounting for bad debts o Allowance method results in a better presentation of accounts receivable on the balance sheet o Accounts receivable are shown at the net amount expected to be collected from customers (net realizable value) o Estimate/record bad debts expense in an end-of-period adjusting entry o Bad debts expense is an operating expense o Allowance for Doubtful Accounts-> contra asset to accounts receivable o Advantages->  It more properly matches revenues with expenses on the income statement  Report accounts receivable on the balance sheet at the net estimated amount that will be collected  Writing off Uncollectible Accounts o Determining that an account is uncollectible is complex, only after many collection efforts can we write off the debt o Debit Allowance for Doubtful Accounts and credit Accounts Receivable  Recovery of Bad Debts o First:  Debit Accounts Receivable  Credit Allowance for Doubtful Accounts o Then:  Debit Cash  Credit Accounts Receivable  Estimating the Amount of Bad Debts Expense o Income Statement Approach  Answers: How much bad debts expense is associated with the year’s sales?  Also known as “percentage of sales approach”  Bases bad debts expense on net sales  Ignore any existing balance in the Allowance for doubtful accounts  Bad debts expense measure the estimated uncollectible portion of the current year’s sales on account  Allowance for Doubtful Accounts measures the estimated uncollectible accounts receivable without regard to when the sales were made o Balance Sheet Approach  Answers: How large a valuation allowance do we need in order to show net receivables at the estimated amount to be collected?  Requires adjusting allowance for doubtful accounts o Aging the Accounts Receivable to Obtain the Desired Allowance Balance  Aging the accounts receivable considers the number of days that have elapsed since the due date  Aging Schedules make the analysis easier  List all accounts in the accounts receivable subsidiary ledger and their balances in the Customer’s Name and Total Balance columns  Next divide into age classifications the amounts that make up each balance in the Total Balance column  Then extend each amount to the appropriate columns   Not Providing for Uncollectible Accounts: The Direct Write-Off Method o When proved uncollectible  Debit Bad Debts Expense  Credit Accounts Receivable o When recovered  Debit Accounts Receivable  Credit Bad Debts Recovered  Debit Cash  Credit Accounts Receivable o Bad Debts Recovered->  A cost recovery account that is often considered to be a revenue account  Record in other revenue  Contra account to bad debts expense  Credit Card Sales o Most firs accept credit cards o Credit card companies charge retailers a fee of 2% to 6% of credit card sales o To record  Debit cash  Debit Credit Card Fees Expense  Credit Sales th Friday, March 6 , 2015 Chapter 8 Books Notes  Understanding Business Issues o Most businesses need to respond to changing market conditions and borrow money on a short-term basis to finance investments  The Short Term Financing Decision o Businesses often use some form of short term financing o Most firms maintain lines of credit with banks under which they can borrow money up to specified limits o Financing decisions are important to running a business o When various financing methods are available to a company, the financial manager must consider  The interest cost of each method  Whether the financing method will continue to be available  The possible effects on the availability and cost of alternative sources of money o Should choose the method that will consistently generate the desired shirt-term funds at the lowest possible overall cost  Promissory Notes o Promissory Note->an unconditional written promise to pay a definite sum of money on demand or at a future date o Maker-> person promising to pay o Payee->person promised payment o Major characteristics  It must be written and signed by the maker  It must contain an unconditional promise to pay money  It must be payable to a bearer (person holding the note) or to a stated person (the payee)  It must be payable either on demand or at a specific time  It may or may not be interest bearing o o Maker  Credit Notes Payable  Note is a liability o Payee  Debit Notes Receivable  Note is an asset o Note can be negotiable  Owner may transfer the note to another person  Owner transfers by endorsing it and delivering to a new owner o Endorsement  A signature on the back of the note that assigns the rights of the note to another party  Computations for Promissory Notes o Maturity Date of Notes  Maturity date -> the date on which payment of a note is due  Other ways to state a maturity date  A specific future date  A specific number of months or years after the date on the note  A specific number of days after the date on the note  If the term of the note is expressed in days, the maturity date is determined by counting the exact number of days after the date of the note  It is important to exclude the date of the note and include the maturity date  Example Computation: o Total Days in month note is dated o Deduct: Date of note in month o =Number of days note runs in month (excluding date) o Add: Number of days to make up term of note (X days)  Days in Month 1  Days in Month 2  Days in Month 3  Computing Interest on Notes o Interest is the charge made for the use of money o Interest is  Expense to borrower  Revenue to lender o Simple interest is computed on the original principal (face value) of a note o I = P x R x T o For time stated in days divide it by 360 o For time stated in months divide it by 12  Maturity Value of a Note o Maturity value- the principal amount of the note plus interest to maturity  Annual Percentage Rate (APR) or Annual Effective Interest o Federal truth in lending law requires lenders to disclose the annual effective interest or APR o 2 ways:  APR is rate x 12  Approximations:  Average outstanding principle= amount / number of years  Annual interest cost: total interest for number of years / number of years  Approximation of APR= interest for one year / average outstanding principle  Notes Payable o Notes payable are amounts payable to creditors supported by formal written promises to pay o Issuance of notes for property, plant, and equipment  Transaction 1  Debit office equipment  Credit notes payable  Transaction 2  Debit notes payable  Debit interest expense  Credit cash o Issuance of notes for merchandise  Transaction 1  Debit Purchases  Credit Accounts payable  Transaction 2  Debit Accounts Payable  Credit Notes Payable  Transaction 3  Debit Notes Payable  Debit Interest Expense  Credit Cash o Issuance of notes in settlements of open accounts  A firm may issue a note to obtain an extension of time to pay an open account payable  Debit Accounts Payable  Credit Notes Payable o Issuance of Notes to Borrow from Banks  Two ways  Lend money on a note bearing interest on face value, the borrower receives the face value of the note and pays the face value plus the accumulated interest on the maturity date o Transaction 1  Debit cash  Credit notes payable o Transaction 2  Debit Notes Payable  Debit Interest expense  Credit Cash  Lend money on a note where the amount of interest on face value is subtracted in advance, this is note payable discounted on face value, borrower receives the face value less the total interest amount but pays the full face value of the note on the maturity date o Transaction 1  Debit Cash  Debit Discount on Notes Payable  Credit Notes Payable o Transaction 2  Debit Interest Expense  Credit Discount on Notes Payable o Transaction 3  Debit Notes Payable  Credit Cash  Bank discount -> the amount of interest deducted in advance from the face value of the note  Effective Interest Calculation o Whenever a business borrows money, it is important for management to know the true cost of the loan. D 360 o Annual Effective Interest Rate -> I = P × T  D=amount of discount  P=the net proceeds  360=days in the year  T=the term of the note in days  End of period Adjusting Entries for Notes Payable o It is necessary to make adjusting entries for the interest expense on notes payable that are written in one accounting period and mature in a later period o Two kinds of adjustments  Accrual of interest on a note payable bearing interest on its face  Adjustment o Debit Interest Expense o Credit Interest Payable  When paid o Debit Notes Payable o Debit Interest Payable o Debit Interest Expense o Credit Cash  Recording the interest expense on a discounted note payable  Adjustment o Debit interest Expense o Credit Discount on Notes Payable  When Paid o Debit Interest Expense o Credit Discount on Notes Payable o Debit Notes Payable o Credit Cash  Notes Receivable o Notes Receivable -> Promissory notes from customers o Receipt of a note for sale  Debit Accounts Receivable  Credit Sales  Debit Notes Receivable  Credit Accounts Receivable  Debit Cash  Credit Notes Receivable o Receipt of a note in settlement of an open account  Businesses often require customers to substitute notes for open accounts when customers do not pay the accounts on time o Dishonor of a notes receivable by the maker  Dishonored note -> note that cannot be collected at maturity  The maker has defaulted on the note  Debit Accounts Receivable  Credit Notes Receivable  Credit Interest Revenue o End of period adjusting entries for Notes Receivable  Adjustment  Debit Interest Receivable  Credit Interest Revenue  When collects note  Debit Cash  Credit Notes Receivable  Credit Interest Receivable  Credit Interest Revenue th Wednesday, March 18 , 2015 Chapter 9 Book Notes  Understanding Business Issues o For both merchandising and manufacturing companies, inventories are a major asset on the balance sheet and cost of goods sold is the major expense on the income statement  Costs to Include in Inventory o Some merchandising firms buy a finished product and sell it to a customer o Inventory for a merchandising firm consists of all goods owned and held for sale in the normal course of business o The cost of an inventory item includes all expenditures incurred to bring the item to its existing condition and location o Cost consists of the invoice price of the merchandise less purchase discounts plus transportation plus insurance while in transit and plus any other expenses o Merchandise inventory is shown as a current asset o The inventory of a buyer includes goods purchased F.O.B. shipping point even if the buyer has not received them o Consignment arrangement  Consignor (owner of the goods) transfers goods to the consignee(retailing company)  The consignee sells the goods on the owner’s behalf but does not take title to the goods or include them in their inventory o Manufacturing firm inventories:  Materials inventory to be used to produce product  Work-in-process inventory for the cost of items partly completed  Finished goods inventory for unites completed and ready for sale  All assets  Inventory Systems o Two alternative systems for recording inventory transactions are the periodic and perpetual systems o Periodic Inventory System  Went over in chapter 5  Record acquisitions of merchandise inventory by debits to a purchases account  Record sales not by any decrease in the Merchandise Inventory account or by any cost of goods sold  Make entries to the Merchandise Inventory account only at the end of the accounting period  Calculate cost of goods sold at the end of the accounting period  Beginning inventory – purchases = cost of goods available for sale – ending inventory =cost of goods sold  Uses individual accounts to record purchases and purchases returns and allowances o Perpetual Inventory System  Continually updates the Merchandise Inventory account  All purchases directly affect the Merchandise Inventory account  The ending balance should be the amount that is on hand o  Inventory Costing Methods o Assigning a cost to units in ending inventory is easy when the costs per unit do not change o In the real world the costs of items change constantly o Specific identification method -> identify each item acquired with its specific cost o Most companies use one of the following three cost flow assumptions  Average cost flow assumption  Assumes that the cost of inventory items sold is a weighted average of the costs incurred to acquire those items  The cost of the units remaining in inventory at the end of the accounting period is the same weighted cost per unit  First-in First-out (FIFO)  Assumes that the cost of the earliest (oldest) goods on hand is the cost of the first inventory item(s) sold  As a result FIFO assumes that the cost of the units remaining in ending inventory is the cost of the latest inventory items acquired  Last-in First-out (LIFO)  An opposite cost flow assumption from FIFO  Assumes that the cost of the latest (newest) goods on hand is the cost of the latest (newest) goods on hand is the cost of the first inventory item(s) sold  As a result LIFO assumes that the cost of the units remaining in ending inventory is the cost of the earliest inventory items acquired o The three cost flow assumptions may be used in periodic or perpetual inventory systems Thursday, March 19 , 2015 th Chapter 9 Book Notes  Periodic Inventory System o Determine the ending inventory value by first taking a physical count of the units on hand, the price the units at costs using either specific identification method or one of the cost flow assumptions o Assumes that the purchased gods not on hand have been sold  This includes lost by theft or breakage o Specific Identification Method  Requires that we assign each inventory item a specific name or number and cost  Cost of goods sold = cost of goods available for sale – ending inventory at specific identification  Feasible when a business handles small numbers of high cost and easily distinguishable inventory items o Weighted Average Method  Values all units at the same weighted average cost computed at the end of each period  Weighted Average Unit Cost = cost of goods available for sale / units available for sale  Cost of goods sold = cost of goods available for sale – ending inventory at weighted average cost o First in First out (FIFO) Method  Assumes that the earliest inventory costs incurred are the first ones transferred out when units are sold  This cost flow assumption relates only to the method of accounting and not to the actual physical flow of goods.  Matches the first costs with revenue  Use the last purchases as the costs ending inventory  Cost of goods sold = cost of goods available for sale – ending inventory at FIFO o Last in First out (LIFO) Method  Assumes that the latest inventory costs incurred are the first ones transferred out when units are sold  This cost flow assumption relates only to the method of accounting and not to the actual physical flow of goods  Matches the latest costs with revenue  Use the first purchases as the costs ending inventory  Cost of goods sold = cost of goods available for sale – ending inventory at LIFO  Perpetual Inventory System o Provides continuous updated information about items on hand o Keeps an inventory record for each inventory item o As purchase or sell units, update the inventory record for the item to show the quantity and value on hand o Moving Average Method  Prices units at a continuous weighted average cost  Compute a new weighted average unit cost each time purchase merchandise  Cost of goods sold is the sum of the Total Cost column in the Sold section of the inventory record  Ex:  Insert Picture from pg. 350 o First in First Out (FIFO) Method  As we receive each shipment of goods, record its quantity, unit cost, (perpetual basis) and total cost as a separate lot  Each time sell goods, transfer out the costs of the earliest goods  Ex:  Insert Picture from pg.351 o Last in First out (LIFO) Method  As we receive each shipment of goods, record its quantity, unit cost, and total cost as a separate lot  Each time sell goods, transfer out the costs of the latest goods on hand at the time of the sale  Ex:  Insert Picture from pg.352  Periodic and Perpetual Systems Combined o Value of the ending inventory and the cost of goods sold is identical under the FIFO periodic and FIFO perpetual inventory systems  In both systems, value the ending inventory units at the cost of the most recently acquired units o Under LIFO, valuations of the cost of goods sold and ending inventory differ under periodic and perpetual  Periodic -> assume that costs at the beginning of the period are in ending valuation  Perpetual -> may have used the beginning costs as we recorded sales  At each sale assume that we assign the latest costs incurred to goods sold o Differences  Insert picture from pg. 353  Cost Flow Assumptions Compared o The cost flow assumption can have a significant effect on the results in the financial statement if prices are changing o During a period of rising prices  FIFO  Lowest cost of goods sold and highest net income  Older (lower) costs are matched with revenues  Higher income taxes because of higher income  LIFO  Net income is the lowest  Cost of goods sold is the greatest  More accurate determination of net income since relatively current (higher) costs are matched with current revenues o During a period of falling prices  FIFO  Highest cost of goods sold  Lowest net income  LIFO  Lowest cost of goods sold  Highest net income o Ending inventory is a current asset o Choice of cost flow assumptions affects balance sheet also o Disadvantage of LIFO -> The balance sheet shows an inventory amount at earlier and out-of-date costs o Inventory is a significant current asset we must consider the method the company uses to assign inventory cost when analyzing the balance sheet  LIFO: Additional Considerations o Notes to the financial statements are an integral part of the financial statements o The notes contain important information that we must consider when evaluating the balance sheet and income statement o Many large companies use different inventory cost flow assumptions in their various divisions o Using LIFO over an extended period of rising prices means that the inventory value shown on the balance sheet will probably be understated  b/c LIFO values the units in ending inventory at the earliest costs o Problem->  When inventory quantities are reduced in a given year  Cost of goods sold will include relatively old costs accumulated in prior years  Resulting use of low-cost inventory quantities (called a LIFO liquidation) causes a lower cost of goods sold and a corresponding increase in net income and income tax expense for the period  Although companies using LIFO in a period of rising prices generally report lower profits (and pay less in taxes) reducing inventory quantities from prior years can raise profits and taxes dramatically  Lower-of-cost-or-market (LCM) o Various cost flow assumptions are means of determining an inventory cost o Certain conditions decrease the value of some of the items in inventory o Show the loss of value as an expense and decrease inventory value o To do this use valuation concept known as lower-of-cost-or- market (LCM) o Market -> the cost of replacing the inventory items as of the balance sheet date o Also refer to it as replacement cost o Process of valuing the inventory at LCM occurs at the end of the accounting period  Determine cost by using any of the cost flow assumptions  Apply the LCM method  To each item individually  To each major inventory category  The entire inventory  Picture on pg. 356  Inventory Estimation Methods o Taking a physical inventory is often costly and time consuming o Instead estimate inventory o Two common methods for estimating:  Gross Margin Method  Uses the historical average gross margin percent to estimate ending inventory  Gross margin percent = gross margin / net sales  Use to check the accuracy of a physical count or to determine the amount of inventory stolen/destroyed  Steps for estimating inventory: o Compute the cost of goods available for sale  Cost of goods available for sale = inventory + purchases + transportation in – purchases returns and allowances o Compute the estimated cost of goods sold  Estimated cost of goods sold = (sales – sales returns and allowance) *(100% - average gross margin percent) o Compute the cost of the estimated ending inventory  Cost of goods available for sale – estimated cost of goods sold  Retail Inventory Method  Uses the current relationship between goods available for sale at cost prices and at retail/selling prices to estimate ending inventory  Used when relatively easy to


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