Acct 201 Final Study Guide
Acct 201 Final Study Guide Acct 201
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ACCT201 Final Study Guide I. Accounting – identify, record and communicate transactions of the business A. Users of Accounting Information Accounting is the language of business because all organizations set up an accounting information system to communicate data to help people make better decisions. 1. External information users are not directly involved in running the organization; they include shareholders, lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. External users have limited access to an organization’s information. Financial accounting is the area of accounting aimed at serving external users by providing them with generalpurpose financial statements. 2. Internal information users are those directly involved in managing and operating an organization. Internal users use the information to help improve the efficiency and effectiveness of an organization. Managerial accounting is the area of accounting that serves the decisionmaking needs of internal users. B. Opportunities in Accounting 1. The four broad areas of opportunities in accounting include (MAFT) managerial accounting, accounting related careers, financial accounting, and taxation. 2. The majority of accounting opportunities are in private accounting, public accounting offers the next largest number of opportunities, still other opportunities exist in government (and notforprofit) agencies, including business regulation and investigation of law violations. 3. The professional standing of accounting specialists are denoted by a certificate (such as certified public accountant (CPA). II. Fundamentals of Accounting Generally Accepted Accounting Principles Accounting principles were historically developed through common usage. A principle was deemed acceptable if permitted by most professionals. Eventually the following groups of professionals were given authority to rule on and develop standards: 1. Setting Accounting Principles a. The Financial Accounting Standards Board (FASB) is the private group that sets both broad and specific principles. b. The Securities and Exchange Commission (SEC) is the government group that establishes reporting requirements for companies that issue stock to the public. 2. Principles of Accounting Accounting principles are both general (basic guidelines, concepts and guidelines for preparing financial statements) and specific (detailed rules used in reporting transactions). The principles discussed in this chapter are: a. Objectivity principle—financial statement information is supported by unbiased evidence, not someone's opinion. b. Cost principle—financial statements are based on actual costs incurred in business transactions. Cost is measured on a cash or equaltocash basis. 1 ACCT201 Final Study Guide c. Goingconcern principle—financial statements are to reflect the assumption that the business will continue operating instead of being closed or sold, unless evidence shows that it will not continue. d. Monetary unit principle—transactions and events are expressed in monetary, or money, units (generally the currency of the country in which the business operates). Accounting generally assumes a stable monetary unit. This means we do not account for change in the value of currency. e. Revenue recognition principle—provides guidance on when a company must recognize revenue; to recognize means to record it. f. Business entity principle—a business is accounted for separately and distinctly from its owner(s). Also, each business is accounted for separately even if controlled by the same owner(s). A business entity can take one of three legal forms: i. Sole proprietorship is a business owned by one person that has unlimited liability. The business is not subject to an income tax but the owner is responsible for personal income tax on the net income of the entity. ii. Partnership is a business owned by two or more people, called partners, who are subject to unlimited liability. The business is not subject to an income tax, but the owners are responsible for personal income tax on their individual share of the net income of the entity. iii. Corporation is a business that is a separate legal entity whose owners are called shareholders or stockholders. These owners have limited liability. The entity is responsible for a business income tax and the owners are responsible for personal income tax on profits that are distributed to them in the form of dividends. III. Transaction Analysis and the Accounting Equation A. Accounting Equation Assets = Liabilities + Owner’s Equity. 1. Assets are resources owned or controlled by a company; these resources are expected to yield future benefits. 2. Liabilities are creditors’ claims on assets. 3. Owner’s Equity is the owner’s claim on assets; equity is also called net assets or residual equity (interest). A corporation’s equity—often called stockholders’ or shareholders’ equity—has two parts: contributed capital and retained earnings: a. Contributed capital refers to the amount that stockholders invest in the company —included under the title common stock. b. Retained earnings refer to income (revenues less expenses) that is not distributed to stockholders. The distribution of assets to stockholders is called dividends, which reduce retained earnings. Revenues increase retained earnings and are the assets earned from a company’s earnings activities. Expenses decrease retained earnings and are the cost of assets or services used to earn revenues. 4. The above breakdown of equity yields the expanded accounting equation: Assets = Liabilities + Equity Assets = Liabilities + Contributed Capital + Retained Earnings 2 ACCT201 Final Study Guide Assets = Liabilities + Common Stock – Dividends + Revenues – Expenses 5. Net income occurs when revenues exceed expenses. A net loss occurs when expenses exceed revenues, which decreases equity. IV. Financial Statements A Income Statement Reports on operating activities by listing amounts for sales, costs, and expenses over a period of time; net income is computed as sales less all costs and expenses. B. Statement of Retained Earnings Reports changes in retained earnings of the business over a period of time. Changes result from net income (or loss) and dividends. C. Balance Sheet Reports on investing and financing by listing amounts for assets, liabilities, and equity at a point in time. D. Statement of Cash Flows Reports on cash flows for operating, investing, and financing activities over a period of time. V. Decision Analysis—Return on Assets (ROA) A. Return on assets, also called return on investment (ROI), is a profitability measure; useful in evaluating management, analyzing and forecasting profits, and planning activities. B. It is calculated by dividing net income by average total assets. Chapter 2 I. Analyzing and Recording Process A. Accounting process identifies business transactions and events, analyzes and records their effects, and summarizes and presents information in reports and financial statements. Steps in accounts process that focus on analyzing and recording transactions and events are: (1) record relevant transactions and events in a journal, (2) post journal information to ledger accounts, and (3) prepare and analyze the trial balance. Accounting records are informally referred as the accounting books, or simply the books. B. Source documents identify and describe transactions and events. Source documents are sources of accounting information (hard copy or electronic form). Examples are sales tickets, checks, purchase orders, bills from suppliers, employee earnings records, and bank statements. Source documents provide objective and reliable evidence about transactions and events. C. An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item. The general ledger, or ledger, is a record containing all accounts used by a company. D. Accounts are arranged in three basic categories based on the accounting equation. A separate accounts is kept for each of the following: 1. Asset Accounts—resources owned or controlled by a company that have expected future benefits; examples include Cash, Accounts Receivable, Note Receivable, 3 ACCT201 Final Study Guide Prepaid Accounts, Supplies, Equipment, Buildings, and Land. 2. Liability Accounts—claims by creditors against assets; obligations to transfer assets or provide products or service to other entities; examples include Accounts Payable, Note Payable, Unearned Revenue, and Accrued Liabilities. 3. Equity Accounts—owner’s residual interest in the assets of the business after deducting liabilities; examples include Common Stock, Dividends, Revenues and Expenses. II. Analyzing and Processing Transactions A. Ledger and Chart of Accounts 1. A ledger (or general ledger) is the sum of all the accounts a company uses. 2. The chart of accounts is a list of all the accounts in the ledger with their identification numbers. B. Debits and Credits 1. A Taccount represents a ledger account and is used to understand the effects of one or more transactions. 2. The left side of an account is called the debit side. A debit is an entry on the left side of an account. 3. The right side of an account is called the credit side. A credit is an entry on the right side of an account. 4. Whether a debit or a credit is an increase or decrease depends on the account. 5. In an account where a debit is an increase, the credit is a decrease. In an account where a credit is an increase, the debit is a decrease. 6. The account balance is the difference between the total debits and the total credits recorded in an account. C. DoubleEntry Accounting 1. Total amount that is debited to accounts must equal the total amount credited to accounts for each transaction. Sum of debit account balances in the ledger must equal the sum of credit account balances. 2. Assets are on the left side of the equation; therefore, the left, or debit, side is the normal balance side for assets. 3. Liabilities and equities are on the right side; therefore, the right, or credit, side is the normal balance side for liabilities and equity. 4. Equity increases from revenues and stock issuances and it decreases from expenses and dividends. Increases (credits) to common stock and revenues increase equity; increases (debits) to dividends and expenses decrease equity. 5. The normal balance of each account (assets, liability, common stock, dividends, revenue, or expense) refers to the left or right (debit or credit) side where increases are recorded. D. Journalizing and Posting Transactions 1. A journal gives a complete record of each transaction in one place; it shows the debits and credits for each transaction. The process of recording each transaction in a journal is called journalizing. The process of transferring journal entry information to the ledger is called posting. 4 ACCT201 Final Study Guide 2. The general journal can be used to record any type of transaction. III. Trial Balance A. Preparing a Trial Balance 1. A trial balance is a list of accounts and their balances at a point in time. 2. The three steps to prepare a trial balance are as follows: a. List each account and its amount (from the ledger), b. Compute the total debit balances and the total credit balances, and c. Verify (prove) total debit balances equal total credit balances. IV. Decision Analysis—Debt Ratio A. A company that finances a relatively large portion of its assets with liabilities has a high degree of financial leverage. Higher financial leverage involves greater risk because liabilities must be repaid and often require regular interest payments (equity financing does not). The risk that a company might not be able to meet such required payments is higher if it has more liabilities (is more highly leveraged). B. One way to assess the risk associated with a company’s use of liabilities is to compute the debt ratio. 1. It is calculated as total liabilities divided by total assets. 2. It tells us how much (what percentage) of the assets are financed by creditors (nonowners) or liability financing; the higher the debt ratio, the more risk a company faces from its financial leverage. Chapter 3 Outline I. Timing and Reporting A. The Accounting Period To provide timely information, accounting systems prepare periodic reports at regular intervals. 1. Timeperiod principle assumes that an organization’s activities can be divided into specific time periods such as a month, a threemonth quarter, a sixmonth interval, or a year. Reports covering a oneyear period are known as annual financial statements. Interim financial statements cover one, three, or six months of activity. 2. Annual reporting period: a. Calendar year—January 1 to December 31. b. Fiscal year—Any twelve consecutive months used to base annual financial reports on. c. Natural business year—a fiscal year that ends when a company's sales activities are at their lowest level for the year. 3. Accounts are adjusted at the end of a period to record internal transactions and events that are not yet recorded. B. Recognizing Revenues and Expenses 1. The revenue recognition principle requires revenue be recorded when earned, not 5 ACCT201 Final Study Guide before and not after. 2. The matching principle requires expenses be recorded in the same period as the revenues earned as a result of these expenses. C. Accrual Basis versus Cash Basis 1. Accrual basis accounting—uses the adjusting process to recognize revenue when earned and to match expenses with revenues. This means the economic effects of revenues and expenses are recorded when earned or incurred, not when cash is received or paid. Accrual basis is consistent with GAAP. 2. Cash basis accounting—revenues are recognized when cash is received and expenses are recognized when cash paid. Cash basis is not consistent with GAAP. 3. Accrual accounting also increases the comparability of financial statements from one period to another. II. Adjusting Accounts An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. This entry also updates a related expense or revenue account. A. Framework for Adjustments Adjustments are necessary for transactions that extend over more than one period. B. Adjusting Prepaid (Deferred) Expenses 1. Prepaid Expenses are items paid for in advance of receiving their benefits. Prepaid expenses are assets. When the assets are used, their costs become expenses. 2. Common prepaid items are prepaid insurance, supplies, and other prepaid expenses. 3. Adjusting entries for prepaids involve increasing (debiting) expenses and decreasing (crediting) assets (with the exception of depreciation on plant and equipment assets). C. Adjusting for Depreciation 1. Plant assets are longterm tangible assets used to produce and sell products and services; they are expected to provide benefits for more than one period. 2. Depreciation is the process of allocating the cost of plant and equipment assets over their expected useful lives. Straightline depreciation allocates equal amounts of an assets’ net cost to depreciation during its useful life. 3. Adjusting entries for depreciation expense involve increasing (debiting) expenses and increasing (crediting) a special account called Accumulated Depreciation. A contra account is an account linked with another account and having an opposite normal balance. 4. Accumulated depreciation is reported as a subtraction from the related plant asset account balance in the balance sheet. 5. Book value is a term used to describe the asset less its contraasset (accumulated depreciation). D. Adjusting Unearned Revenues 1. Unearned Revenues (also called deferred revenues) are liabilities created by cash received in advance of providing products or services. The obligation is to provide the service or product. As they are provided unearned revenues (liabilities) become earned revenues (revenues). 6 ACCT201 Final Study Guide 2. Adjusting entries for unearned revenues involve increasing (crediting) revenues and decreasing (debiting) unearned revenues. V. Classified Balance Sheet—organizes assets and liabilities into subgroups that provide more useful information to decision makers: A. Classification Structure 1. One of the more important classifications is the separation between current and noncurrent assets and liabilities. 2. Current items are expected to come due (both collected and owed) within one year or the company’s operating cycle, whichever is longer. 3. The operating cycle is the time span from when cash is used to acquire goods and services until cash is received from the sale of those goods and services. Most operating cycles are less than one year; a few companies have an operating cycle longer than one year. B. Classification Categories 1. Current assets—cash or other assets that are expected to be sold, collected, or used within one year or the company’s operating cycle, whichever is longer. Examples: cash, shortterm investments, accounts receivable, shortterm notes receivable, goods for sale (called merchandise or inventory), and prepaid expenses. 2. LongTerm Investments—assets that are expected to be held for more than the longer of one year or the operating cycle. Examples: notes receivable, investments in stocks, and land held for future expansion. 3. Plant Assets—tangible, longlived assets that are both longlived and used to produce or sell goods and services. Examples: equipment, machinery, buildings, and land that are used to produce or sell products and services. 4. Intangible Assets—longterm resources that benefit business operations. They usually lack physical form and have uncertain benefits. Examples: patents, trademarks, copyrights, franchises, and goodwill. 5. Current Liabilities—obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Examples: accounts payable, notes payable, wages payable, taxes payable, interest payable, and unearned revenues. Any portion of a longterm liability due to be paid within one year or the operating cycle, whichever is longer, is a current liability. 6. LongTerm Liabilities—obligations not due within one year or the operating cycle, whichever is longer. Examples: notes payable, mortgages payable, bonds payable, and lease obligations. 7. Equity—owners’ claim on assets; divided into two main subsections: common stock and retained earnings. VI. Decision Analysis—Profit Margin and Current Ratio A. Profit Margin 1. Profit margin (also called return on sales), a useful measure of a company’s operating results, is the ratio of its net income to sales. 7 ACCT201 Final Study Guide 2. It is calculated as net income divided by net sales. 3. It is interpreted as reflecting the portion of profit in each dollar of sales. B. Current Ratio 1. The current ratio is an important measure of a company’s ability to pay its shortterm obligations. 2. It is calculated as total current assets divided by total current liabilities. Chapter 4 Outline I. Merchandising Activities Products that a company acquires to resell to customers are referred to as merchandise (also called goods). A merchandiser earns net income by buying and selling merchandise. A wholesaler in an intermediary that buys products from manufacturers or other wholesalers and sells them to retailers or other wholesalers. A. Reporting Income for a Merchandiser Revenue (net sales) from selling merchandise minus the cost of goods sold (the expense of buying and preparing the merchandise) to customers is called gross profit (also called gross margin). This amount minus expenses (generally called operating expenses) determines the net income or loss for the period. B. Reporting Inventory for a Merchandiser 1. A merchandiser's balance sheet is the same as service business with the exception of one additional current asset, merchandise inventory, or simply inventory. 2. The cost of this asset includes the cost incurred to buy the goods, ship them to the store, and make them ready for sale. C. Operating Cycle A merchandising company’s operating cycle begins by purchasing merchandise and ends by collecting cash from selling the merchandise. D. Inventory Systems 1. Merchandise available for sale consists of what it begins with (beginning inventory) and what it purchases (net cost of purchases). The merchandise available is either sold (cost of goods sold) or kept for future sales (ending inventory). 2. Two alternative inventory systems are used to collect information about cost of goods sold and the inventory: a. Perpetual inventory system—continually updates accounting records for merchandise transactions (Specifically, for those records of inventory available for sale and inventory sold). b. Periodic inventory system—updates the accounting records for merchandise transactions only at the end of a period. II. Accounting for Merchandise Purchases The invoice serves as a source document for this event. 8 ACCT201 Final Study Guide A. Trade Discounts 1. In catalogs, each item has a catalog price. An item’s intended selling price equals list price minus a given percent called a trade discount. 2. A buyer records the net amount of list price minus trade discount. B. Purchases Discounts Credit terms for a purchase include the amounts and timing of payments from a buyer to a seller. The amount of time before full payment is due is called the credit period. 1. Sellers can grant a cash discount to encourage the buyer to pay earlier. A seller views a cash discount as a sales discount and a buyer views a cash discount as a purchases discount. Reduced payment applies only for the discount period. 2. Example: credit terms, 2/10 n/30, offer a 2 % discount if invoice is paid within 10 days of invoice date. 3. Entry (for buyer) for purchase of merchandise on credit: debit Merchandise Inventory, credit Accounts Payable. 4. Entry (for buyer) to record payment within discount period: debit Accounts Payable (full invoice amount), credit Cash (amount paid = invoice – discount), credit Merchandise Inventory (amount of discount). C. Purchase Returns and Allowances 1. Purchase returns refer to merchandise a buyer acquires but then returns to the seller. 2. A purchase allowance is a reduction in the cost of defective or unacceptable merchandise in the buyer’s records. 3. The buyer issues a debit memorandum to inform the seller of a debit made to the supplier's account. 4. Entry (for buyer) to record purchase return or allowance: debit Accounts Payable or Cash (if refund given) and credit Merchandise Inventory. 5. When goods are returned, a buyer can take a purchase discount on only the remaining balance of the invoice. D. Transportation Costs and Ownership Transfer The buyer and seller must agree on who is responsible for paying any freight costs and who bears the risk of loss during transit for merchandising transactions. The point of transfer is called the FOB (free on board) point. 1. FOB shipping point—buyer accepts ownership when goods depart sellers’ place of business; buyer pays shipping costs. a. Shipping costs Increase the cost of merchandise acquired (cost principle) b. Entry (for buyer) to record shipping costs: Debit Merchandise Inventory, credit Cash or Accounts Payable (if to be paid for with merchandise later) 2. FOB destination—ownership of goods transfers to buyer when goods arrive at buyer’s place of business; seller pays shipping costs. a. Shipping costs are an operating (selling) expense for seller b. Entry (for seller) to record shipping costs: Debit Delivery Expense (or 9 ACCT201 Final Study Guide TransportationOut or FreightOut), credit Cash. III. Accounting for Merchandise Sales A. Sales of Merchandise Each sales transaction involves two parts: 1. Recognize revenue—entry (for seller) to record: debit Accounts Receivable (or cash), credit Sales (for the invoice amount). 2. Recognize cost— entry (for seller) to record: debit Cost of Goods Sold, credit Merchandise Inventory (for the cost of the merchandise sold). B. Sales Discounts Sales discounts are usually not recorded until a customer actually pays with the discount period. 1. Entry (for seller) to record collection after discount period—Debit Cash, Credit Accounts Receivable (full invoice amount). 2. Entry (for seller) to record collection within discount period—debit Cash (invoice amount less discount), debit Sales Discount (discount amount), credit Accounts Receivable (invoice amount). 3. Sales Discount is a contrarevenue account; it is subtracted from Sales account when computing a company’s net sales. 4. Sales discounts are monitored to assess effectiveness and cost of discount policy. C. Sales Returns and Allowances 1. Sales returns—merchandise that a customer returns to the seller after a sale. 2. Sales allowances—reductions in the selling price of merchandise sold to customers (usually for damaged or defective merchandise that a customer is willing to keep at a reduced price). 3. Entry (for seller) to record sales return or allowance: debit Sales Returns and Allowances and credit Accounts Receivable; additional entry if returned merchandise is salable: debit Merchandise Inventory, credit Cost of Goods Sold. 4. Seller prepares a credit memorandum to inform buyer of the seller’s credit for the buyer’s return or allowance to the buyer’s account (on the sellers’ books). IV. Completing the Accounting Cycle A. Adjusting Entries for Merchandisers Generally same as discussed in chapter 3 for a service business. 1. Additional adjustment needed to update inventory to reflect any loss of merchandise, including theft and deterioration, is referred to as shrinkage. 2. Shrinkage is determined by comparing a physical count of the inventory with recorded quantities. 3. Entry to record shrinkage: debit Cost of Goods Sold, credit Merchandise Inventory. B. Preparing Financial Statements The financial statement for a merchandiser are similar to those for a service company described in chapters 2 and 3. 1. The income statement mainly differs by the inclusion of cost of goods sold and 10 ACCT201 Final Study Guide gross profit. Net sales is affected by discounts, returns, and allowances, and some additional expenses are possible. 2. The balance sheet mainly differs by the inclusion of merchandise inventory as part of current assets. C. SingleStep Income Statement A singlestep income statement includes cost of goods sold as an operating expense and shows only one subtotal for total expenses, one subtraction to arrive at net income. D. Classified Balance Sheet The merchandiser’s classified balance sheet reports merchandise inventory as a current asset, usually after accounts receivable. VI. Decision Analysis—AcidTest and Gross Margin Ratios A. AcidTest Ratio 1. The acidtest ratio is used to assess the company's liquidity or ability to pay its current debts; differs from current ratio by excluding less liquid current assets. 2. It is calculated by dividing quick assets by current liabilities; quick assets are cash, shortterm investments, and current receivables. 3. Rule of thumb is that the acidtest ratio should have a value of at least 1.0 to conclude that a company is unlikely to face nearterm liquidity problems. B. Gross Margin Ratio 1. The gross margin ratio is used to assess a company’s profitability before considering operating expenses. 2. It is calculated by dividing gross margin (or net sales – cost of goods sold) by net sales. Chapter 5 Outline I. Inventory Basics A. Determining Inventory Items II. Inventory Costing under a Perpetual System Major goal is to properly match costs with sales. The matching principle is used to decide how much of the cost of goods available for sale is deducted from sales (on the income statement) and how much is carried forward as inventory (on the balance sheet). A. Inventory Cost Flow Assumptions Four methods are commonly used to assign costs to inventory and cost of goods sold. Each method assumes a particular pattern for how costs flow through inventory. Physical flow and cost flow need not be the same. 1. Firstin, firstout (FIFO)—assumes costs flow in the order incurred. 2. Lastin, firstout (LIFO)—assumes costs flow in the reverse order occurred. 3. Weighted average—assumes costs flow in an average of the costs available. 4. Specific identification—each item can be identified with a specific purchase and invoice. 11 ACCT201 Final Study Guide Note: The following sections assume the use of a perpetual system, the assignment of costs to inventory using a periodic system is described in Appendix 5A. B. Inventory Costing Illustration 1. Specific identification—As sales occur, cost of goods sold is charged with the actual or invoice cost, leaving actual costs of inventory on hand in the inventory account. 2. Firstin, firstout (FIFO)—As sales occur, FIFO charges costs of the earliest units acquired to cost of goods sold, leaving costs of most recent purchases in inventory. 3. Lastin, firstout (LIFO)—As sales occur, LIFO charges costs of the most recent purchase to cost of goods sold, leaving costs of earliest purchases in inventory. 4. Weighted average—As sales occur, weighted average computes the average cost per unit of inventory at time of sale and charges this cost per unit sold to cost of goods sold leaving average cost per unit on hand in inventory. C. Financial Statement Effects of Costing Methods 1. When purchase prices do not change, each inventory costing method assigns the same amounts to inventory and to cost of goods sold. When purchase prices are different, the methods assign different cost amounts. When purchase costs regularly rise: a. FIFO assigns the lowest amount to cost of goods sold resulting in the highest gross profit and the highest net income. Advantage: Inventory on the balance sheet approximates its current replacement cost; it also mimics the actual flow of goods for most businesses. b. LIFO assigns the highest amount to cost of goods sold resulting in the lowest gross profit and the lowest net income. Advantage: Better match of current costs with revenues in computing gross margin. c. Weighted average method yields results between FIFO and LIFO. Advantage: Smoothing out of price changes. d. Specific identification also yields results that depend on which units are sold. Advantage: Exactly matches costs and revenues. When costs regularly decline, the reverse occurs for FIFO and LIFO. D. Tax Effects of Costing Methods Since inventory costs affect net income, they have potential tax effects. 1. Financial reporting often differs from the method used for tax reporting. 2. Exception: LIFO may only be used for tax purposes if it is also used for financial reporting. E. Consistency in Costing Methods 1. Consistency principle requires use of same accounting methods period after period so the financial statements are comparable across periods. 2. Method change is acceptable if it will improve financial reporting. The fulldisclosure principle requires statement notes report type of change, its justification, and its effect on income. 3. Different methods may be consistently applied to different categories of inventory. III. Valuating Inventory at LCM and the Effects of Inventory Errors A. Lower of Cost or Market 12 ACCT201 Final Study Guide Accounting principles require that inventory be reported on the balance sheet at the lower of cost or market (LCM). 1. Market is the current replacement cost of purchasing the same inventory items in the usual manner. 2. When the recorded cost of inventory is higher than the replacement cost, a loss is recognized; when the recorded cost is lower, no adjustment is made. 3. Lower of cost or market pricing is applied either to: a. Each individual item separately, b. Major categories of items, or c. To the entire inventory. 4. Accounting rules require that inventory be adjusted to market when market is less than cost, but inventory usually cannot be written up to market when market exceeds cost. The conservatism principle prescribes the use of the less optimistic amount when more than one estimate of the amount to be received or paid exists and these estimates are about equally likely. IV. Decision Analysis—Inventory Turnover and Days’ Sales in Inventory A. Inventory Turnover 1. Inventory turnover is used to measure how quickly a company sells its inventory and can effect a merchandiser’s ability to pay its shortterm obligations. 2. It is calculated by dividing cost of goods sold by average inventory. 3. It measures the number of times a company's average inventory was sold during an accounting period. B. Days' Sales in Inventory 1. Day’s sales in inventory measures how much inventory is available in terms of the number of days’ sales. 2. It is calculated by dividing ending inventory by cost of goods sold, and then multiplying the result by 365. Chapter 6 Outline I. Internal Control A. Purpose of Internal Control An internal control system is all policies and procedures managers use to: 1. Protect assets. 2. Ensure reliable accounting. 3. Promote efficient operations. 4. Urge adherence to company policies. B. Principles of Internal Control Certain fundamental internal control principles apply to all companies. The principles of internal control are to: 1. Establish responsibilities. 2. Maintain adequate records. 13 ACCT201 Final Study Guide 3. Insure assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and independent reviews. C. Technology and Internal Control Technology provides rapid access to large quantities of data. Examples of technological impacts on internal control: 1. Reduced processing errors. 2 More extensive testing of records. 3. Limited evidence of processing. 4. Crucial separation of duties. D. Limitations of Internal Control 1. Internal control policies and procedures are applied by people; the human element creates several potential limitations: a. Human error—resulting from negligence, fatigue, misjudgment, or confusion. b. Human fraud—involving intent by people to defeat internal controls, such as management override, for personal gain. 2. Costbenefit principle—the costs of internal controls must not exceed their benefits. II. Control of Cash Basic guidelines for control of cash include: handling of cash must be separate from recordkeeping of cash, cash receipts are promptly deposited in bank, and disbursements of cash are by check. A. Cash, Cash Equivalents, and Liquidity 1. Liquidity refers to a company’s ability to pay for its nearterm obligations. Cash and similar assets are called liquid assets because they can be readily used to settle such obligations. 2. Cash includes currency and coins, deposits in bank and checking accounts, many savings accounts, and items that are acceptable for deposit in those accounts. 3. Cash equivalents are shortterm, highly liquid investment assets meeting two criteria. (Note: Only investments purchased within three months of their maturity dates usually satisfy these criteria.) a. Readily convertible to a known cash amount. b. Sufficiently close to their maturity date so that market value is not sensitive to interest rate changes. B. Control of Cash Receipts 1. Overthecounter cash receipts: a. Record on a cash register at time of sale. 14 ACCT201 Final Study Guide b. Separate custody from recordkeeping. 3. Cash receipts by mail: a. Two people open mail and prepare list of cash received; copies to cashier, recordkeeper in accounting area, and clerks who open mail. b. Cashier deposits. c. Recordkeeper records. d. Bank account reconciled by another person. C. Control of Cash Disbursements To safeguard against theft—require all expenditures be made by check (except for small payments made from petty cash fund) and deny access to the accounting records to anyone, other than the owner, who has authority to sign checks. 1. A voucher system is a set of procedures and approvals designed to control cash disbursements and the acceptance of obligations. The voucher system includes procedures for: a. Verifying, approving, and recording obligations for eventual cash disbursements. b. Issuing checks for payment of verified, approved, and recorded obligations. c. Key factors in a voucher system: i. Only approved departments and individuals are authorized to incur such obligations. ii. Several business documents (purchase requisition, purchase order, invoice, receiving report, and check) are accumulated in a voucher, which is an internal document (or file) used to accumulate information to control cash disbursements. 2. Use a petty cash system of control as follows: a. Write and cash a check to establish petty cash fund. Entry to record establishment: debit Petty Cash, credit Cash. b. Assign a petty cashier (custodian) to account for the amounts expended and keep receipts. c. Entry to record reimbursement: debit the related expense and/or asset accounts for the amounts paid for with petty cash, credit Cash for the amount reimbursed to the petty cash fund. d. Sometimes, the petty cash payments report plus the cash remaining will not total to the fund balance. i. A shortage is recorded as an expense in the reimbursing entry with a debit to the Cash Over and Short account. ii. An overage is recorded with a credit to the Cash Over and Short account in the reimbursing entry. III. Banking Activities as Controls A. Basic Bank Services Bank accounts permit depositing money for safeguarding and help control withdrawals. 1. A bank account is a record set up by a bank for a customer. To limit access, all 15 ACCT201 Final Study Guide persons authorized to write checks, documents instructing the bank to pay a specified amount of money to a designated recipient, sign a signature card. Each bank deposit is supported by a deposit ticket. 2. Electronic Funds Transfer (EFT) is the electronic communication transfer of cash from one party to another. B. Bank Statement Once a month, the bank sends each depositor a bank statement showing activities of a bank account. C. Bank Reconciliation 1. A bank reconciliation is a report used to prove the accuracy of the depositor's cash records by preparing a bank reconciliation. 2. The balance reported on the bank statement rarely equals the balance in the depositor’s accounting records; this is usually due to information that one party has that the other does not. Factors causing the bank statement balance to differ from the depositor's book balance are: a. Outstanding checks. b. Deposits in transit. c. Deductions for uncollectible items and for services. d. Additions for collections and for interest. e. Errors. 3. Steps in preparing the bank reconciliation: a. Identify the bank statement balance of the cash account (balance per bank). b. Identify and list any unrecorded deposits and any bank errors understating the bank balance. Add them to the bank balance. c. Identify and list any outstanding checks and any bank errors overstating the bank balance. Deduct them from the bank balance. d. Compute the adjusted bank balance, also called corrected or reconciled balance. e. Identify the company's balance of the cash account (balance per book). f. Identify and list any unrecorded credit memoranda from the bank, interest earned, and errors understating the book balance. Add them to the book balance. g. Identify and list any unrecorded debit memoranda from the bank, service charges, and errors overstating the book balance. Deduct them from the book balance. h. Compute the adjusted book balance, also called corrected or reconciled balance. i. Verify the two adjusted balances from steps d. and h. are equal. If yes, they are reconciled. If not, check for mathematical accuracy and missing data. 4. A bank reconciliation often identifies unrecorded items that need recording. Only the items reconciling the book balance require adjustment. a. All reconciling additions to book balance are debits to cash. Credit depends on reason for addition. 16 ACCT201 Final Study Guide b. All reconciling subtractions from book balance are credits to cash. Debit depends on reason for addition IV. Decision Analysis—Days' Sales Uncollected A. One measure of the receivables’ nearness to cash is the days’ sales uncollected ratio (also called days' sales in receivables). B. It is calculated by dividing accounts receivable by net sales and multiplying the result by 365. C. It is used to estimate how much time is likely to pass before the current amount of accounts receivable is received in cash. Chapter 7 Outline I. Accounts Receivable A receivable is an amount due from another party. Accounts Receivable are amounts due from customers for credit sales. A. Sales on Credit 1. Credit sales are recorded by increasing (debiting) Accounts Receivable. a. The General Ledger continues to keep a single Accounts Receivable account. b. A supplementary record, called the accounts receivable ledger, is created to maintain a separate account for each customer. c. The sum of the individual accounts in the accounts receivable ledger equals the debit balance of the Accounts Receivable account in the general ledger. 2. Entry to record credit sale: debit Accounts Receivable—Customer Name, credit Sales. The debit is posted to the Accounts Receivable account in the general ledger and to the customer account in the accounts receivable ledger. 3. Many larger retailers maintain their own credit cards to grant credit to preapproved customers and to earn interest on unpaid balances. The entries are the same as in 2 above except for the possibility of added interest revenue; entry to record accrued interest: debit Interest Receivable, credit Interest Revenue. B. Credit Card Sales (examples: Visa, MasterCard, American Express) 1. Sellers allow customers to use thirdparty credit and debit cards for several reasons: a. The seller does not have to make decisions about who gets credit and how much. b. The seller avoids the risk of extending credit to customers who do not pay. c. The seller typically receives cash from the credit card company sooner than had it granted credit directly to customers. d. A variety of credit options for customers offers a potential increase in sales volume. 2. Entry for credit card sales when cash is received upon deposit of sales receipt: 17 ACCT201 Final Study Guide debit Cash (for the amount of sale less the credit card company charge), debit Credit Card Expense (for the fee), credit to Sales (for the full invoice amount). C. Valuing Accounts Receivable Accounts of customers who do not pay what they promised are uncollectible accounts, commonly called bad debts. Two methods are used to account for uncollectible accounts. 1. Direct Writeoff Method—records the loss from an uncollectible account receivable when it is determined to be uncollectible. a. Entry to write off uncollectible and recognize loss: debit Bad Debt Expense, credit Accounts Receivable. b. If a written off account is later collected, this results of a reversal of the write off (see a.) and a normal collection of account entry. c. The matching principle requires expenses to be reported in the same accounting period as the sales they helped produce; the direct writeoff method usually does not best match sales and expenses. d. The materiality principle states that an amount can be ignored if its effect on the financial statements is unimportant to the users’ business decision; it permits the use of the direct writeoff method when bad debts expenses are very small in relation to a company’s other financial statement items. 2. Allowance Method—matches the estimated loss from uncollectibles against the sales they helped produce. a. At the end of each accounting period, bad debts expense is estimated and recorded in an adjusting entry. b. Advantages of method: 1. Records estimated bad debt expense when the related sales are recorded. 2. Reports accounts receivable on balance sheet at the estimated amount of cash to be collected. c. Entry to record estimate of bad debt expense: Debit Bad Debt Expense, credit Allowance for Doubtful Accounts, a contraasset account. (This contra account is used instead of Accounts Receivable because, at the time of the adjusting entry, the company does not know which customers will not pay.) d. Realizable value is the expected proceeds from converting an asset to cash; in the balance sheet, the Allowance for Doubtful Accounts is subtracted from Accounts Receivable to show the amount expected to be collected. e. Entry to write off a bad debt (that is, a specific account identified to be uncollectible): debit Allowance for Doubtful Accounts, credit Accounts Receivable. (Note that the writeoff does not affect the realizable value of accounts receivable.) f. If a written off account is later collected (referred to as a recovery of a bad debt), this results of a reversal of the write off (see e above) and a normal collection of account entry. 18 ACCT201 Final Study Guide D. Estimating Bad Debts Expense The allowance method requires an estimate of bad debt expense to prepare an adjusting entry at the end of the accounting period. There are two common methods: 1. The percent of sales method—uses income statement relations to estimate bad debt expense. a. Based on experience, company estimates what percentage of credit sales will be uncollectible. b. Bad debts expense is calculated as the estimated percentage times sales for the period. 2. Accounts receivable methods—uses balance sheet relationships. a. Goal of the bad debts adjusting entry for these methods is to make the Allowance for Doubtful Accounts balance equal to the portion of accounts receivable that
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