Exam 2 Study Guide
Exam 2 Study Guide acct 2110
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This 23 page Study Guide was uploaded by jemialk on Friday September 23, 2016. The Study Guide belongs to acct 2110 at Auburn University taught by Cornett in Fall 2016. Since its upload, it has received 73 views. For similar materials see Accounting in Accounting at Auburn University.
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Exam 2 ‐ What to Expect Thursday, September 22, 2016 9:48 PM EXAM 2 60% multiple choice from all chapters equally ‐ problem solving more than definitions (not rote memory, must understand concepts) 40% open format ‐ mostly adjustments at end of period She gives information and we make computations and adjustments ***Lots of journal entries (adjustments, write offs, etc.)*** Helpful tools in Canvas Panopto video ‐ adjusting entries review Bonus Iclicker 346,000 in A/R and estimates BDE at 5% of A/R How much BDE recorded if Allowance account has 5, 000 credit balance ACCT 2110 – Cornett Chapter 3 Notes Objectives 1. Explain the difference between cash-basis and accrual-basis accounting. 2. Explain how the time-period assumption, revenue recognition, and expense recognition (or matching) principles affect the determination of income. 3. Identify the kinds of transactions that may require adjustments at the end of an accounting period. 4. Prepare adjusting entries for accruals and deferrals. 5. Prepare financial statements from an adjusted trial balance. 6. Explain why and how companies prepare closing entries. 7. Understand the steps in the accounting cycle. 8. (Appendix 3A) Understand how to use a worksheet to prepare financial statements. Objective 1 COMPLETING THE ACCOUNTING CYCLE Chapter 3 begins where chapter 2 left off in covering the accounting cycle. Chapter 2 covered the first 4 steps – analyze transactions, journalize transactions, post to the ledger, and prepare a trial balance. Now we’re to step 5 – Adjust the Accounts. Sometimes business activities occur over more than one accounting period, and making adjustments to accounts impacted is necessary. Adjustments are made using accrual-basis accounting rather than cash-basis accounting. Accrual-accounting requires that incomplete activities be recognized in financial statements. Cash basis looks at only the transactions that have been made, regardless of the time period they cover. So if you pre-pay for a few months of insurance, it’s only reported when you pay, rather than by month of coverage. Accrual-accounting is better than cash-accounting because it links income measurement/revenue to selling (service or products) Chapter will address following questions: what’s the difference in cash vs. accrual, what’s the purpose of adjusting entries, what types of entries require adjustments and how to record them, and which accounts are closed at end of period and why is that necessary? ACCT 2110 – Cornett Objective 2 KEY ELEMENTS OF ACCRUAL ACCOUNTING Accrual-accounting rests on 3 elements of conceptual framework (principles) previously introduced in book. 1) Time period 2) Revenue Recognition, & 3) Expense Recognition/Matching In the previous chapters, we covered how accounting provides information to internal and external users. These users want timely information (and for a specific period of time). The time-period assumption allows accountants to artificially create time periods to record information THE REVENUE RECOGNITION PRINCIPLE Determines when revenue is recorded and reported Recognized and recorded when 1) it has been earned, and 2) collection of cash is reasonably assured Pretty much when delivery of goods has occurred or services were performed, these conditions are “met” because risks and rewards of ownership have transferred to purchaser THE EXPENSE RECOGNITION (OR MATCHING) PRINCIPLE Expenses are incurred in a variety of ways, e.g. when an asset is used or a liability created Expenses should be recorded WHEN INCURRED. Match the time period the expense occurred with the period in which it’s recorded. Delaying reporting expenses to make financial statements look better constitute fraud and can result in massive fines and criminal charges/prison sentences APPLYING THE PRINCIPLES Cash for revenue and expenses doesn’t always go out or come in when revenue is earned or expenses incurred. In order to accurately report, adjustments to the accounts must be made. Example: you may use electricity in the month of September but not pay the bill until October, or you may do work for someone in September and not get paid until November. Both amounts would be reported in September, regardless of payment. Objective 3 WHICH TRANSACTIONS REQUIRE ADJUSTMENT Business activities that continue for a period of time which is longer than an accounting period will require adjustments Adjustments record partially complete activities Adjusting entries are journal entries made at the end of an accounting period (or sometimes later) to record the completed portion of the transaction Adjustments are necessary for accurate financial reporting ACCT 2110 – Cornett Objective 4 STEP 5: ADJUSTING THE ACCOUNTS 2 Categories or adjustments with 2 sub-types each = 4 types of adjustments Accruals (Cash after recording transaction) Accrued revenues – revenues earned but not yet received Accrued expenses – expenses incurred buy not yet paid Deferrals (Cash before recording transaction) Deferred (unearned) revenues – liabilities arising from receipt of cash without having earned the revenue Deferred (prepaid) expenses – assets arising from payment of cash for assets you haven’t completely used up Adjustments DO NOT affect cash. Cash is a point-in-time transaction, not something that happens over a period of time. When cash goes up or down, another account goes with it (prepaid something, something payable, unearned revenue, etc.), and that account from the balance sheet will be affected in an adjustment with an account on the income statement (revenue or expense) Again, adjustments affect one Balance Sheet account and one Income Statement account 3-step procedure for making adjustments Identify the pair of accounts impacted (one Bal. Sheet and one Inc. Statement) Calculate the amount of adjustment based on revenue earned or expense incurred during that period Record the entry ACCRUED REVENUES Partially completed services or sales Interest earned on a loan but not yet paid Company rents office space on Nov. 1 for $5,000/month to be paid at end of 3-month period. Adjustment must be made at end of year to account for 2 months of the rent revenue the company has earned but not yet received. Assets (rent receivable) and S.E. (rent revenue) go up. Assets (Debit) = Liabilities + Stockholders’ Equity (Credit) +10k +10k Date Account and Explanation Debit Credit Dec. 31 Rent Receivable $10,000 Rent Revenue $10,000 Assets (Debit) = Liabilities + Stockholders’ Equity (Credit) (+15k) +5k -10k (rent receivable) Date Account and Explanation Debit Credit Jan. 31 Cash $15,000 Rent Revenue $5,000 Rent Receivable $10,000 ACCT 2110 – Cornett Adjustment above must be made because if you just recorded the cash transaction, revenues from the previous year would have been understated by 10k, and the current year overstated by 10k. ACCRUED EXPENSES Salaries earned one month but not paid until the next Taxes owed for one year but not paid until the next Expense incurred prior to payment of cash Company pays employees every 2 weeks (10 work days). Wages for 10 days is $50,000. Year ends 4 work days in to 2-week cycle. (4 days = $20,000) =Liabsiite+StockholEdqeurist’y +$20,000 -$20,000 Date Account and Explanation Debit Credit Dec. 31 Salaries Expense $20,000 Salaries Payable $20,000 Since the expense under Stockholders’ Equity is going down, that’s the debit and is thus listed first. = Lisbelisties+ StockhoEqrsi’ty -5020k-30k Date Account and Explanation Debit Credit Jan 10 Salaries Expense $30,000 Salaries Payable $20,000 Cash $50,000 DEFERRED (UNEARNED) REVENUES Companies may accept (or require) pre-payment for sale of goods or services Examples include: prepaid rent, magazine subscriptions, airline (or other transit) tickets, or in the case of Auburn University, tuition payments from students (paid at beginning of semester and earned throughout) Adjustments are needed as services are provided and the revenue is earned. Revenue is not recognized at time of payment, the recognition is deferred until it is actually earned Porter Properties rented office space to a travel agency on Nov. 1, 2013 for $5,000/month with payment every 3 months. If first three months are paid in advance, there is a discount of $500/month. What do the entries look like? Date Account and Explanation Debit Credit Nov. 1 Cash $13,500 Unearned Rent Revenue $13,500 Two months’ rent in 2013 = $9,000 Date Account and Explanation Debit Credit Dec. 31 Unearned Rent Revenue $9,000 Rent Revenue $9,000 ACCT 2110 – Cornett DEFERRED (PREPAID) EXPENSES Companies acquire goods and services before they are used up Examples include: insurance, supplies, rent, advertising As prepaid supply is used up in operations to earn revenue, adjustments are made Porter Properties had $4,581 of office supplies as of beginning of November. On Nov. 10, they purchased $12,365 more of office supplies. At year end, the account balance totals $16,946, but there are only $3,263 worth of office supplies left. Date Account and Explanation Debit Credit Nov. 10 Supplies $12,365 Cash $12,365 Account balance minus remaining supplies = 16,946 – 3,263 = 13,683 worth of expenses Date Account and Explanation Debit Credit Dec. 31 Supplies Expense $13,683 Supplies $13,683 Depreciation The purchase of long-lived assets (buildings and equipment) present a unique situation and the adjustment is a little different These assets help produce revenue across multiple accounting cycles, not just one or two In order to fulfill the matching principal, depreciation of the asset is used Date Account and Explanation Debit Credit Dec. 31 Depreciation Expense $15,000 Accumulated Depreciation $15,000 Accountants use contra accounts to reduce the value of a long-lived asset Contra accounts are accounts with balances opposite of what would be expected. (i.e. – assets are normally debit, contra assets are credit) By increasing the contra asset, it lowers the book value of the asset. SUMMARY OF FINANCIAL STATEMENT EFFECTS OF ADJUSTING ENTRIES Types of Asset Liability Stockholders’ Revenue Expense Adjustment Equity Accrued Revenue UP UP UP Accrued Expense UP DOWN UP Deferred Revenue DOWN UP UP Deferred Expense DOWN DOWN UP Adjusting entries are internal events to record revenues and expenses in accurate time period As revenues and expenses are adjusted, so will asset and liability accounts be, so 1 account from each statement (income statement and balance sheet) will be affected. NEVER ADJUST CASH ACCT 2110 – Cornett COMPREHENSIVE EXAMPLE Many adjustment examples are listed in the book. Objective 5 STEP 6: PREPARING THE FINANCIAL STATEMENTS After journalizing and adjusting entries are posted, the trial balance must be updated Adjusted trial balance is primary source of info for preparation of financial statements Financial statements prepared in a particular order Income statement prepared from revenue and expense accounts Net income is figured from income statement and with dividends are used to prepare the retained earnings statement Balance sheet is prepared using ending balance of retained earnings from above statement. Objective 6 CLOSING THE ACCOUNTS Balance sheet contains permanent accounts – assets, liabilities, and stockholders’ equity. The balances are carried forward from one period to the next. Revenue, expense, and dividend accounts are temporary accounts and must be closed at end of accounting cycle. Transfer effects of revenues, expenses, and dividends to permanent stockholders’ equity account (Retained Earnings) Clear revenue, expenses, and dividends (zero out the accounts) so they’re ready to go when next accounting period starts Journal Entries are made to close temporary accounts Close revenues to Income Summary Close expenses to Income Summary (balance in Income Summary should now be equal to Net Income) Close Income Summary to Retained Earnings Close Dividends to Retained Earnings For the year 2013, Porter Properties’ general ledger shows following balances: Rent Revenue – $2,174,000 Salaries Expense – $1,300,000 Supplies Expense – $150,000 Interest Expense – $15,000 Insurance Expense – $20,000 Beginning Retained Earnings – $1,135,000 Dividends - $5,000 All accounts have a normal balance ACCT 2110 – Cornett Close revenues to Income Summary Date Account and Explanation Debit Credit Dec. 31 Rent Revenue $2,174,000 Income Summary $2,174,000 Close expenses to Income Summary Date Account and Explanation Debit Credit Dec. 31 Income Summary $1,485,000 Salaries Expense $1,300,000 Supplies Expense $150,000 Interest Expense $15,000 Insurance Expense $20,000 Close Income Summary to Retained Earnings Date Account and Explanation Debit Credit Dec. 31 Income Summary $689,000 Retained Earnings $689,000 Close Dividends to Retained Earnings Date Account and Explanation Debit Credit Dec. 31 Retained Earnings $5,000 Dividends $5,000 Revenues, normally a credit balance, are closed by debiting the account Expenses, normally a debit balance, are closed by crediting the account The amount left in the income summary after closing expenses and revenues is transferred to retained earnings The accounting cycle ends and then starts anew Objective 8 APPENDIX 3A: USING A WORKSHEET TO PREPARE FINANCIAL STATEMENTS Worksheet located in book AND in online resources. OTHER TIPS Do the assigned homework problems if you haven’t. It helps. Use the online CENGAGE NOW resources. They have a study assessment that’s great to know where in the chapter you need to study more. They also have a quiz bowl activity that is great for practice. ACCT 2110 – Cornett Chapter 4 Notes Objectives 1. Discuss the role of internal controls in managing a business. 2. Discuss the five components of internal control. 3. Describe how businesses account for and report cash. 4. Describe how businesses control cash. 5. Describe the operating cycle and explain the principles of cash management. Objective 1 ROLE OF INTERNAL CONTROL Except for small businesses, most top management delegates responsibility for financial matters to underlings or a department of underlings Management wants those to whom they delegate authority to 1) operate within their scope of assigned responsibility and 2) act for the good of the business The procedures top management and the board of directors puts in place to insure the above are called an internal control system These systems are designed to meet 3 objectives of the company Operations Objectives – effectiveness and efficiency of entity’s operations, including financial performance goals and safeguarding asset against loss Reporting Objectives – reliability of reporting. Internal and external financial and non-financial reporting Compliance objectives – compliance with applicable laws and regulations Internal controls encompass things unrelated AND related to the accounting system and financial statements (unrelated like regulations about how research is carried out) Sarbanes-Oxley Act of 2002 Top management of publically traded corporations have a HIGHER BURDEN OF RESPONSIBILITY (good thing – less likely to fleece the public) for internal controls MUST produce an internal control report which acknowledges that management is responsible for financial reporting and that they assess the effectiveness of these controls Requires principal executive and financial officers to certify that they are responsible for establishing and maintaining the system of internal controls over financial reporting Enacted to prevent top management from denying responsibility or understanding of shady/deceptive financial reporting (WorldCom, Enron, etc.) The following questions will be addressed in this chapter What are the five components of internal control How are those controls applied to cash How does the operating cycle affect cash Why is cash management so important to a company ACCT 2110 – Cornett Objective 2 COMPONENTS OF INTERNAL CONTROL The COSO (Committee of Sponsoring Organizations of the Treadway Commission) – identified five components of an internal control system Each component is crucial to meeting the company’s objectives and relevant to every level of a company’s organizational structure Individual units of the company are under this system as well Control Environment and Ethical Behavior This is the collection of environmental factors that influence the effectiveness of control procedures Includes the following Philosophy and operating style of the management Personnel policies and practices of the business Overall integrity, attitude, awareness, and actions of everyone in the business concerning the importance of control (tone at the top) Foundational to the environment, you must realize that an individual employee may not have the same goals as the organization or even others in the organization Example: if a manager knew he got a bonus based on sales and wasn’t quite at that threshold at year end, he might ship a bunch of unordered merchandise to customers to put him over that threshold (channel stuffing – bad idea!). That would be unearned revenue for the company and may likely be returned and not ever earned. Management might have a zero-tolerance policy for unethical behavior regarding hiring and firing to cut down on this Ethical hotlines exist for employees to anonymously report unethical behavior (but there must be procedures in place to make sure that info is followed up on and not covered up or destroyed) Ethical Decisions Donna is hired as an accounting clerk and one of her duties is to summarize invoices presented for payment by various creditors which are then presented to Carmen, assistant controller and then Dick, the controller, for approval Carmen tells Donna X Company likes to be paid and to skip waiting for Dick’s signature and just put the unsigned invoice in the approved pile. Donna thinks Carmen will give her a bad review if she doesn’t go along, and it probably wouldn’t be caught, but knows it’s wrong If she goes along, an auditor may come through and figure out X Company is really just Carmen paying herself. At Carmen’s trial, Donna’s part comes to light and she gets fired and has trouble finding a new job. If she doesn’t go along, she may get bad review from Carmen and get fired, but could possibly bring situation to light in exit interview and then when company investigates, Carmen gets in trouble and Donna invited to return to company When individuals face ethical dilemmas, tone at the top and the internal control system can impact the decisions employees make. Risk Assessment Strategic risks – threats from external sources Porter’s five - competitors, customers, substitute products or services (name- brand vs. generic), suppliers, and threat of new competitors PEST – political, economic, social and technological ACCT 2110 – Cornett Example – Barnes & Noble is in high growth and doing well, then along comes Amazon (competitor and technological) and makes bank. B&N is vested in bricks and mortar and doesn’t respond to the technological side quickly enough and is still trying to recover Business Process Risks – internal processes of the company, specifically how the company allocates its resources to meet its objective Materials acquisition, production, logistics and distribution, branding and marketing, and human resources Not all companies have same goals and thus have different internal controls Control Activities Policies and procedures top management establishes to help insure that its objectives are met Clearly Defined Authority and Responsibility The authority to perform important duties is delegated to specific individuals and they are held responsible for the performance of those duties in the evaluation of their performance Example – cashiers at Walmart have their own code to enter into the register and are responsible for their own cash drawer which is counted at end of shift by a supervisor Segregation of Duties Use different people for accounting and administrative duties so no one individual does all the things Reduces likelihood that records can be used to conceal irregularities (intentional misstatements, theft, or fraud) and increases the likelihood those irregularities will be discovered Also reduces probability of unintentional errors going undiscovered Doesn’t eliminate possibility of fraud, but makes people work together (to keep them honest). Fraud would require collusion – employees working together to defraud the company. Important aspect – separating the record-keeping responsibility from the physical control of the assets. Adequate Documents and Records Because the accounting records are the basis for financial statement preparation and preparation of other reports, summary documents and underlying documentation must be accurate Pre-numbered shipping documents provide basis for monitoring shipments of goods to customers – prevents 1 going missing with nobody noticing Safeguards over Assets and Records Both assets and records should be secured against theft and destruction Physical protection – fireproof vaults, locked storage facilities, keycard access, anti-theft tags on merchandise Safeguarding computers is becoming more vital – passwords (alphabet, numbers, special characters, changing passwords every so often), firewalls, certain programs Check on Recorded Amounts Recorded amounts should be checked by an independent person to determine amounts are correct and that they correspond to properly authorized activities Procedures to include clerical checks, reconciliations, comparisons or asset inspection reports with recorded amounts, computer-programmed controls, and management review of reports Accounting records to be checked and reconciled to bank statement. Essential in protecting company against unintentional errors, theft, and fraud ACCT 2110 – Cornett Information and Communication Pertinent and material information should be gathered or identified and communicated to the appropriate people in a timely fashion, so that mistakes can be corrected before too much damage is done Car manufacturer that targets high-end customers has a quality control issue. It should be identified and communicated to management so changes can be made before the cars are shipped to customers who would then unhappily return malfunctioning cars and damage the brand reputation Monitoring Process of tracking potential and actual problems in internal control system Can be as simple as a manager asking an employee how things are going (or how specific project is going, etc.) Accomplished through normal supervising activities Best practices – an internal audit group (Sarbanes-Oxley requires this of publically traded corporations) Internal audit may be outsourced to another business Relationship between Control Activities and the Accounting System Accounting system and internal control system are interrelated How a company assigns accounting duties and structures themselves can affect its well- being Objective 3 ACCOUNTING AND REPORTING CASH The definition of cash for financial purposes is not just bills and coins (currency), but also savings accounts, checking accounts, and negotiable instruments like checks or money orders (liquidity) When cash is received, debit the account to increase and when paid out, credit the account to decrease Cash is reported on two financial statements – the balance sheet and the statement of cash flows Cash equivalents include all highly liquid investments with an original maturity of 3 months or less at date of inception – investing in short term can be more beneficial than keeping it as cash because possibility of greater rate of return Objective 4 CASH CONTROLS Liquid assets (cash and other assets easilyerted into cash) are highly vulnerable to theft 80% of workplace frauds involve employee theft of company assets and 90% ofthose include cash Internal controls to effectively control cash include Delegate authority to specific individuals and separate the duties of cash-handling and cash record-keeping Records should frequently be examined by an objective party Controls should be supported by an appropriately designed record-keeping system ACCT 2110 – Cornett Cash should be safeguarded (lockboxes, safes, vaults, banks) Three areas where the accounting system inte racts with the internal control system to strengthen cash controls Bank reconciliations Cash over and short Petty cash Reconciliation of Accounting Records to Bank Statement Bank record is a duplicate record of the accounting records a company should keep They don’t always agree because transactions aren’t always recorded at the same time Differences in the records should be reconciled to prevent errors and promote accuracy The bank will periodically (monthly) provide a statement which you can use to reconcile the accounts which serves 2 functions Serves control function by identifying errors and providing an inspection of detailed records that deters theft Serves a transaction detection function by identifying transactions performed by the bank so the business can make the necessary entries in its records Difference come from three sources Transactions recorded by the business, bu t not recorded by the bank in time to appear on the statement (time lag) Outstanding checks – check issued by company (and recorded in journal) that has not been cashed by the recipient of the check Deposits in transit – amount received and recorded by the business, not yet recorded by the bank in time to appe ar on the current bank statement (for instance – someone comes in and pays a bill at 4:45 PM on the last day of the month and you can’t get the deposit to the bank before they close) Transactions recorded by the bank, but not yet recorded by the business (time lag) Service charges – fees charged by thbank for checking account services (sometimes unknown to the business until they check the bank statement at the end of the month) – bank balance smaller than cash account balance Non-sufficient funds checks (NSF) – ch eck that has been returned to the depositor because funds in the issuer’s account are not sufficient to pay the check (bounced check) – bank balance smaller than cash account balance Debit and Credit Memos Debit memo – if the bank makes a prearranged deduction from the business’s account to pay a utility bill – bank balance smaller than cash account balance Credit memo – if the bank collecteda note receivable for the business and deposited the funds in the bu siness’s account – bank balance larger than cash account balance Errors in recording transactions on eitt of records (unintentional or intentional) Errors are inevitable Once discovered, should be corrected as quickly as possible. Performing a bank reconciliation Compare deposits on bank statement and de posits debited to the cash account. Deposits missing on the bank statements arelikely “in transit” and person performing reconciliation should double check to makesure funds were deposited (deposit ticket – supporting documentation!!!). Deposits in transit shouldbe added to bank balance. Compare paid (cancelled) checks that are electronically returned with the bank statement to the amounts credited to the cash account and the list of outstanding checks from prior months. Look for outstanding checks (issued but not deposited by payee). Deduct balance from bank statement. ACCT 2110 – Cornett Look for other items that don’t match (bankfees, NSF checks, credit or debit memos, interest payments, etc.). Verify amountsAdd to or subtract from cash account balance (company records) If balances don’t match, look for ertpos, etc). Adjust the appropriate balance. If the person who writes and approves the checks iloniet reconciliation, it’s easier for them to get away with fraud. Segregate those duties! Making adjusting entries as a result of the bank reconciliation If amounts don’t match, adjustments may be necessary Don’t adjust for deposits in transit or outstanding checks NSF checks, bank fees, errors, debit and credit memos will need adjusting Cash Over and Short Control activity – cash receipts be deposited in a bank daily Amount of cash received during the day is debited to the cash accounts to which it has been deposited Sometimes errors occur even when people are being careful (human error), or sometimes it’s theft Discrepancy recorded in account called cash over and short Cash short requires a debit to cash over and short and an overage requires a credit Petty Cash Cash controls are more effective when a company pays with a check for two reasons Only certain people have the authority to sign the check – those authorized to sign do not keep the accounting records and are only supposed to sign with accurate supporting documentation (evidence that the goods being paid for were properly ordered and received) Supporting documents are marked paid to avoid duplicate payment Checks are pre-numbered, which makes it easy to identify any missing checks Sometimes, there are instances when that’s just too many steps and not necessary – Enter the Petty Cash Examples include: buying stamps, an employee’s birthday cake, bathroom runs out of toilet paper, etc.) The fund is overseen by a custodian who can pay small amounts from the fund and also reimburse others who’ve paid for things when they turn in a receipt. At the end of the month, the custodian submits all receipts and supporting documentation to the company Someone else reviews receipts and documentation and determines everything is in order and petty cash fund is replenished. Company records amounts in account records Adjustments are made when fund is set up and when it is replenished (usually monthly unless it gets low during a month) Cash should periodically be counted and compared to receipts to verify amounts Internal controls in general and specifically over cash are important for two reasons Internal controls are an integral part of the accounting system and business Accounting and reporting of cash is not that difficult There are cash management strategies, but first, we’ll learn about… The Operating Cycle affects the amount of cash needed ACCT 2110 – Cornett Objective 5 OPERATING CYCLE The elapsed time between the purchase of goods for resale (or purchase of material to produce salable goods or services) and the collection of cash from customers (presumably a larger amount of cash than was invested in the goods sold). Although it’s typically a year or less, the cycle can be as short as a few days (perishable goods) or as long as many years for the production and sale of products (wine, timber) Example: HH Gregg (large appliance retailer) has an operating cycle of 15 months – appliances in inventory for 3 months and once sold are financed for about 12 months The length of the operating cycle influences the classification of assets and liabilities on balance sheets Operating cycle plays important role in measurement of income Cash Management Activities of the operating cycle turn cash into goods and services which are then turned back into cash Continual process of paying cash and receiving cash payments A company can increase its net income by: Delaying paying suppliers (so a company ca earn as much interest on their cash as possible) Speeding up collection from customers in order to invest the cash sooner or reduce the need for additional financing Earning the greatest return on any excess cash Buying Inventory First stage of operating cycle Keep inventory levels low!!! Sell Sell Sell! Arrange for on-time deliveries rather than early Paying for Inventory Second stage of operating cycle Delay payments as long as possible while maintaining a good relationship with the payee You can only continue earning interest on your money if it’s still in your account Selling Inventory Third stage of operating cycle Companies do what they can to increase speed of collection of receivables Some companies sell their receivables rather than wait for their customers to pay (sell them for less than owed, but receive cash more quickly (represents interest and return for the buyer) Companies don’t have to hire employees to deal with receivables Short-Term Investments Most bank accounts earn relatively small amounts of interest, so companies tend to keep their accounts low and instead make short-term investments The investments are from surpluses of cash and are generally pretty liquid Effective cash management requires knowledge of future cash flows (intent to pay off a loan, approaching busy time of year – like summer for pool maintenance, etc.) ACCT 2110 – Cornett Chapter 5 Notes – Sales and Receivables Objectives Explain the criteria for revenue recognition Measure net sales revenue Describe the principal types of receivables Measure and interpret bad debt expense and the allowance for doubtful accounts Describe the cash flow implications of accounts receivable Account for notes receivable from inception to maturity Describe internal control procedures for merchandise sales Analyze profitability and asset management using sales and receivables Objective 1 TIMING OF REVENUE RECOGNITION Accrual-basis accounting recognizes revenue when it is 1) realized or realizable and 2) earned Realized means that noncash resources (inventory) have been exchanged for cash or near cash (accounts receivable) R(ex. – a goldmine extracts gold and that can be converted into money)amounts of cash Revenues are considered earned when earnings process is substantially complete – frequently happens at point of sale (ex. – when someone purchases a good, or when they pay for a yearly membership, earnings are recognized monthly) The Securities and Exchange Commission (SEC) issues guidance on revenue recognition to prevent companies from recognizing it too soon. Following criteria must be met: Persuasive evidence of an arrangement exists (contract or other proof) Delivery has occurred or services have been provided Seller’s price to the buyer is fixed and determinable Collectability is reasonably assured IFRS – similar to U.S. GAAP, but with less detailed guidance on when revenue should be recognized The criteria are easily understood, but it’s sometimes difficult to apply to real world situations and are not always consistently applied FASB has proposed further guidance in order to “bring discipline” and consistency Ethical Decisions – when under extreme pressure to meet sales goals, some corporations (or people in them) resort to shady methods to make their numbers look pretty ACCT 2110 – Cornett Channel stuffing – an unethical decision where a company will ship unordered merchandise to customers to make sales goals in one period. When they get returned later, it will lower subsequent sales numbers Objective 2 AMOUNT OF REVENUE RECOGNIZED Generally, the appropriate amount to recognize is the cash received or the equivalent of the account receivable, but sometimes companies modify terms of the sale to induce customers to buy more and pay more quickly Sales Discounts Reduction of normal selling price of good or service Attractive to buyers because, hey, it costs less Attractive to sellers because it means they’ll generally have more sales and more money on hand more quickly than they would otherwise and possibly won’t have to borrow money for operating costs If the seller expects payment in 30 days, but will knock off 2% if they pay in 10, it would be denoted 2/10, n/30 Most companies record the sale at the gross amount (full price) and will record the discount in a contra-revenue account – it’s better record- keeping to know how much of what you bring in is sales and which clients are taking advantage of the discounts May 5, 2013 – a sale of $15,000 is billed for services provided in April. Terms are 2/10, n/30. 1) Record Sale Date Account and Explanation Debit Credit May 5 Accounts Receivable 15,000 Sales Receivable 15,000 2) Assume payment received May 15 (in discount period) Date Account and Explanation Debit Credit May 15 Cash 14,700 Discounts Sales 300 Accounts Receivable 15,000 3) Assume payment received May 25 (after discount period) Date Account and Explanation Debit Credit May 25 Cash 15,000 Accounts Receivable 15,000 4) How would sales revenues be disclosed on the income statement assuming the payment is made within ten days? RSalenue5,000 (300) Silss:nts salest4,700 It’s important to monitor changes in how customers use sales discounts. It can be a kind of early warning system if they have used them and then stop that they might have some cash flow issues If nobody is taking advantage of the sales discounts, maybe the company needs to up their game (and their discount) ACCT 2110 – Cornett Sales discounts are different from trade discounts (reduction in selling price granted by the seller to a particular class of customers – like those who resale instead of end users) and quantity discounts (reduction in price granted by seller because costs per unit are less when larger quantities are ordered) For accounting purposes, the selling/invoice price is usually assumed to be the price after adjustment for the trade or quantity discounts. Trade and quantity discounts ARE NOT RECORDED SEPARATELY in the accounting records Sales Returns and Allowances Sometimes goods are unsatisfactory and are returned or have minor defects and the customer is willing to keep with a discount (allowance) A contra-revenue account called sales returns and allowances is used to record those adjustments Nov. 1, GCD Advisors completed a consulting project. Original agreement was $11,400 to be done by September 15. GCD offered allowance of $1,600 for missed deadline Date Account and Explanation Debit Credit Nov. 1 Accounts Receivable 11,400 Sales Revenue 11,400 Nov. 1 Sales Returns and Allowances 1,600 Accounts Receivable 1,600 If the bill was already paid, seller can either refund a portion and record a credit to cash or apply the allowance against future purchases by the customer by recording a credit to accounts receivable Merchandise or goods returned are sales returns and these are recorded in sales returns and allowances rSevlesue $752,000 Less: Sales returns and allowances (1,600) Net sales $750,400 Presenting gross sales revenue separate from sales returns and allowances allows financial-statement users to respond to unusual behavior in either account Objective 3 TYPES OF RECEIVABLES IFRS is generally the same as U.S. GAAP A receivable is money due from another business or individual and are typically categorized in three different dimensions Accounts Receivable or Notes Receivable Note – a legal document given by a borrower to a lender stating the timing of repayment and the amount (principal and/or interest) to be repaid Accounts receivable – no formal note Current or Noncurrent Receivables Current – can be notes receivable or accounts receivable, but anything due within a year Noncurrent – due date is over a year from issuance Trade or Nontrade Receivables ACCT 2110 – Cornett Trade – due from customers purchasing inventory in the ordinary course of business Nontrade – not involving inventory (interest receivable, cash advances to employees) Objective 4 ACCOUNTING FOR BAD DEBTS It is important to ensure the proper amount for accounts receivable is shown on the balance sheet GAAP requires accounts receivable be shown at their “net realizable value” – the amount the company expects to collect The reality is, sometimes people just don’t pay what they owe (bankruptcy, general dodginess) When customers don’t pay, bad debts are the result (uncollectable accounts) Unlike with sales allowances and returns, this won’t be recorded into a contra-revenue account. That is for actions on the part of the seller, not the purchaser Rather than record bad debt as a contra-revenue, it is recorded as an expense, and the question of when to record it is raised (matching principle) Two methods to record bad debt expense Direct Write Off Method (fails to satisfy GAAP) Once the account is deemed uncollectible, accounts receivable is reduced and the bad debt expense is recorded GAAP says expenses should be matched with the revenue those expenses helped to earn Allowance Method(satisfies GAAP) Bad debt expense is recorded in the same period as the sale – allows for matching BUT, this means the debt is recognized before the customer actually defaults on their payment That means accounts receivable shouldn’t be lowered and you have to use a storage account to record the bad debt At end of year, Hawthorne has A/R balance of $1,000,000, but believes $25,000 is uncollectible. Recording entry Date Account and Explanation Debit Credit Dec. 31 Bad Debt Expense 25,000 Allowance for Doubtful Accounts 25,000 Similar to direct write-off, but timing of entry is different. Balance sheet would show: Accoucetisvable$1,000,000 Less: Allowance for doubtful accounts (25,000) Accounts receivable (net) $ 975,000 At year end, full amount still shows in Accounts Receivable, so when the amount is actually determined to be uncollectable, it is written off by debit to allowance account and credit to accounts receivable (the write off removes defaulted balance from A/R and also from the storage account ACCT 2110 – Cornett Two methods used to estimate bad debt under allowance method Percentage of credit sales method The simpler method of the two Using past experience and management’s views of how future will be different than past, can estimate percent of total A/R that will become uncollectable Total Credit Sales * Percentage of Credit Sales Estimated to Default Esxpeaded Crimson Company has credit sales of $620,000 during 2013 and estimates at end of year 1.43% will eventually default. During 2013, a customer defaults on $524 balance related to goods purchased in 2012. Prior to write0off and adjusting entry, Crimson’s accounts receivable and allowance for doubtful accounts balances ore #304,000 and $134 (credit), respectively. 1) Estimate bad debt expense for the period $620,000 * 0.0143 = $8,866 2) Prepare the journal entry to record the write-off of the defaulted $524 balance. Date Account and Explanation Debit Credit Dec. 31 Allowance for Doubtful Accounts 524 Accounts Receivable 524 Record write-off of defaulted account 3) Prepare the adjusting entry to record the bad debt expense for 2013. Note: the calc. in solution 1 estimated the ending balance of bad debt expense. This is also the adjustment because the balance before the adjustment is zero because it’s an income statement account closed at end of prior year Date Account and Explanation Debit Credit Dec. 31 Bad Debt Expense 8,866 Allowance for Doubtful Accounts 8,866 Record adjusting entry for bad debt expense estimate Bad Debt Expense Preadjustment balance, 12/31 0 Adjustment 8,866 Ending Balance 8,866 Allowance for Doubtful Accounts 134 Beginning balance Write-offs during 2013 524 Preadjustment balance, 12/31 390 8,866 Adjustment 8,476 Ending Balance 4) What is the net accounts receivable balance at the end of the year? Ow would this balance have changed if Crimson had not written off the $524 balance during 2013? ACCT 2110 – Cornett Year End Assuming No Write-off Accounts receivable $303,476 $304,000 Less: Allowance for doubtful accounts (8,476) (9,000) Net accounts receivable $295,000 $295,000 Does not affect net accounts receivable because equal amounts cancelled on both sides of equation If part of amount already written off is actually paid, two entries would be made. Debit A/R and credit Allowance for Doubtful Accounts in amount of payment (reverse portion of write-off), and then debit Cash and credit A/R in amount of payment (record collection of account receivable) Aging method Comparison of Percentage of Credit Sales Method and Aging Method Bad Debts from a Management Perspective Although bad debts happen when the customer doesn’t pay, it relates to credit policies of company. i.e. if we know someone is a credit risk, why extend credit? It’s like giving a deadbeat friend $20 and expecting them to repay it. I mean, it’s their fault if they don’t, but we could have chosen not to loan them the money. Objective 5 CASH MANAGEMENT PRINCIPLES RELATED TO ACCOUNTS RECEIVABLE Factoring Receivables A principle of cash management is increasing speed of cash collection Factoring is selling receivables. The seller receives an immediate cash payment reduced by the factor’s fees. The factor acquires the right to collect the receivables and the risk of uncollectibility The sellers of the receivables have no continuing responsibility for their collection Factors probably charge a fee in the 1-3% ballpark Receivables are frequently packaged together when sold to factors Credit Cards Bank credit cards (Visa and MasterCard) are a special form of factoring The bank issues the card and when the purchaser buys something, the seller accepts the card in payment and pays a portion of that collectible to the bank that issued the card. Ex. – hair salon charges $100 for haircut. Customer pays with Citibank card (11.55% service charge). Salon records AEcpldnttion DeCirtedit 5 4 . 8 h s a C SeCvirense 1.55 Sales Revenue 100.00 Even with service charges, there are benefits to accepting credit cards for payment Sellers receive money immediatelys ACCT 2110 – Cornett Sellers avoid bad debts because credit card company absorbs the cost of customers who don’t pay Recordkeeping costs decrease because employees are not needed to manage these accounts Sellers sales may increase because people are more willing to purchase from them Some stores issue their own cards and accept the risk of uncollectibility and cost of servicing accounts American Express – nonbank credit card – higher service charge and does not immediately pay the cash to the seller Debit Cards Authorizes a bank to make an immediate electronic withdrawal (debit) from the holder’s bank account Functions like credit card, but directly reduces (debits) holder’s bank account and increases (credits) merchant’s bank account for amount of the sale Sometimes bad for customer because inability to stop payment Isn’t delayed like a check would be, so have to be careful of funds Some banks offer protections for customers as incentives to use debit cards rather than credit cards Objective 6 NOTES RECEIVABLE Receivables which specify interest rate and maturity date at which interest and principal must be repaid This chapter only covers simple, one-time-payment notes (not like home mortgages or car loans) Amount lent is principal. Excess of money collected is interest. Interest is compensation paid to lender for giving up use of resources for the period of the note (time value of money) Interest = Principal * Annual Interest Rate * Fraction of 1 year Interest must be matched to period Examples of accounting for notes receivable on pages 251 and 252 of the book Objective 7 INTERNAL CONTROL FOR SALES Sales revenues have a significant effect on a company’s net income, therefore internal control procedures must be established to ensure amounts reported for these items are correct Controls normally involve following procedure Accounting for a sale begins with receipt of a purchase order or some similar document from a customer – this is necessary for the buyer to be obligated to pay for the ordered goods (channel stuffing is bad) Shipping and billing documents are prepared based on the order document. Billing documents are usually called invoices A sale and the associated receivable are only recorded when order, shipping, and billing documents are all present ACCT 2110 – Cornett Sales revenue should only be recorded when all the supporting documents are present Without supporting documents, valid sales may be unrecorded and invalid sales may b
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