Financial Accounting (Binghamton University) Chapters 5-8 PDF

lOMoARcPSD|49752648 Chapters 5-8 Financial Accounting (Binghamton University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Bala Abubakr ([email protected]) ...

lOMoARcPSD|49752648 Chapters 5-8 Financial Accounting (Binghamton University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Chapter 5: Accounting for Merchandising Operations Learning Objective #1: Explain the operations of a merchandising company and contrast that with the operations of a service company Merchandising Operations Manufacturers convert raw materials and component parts into finished products Merchandisers buy finished products for resale to a customer ○ Wholesalers but finished products in large volumes from manufacturers and sell the product in smaller quantities to retailers ○ Retailers typically buy products from wholesalers for sale to the general public Operating Cycle of a Merchandising Firm Three primary steps for merchandising firms: (1) Purchase merchandise (inventory) (2) Sell merchandise (Accounts receivable) (3) Payment from customer (Cash) Operating Cycle of a Service Firm Two primary steps for service firms: (1) Perform service (Accounts receivable) (2) Payment from customer (Cash) Cost Flows Inventory Systems Perpetual System ○ Cost of goods sold is calculated after every sa;e ○ Inventory balance is kept “perpetually” up-to-date ○ Provides greater control over inventory ○ Better able to determine theft or spoilage 1 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Periodic System ○ Cost of goods sold is calculated “periodically” when a physical count of inventory is taken ○ Actual balance of inventory is unknown until the periodic count Learning Objective #2: Describe the accounting for purchases of merchandise Accounting for Purchases of Merchandise - Perpetual Inventory System Debit inventory for the acquisition cost and either: ○ Credit cash id the purchase is for cash, or ○ Credit accounts payable if the purchase is on account Kali Company purchases 200 cameras on account for resale to customers. The cost of the cameras is $42,000. The following journal entry records this transaction: Inventory (+A) 42,000 Account Payable (+L) 42,000 To record the purchase of 200 cameras for resale Transportation Costs All costs incurred to get the merchandise ready for resale are included in the cost of inventory. Kali Company pays $200 in shipping costs. The following journal entry records this transaction: Inventory (+A) 200 Cash (-A) 200 To record shipping costs paid for 200 cameras Purchase Returns and Allowances Purchase returns ○ Return of merchandise by the buyer for credit Purchase allowances ○ Reduction in the purchase price, often to induce the buyer to keep merchandise that might otherwise be returned Assume Kali returns 20 cameras. The cameras originally cost Kali $210 each. Accounts Payable (-L) 4,200 Inventory (-A) 4,200 To record the return of 20 cameras Purchase Discounts Sellers often extend credit to customers to increase sales. ○ The credit period is the maximum time given for payment ○ For example, 30 day terms will be stated as n/30 Extending credit delays the receipt of cash for the sale ○ A purchase discount may be given to provide an incentive for faster payment ○ For example, a 2% discount if paid in 10 days is stated as 2/10 In this example the full terms are 2/10, n/20; this emasn the buyer can take a 2% discount is paid in 10 days, otherwise the full amount is due in 30 days Assume Kali purchased the cameras on account with terms 2/10, n/30 and pays within the discount period. 2 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 - Payment due before discount: $42,000-$4,200 returns = $37,800 - Discount: $37,800 x 2% = $756 - Net cash payment: $37,800 - $756 = $37,044 Kali records the following journal entry: Accounts Payable (-L) 37,800 Inventory (-A) 756 Cash (-A) 37,044 To record payment for 180 cameras within the discount period. Learning Objective #3: Describe the accounting for sales of merchandise Accounting for Sales of Merchandise - Perpetual System Requires two journal entries (1) Record sales revenue (a) Credit sales revenue and either (i) Debit cash if the sale is for cash, or (ii) Debit accounts receivable if the sale is on account (2) Record cost of goods sold (a) Debit cost of goods sold and credit inventory Kali Company sells 30 cameras on account for $500 each. (1) Record sales revenue Accounts Receivable (+AR) 15,000 Sales Revenue (+R, +SE) 15,000 To record the sale of 30 cameras (2) Record cost of goods sold ($42,000 - $4,200 - $756)/(200 - 20) = $205.80 each Cost of Goods Sold (+E, -SE) 6,174 Inventory (-A) 6,174 To record the cost of 30 cameras sold Sales Returns and Allowances Sales returns also require two journal entries Assume Kali had 5 cameras returned from the previous sale Sales returns and allowances (+XR, -SE) 2,500 Accounts Receivable (-A) 2,500 To record the return of 5 cameras with a unit sales price of $500 Inventory (+A) 1,029 Cost of Goods Sold (-E,+SE) 1,029 To record the return of 5 cameras with a unit cost of $208.80 Sales allowances only require the first journal entry because the goods are not returned. Sales Discount Assume Kali sold teh cameras on account with terms 2/10, n/30 and receives payment within the discount period. - Amount due before discount: $15,000 - $2,500 returns = $12,500 - Discount: $12,500 x 2% = $250 3 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 - Net cash received: $12,500 - $250 = $12,250 Kali records the following journal entry: Cash (+A) 37,800 Sales Discount (+XR,-SE) 756 Accounts Receivable (-A) 37,044 To record cash received and discount for 180 cameras within the discount period. Net Sales Sales returns and allowances and sales discounts are contra-revenue accounts with a normal debit balance Subtracted from gross sales revenue to yield net sales reported on the income statement Learning Objective #4: Define gross profit percentage and the return on sales ratio, and explain their use in profitability analysis Gross Profit Percentage 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 Key measure of profitability followed by analysts Indicates a company's ability to sell its products at acceptable prices Kali Company Income Statement – Partial For Month of December Sales $15,000 Less: Returns 2,500 Net sales 12,500 Cost of goods sold 5,145 Gross profit on sales $ 7,355 Gross Profit Percentage = 7,355/12,500 = 58.8% Return on Sales Ratio 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆𝑎𝑙𝑒𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 Reveals the net income earned on each dollar of sales Subtracts all costs from net sales, not just the cost of goods sold Learning Objective #5: Describe and illustrate a periodic inventory system Periodic Inventory System Less widely used than the perpetual system Does not update the Inventory account or the Cost of Goods Sold account as merchandise transactions take place 4 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Updates are made at the end of the accounting period when a physical count of inventory is made Comparison of Perpetual and Periodic Systems Learning Objective #6: Describe and illustrate the revenue recognition standard for sales returns and allowances and sales discounts The Revenue Recognition Standard Core principle - companies should recognize revenue when goods or services are transferred to a customer The amount of revenue recognized should reflect the amount expected to be received in the exchange End-of-Period Adjustments Many companies initially record revenue at the gross amount of the sale End-of-period adjusting entries are recorder to reduce gross amounts to the net amount that the company expects to receive after considering sales discounts and sales returns and allowances ○ Sales discounts - reasonable to assume that nearly all customers will take the discount ○ Sales returns and allowances - use past experience to estimate Assume Kelly Co. sells $200,000 of merchandise on credit with a cost of goods sold of $150,000. These sales will initially be recorded by Kelly as follows: Various Dates Accounts Receivable (+A) 200,000 Sales Revenue (+R,+SE) 200,000 To record sale of merchandise on account Various Dates Cost of Goods Sold (+E,-SE) 150,000 Inventory (-A) 150,000 To record cost of goods sold 5 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Adjusting Journal Entry for Sales Discounts Kelly Co. offers terms of 2/10, n/30 to encourage early payment. At year-end, there are $5,000 of outstanding sales on account eligible for the 2% discount, which Kelly expects to be paid within the discount period. Dec. 31 Sales Discounts (+XR,-SE) 100 Allowances for sales discounts (+XA,-A) 100 To record estimated sales discounts ($5,000x2%) Adjusting Journal Entry for Sales Returns and Allowances Kelly Co. allows a 90-day return privilege. At year-end, Kelly estimates there remains $60,000 of sales (with a cost to Kelly of $45,000) that are still within the 90-day return period. Past experience has shown that 15% of this merchandise will be returned. Dec. 31 Sales returns and allowances (+XR,-SE) 9,000 Sales refunds payable (+L) 9,000 To record estimated merchandise returns ($60,000x15%) Dec. 31 Estimated inventory return (+A) 6,750 Cost of goods sold (-E,+SE) 6,750 To record estimated merchandise returns ($45,000x15%) End-of-Period Adjustments In future periods, management will analyze and adjust the following accounts (upwards or downwards) to reflect current expectations: ○ Allowance for sales discounts ○ Sales refunds payable ○ Estimated inventory return 6 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Chapter 6: Accounting for Inventory Learning Objective #1: Explain inventory concepts and management practices Inventory Categories Merchandisers generally only have one category of inventory - inventory that is finished and ready for sale Manufacturers have three categories of inventory: (1) Raw materials inventory - items to be used in the production of products (2) Work-in-process inventory - items partially completed (3) Finished goods inventory - items fully manufactured and ready for sale Inventory Management Just-in-Case Inventory ○ Inventory held as a buffer just in case unexpected problems occur ○ Costly to maintain because of insurance, storage, usage, and the cost of capital invested, among other holding costs (inventory carrying costs) Just-in-Time Management ○ Seeks to minimize the amount of inventory on hand Inventory Ownership Ownership of goods in transit at the end of the period must be determined to property measure inventory quantities F.O.B. (free on board) shipping point ○ Ownership transferred when goods are shipped ○ Buyer pays shipping costs F.O.B. (free on board) destination ○ Ownership transferred when goods are delivered ○ Seller pays shipping costs Physical Count of Inventory A physical count of inventory is completed to verify the amount of inventory on hand Reasons actual inventory may differ from the accounting records: (1) Periodic inventory method is used (2) Theft (3) Spoilage (4) Errors Savanna Company maintains a perpetual inventory method. The physical count of inventory taken at year-end reveals that the balance in the Inventory account is $800 more than indicated by the physical inventory count. The following journal entry is recorded to correct the inventory balance. Cost of goods sold (+E,-SE) 800 Inventory (-A) 800 To adjust inventory balance to the physical inventory count Learning Objective #2: Describe inventory costing using specific identification, FIFO, LIFO, and weighted-average cost Goods Flow vs. Cost Flow Goods Flow ○ Actual physical flow of goods through inventory 7 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Cost Flow ○ Assumed flow of goods through inventory for accounting purposes GAAP permits companies to use an assumed cost flow that does not reflect the actual goods flow Methods of Costing Inventory Methods will generally produce different costs assigned to cost of goods sold and inventory Specific Identification Method The cost of the specific items sold is recorded as cost of goods sold The cost of the specific items still on hand is the balance of ending inventory Used for unique items with small volume and high unit cost (fine art or jewelry) First-In, First-Out (FIFO) Method Assumes that the earliest units purchased are the first units sold Last units purchased remain in ending inventory Last-In, Last-Out (LIFO) Method Assumes that the last units purchased are the first units sold Earliest units purchased remain in ending inventory LIFO Conformity Rule: Any company that chooses LIFO for tax reporting must also use LIFO for financial reporting Weighted-Average Cost Method Averages the total cost of goods available for sale equally among all units ○ Each unit in cost of goods sold and each unit in ending inventory has the same average cost Each time new units are purchased the average cost is recalculated Best suited for business that warehouse a large value of identical goods ina common area (grain, coal, fuel) An Example Using FIFO/LIFO/Weighted-Average Periodic Inventory System Kanzu Co. sells dog collars. Inventory data for June is as follows: Balance June 1 20 collars @ $12.00 each Purchase June 8 40 collars @ $13.00 each Sale June 13 48 collars @ $30.00 each Purchase June 21 36 collars @ $14.00 each Sale June 26 26 collars @ $30.00 each 8 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 FIFO Goods Available Ending Inventory Date Units Unit Cost Total Cost Units Unit Cost Total Cost June 1 20 $ 12 $ 240 June 8 40 13 520 June 21 36 14 504 22 $14 $ 308 $1,264 22 $ 308 96 Cost of goods available for sale $1,264 Less: Ending inventory 308 Cost of goods sold $ 956 LIFO Goods Available Ending Inventory Date Units Unit Cost Total Cost Units Unit Cost Total Cost June 1 20 $ 12 $ 240 20 $ 12 240 June 8 40 13 520 2 13 26 June 21 36 14 504 $1,264 22 $266 96 Cost of goods available for sale $1,264 Less: Ending inventory 266 Cost of goods sold $ 998 Weighted- Goods Available Average Date Unit Unit Cost Total Cost June 1 20 12 $ 240 June 8 40 13 520 June 21 36 14 504 96 $1,264 Cost of goods available for sale $1,264 = = $13.17 Average Unit Cost Total units available for sale 96 * Rounded Cost of goods available for sale $1,264* (96 x 13.17) Less: Ending inventory 290* (22 x 13.17) Cost of goods sold $ 974* (74 x 13.17) Learning Objective #3: Analyze the effects of different inventory costing methods on company profit Comparing Inventory Costing Methods FIFO Weighted-Average LIFO Revenue (74 @ $30) $2,220 $2,220 $2,220 Cost of goods sold 956 974 998 Gross profit $1,264 $1,246 $1,222 9 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Ending Inventory 308 290 266 Gross profit is larger using FIFO when prices are rising ○ Better for reporting to shareholders Gross profit is smaller using LIFO when prices are rising ○ Better for reporting on the company’s income tax return Review of Cost Flow Methods Specific identification precisely measures the cost of goods sold and ending inventory FIFO more closely approximates the physical goods flow for most firms LIFO is popular when inventory costs are rising because of the tax savings Weighted-average cost of goods sold and ending inventory fall between FIFO and LIFO Errors in Inventory Count Inventory costing methods allocate total goods available for sale to ending inventory and cost of goods sold An error in the ending inventory count will cause an error of an equal amount but opposite direction in cost of goods sold Because ending inventory carries over to become beginning inventory for the following year, both beginning inventory and goods available for sale will be incorrect. This will also cause cost of goods sold to be incorrect Inventory Errors Year 1 Nova Co. had beginning inventory totaling $30,000 and made purchases during the year of $300,000. The count of ending inventory was $40,000. However, $5,000 of inventory was accidentally counted twice. The correct inventory count should have been $35,000. Year 2 Nova Co. carried forward the incorrect ending inventory of $40,000 as the beginning inventory balance for the next year. During the year, they made purchases of $350,000. The count of inventory at the end of the year was $50,000, which was the correct count. 10 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Learning Objective #4: Apply the lower-of-cost-or-net realizable value method Lower-of-Cost-or-Net Realizable Value Method The recorded cost of ending inventory (using one of the inventory costing methods) cannot exceed its net realizable value (estimated selling price less expected selling costs) COMPARE Recorded cost of inventory and Net realizable value of inventory ○ If net realizable value is less than cost → Write down inventory to the lower net realizable value ○ If net realizable value is greater than cost → Inventory value remains at cost Can be applied to each individual item in inventory or to the total of all inventory At the end of June, Kanzu Co. had 22 collars in inventory with a recorded cost of $14.00 each. The estimated selling price less the cost to sell each collar is $12.00 each. Cost Net realizable value $14.00 x 22 = $308 ← COMPARE → $12.00 x 22 = $264 Assets = Liabilities + Shareholders’ Equity Inventory Retained Earnings Cost 308 Write-down (44) (44) 264 cost of goods sold Learning Objective #5: Define inventory turnover and days’ sales in inventory and explain the use of these ratios Inventory Turnover Indicates how many times a year, on average, a firm sells its inventory 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 ○ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 Assume Kanzu Co. maintained an average inventory level of $300, and its cost of goods sold for the year was $7,500. Kanzu’s inventory turnover is: $7,500 300 = 25 𝑡𝑖𝑚𝑒𝑠 Days’ Sales in Inventory Indicates how many days, on average, it takes a company to sell its inventory 365 ○ 𝐷𝑎𝑦𝑠' 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 For Kanzu Co. days’ sale in inventory is: 11 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 $365 25 = 14. 6 𝑑𝑎𝑦𝑠 In general, the faster a company turns over its inventory (the smaller the days’ sales in inventory), the more profitable the company will be Learning Objective #6: Describe inventory costing under a perpetual inventory system using specific identification, FIFO, LIFO, and weighted-average cost Periodic vs. Perpetual Inventory Systems Periodic inventory system ○ Inventory and cost of goods sold are computed periodically at the end of the accounting period after a physical count of the ending inventory Perpetual inventory system ○ Inventory and cost of goods sold are kept perpetually up-to-date, with updates occurring after every purchase and every sale Kanzu Co. sells dog collars. Inventory data for June is as follows: Balance June 1 20 collars @ $12.00 each Purchase June 8 40 collars @ $13.00 each Sale June 13 48 collars @ $30.00 each Purchase June 21 36 collars @ $14.00 each Sale June 26 26 collars @ $30.00 each FIFO Purchases Purchase Price Total Sales FIFO FIFO Date (# of collars) Each Cost (# of collars) Cost of Goods Sold Ending Inventory June 1 20 12 $ 240 20 @ $12 June 8 40 13 520 20 @ $12 40 @ $13 June 13 48 20 @ $12 $240 12 @ $13 28 @ $13 364 June 21 36 14 504 12 @ $13 36 @ $14 June 26 26 12 @ $13 156 22 @ $14 14 @ $14 196 96 $1,264 74 $956 $308 LIFO Purchases Purchase Price Total Sales LIFO LIFO Date (# of collars) Each Cost (# of collars) Cost of Goods Sold Ending Inventory June 1 20 12 $ 240 20 @ $12 June 8 40 13 520 20 @ $12 40 @ $13 June 13 48 40 @ $13 $520 12 @ $12 8 @ $12 96 June 21 36 14 504 12 @ $12 36 @ $14 June 26 26 26 @ $14 364 12 @ $12 10 @ $14 96 $1,264 74 $980 $284 Weighted Average Purchases Purchase Price Total Sales Weighted-Average Weighted-Average Date (# of collars) Each Cost (# of collars) Cost of Goods Sold Ending Inventory June 1 20 12 $ 240 20 @ $12.00 June 8 40 13 520 60 @ $12.67* 12 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 June 13 48 48 @ $12.67 $608† 12 @ $12.67* June 21 36 14 504 48 @ $13.67** June 26 26 26 @ $13.67 355† 22 @ $13.67 96 $1,264 74 $963† $301† Comparing Methods FIFO Weighted-Average LIFO Revenue (74 @ $30) $2,220 $2,220 $2,220 Cost of goods sold 956 963 980 Gross profit $1,264 $1,257 $1,240 Ending Inventory 308 301 284 Gross profit is larger using FIFO when prices are rising ○ Better for reporting to shareholders Gross profit is smaller using LIFO when prices are rising ○ Better for reporting on the company’s income tax return Learning Objective #7: Describe the LIFO reserve and explain how it is used to compare the performance of companies using LIFO and FIFO inventory costing methods LIFO Inventory Reserve Measures the difference between the ending inventory reported under LIFO and what the inventory would have been valued under FIFO Ending Inventory (FIFO) - Ending inventory (LIFO) Companies using LIFO must disclose the LIFO inventory reserve financial statements notes Why is disclosure important? ○ Enables users to recast the financial statements to a FIFO basis for comparison to other companies Kanzu’s ending inventory under LIFO and FIFO are as follows: FIFO LIFO Ending Inventory Ending Inventory 22 @ $14 20 @ $12 2 @ $13 $308 $266 LIFO inventory reserve for Kanzu = FIFO cost of ending inventory $308 LIFO cost of ending inventory 266 LIFO inventory reserve 42 13 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Chapter 7: Internal Control and Cash Learning Objective #1: Define the three elements of fraud Fraud An act by management or employees of a business involving an international deception for personal gain Types of fraud: ○ Embezzlement of cash ○ Theft of assets ○ Filing false insurance claims ○ Financial statement fraud Any person, under the right circumstances, is capable of committing fraud The Fraud Triangle Pressure ○ Nearly all frauds are committed by individuals under financial pressure ○ Financial statement fraud is often associated with pressure to meet or beat expectations Rationalization ○ Attempt to justify actions to overcome feelings of guilt Opportunity ○ Perception that there is a chance to get away with it Learning Objective #2: Discuss how the COSO framework helps prevent fraud, identify potential internal control failures, and discuss SOX regulations Internal Controls Measures undertaken by a business to ensure the reliability of the accounting data, protect assets from unauthorized use, and ensure employees are following policies and procedures ○ Reduce the likelihood of errors ○ Catch any errors that may occur ○ Responsibility of management The COSO Framework The Committee On Sponsoring Organizations’ framework identifies five internal control components: (1) Control Environment The control environment sets the tone for the organization ○ Provides the foundation for all other internal control components The control environment includes: ○ Management philosophy and style ○ Assignment of authority and responsibility ○ Process for attracting and developing competent employees ○ Reward system to drive accountability (2) Risk Assessment Risk is the possibility that an event will occur that will have a negative impact on the organization Risk assessment involves identifying and analyzing relevant risks 14 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 ○ Ongoing dynamic and iterative process (3) Control Activities Control activities are specific policies and procedures designed to reduce risk ○ Prevention controls are intended to deter a problem before it occurs ○ Detection controls are designed to uncover problems after they occur Prevention controls are generally preferred to detection controls ○ It is almost always less expensive to prevent a problem than it is to recover from one ○ “An ounce of prevention is worth a pound of cure” Establish Clear Lines of Authority and Responsibility Prevention control ○ Employees are more likely to follow established policies and procedures if they know somebody with authority is evaluating their performance Detection Control ○ Supervisors are likely to discover errors when reviewing the performance of employees Segregation of Duties Prevention control ○ No one individual is assigned responsibilities that allow them to perpetrate and then conceal fraud The following functions should be separated: ○ Authorization ○ Recording ○ Custody Hire Competent Personnel Prevention control ○ Screening job applicants and providing training to employees to ensure they are capable of meeting the requirements and expectations of their job Detection control ○ Job rotation and mandatory vacations can result in the discovery of errors or irregularities Use Control Numbers Detection control ○ Pre-printing business documents such as checks, sales invoices, and purchase orders with control numbers makes it possible to identify missing or unapproved transactions Develop Plans and Budgets Prevention Control ○ Plans and budgets provide a roadmap that guides business decisions Detection Control ○ Budgets provide a benchmark for comparison to actual results ○ Material deviations should be carefully examined 15 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Maintain Adequate Accounting Records Detection control ○ Accounting records make it possible to verify company assets and liabilities Compare to physical counts of inventory and plant assets Compare to confirmations from external parties of the amount of cash, accounts receivable, and accounts payable Provide Physical and Electronic Controls Prevention control ○ Limts the ability of unauthorized individuals (external parties or employees) to access company assets and records Locked doors, safes, fences with guards, security cameras, electronic cash registers Detection control ○ If a breach does occur, can aid in tracking down the perpetrator (4) Information and Communication Individuals must receive a clear message from top management that control responsibilities are to be taken seriously ○ Updating and communicating information should be a continual process (5) Monitoring Activities Monitoring activities involve ongoing evaluations, special evaluations, or both Internal audits ○ Provide an appraisal of a company’s internal control, financial records, and operations Role of the internal auditor ○ Determines if adequate controls are in place and functioning as planned ○ Makes recommendations to management for improvements Control Failures Even the best internal controls may fail at times Unintentional - employee forgets to lock a door Intentional - collusion among employees to steal assets ○ Difficult to prevent or detect ○ Hire high-quality employees, pay them adequately, provide adequate supervision, and maintain an ethical environment Companies typically purchase insurance to compensate for losses when control failures occur Sarbanes-Oxley Act Requires publicly traded companies to maintain an adequate system of internal controls ○ Top management must ensure the reliability of controls ○ External auditors must attest to the adequacy of controls Learning Objective #3: Define cash and discuss the accounting for cash Accounting for Cash Cash includes coins, currency, checks, money orders, checking and savings accounts Cash is often reported combined with cash equivalents 16 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 ○ Liquid investments with maturity of 90 days or less ○ Certificates of deposit, U.S. Treasury bills, and money market accounts Cash that is restricted in its use must be reported separately Learning Objective #4: Describe the internal controls for cash Internal Control for Cash Most companies have developed elaborate internal controls to safeguard cash Segregation of duties ○ Mailroom or retail sales area receives cash and prepares a remittance list. Sends cash to Treasurer and remittance lost to Controller ○ Treasurer deposits cash and sends deposit slip to controller ○ Controller compares deposit slip to remittance list and records journal entry ○ Internal audit reconciles bank statement to general ledger cash account Learning Objective #5: Illustrate the bank reconciliation process Bank Reconciliation The bank reconciliation is a schedule that accounts for all differences between the balance of cash on the bank statement the Cash account in the general ledger After preparing the bank reconciliation, internal audit records journal entries to bring the balance in the Cash account to the reconciled cash balance Learning Objective #6: Describe the four primary activities of effective cash management Effective Cash Management Manage accounts receivable ○ Faster collection provides cash to pay obligations as they come due Manage inventory levels ○ Keep inventory levels as low as possible without losing sales Manage payables 17 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 ○ Delay payment as long as reasonably possible without damaging relationships with suppliers or incurring penalties Invest excess cash ○ Hold the amount of cash necessary to meet day-to-day needs; invest and excess to earn a higher return Monitor the effectiveness of a company’s cash management using the statement of cash flows Learning Objective #7: Describe financial statement audits and operational audits Auditing Financial Statement Audits ○ Examination of the annual financial statements by an independent external auditor ○ Audit procedures established by the Public Company Accounting Oversight Board (PCAOB) ○ The audit report expresses an opinion on the financial statements Operational Audits ○ An evaluation of activities, systems, and internal controls to determine their efficiency and effectiveness ○ Can be performed by an external auditor or the internal audit department of the company 18 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Chapter 8: Accounting For Receivables Learning Objective #1: Define accounts receivable, explain losses from uncollectible accounts, and describe the allowance method of accounting for doubtful accounts Accounts Receivable Asset created by the sale of merchandise or provision of a service on a credit basis ○ Amount owed to the seller by the customer ○ Usually classified as a current asset Accounts receivable (+A) 100 Sales Revenue (+R,+SE) 100 To record sale on account Cash (+A) 100 Accounts receivable (-A) 100 To record collection of cash on account Losses from Uncollectible Accounts Benefit of extending credit: ○ Increases sales relative to a cash-only policy Cost of extending credit: ○ Customers may fail to pay some or all of teh amount they owe Credit losses are considered an operating expense and are debited to an account called Bad Debt Expense Allowance Method GAAP requires companies to estimate and record credit losses at the time the related revenue is recognized ○ Example of the matching principle The estimate results in an adjusting entry to the contra-asset account Allowance for Doubtful Accounts ○ Accounts receivable less the allowance for doubtful accounts is the amount the company expects to collect (estimated realizable value) Allowance for Doubtful Accounts (Ex) Scripp’s Company estimates its bad debts expense for the first year of operations is $500. Bad debt expense (+E,-SE) 500 Allowance for doubtful accounts (+XA,-A) 500 To record bad debt expense for the year Reporting Accounts Receivable Scripp’s has gross accounts receivable of $14,000 Current Assets Cash $ 3,000 Accounts receivable $14,000 Less: Allowance for doubtful accounts 500 13,500 Inventory 9,000 Other current assets 1,000 Total Current Assets $26,500 19 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Writing Off Specific Receivables Companies write off specific receivables when it is determined the amount will not be collected Scripps determines that the account of Lakeland Co. is uncollectable and writes off the $20 balance Allowance for doubtful accounts (-XA,+A) 20 Accounts receivable - Lakeland Co. (-A) 20 To write off account deemed uncollectible Reporting Accounts Receivable The write off does not affect expenses ○ Bad debt expense is recorded as a year-end adjusting entry, not at the time of the write off The write off does not affect total assets ○ Reduces accounts receivable and the allowance for doubtful accounts by the same account Current Assets Cash $ 3,000 Accounts receivable $13,980 Less: Allowance for doubtful accounts 480 13,500 Inventory 9,000 Other current assets 1,000 Total Current Assets $26,500 Recovery of Accounts Written Off Occasionally an account that was written off is subsequently collected Requires two entries to be recorded: (1) Reverse the original write-off (2) Record the cash collected The $20 receivable written off by Scripps was later collected To reinstate account: Accounts receivable - Lakeland Co. (+A) 200 Allowance for doubtful accounts (+XA,-A) 200 To reinstate previously written-off account To record receipt of cash: Cash (+A) 200 Accounts receivable - Lakeland Co. (-A) 200 To record collection of cash on account Learning Objective #2: Describe and illustrate the percentage of net sales method and the accounts receivable aging method for estimating a business’s bad debt expense Percentage of Sales Method (1) Estimate the adjusting entry for bad debt expense by multiplying total credit sales for the period by a percentage that reflects historical credit loss experience 20 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 (a) Adjust historical percentage to reflect current economic circumstances (2) Calculate the ending balance of the Allowance for Doubtful Accounts Penn Company has credit sales of $700,000. Based on past experience, Penn estimates that credit losses will be 3% Bad debts expense = $700,000 x 0.03 = $21,000 Bad debt expense (+E,-SE) 21,000 Allowance for doubtful accounts (+XA,-A) 21,000 To record bad debt expense estimate for the year Penn has a beginning credit balance in the allowance for doubtful accounts of $23,500. During the year, Penn wrote off $22.900 of accounts receivable The ending balance of the allowance for doubtful accounts is calculated as follow: Allowance for Doubtful Accounts 23,500 Beg. bal. Bad debt Write off 22,900 21,000 expense 21,600 End. Bal. Accounts Receivable Aging Method (1) Estimate the ending balance of the allowance for doubtful accounts as a percentage of the outstanding accounts receivable (a) Prepare an aging schedule detailing how long an account has been unpaid and apply a percentage to each age category reflecting the historical probability of non collection (2) Calculate bad debts expense as the amount necessary to achieve the estimated ending balance of the allowance account The aging schedule for Tolson Inc.’s accounts receivable is as follows: Probability of Allowance Amount Noncollection Required Current $10,000 3% $ 300 0-30 days past due 8,000 4 320 31-60 days past due 5,000 5 250 61-90 days past due 3,000 10 300 Over 90 days past due 4,000 30 1,200 Total allowance required $30,000 $ 2,370 Tolson has a beginning credit balance in the allowance for doubtful accounts of $400. During the year, Tolson wrote off $320 of accounts receivable Allowance for Doubtful Accounts 400 Beg. bal. Write off 320 21 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 2,370 End. Bal. Bad debt expense (+E,-SE) 2,290 Allowance for doubtful accounts (+XA,-A) 2,290 To record bad debt expense for the period Review of Estimating Credit Losses Companies should monitor the balance in the allowance for doubtful accounts to ensure that it reflects the amount of accounts receivable that is uncollectible. Learning Objective #3: Discuss the accounting treatment of credit card sales Credit Card Sales When a customer uses a credit card to make a purchase, the seller collectsc ash from teh credit card company. The customer then pays the credit card company when billed at a later date Benefits ○ Seller does not have to evaluate the creditworthiness of the customer and avoids risk of non collection ○ Seller receives cash faster than if they extended trade credit Costs ○ Seller is charged a fee, typically 1-5% of the purchase Coronado Resorts made $5,000 of credit card sales on June 1. The credit card company charges a 3% credit card fee. The journal entry to record the sales is as follows: Cash (+A) 4,850 Credit card fee expense (+E,-SE) 150 Sales Revenue (+R,+SE) 5,000 To record credit card sales and collection, less a 3% fee Learning Objective #4: Illustrate a promissory note receivable, discuss the calculation of interest on notes receivable, and present journal entries to record notes receivable and interest Notes Receivable A promissory notes is a written promise to pay a specified sum of money on demand or at a fixed future date, plus interest at the rate stated in the note Formula for calculating interest: Principal x Interest Rate x Interest time 22 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 Recording Issuance of Notes Receivable Hillside Farms receives a signed promissory note for $10,000 from Soencer Catering to settle the balance of their account. The note is payable in 3 months at an annual interest rate of 6%. Hillside records the following journal entry upon receipt of the note: Note receivable - Spencer (+A) 10,000 Accounts receivable - Spencer (-A) 10,000 To record note in payment of account Recording Collection of Notes Receivable Interest on the note = $10,000 x 0.06 x 3/12 = $150 Hillside records the following journal entry when Spencer pays the note with interest at maturity: Cash (+A) 10,150 Note receivable - Spencer (-A) 10,000 Interest Income (+R,+SE) 150 To record collection of Spencer Farms note If the term of a note extends beyond the end of the accounting period, an adjusting journal entry is necessary to reflect the interest earned during the period Learning Objective #5: Define accounts receivable turnover and average collection period, and explain their use in the analysis and management of accounts and notes receivable Analyzing and Managing Receivables A key concern in analyzing and managing receivables is how fast they are being collected ○ Accounts receivable turnover measures how many times a year, on average, accounts receivable is collected 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 ○ Average collection period measures how many days it takes, on average, to collect accounts receivable 365 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 Factoring and Discounting A company can speed up the collection of cash by selling its receivables ○ Factoring - selling an account receivable ○ Discounting - selling a note receivable The company or financial institution that buys the receivables is called a factor and typically charges a fee of 2-5% Receivables can be sold under two conditions ○ With recourse - the buyer has the right to return the uncollected receivables to the seller ○ Without recourse - the buyer does not have the right to return uncollected receivables to the seller Learning Objective #6: Illustrate the direct write-off method and contrast it with the allowance method for accounting for doubtful accounts Direct Write-Off Method Recognizes bad debts expense in the period accounts are deemed to be uncollectible ○ No estimate is made for bad debts expense in the period revenue is recognized 23 Downloaded by Bala Abubakr ([email protected])  lOMoARcPSD|49752648 ○ No allowance for doubtful accounts is used Scripps determines that the account of Lakeland Co. is uncollectible and writes off the $20 balance Bad debts expense (+E,-SE) 20 Accounts receivable - Lakeland Co. (-A) 20 To write off uncollectible account GAAP does not allow the direct write-off method unless the amount of bad debts is immaterial 24 Downloaded by Bala Abubakr ([email protected])