Accounting Lecture Notes PDF

# Lectures ## Monday, October 14, 2024 ## Introduction ### Part I: The Role of Accounting in Communicating Financial Information - Accounting: An information system that measures business activities, processes data into reports, and communicates results to decision-makers. - **Types of Decision Make...

# Lectures ## Monday, October 14, 2024 ## Introduction ### Part I: The Role of Accounting in Communicating Financial Information - Accounting: An information system that measures business activities, processes data into reports, and communicates results to decision-makers. - **Types of Decision Makers:** - **External Decision Makers:** Investors, creditors, government agencies, the public (Financial Accounting). - **Internal Decision Makers:** Managers and employees (Management Accounting). ### Types of Business Entities: 1. **Proprietorship:** - Single owner, personally liable, profits taxed as personal income. - **Advantages**: - You're the boss. - It's easy to get started. - You keep all profits. - Income from business is taxed as personal income. - You can discontinue your business at will. - **Disadvantages**: - You assume unlimited liability. - The amount of capital you can raise is limited. - The life of the business is dependent on the owner's. 2. **Partnership:** - Two or more owners, income flows through to partners, limited liability for LLPs. - ** Advantages:** - Two heads are better than one. - It's easy to get started. - More capital is available. - Partners only pay personal income tax. - **Disadvantages:** - Partners have unlimited liability (in general partnerships). - Partners must share all profits. - Partners may disagree with each other. - The life of the business is limited. 3. **Corporation:** - Owned by shareholders, limited liability, can raise large capital, separate legal entity. - **Advantages:** - Shareholders have limited liability. - Corporations can raise the most capital. - Corporations have unlimited life. - Ownership is easily transferable. - Corporations utilize specialists. - **Disadvantages:** - Double taxation - Starting a corporation is expensive - Closely regulated by government agencies ## Part II: Accounting Concepts in the IFRS Conceptual Framework - **Accounting Standards:** - **IFRS:** Formulated by the International Accounting Standards Board (IASB). - **GAAP:** Formulated by the Financial Accounting Standards Board (FASB) in the US. - **IFRS Conceptual Framework:** - Provides the "why, who, what, how" of financial reporting. - Lays the foundation for setting accounting standards and resolving accounting issues. - **Key Questions Addressed by the Conceptual Framework:** - Why is financial reporting important? - Who are the users of financial reports? - What makes financial information useful? - What are the constraints in providing useful information? - What assumptions are made in financial reporting? - **Objective:** - To provide financial information that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity - **Financial Information:** - General purpose financial reports which provide information on the entity's economic resources, claims, and changes in resources and claims. - **Qualitative Characteristics**: - **Fundamental:** Relevance and Faithful Representation - **Enhancing:** Comparability, Verifiability, Timeliness, Understandability - **Constraint and Assumptions:** - **Cost Constraint** - **Elements:** - **Assets** - **Liabilities** - **Equity** - **Income** - **Expenses** - **Going Concern** - **Qualitative Characteristics of Useful Financial Information:** - **Fundamental Characteristics:** - **Relevance:** Information must be significant for decision-making. - **Faithful Representation:** Information should accurately reflect the business situation. - **Enhancing Characteristics:** - Comparability, Verifiability, Timeliness, Understandability. - **Assumptions:** - Accrual Basis Accounting: Transactions are recorded when they occur, not when cash is received or paid. - Going Concern: The business will continue to operate for the foreseeable future. ## Elements of Financial Statements - **Assets:** Economic resources controlled by the entity that provide future benefits. - **Liabilities:** Present obligations to transfer resources. - **Shareholders' Equity:** Residual claim on assets after liabilities are deducted. - **Income:** Increases in equity from business operations. - **Expenses:** Decreases in equity from the cost of operations. - **Assets = Liabilities + Owners' Equity** ## Part III: Insights into Business Operations Through Financial Statements - **Flow of Financial Statements:** - **Income Statement:** Reports revenues and expenses over a period. - **Statement of Changes in Equity:** Shows transactions with owners. - **Balance Sheet (Statement of Financial Position):** Reports assets, liabilities, and equity at a specific point in time. - **Statement of Cash Flows:** Shows cash receipts and payments categorized into operating, investing, and financing activities. ## The Income Statements - Shows a company's financial performance - Reports revenues and expenses for the period - The bottom line = Total income - Total expenses - Net income if positive, Net loss if negative ## Statement of changes in equity - Shows a company's transactions with its owners - It is prepared after the income statement because the net income/loss from the income statement is needed to prepare the statement of changes in equity ## The balance sheet - Also called the statement of financial position - Reports three items; Assets, Liabilities & Shareholder's Equity - **Assets:** - **Current assets** - expected to be used or converted to cash within one business cycle - **Long-term assets** - **Liabilities:** - **Current liabilities** - debts due within one year - **Long-term liabilities** - **Shareholders' Equity** - Shareholders' ownership of the business's residual assets - Reflects the company's position at a specific moment in time ## The statement of cash flows - Measure cash receipts and payments - Three types of activates: - **Operating activities** - cash flows from selling goods and services to customers - **Investing activities** - cash flows from purchasing and selling long-term assets - **Financial activities** - cash flows from borrowing or repaying funds or equity transactions ## Part IV: Financial Statement Interrelationships - Financial statements are interconnected. For example, the net income from the income statement flows into the statement of changes in equity, and ending balances in the equity section transfer to the balance sheet. ## Part V: Ethics in Accounting - **Ethical Business Decisions:** - Economic: Maximize benefits. - Legal: Comply with the law. - Ethical: Some actions may be legal and profitable but still unethical. - **Code of Ethics for Professional Accountants (IESBA):** - Integrity - Objectivity - Professional Competence and Due Care - Confidentiality - Professional Behavior ## Recording Business Transactions - **Where do all the numbers come from in the financial statements?** - Financial statements: - Statement of Cash Flows - Statement of Changes in Equity - Balance Sheet - Income statement ## Part I: Explain what a Business Transaction is - **Eight Steps in the Accounting Cycle:** 1. Start with source documents (sales slips, bank statements, etc.). 2. Analyze transactions. 3. Record journal entries. 4. Post journal entries to ledger accounts. 5. Prepare unadjusted trial balance. 6. Adjust entries. 7. Prepare adjusted trial balance. 8. Prepare financial statements. - **What is a Transaction?** - A transaction is any event that has a financial impact on the business and can be measured reliably in monetary terms. - A change in an organization's resources and claims to those resources must occur before an organization can record anything. - Otherwise, you would be recording fake transactions without any economic substance. - Accounting records the financial impact of transactions in quantifiable monetary amounts (e.g., price charged/paid and cash collected/paid). - In certain situations, some estimation based on observable data or assumptions is necessary. ## Requirement: Classify each of the events as: 1. Business-related event but not a transaction to be recorded by the business or shareholder. 2. Business transaction for the shareholder but not recorded by the business. 3. Business transaction to be recorded by the business. ## The "Dual Effects" of Transactions - All business transactions include at least two effects on an entity's financial statement elements. - At some point in the thirteenth century, it became clear that all transactions could be seen as having two effects. ## Example: - Suppose a company's first transaction is its owners putting $40 cash into the company. Two things have happened: 1. The company has $40 more cash (increase in assets). 2. The owners have an interest of $40 in the company (increase in shareholders' equity). - **Balance Sheet (I) shows the result.** - **Balance Sheet (I)** - Cash + 40 - Owner + 40 ## Now, suppose the company borrows $60 cash from a bank. Two things happen: 1. The company has $60 more cash (increase in assets). 2. The company owes $60 to the bank (increase in liabilities). ## Balance Sheet (II) shows the result. - **The balance sheet is balanced!** - **Balance Sheet (II)** - Cash 40 - Owner 40 - + 60 Debt + 60 ## Financial Accounting & Double-Entry System - Financial accounting is based on a double-entry system, which records the dual effects on the business entity. - At all times, the accounting equation (Assets = Liabilities + Shareholders' Equity) must remain balanced. ## Advantages of the Double-Entry System 1. Discipline: Ensures high-quality recording. 2. Profit Calculation: Enables the calculation of profit and presentation of financial position. 3. Balancing Result: Provides a satisfying, balancing result. 4. Error Alert: Alerts accountants to errors in recording because a lack of balance indicates an error. ## Part II: Keep Track of Financial Statement Items - **Define Account (1 of 3)** - The accounting equation expresses the basic relationship of accounting. - Assets = Liabilities + Owners' Equity - **Define Account (2 of 3)** - An account is the record of all the changes in a particular asset, liability, or shareholders' equity during a period. It is a basic summary device. - **Define Account (3 of 3)** - The basic unit for recording transactions, used to aggregate amounts into total assets, total liabilities, and total shareholders' equity. ## List and Differentiate Between Different Types of Accounts (1 of 5) - **Assets:** - Present economic resources controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. - **1. Cash:** Money, including bank account balances, paper currency, coins, certificates of deposits, and checks. - **2. Accounts Receivable:** Promise for future collection of cash for goods or services sold. - **3. Notes Receivable:** Promissory note specifying an interest rate, signed by a customer to pay on a certain day. - **4. Inventory:** Finished products ready for sale to customers. ## List and Differentiate Between Different Types of Accounts (2 of 5) - **Assets:** - **Prepaid expenses:** Expenses paid in advance (e.g., insurance or rent). - **Property, plant, and equipment (PPE):** The cost of land, buildings, and equipment owned by a company. ## List and Differentiate Between Different Types of Accounts (3 of 5) - **Liabilities:** - Present obligations to transfer economic resources as a result of past events. - **1. Accounts Payable:** Promise to pay debt. - **2. Notes Payable:** Signed notes promising to pay a future amount, usually specifying an interest rate. - **3. Accrued Liabilities:** Liability for an expense that has not yet been paid (e.g., interest payable, salary payable). ## List and Differentiate Between Different Types of Accounts (4 of 5) - **Equity:** - Shareholders' residual claim to the entity's assets, i.e., what's left after deducting liabilities. - **1. Share Capital:** Shareholders' investment in the corporation through shares. - **2. Retained Earnings:** Cumulative net income minus cumulative dividends over the company's lifetime. - **3. Dividends:** Distribution of the company's earnings to shareholders as a return on their investment. ## List and Differentiate Between Different Types of Accounts (5 of 5) - **Equity:** - **Income:** Increase in shareholders' equity from delivering goods or services (e.g., sales revenue, service revenue). - **Expenses:** Decrease in shareholders' equity due to the cost of operating a business (e.g., salary expense, rent expense, utilities expense). ## Example: Chart of Commonly Used Accounts | Assets | Balance Sheet Accounts | Liabilities | Shareholders' Equity | Income Statement Accounts (Part of Shareholders' Equity) | Income | Expenses | |-----------------------|------------------------------------------|----------------------|------------------------|-----------------------------------------------------------|-------------|----------------------------------| | 101 Cash | 201 Accounts Payable | 301 Share Capital | 311 Dividends | 401 Service Revenue | | 501 Rent Expense | | 111 Accounts Receivable | 231 Notes Payable | 312 Retained Earnings | 402 Gain on Sale of Land | 502 Salary Expense | | 503 Utilities Expense | | 141 Office Supplies | | | | | | 504 Depletion Expense | | 151 Office Furniture | | | | | | 505 Amortization Expense | | 191 Land | | | | | | 506 Interest Expense | | | | | | | | 507 Bad Debt Expense | | | | | | | | 508 Depreciation Expense | | | | | | | | 509 Amortization Expense | | | | | | | | 510 Inventory Write-Down Expense | | | | | | | | 511 Warranty Expense | ## Part III: Analyze the Impact of Business Transactions on Accounts - **Transaction 1:** - On, April 1, 2018, Zaheer and a few friends invest $50,000 to open RedLotus Security, and the business issues ordinary shares to the shareholders. | Transaction | Type | Account Title | Amount | |-------------|--------------------------------------|---------------|---------------------| | 1 | Issuance of ordinary shares | Cash | +$50,000 | | | | Share Capital | +$50,000 | - **Transaction 2:** - RedLotus purchases land for a new location and pays cash of $40,000. | Transaction | Type | Account Title | Amount | |-------------|--------------------------------------|---------------|---------------------| | 1 | Issuance of ordinary shares | Cash | +$50,000 | | | | Share Capital | +$50,000 | | 2 | Purchase of land | Land | +$40,000 | | | | Cash | -$40,000 | - **The T-Account** - A record of increases and decreases in a specific asset, liability, equity, income, or expense. - Represented by the letter "T" with debits on the left and credits on the right. - Every transaction involves both a debit and a credit. - Total debits must equal total credits. - **The type of account determines how to record increases and decreases.** - **Expansion of the Accounting Equation** ## Final Form of the Rules of Debit and Credit: - Debit means left, and Credit means right. These are just symbols, neither good nor bad. - **Liabilities** - **Assets** - **Shareholders' Equity** - Share Capital - Beginning Retained Earnings - **Assets** - **Liabilities** - **Shareholders' Equity** - Retained Earnings (Income - Expenses) - Dividends - Share Capital - Beginning Retained Earnings - **Income** - Income Statement - Expenses - Dividends - **Assets** - **Liabilities** - **Shareholders' Equity** - Share Capital - Retained Earnings - Income - **Dividends** - Expenses ## Part IV: Record Transactions in the Books - **Flow of Accounting Data:** - **1. Journalizing:** - Record transactions in chronological order. - Specify each account affected by the transaction, determine if the account increases or decreases (debit or credit), then record in the journal. - **2. Posting:** - Copy information from the journal to the ledger accounts. ## Journalizing Example: 1. Issuance of ordinary shares: - Debit Cash $50,000, Credit Share Capital $50,000. 2. Purchase of land: - Debit Land $40,000, Credit Cash $40,000. ## Normal (ending) Balances of the Accounts | | | | |--------|--------|--------------| | **Assets** | Debit | | | **Liabilities** | Credit | | | **Shareholders' Equity-overall** | Credit | | | **Share capital** | Credit | | | **Retained earnings.** | Credit | | | **Dividends.** | Debit | | | **Income (revenue and gains).** | Credit | | | **Expenses (including losses).** | Debit | | ## Analyzing Accounts: - **Cash Account:** - Began with $33,000, received $8,000 during May, ending with $35,000. The total cash payments can be computed by analyzing the cash account. ## Part V: Construct and Use a Trial Balance - **Trial Balance:** - Lists all accounts with their ending balances - Assets listed first, then liabilities and shareholders' equity - Shows that total debits equal total credits for all accounts - Usually prepared at the end of the financial period - Facilitates preparation of the financial statements - **Purpose?** - A trial balance proves the equality of debit and credit. - It does not prove that the correct accounts were debited and credited or that the correct amounts were necessarily recorded. - It simply ensures that the balance of all the debits in the ledger accounts is equal to the balance of all the credits at any point in time. ## Example: - RedLotus Security - Trial Balance - April 30, 2018 | Account Title | Balance | Debit | Credit | |---------------|---------|------|-------| | Cash | | 10,000 | | | Land | | 40,000 | | | Share Capital | | | 50,000 | | Total | | 50,000 | 50,000 | ## Typical errors: - Wrong input data - Data entered twice or never - A debit entered as a credit, and vice versa ## Correcting Accounting Errors 1. Compute the difference between total debits and credits. 2. Search for missing accounts. 3. Divide the out-of-balance amount by 2. 4. Divide the out-of-balance amount by 9 to detect sliding or transposition errors. ## Accrual Accounting & Presentation of Financial ## Statements ## Part I: Accrual Accounting vs. Cash-Basis Accounting - **Accrual Accounting:** - Records the impact of transactions when they occur. - Income is recorded when earned, and expenses when incurred. - Required by IFRS. - **Cash-Basis Accounting:** - Records only cash transactions: cash receipts and cash payments. - Fails to capture the underlying economic phenomenon. - Results in incomplete financial statements. - Used only by businesses that do not follow accounting standards. - **Accrual accounting records:** - Cash transactions such as collecting cash from customers and paying salaries, rent, etc. - Non-cash transactions such as sales on account and purchase of inventory on account. ## The Time-Period Concept - Accounting information is reported at regular intervals. - Basic accounting period is one year, but companies also prepare financial statements for interim periods ## Part II: Apply the revenue and expense recognition principles ## Revenue Recognition and Expense Recognition Principles - **Revenue Recognition Principle:** - Deals with two issues: when to record revenue and what amount of revenue to record. - According to IFRS 15-Revenue from Contracts with Customers, revenue is recognized when the entity satisfies its performance obligation. - Revenue should reflect the consideration the entity expects to receive in exchange for goods or services. - Contracts between two parties create enforceable rights or performance obligations. - **Expense Recognition Principle (Matching Principle)** - Identify all expenses incurred during the period and recognize them in the same period as any related revenues. - Expenses should be matched to related revenues to compute net income or net loss. ## Matching Expenses with Revenue - **Direct Matching Example: Cost of Goods Sold:** - If a business sells 8,000 units at $10 each, the matching principle requires that the cost of goods sold (at $4 per unit) be recognized in the same period, resulting in $80,000 revenue and $32,000 expense. - **Indirect Matching Example: Rent Expense:** - If a business incurs $9,000 rent annually, the expense must be allocated monthly, with $750 matched against revenue for each period, regardless of revenue fluctuations. ## Part III: Adjusting the Accounts - **Adjusting Entries:** - **Deferrals:** Adjustments for items where cash has been paid or received in advance. - **Accruals:** Adjustments for items where cash will be paid or received later. - **Depreciation:** Allocates the cost of Property, Plant, and Equipment (PPE) over their useful life. - **Categories of Adjusting Entries:** - **1. Accrued Revenue:** Recognize revenue before cash is received. - **2. Accrued Expense:** Recognize expense before cash is paid. - **3. Deferred Revenue:** Cash is received before revenue is recognized. - **4. Deferred Expense:** Cash is paid before the expense is recognized. ## Deferrals - **1. Prepaid Expenses:** Assets created by cash payment in advance (e.g., prepaid rent) ## Prepaid Rent: - Suppose RedLotus Security, prepays three months' store rent ($3,000) on June 1. ## Prepaid Rent. Throughout June, Prepaid Rent carries the balance of $3,000. At June 30, an adjusting entry is required to transfer $1,000 ($3,000 + 3) from Prepaid Rent to Rent Expense. ## Supplies: - The cost of supplies is recorded as an asset initially, then adjusted as the supplies are used. ## Supplies. On June 2, RedLotus paid cash of $700 for cleaning supplies. ## Supplies. A count at June 30 indicates that $400 of supplies remain on hand. ## Unearned Service Revenue: - Cash received before services are performed creates a liability. - Suppose a client engages RedLotus Security and paid in advance $400 for work to be done. - When this cash is received on June 15, RedLotus will record this transaction as follows: ## Depreciation: - Depreciation allocates the cost of long-lived assets (PPE) over their useful life. - **Straight-Line Depreciation:** - Divide the asset's cost by its useful life. - **Example:** - Equipment costing $24,000 with a 5-year life results in $400 monthly depreciation - Annual depreciation = $24,000 / 5 year = $4,800 per year - Monthly depreciation = $4,800 / 12 months = $400 per month - **Depreciation expense for June is recorded as follows:** - **Accumulated Depreciation:** - Shows the sum of all depreciation expense from using the asset - The balance increases over the asset's life - An asset account with normal credit balance, i.e. contra account to PPE - A business carries an accumulated depreciation account for each class of depreciable assets. - A contra account has two distinguishing characteristics: - Always has a companion account - Normal (ending) balance is opposite to that of the companion account ## Accruals Expenses - Arises from an expense that has not yet been paid - Not recorded daily or weekly, but rather at the end of the period as an adjustingentry ## Accrued Salary Expense: - Example: RedLotus pays its employee $1,800 monthly, with half paid on the 15th and half on the last day of the month. At June 30, an adjustment records $900 of unpaid salary. - During June, RedLotus Travel paid its employee the first half- month salary of $900. ## Accrued Revenue: - Example: RedLotus works 6 hours for a hotel event in June but won't be paid until July. An adjustment is made on June 30 to recognize the $300 earned. ## Summary of the Adjusting Process - Adjusting entries serve two purposes: 1. Measure income. 2. Update the balance sheet. - Every adjusting entry affects both revenue/expense and asset/liability. ## Part IV: Prepare Updated Financial Statements - **Adjusted Trial Balance:** - Summarizes all accounts and their final balances after adjusting entries are posted. - Financial statements are prepared directly from the adjusted trial balance, including the income statement, statement of changes in equity, and balance sheet. - **Income Statement:** - *Revenue:* - Service revenue - *Expenses:* - Salary expense - Rent expense - Utilities expense - Depreciation expense - Supplies expenses - *Income before tax* - *Income tax expense* - *Net income* - **Statement of Changes in Equity:** - Total equity, May 31, 20X8 - Add: Net income - Less: Dividends - Total equity, April 30, 20X8 - **Balance Sheet** - *Assets* - Cash - Accounts receivable - Supplies - Prepaid rent - Land - Equipment - Less: Accumulated depreciation - * Liabilities* - Accounts payable - Salary payable - Unearned service revenue - Income tax payable - *Shareholders' Equity* - Share capital - Retained earnings - Total shareholders' equity - Total liabilities and shareholders' equity - Total assets ## Part V: Closing the Books - Close Temporary Accounts: Income, expenses, and dividends are closed at the end of the accounting period. - Permanent accounts (assets, liabilities, equity) remain open. - **Steps to Close the Books:** 1. Close income accounts into retained earnings. 2. Close expense accounts into retained earnings. 3. Close dividends into retained earnings. ## Part VI: General Presentation Requirements of Financial Statements - **IAS 1: Presentation of Financial Statements:** - Prescribes the basis for the presentation of financial statements to ensure comparability across periods and entities. - **Financial Statements Comprise:** - Statement of Financial Position (Balance Sheet). - Statement of Comprehensive Income (Income Statement). - Statement of Changes in Equity. - Statement of Cash Flows. - Notes (summary of accounting policies and other information). - **Required Disclosures:** - The entity's name, if the account is consolidated, reporting period, presentation currency, and rounding conventions. - **Fair Presentation:** - Entities must comply with IFRS and explicitly state compliance in the notes. - **Going Concern:** - Management must assess the entity's ability to continue operating and disclose uncertainties if there are significant concerns. - **Accrual Basis of Accounting:** - Reflects changes in net assets, not just cash flows. - **Materiality and Aggregation:** - Significant items must be presented separately, and similar items may be aggregated unless immaterial. - **Consistency and Comparability:** - Entities must maintain consistency in presentation and classification across periods. ## Internal Control, Cash, & Receivables ## Part I: Describe Fraud and Its Impact - **Definition of Fraud:** - Fraud is an intentional misrepresentation of facts made for the purpose of persuading another party to act in a certain way, causing injury or damage to that party. ## Types of Fraud: 1. **Misappropriation of Assets:** - Committed by employees. - Examples: Theft of money or inventory, bribery, kickback schemes, overstated expense reimbursements. 2. **Fraudulent Financial Reporting:** - Committed by managers. - Examples: False and misleading journal entries, deceiving investors and creditors ("Cooking the Books"). ## The Fraud Triangle 1. **Opportunity:** A situation that allows fraud to occur. 2. **Pressure:** Incentives or motivations to commit fraud. 3. **Rationalization:** The mindset that justifies fraudulent behavior. ## Example: The Wirecard Scandal - **Wirecard Timeline:** - Founded in 1999 in Munich, Germany. - Provided electronic payment and risk management services. - By 2018, Wirecard became Europe's largest fintech, replacing Commerzbank in the German DAX 30 index. - In 2019, documents surfaced revealing inflated profits in its Dubai and Dublin units. - In 2020, Wirecard acknowledged a potential accounting fraud involving €1.9 billion of missing cash. - CEO Markus Braun was arrested, and Wirecard declared bankruptcy in June 2020. ## Part II: Understand the Role of Internal Controls and Corporate Governance - **Internal Control:** - The primary method to prevent, detect, and correct fraud. - A plan of organization and procedures that achieve five objectives: - 1. Safeguard assets. - 2. Encourage employees to follow company policies. - 3. Promote operational efficiency. - 4. Ensure accurate and reliable accounting records. - 5. Comply with legal requirements. - **Example:** Sarbanes-Oxley Act (SOX), passed in 2002, which mandates internal control reports and establishes the Public Company Accounting Oversight Board (PCAOB). ## Internal Control Procedures: - **Separation of Duties:** - Different people should handle asset management, record-keeping, and transaction approvals. - **Monitoring of Controls:** - Internal and external audits evaluate the effectiveness of internal controls. - **Limitations of Internal Control:** - Collusion, management override, and human limitations (e.g., fatigue or negligence) can circumvent controls. ## Part III: Prepare and Use a Bank Reconciliation - **Bank Reconciliation:** - A process that explains the differences between the cash balance reported in the company's books and the bank's statement. - **Common Reconciling Items:** - **1. Bank Side:** - Deposits in transit. - Outstanding checks. - Bank errors. - **2. Book Side** - Bank collections. - Electronic funds transfers (EFTs). - Service charges. - Interest revenue. ­ - Non-sufficient funds (NSF) checks. - Book errors. ## Example: Bank Reconciliation 1. Bank Side Example: - Deposit in transit: $1,600 recorded by the company but not yet by the bank. ­ 2. Book Side Example: - Bank service charge: $20 deducted automatically by the bank but not yet recorded in the company's books. ## Journalizing Transactions from the Bank Reconciliation - Transactions identified in the reconciliation must be recorded in the company's books to adjust the cash balance to the correct amount. ## Part IV: Account for Receivables and Potential Impairment - **Types of Receivables:** - **Accounts Receivable:** Current assets from selling goods or services on credit. ## Accounts Receivable. ## Service Revenue... ## Performed a service on account. ## Notes Receivable: - Arises from lending money (includes interest). ## Accounting for Receivables 1. **Accounts Receivable:** - Considered a current asset, often called trade receivables. - The company maintains a control account, summarizing total receivables from all customers. ## Allowance Method (for uncollectible accounts): - Estimates bad debts in advance, recording an "Uncollectible Account Expense." - A contra-account is created: Allowance for Doubtful Accounts, showing the estimated amount not expected to be collected. ## Writing Off Uncollectible Accounts 1. Allowance Method: - When a specific account is determined to be uncollectible, the receivable is written off. - Example: LEGO writes off receivables from two customers, reducing both accounts receivable and the allowance account. ## Writing Off Uncollectible Accounts: - Assume, at the beginning of 2024, LEGO had these accounts receivable (in millions): ## Write Off Uncollectible Accounts:: - Early in 2024, LEGO's credit department determines that LEGO can't collect from Toys Kingdom and Hamleys. - LEGO then wrote off the receivables from these customers with the following entry: ## Writing Off Uncollectible Accounts ## Direct Write-Off Method: - No allowance is made, and bad debts are recognized only when the receivable is uncollectible. - This method can overstate assets and fails to apply the matching principle. - The journal entry to write off Toys Kingdom and Hamleys using the direct write-off method is ## Notes Receivable - A formal, written promise to pay a specific amount of money, with interest, at a future date. - **Key Terms:** - Creditor: Lender. - Debtor: Borrower. - Interest: Cost of borrowing money. - Maturity Date: Date when the note must be paid. - Maturity Value: The sum of principal and interest. ## Accounting for Notes Receivable - After Lauren Holland signs the note, Continental Bank gives her $1,000 cash. - The bank makes the following entry to record the loan. ## Continental Bank earns interest revenue during September, October, November, and December. - At December 31, 2016, the bank accrues 9% interest revenue for four months: ## Continental Bank reports these amounts in its financial statement at December 31, 2016 as follows: