Accounting Notes Chapter 4-6 PDF

1. Describe merchandising activities and cost flows a. Reporting income for a service company i. Service companies sell time to earn revenue ii. Ex: accounting firms, law firms, and plumbing services iii. Revenues - expenses = net income b. Reportin...

1. Describe merchandising activities and cost flows a. Reporting income for a service company i. Service companies sell time to earn revenue ii. Ex: accounting firms, law firms, and plumbing services iii. Revenues - expenses = net income b. Reporting income for a merchandiser i. Merchandising companies sell products to earn revenue ii. Ex: sporting goods, clothing, auto parts iii. Net sales-cost of goods sold= gross profit iv. Gross profit - expenses= net income v. Sales-sales discounts- sales returns and allowances= net sales vi. Revenue - expenses = net income vii. Gross profit/ net sales x100= gross margin ratio viii. Cost of goods formula: beginning inventory + purchases- ending inventory c. Operating cycle for a merchandiser i. Begins with the purchase of merchandise and ends with the collection of cash from the sale of merchandise d. Inventory systems (IS) i. Beginning inventory + net purchases ii. Equals merchandise available for sale iii. Ending inventory + cost of goods sold e. Inventory systems: Definitions i. Perpetual systems: Updates accounting records for each purchase and each sale of inventory ii. EX: staples, target, you always know what is in stock/in the store iii. Periodic systems: updates accounting records for purchases and sales of inventory only at the end of a period (Not very effective) 2. Analyze and record transactions for merchandise purchases using a perpetual system a. Cash discounts, purchase discounts, returns, and allowances are contra accounts!! b. Purchases i. Debit merchandise inventory ii. Credit cash c. Purchases with returns and allowances i. Purchase return: merchandise returned by the purchaser to the supplier. EX: you hate something so you send it back. ii. Purchase allowance: a price reduction to the buyer of defective or unacceptable merchandise. EX: You like something but there is a stain or a hole so you get some money back d. Purchase allowances i. Debit accounts payable ii. Credit merchandise inventory iii. Purchase returns are accounted for the same way! e. Purchases and transportation cost  i. FOB Shipping points: BUYER OWNS SOONER ownership transfers at shipping port, goods in transit owned by buyer, transportation cost paid by buyer, debit merchandise inventory, credit cash ii. FOB Destination: SELLER OWNS LONGER ownership transfers at destination, goods in transit owned by seller, transportation costs paid by seller, debit delivery expense, credit cash f. Transportation costs i. Debit merchandise inventory, credit cash g. Itemized cost of purchases i. Format: invoice cost of merchandise purchases, - purchase discounts received - purchase returns and allowances + cost of transportation = total net cost of merchandise purchases 3. Analyze and record transactions for merchandise sales using a perpetual system a. Gross profit computation i. Net sales (net of discounts, returns, and allowances) - cost of goods sold =gross profit ii. What is left over after you sell something and the cost to make it!jm b. Sales of Merchandise i. Each sales transaction for a seller of merchandise involved two parts: 1. Revenue received in the form of an asset from a customer 2. Recognition of the cost of merchandise sold to a customer c. Sales i. Z-mart sold 1,00 of merchandise on credit. The merchandise has a cost basis to z-mart of $300 ii. Revenue side journal entry: debit accounts receivable 1000, credit sales iii. Cost side journal entry: cost of goods sold 300. Merchandise inventory 300 d. Sales returns and allowances i. usually involve dissatisfied customers and the possibility of lost future sales ii. Sales return refer to merchandise that customers return to the seller after a sale iii. Sales allowances refer to reductions in the selling price of merchandise sold to customers e. Sales with returns and allowances i. Customer returns merchandise which sold for $15 and cost $9: debit sales returns and allowances, credit costs ii. Returned goods- not defective: credit merchandise inventory, debit cost of goods sold f. Buyer granted allowance for defective goods i. Assume that $40 of the merchandise z-mart sold on november 12 is defective but the buyer decides to keep it because z-mart offers a $10 price reduction ii. Debit sales returns and allowances, credit cash 4. Prepare adjustments and close accounts for a merchandising company a. Closing Entries for Merchandisers i. Close credit balances in temporary accounts to income summary 1. Debit Sales 2. Credit income summary ii. Close debit balances in temporary accounts to income summary 1. Debit income summary 2. Credit sale discount, returns and allowances, cost of goods sold, depreciation expense, salaries expense, insurance expense, rent expense, supplies expense, advertising expense iii. Close income summary 1. Debit income summary 2. Credit retained earnings iv. Close dividends 1. Debit retained earnings 2. Credit dividends 5. Define and Prepare multi-step and single-step income statements a. Multiple step income statement i. Sales: credit sales, debit and subtract sales discount and returns, credit net sales, credit cost of goods sold ii. Net sales iii. Operating expenses iv. Selling expenses 1. Debit depreciation expenses 2. Sales salaries expense 3. Rent expense or selling space 4. Storage supplies expense 5. Advertising expense 6. Credit total selling expense v. General and administrative expenses 1. Debit depreciation expense of office equipment 2. Office salaries expense 3. Insurance expense 4. Rent expense for office space 5. Office supplies expense vi. Total administrative expense vii. Total operating expense viii. Income from operations ix. Other revenues and gains 1. Interest revenue 2. Gain on sale of building 3. Interest expense x. Total other revenues and gains xi. Net income  b. Single Step income statement i. Revenues 1. Net sales 2. Interest revenue 3. Gain on sale of building 4. Total revenues (all things added up) ii. Expenses 1. Cost of goods sold 2. Selling expenses 3. General and administrative expenses 4. Interest expenses 5. Total expense (add all factors up) iii. Net income (revenues - expenses) c. Classified balance sheet i. Current assets 1. Cash 2. Accounts receivable 3. Merchandise inventory 4. Office supplies 5. Store supplies 6. Prepaid insurance 7. Total current assets (all of these things added up) 6. Compute and analyze the acid-test ratio and gross-margin ratio a. Acid test ratio: quick assets/current liabilities i. Acid test ratio: cash+short term investment + receivables/current liabilities ii. Should be a value of at least 1.0, shows they are unlikely to face liquidity problems in the future iii. You want this to be high b. Gross Margin Ratio i. Gross Margin Ratio (or gross profit): net sales- cost of goods sold/ net sales ii. Shows percent of dollar sales available to cover expenses and provide profit Chapter 5: Reporting and analyzing inventories 1. Identify the items and costs of merchandise inventory a. Determining inventory items: merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. i. Items requiring special attention include: 1. Goods in transit 2. Goods on consignment 3. Goods damaged or obsolete b. Goods in transit i. FOB shipping point: goods included in buyers inventory when shipped  ii. FOB destination: goods included in buyers inventory after arrival at destination c. Goods on consignment i. Consignor: owner of goods ii. Consignee: sells goods for the owner iii. Merchandise is included in the inventory of consignor iv. Consignee never reports consigned goods in inventory d. Goods damaged or obsolete i. Damaged or obsolete goods are not reported in inventory if they cannot be sold ii. Damaged or obsolete goods which can be sold are included in inventory at net realizable value iii. Net realizable value= sales price minus selling cost iv. Loss is recorded when damaged or obsolescence occurs v. Some things go obsolete because they are no longer useful for popular, ex: typewriters, silly bands, ipods, etc vi. All obsolete or damaged goods need to have their value market down. e. Determining inventory costs i. Include all expenditures necessary to bring an item to a salable condition and location. ii. Any cost you incur to get the inventory and get it ready to sell (storage ,import dues, shrinkwrap, packaging, moving it around, etc) all needs to be counted towards inventory cost! iii. Inventory cost- invoice cost- discounts + other costs iv. Other costs include: 1. Shipping 2. Storage 3. Insurance 4. Import duties f. Internal controls and taking a physical counts i. Most companies take a physical count of inventory at least once each year ii. When the physical count does not match the merchandise inventory account, an adjustment must be made iii. Good internal controls over the inventory count include 1. Pre Numbered inventory tickets 2. Counters have no inventory responsibility 3. Counters confirm existence, amount, and condition of inventory 4. Second Count is taken by a different counter 5. Manager confirms all items counted only once g. Inventory costing methods i. Four methods are used to assign costs to inventory and to cost of goods sold 1. Specific identification  a. You know things item by item. b. EX: A car dealership- They know all types of cars, features, and details c. Will be given how much was sold, how much is left and other important info 2. First in, first out (FIFO) a. Grocery stores want the first things they buy to be the first things they sold to keep everything fresh 3. Last in, first out (LIFO) a. Grocery stores DON'T do this, it would cause everything to be rotten and gross b. Wine distributions: want wine to be richer and more aged, also increase value of the product c. EX: selling mulch or coal from a big pile, you just take parts of it 4. Weighted average a. Gas station: new and old gas is mixed together and you have to buy it. Can't request gas delivered one day vs one week ago b. Does NOT have to match the physical flow c. Most companies have this method bc of the tax benefit h. Inventory cost flow assumptions i. FIFO: cost flow in the order occurred 1. Cost of goods sold is the oldest 2. Ending the inventory approximates current cost 3. Inventory is the newest ii. LIFO: costs flow in the reverse order incurred 1. Cost of goods sold is the newest 2. Cost of goods sold on income statement approximates its current cost 3. Inventory is the oldest iii. Weighted average: costs flow at an average of costs available 1. Cost of goods sold is the average 2. Inventory is the average 3. Smooths out price changes i. Income statements: i. Debit net sales, credit cost of goods sold, subtract for gross profit ii. Balance sheet- goes under inventory 2. Compute inventory in a periodic system using the methods of specific identification, FIFO, LIFO, and Weighted Avg a. Inventory costing under a periodic system i. Balance sheet:Ending inventory ii. Income statement: cost of goods sold iii. Both inventory affects!!  iv. Physical flow does NOT need to follow cost flow! b. View images for Inventory costing illustration periodic system and other types c. Inventory costing illustration periodic system- weighted average i. When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold 3. Analyze the effects of inventory methods for both financial and tax reporting a. Financial statement effects of inventory costing methods: periodic methods i. Because prices change, inventory methods nearly always assign different cost amounts b. Tax effects of costing methods i. The internal revenue service (IRS) requires that when LIFO is used for tax reporting, it must also be used for financial reporting. This is allied the LIFO conformity rule. 4. Compute the lower of cost or market amount of inventory a. Lower cost or market i. Inventory must be reported at market value when market is lower than cost ii. Defined as current replacement cost (not sales prince).consistent with the conservatism principles iii. Can be applied three ways 1. Separately to each individual item 2. To major categories of assets 3. To the whole inventory iv. It would be unethical if inventory is overstated. Not fair to people who invest in your company!! 5. Analyze the effects of inventory errors on current and future financial statements a. Income statement effects of inventory errors: i. If you overstate one year, understate the next year ii. They will fix themselves after two years (retained earnings will balance out) iii. Companies who have to restate their retained earnings usual face dropped stock prices 6. Assess inventory management using both inventory turnover a days sales in inventory a. Inventory turnover i. Shows how many times a company turns over its inventory during a period. Indicator of how well management is controlling the amount of inventory available ii. Inventory turnover= cost of goods sold/ average inventory iii. Average inventory= beginning inventory + end inventory / 2 iv. Think of McDonalds vs. Ace hardware, mcd has a faster turnover like every day while ace might have a longer one bc some items don't sell for a while v. Items with slower turnover can get damaged or obsolete  vi. Items with turnover too fast can have stock outs like items selling out too fast vii. Higher inventory turnover is the more it turns b. Days sales in inventory i. Reveals how much inventory is available in terms of the number of days sales ii. Days sales in inventory= ending inventory/cost of goods sold x365 c. Analysis of inventory management i. Merchandisers plan and control inventory purchases and sales ii. Costco and walmart’s inventory turnover and days sales usually have high inventory turnover and medium days in inventory Chapter 6 1. Define internal control and identify its purpose and principles a. Internal control System i. Internal control is used to monitor and control business activities. It includes the policies and procedures used to 1. Protect assets 2. Ensure reliable accounting 3. Uphold company policies 4. Promote efficient operations b. Sarbanes-oxley acts (SOX) i. Requires managers and auditors of public companies to document and certify the system of internal controls ii. First thing that stated that people singing off will go to jail if its fraud iii. Requirements include 1. Company must have efficient internal controls 2. Auditors must evaluate internal controls 3. Violators receive harsh penalties up to 25 years in prison with fines 4. Auditors work is overseen by public company accounting oversight board iv. COst of implementing sox 1. 6 million to 39 million annually 2. Section 404 alone would cost 1.24 billion c. Committee of sponsoring organizations i. Committee of sponsoring organizations five ingredients of internal control which add quality to accounting information 1. Control environment a. Companies doing title 9 harassment prevention training, establishing a positive tone in the company. 2. Risk assessment a. Where can we get hit with something financial, how can we mitigate the risk. Trainings, policies, restricting access 3. Control activities  4. Information and communication 5. Monitoring d. Principles of internal control i. Common to all companies 1. Establish responsibilities a. Being direct, assigning roles, helps to know who is at fault when something happens, setting rules b. Tasks should be clearly established c. Tasks should be assigned to one person d. Can then determine who is at fault 2. Maintain adequate records a. Being able to follow electronic and paper trails is key, ensuring everything is done right b. Protect assets c. Helps managers monitor company activities d. Includes detailed records, use of chart of accounts, preprinted forms, prenumbered sales slips, computerized point of sale systems 3. Insure assets and bond key employees a. Adding insurance to valuable items, place value/insurance on workers so if something goes missing the company gets paid and the bond company goes after them. Helps decrease risk for employers and wont hold them responsible b. Assets should be insured against losses c. Employees handling a lot of cash and other assets should be bonded d. Bonded means the company has purchased an insurance policy against theft by tat employee 4. Separate recordkeeping from custody of assets a. Know the difference b. Person who cnontrols or has access to assets must not have access to that assets accounting records c. Reduces risk of theft or waste of an asset d. Employees would need to collude, agree in secret to commit fraud under this control 5. Divided responsibility for related transactions a. Divide responsibility so sensitive transactions wont go wrong. b. If you can not segregate duties bc of small size the owner should do it, they wouldn't steal from themselves c. Responsibility for a transactions should be divided between to or more individuals  d. Ensures work of one person acts as a check on the other to prevent fraud or errors e. Called separation of duties 6. Apply technological controls a. Passwords, limit access, b. Cash registers make an electronic file/record of each sale c. Time clock records exact time employee works d. Personal scanners limit access to authorized individuals 7. Perform regular and independent reviews a. Helps ensure that procedures are followed b. Preferably done by auditors not directly involved in the activities c. Auditors evaluate the efficiency and effectiveness of internal controls e. Technology, fraud, and internal control i. Reduce processing errors ii. More extensive testing of records iii. Separation of duties iv. Increased e commerce v. New evidence of processing f. Blockchain as a control i. A more secure type of accounting ledger which continuously and simultaneously updates and verifies the ledger 1. Prevents modification without the detailed record of changes 2. Changes cannot be destroyed or hidden 3. Auditors focus on testing the effectiveness of companies blockchain processes and technology g. Limitations of internal control i. Human error: carelessness, misjudgement, confusion ii. Human fraud: intentionally defeating internal controls for personal gain iii. Fraud triangle: opportunity, pressure, and rationalization iv. Cost benefit constraint: costs of internal controls must not exceed their benefits 2. Define cash and cash equivalents and explain how to report them a. Cash, cash equivalents, and liquidity i. Cash and similar assets are called liquid assets because they can be readily used to pay current liabilities ii. Cash: currency, coins, and deposits in bank accounts. Also includes items such as customer checks, cashier checks, certified checks, and money orders iii. Cash equivalents: short -term highly liquid investments that are readily convertible to a known cash amount and close it maturity date and not sensitive to changes b. Cash management  i. Goals of cash management are twofold 1. Plan cash receipts to meet cash payments when due 2. Keep a minimum level of cash necessary to operate ii. Effective cash management involves applying the following cash management strategies 1. Encourage collection of receivables 2. Delay payments of liabilities 3. Keep only necessary assets 4. Plan expenditures 5. Invest excess cash c. Control of cash i. An effective system of internal control that protects cash and cahs equivalents should meet three basic guidelines 1. Handling cash is separated from record keeping for cash 2. Cash receipts are promptly deposited in a bank 3. Cash payments are made by check or EFT 3. Apply internal controls to cash receipts and payments a. Cash receipts by mail i. Two people are assigned the task of opening the mail ii. The cashier deposits the cash in a bank iii. The record keeper records the amounts received in the accounting records b. Control of cash payments i. Important because most large thefts are from payment of fictitious invoices ii. Keys to controlling cash payments 1. Require all payments to be made by check 2. Limit access to checks except for those who have the authority to sing checks iii. Cash budget 1. Includes projected cash receipts and cash payments c. Basic bank services 1. Signature cards 2. Deposit tickets 3. Bank statements 4. Electronic funds transfer 5. Checks 6. Bank accounts d. Deposit ticket i. Used to deposit money in the bank ii. Lists cash and checks along with the amounts iii. serves as proof of deposit e. Check i. Used to withdraw money from the bank  ii. Includes maker, signor of check, payee, and payer f. Bank statement i. Usually once a month the bank sends each depositor a bank statement showing the activity in the account 4. Prepare a bank reconciliation a. Bank reconciliation i. Prepared periodically to explain the difference between cash reported on the bank statement and the cash balance on company books ii. Bank balance adjustments: add deposits in transit, subtract outstanding checks, add or subtract corrections of bank errors iii. Book balance adjustments: add interest earned and unrecorded cash receipts, subtract bank fees and NSF checks, add or subtract corrections of book errors b. Purpose of bank reconciliation i. The balance of a checking account reported on the bank statement rely equals the balance in the depositors accounting records ii. Adjusting entries are recorded for the reconciling items on the book side of reconciliation 1. Cash balance per bank 2. Plus deposits in transit 3. Minus outstanding checks 4. Plus or minus bank errors 5. Equal adjusting cash balance iii. Adjusting entries from a bank reconciliation 1. Only items reconciling the book balance require adjustments a. Collection of note i. Debit cash, credit notes receivable b. Interest earned i. Debit cash credit interest revenue c. Check printing i. Debit Miscellaneous expenses, credit cash d. NSF check i. Debit accounts receivable credit cash 5. Compute the days sales uncollected ratio and use it to assess liquidity a. Days sales uncollected i. Indicates how much time is likely to pass before we receive cash receipts from credit sales ii. Days sales uncollected= accounts receivable/net sales x 365 iii. Lowering days sales uncollected is generally better iv. Often an area where people have fraud Jeopardy questions: Two types of inventory systems: periodic and perpetual How deposits in transit are handled on a bank rec: added to the bank side Cost of goods sold end up in: ending inventory or cost of goods sold Quick asset accounts: cash, cash equivalents, short term investments, accounts receivable The main salary would normally show up where in a multi-step income statement: General administrative expense, under operating expenses Gross profit- operating expenses =income from operations The two entries needed to record a sale of merchandise on account using a perpetual system: debit accounts receivable, credit sales, debit cost of goods, sold credit inventory two types of income statements: single step, multi step Hows is interest earned treated on a bank rec: added to the book balance Sales commissions general,y show up where in a multi step income statement:selling expenses Items requiring and adjustment: things the company didn't know about, adjust on the book side! What is the LIFO conformity rule: if lifo is used for tax purposes you have to use it for reporting purposes **** know some Principles of good internal control**** A good technique for managing cash: timely collection of receivables, delay payment of liabilities, keep only necessary cash on hand, invest excess cash, etc 2 characteristics of cash equivalents: short -term, highly liquid investments A major advantage of this method is that the ending inventory is stated in terms of an approximate current cost figure: FIFO