ACCT 101
MIDTERM II (CHAPTER 5-8)
Some Things to Note:
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Current Asset – asset that can be converted to cash and will be used within one year
Non-current Asset – will not be converted to cash within one year
Chapter 5:
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Fraud – attempt to deceive others for personal gain
o Corruption – misusing a position of trust for inappropriate personal gain
o Asset misappropriation – theft (embezzlement)
o Financial Statement Fraud – misreporting amounts in the financial statements
 There is more frequency of asset misappropriation cases, but financial
statement frauds cause the most loss
The Fraud Triangle:
o Incentive – employee’s reason
 Can be personal financial reasons or to make the business appear
successful to attract investors
 Loan covenants – if the terms of a loan agreement are broken,
then the lender can renegotiate the terms or force repayment
 Loan covenants may require company to meet specific levels of
assets or shareholders’ equity, so dishonest managers may
misreport to avoid extra charges.
o Opportunity – employee’s means
 Usually weak internal controls
o Rationalization – employee sees the deed as unavoidable or justified
Top management overstates earnings by overstating revenue and understanding
expenses
Enron Case:
o Overstated their assets and shareholders’ equity, was caught and their shares
dropped dramatically, leaving them bankrupt.
o The $50 Billion Ponzi Scheme
o Lehman Brothers had suspicious financial statements
Sarbanes-Oxley Act (SOX)
o Created by U.S Congress in 2002
o Regulations on many topics, including internal control systems and certification
of executives
o Gov. of Ontario passed Bill 198 (C-SOX), similar to SOX
 Key requirements:
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Counteract Incentives
o Stiffer fines and prison terms
Encourage Honesty
o Anonymous tip lines
o Whistler-blower protection
o Code of ethics
Reduce Opportunities
o Internal control report from management
o Stronger oversight by directors
o Internal control testing by external auditors
Internal Control
o Objectives: Provides reasonable assurance regarding the reliability of the
company’s:
 Financial reporting
 Effectiveness and efficiency of its operations
 Compliance to laws and regulations
o Components:
 Control environment – attitude of people in the organization have
regarding internal control
 Influenced by what policies the board of directors / senior
mangers set, their integrity and ethics, the kind of people they
hire
 Risk Assessment – continuously assess the potential for fraud, and other
risks that could prevent the company from achieving their objectives
 Control activities – various work responsibilities completed by employees
to reduce risks to an acceptable level
 Information and communications – generate and communicate info to
support sound decision making
 Monitoring activities – evaluate the internal control system often
o Common Principles of Internal Control
 Establish responsibility – assign each task to only one employee
 Ex. Give a separate cash register to each cashier at the start of the
shift
 Segregate duties – do not make one employee responsible for all parts of
a process
 Ex. Inventory buyers do not also approve payments to suppliers
 Restrict access – do not provide access to assets or info unless it is
needed to fulfill assigned responsibilities
 Secure valuable assets such as cash and restrict access to
computer systems via passwords, firewalls, etc.
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Document procedures – prepare documents to show activities that have
occurred
 Pay supplies using prenumbered checks and digitally documented
electronic fund transfers
 Independently verify – check others’ work
 Compare the cash balance in the company’s accounting records to
the cash balance reported by the bank account for any differences
o Limitations:
 Cost vs. benefit
 An organization will only implement internal controls to the
extent that their benefits exceeds their costs
 Human error vs. fraud
 An honest mistake can be made, but some may use that excuse to
override the internal controls or collude (work together) with
others to get around them
Internal control of cash
o Important for 2 main reasons:
 The volume of cash transactions is enormous
 Highly vulnerable to theft because it is valuable and portable
o The primary internal control goal for cash receipts is to ensure that the business
receives the appropriate amount of cash and safely deposits it in the bank
o Cash received in Person:
 Separating duties ensures that handling cash is separate from recording
cash
 Journal entries:
 Any difference between Cash and Revenue is recorded in a Cash
Shortage (Overage) account, which is reported on the income
statement as a miscellaneous expense (or revenue). Example:
o Dr. Cash (+A) 6,097
o Dr. Cash Shortage (+E, -SE) 3.00
 Cr. Sales Revenue (+R, +SE) 6,100
o Cash received by Mail:
 Processed the same way as cash receipts, except instead of a cash
register, a clerk opens the mail and lists the accounts received on the
cash receipt list
 Cash received Electronically:
 Payments via electronic fund transfer (EFT) are deposited directly
to the company’s bank account and only needs a journal entry to
record it
o Controls for Cash Payments:
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Most cash payments involve:
 Cheque or EFT to suppliers
 Paying employees via EFT
 Petty cash system
 The primary goal of internal control for cash payments is to ensure that
the business pays only for properly authorized transactions
 Cash Paid by Cheque
 Most companies use a Voucher System – a process for approving
and documenting all purchases and payments made on account
(documents prepared at each step in the system)
 Cash Paid to Employees via EFT
 Known as direct deposits
 Risk of under/overpaying so they can use an Imprest System – a
process that controls the amount paid to others by limiting the
total amount of money available for making payments
 Cash Paid to Reimburse Employees (Petty Cash)
 Company removes some cash from bank account to a locked cash
box and then reimburse employees for expenditures rather than
having to write out checks every time
 Petty Cash is an asset, and when funds are taken out the
custodian and payee both have to sign the petty cash receipt and
the custodian puts any invoices, etc. to it as well
 Payments out of petty cash are not recorded in the accounting
system until the fund is replenished
 To replenish the fund, a cheque is issued for how much was spent
in total and is a credit to Cash and a debit to all the things it paid
for like supplies or expenses. Basically, so that the custodian could
go the bank and cash out more money to replace the ones they
gave to the employees.
o Controls from Bank Procedures
 Banks help control cash by:
 Restricting access
 Documenting procedures
 Independently verifying activity
 Bank Reconciliation – internal report prepared to verify the accuracy of
both the bank statement and the cash accounts for a business or
individual
 Done to compare company books and bank statements
 Bank Statement:
o Presented from the bank’s point of view
o Cheques that have been deposited in the bank, and taken
out of another’s account, are known to have “cleared the
bank”
o Deposits are recorded in the bank during business hours, if
you deposit money after hours then it could take some
time to go into the account
o Other transactions include service charges and interest
o Business consider cash in the bank an asset (debit), but to
the bank the cash is a liability (credit)
o The withdrawal side is a credit (outflow), and the deposit
side is a debit (inflow)
o
Company books:
o Cash increase to debit side (inflow), decrease to credit side
(outflow)
 Updates to bank statement is on right side and updates to
company’s books is on the left side
o On Bank Side:
 Additions: Deposits in Transit
 Deductions: Outstanding Cheques, Bank Errors
o On Company Books Side:
 Additions: Interest Received/Earned, EFTs
 Deductions: NSF Cheques, service charges, errors in
recording cheques
 After updating, do journal entries ONLY for the company books,
even if the banks have made errors. The Adjusting Journal Entries
for Bank Reconciliation always involve cash.
Reporting Cash (on Balance Sheet)
o Cash includes literal cash, petty cash on hand and cash equivalents
o Cash equivalents – short-term, highly liquid investments purchased within three
months of maturity
 Ex. Term deposits, money market funds, government bonds, etc.
o Restricted Cash – Not available for general use but rather restricted for a specific
purpose
 Reported separately on balance sheet
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Dr. Supplies (+A) 65
Cr. A/P (+L) 65
Dr. A/P (-L) 56
Cr. Cash(-A) 56
AJE:
Dr. A/P (-L) 9
Cr. Cash (-A) 9
Chapter 6:
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Operating Cycles – a series of activities that a company undertakes to generate
revenues and ultimately cash
o Service Companies – sell services rather than physical goods
 Simple operating system; sell service to customers, collect cash and pay
operating expenses
o Merchandising Companies – sell goods that have been obtained from a supplier
 Inventory (assets acquired for resale to customers) is sold to customers,
collect cash, pay operating expenses and buy more inventory
 Retailers, such as Walmart and Costco, sell directly to individual
consumers
 Wholesalers sell their inventory to retail business for resale to consumers
o Manufacturing Companies – sell goods they made themselves (not covered in
this course)
o Inventory is NOT the same as supplies (supplies are goods acquired for internal
use)
o Service vs. Merchandising
 Merchandisers report inventory as a current asset, servicers do not.
Instead they report supplies
 Service companies earn revenue from service; merchandisers earn
revenue from sales
 Merchandiser reports the Cost of Goods Sold expense, service companies
don’t because they don’t sell goods.
 Companies that operate as both separately report everything
Inventory Systems
o Sales Revenue and Cost of Goods Sold indicate the total selling price and cost of
all goods that the merchandiser sold to customers during the period
o Gross Profit = Net Sales – Costs of Goods Sold
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Profit earned before other expenses such as salaries, wages,
depreciation, etc. are taken into account
 Net Sales = Sales Revenue – Returns, Allowances, Discounts
o Cost of Goods Sold (CGS) – expresses the relationship between inventory on
hand, purchased, and sold
 Goods available for sale is the sum of beginning inventory and purchases
for the period
 Equation: BI + P - EI = CGS or BI + P – CGS = EI
 BI (Beginning Inventory), P (Purchases), EI (Ending Inventory)
 Goods Available for Sale = BI + P
 When those goods are sold its reported under CGS (an expense) on the
income statement and those still on hand are reported as EI (an asset) on
the balance sheet
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o Periodic Inventory System
 Ending Inventory and CGS are determined only at the end of the
accounting period based on a physical inventory count
o Perpetual Inventory System
 A detailed inventory record is maintained by recording each purchase
and sale of inventory during the accounting period. Walmart does this
and when the cashier scans the barcode it is recorded in their systems as
a revenue and also in the inventory
 Provides better control over inventory and allows the company to
estimate shrinkage (the cost of inventory lost to theft, fraud and error)
 When recording shrinkage, there is a debit to CGS and credit to
Inventory. In this system, the book-to-physical adjustment must be made
before the two accounts are completed
Recording Inventory PURCHASES
o Inventory Purchases
 Perpetual also automatically issues purchase orders to replenish
inventory on hand, however this is only a promise not a transaction. Once
the company receives the goods, then you record it into the system
o Transportation Cost
 Depending on terms of sale, the transportation cost (freight-in) may be
paid by the retailer or supplier
 FOB (Free on Board) Shipping Point – a term of sale indicating that says
the ownership of the goods being transferred become the retailer’s, so
they have the retailer pays the cost
 The transportation cost is recorded as an addition in the inventory
account, or anything else that is required to get the inventory
ready for sale. Costs incurred after the inventory is ready are
selling expenses.
 FOB Destination – a term of sale that the ownership of the goods being
transferred are still the seller’s until they reach the destination, so the
supplier incurs the costs
o Purchase Returns and Allowances
 A reduction in the cost of inventory purchases associated with
unsatisfactory goods
 Return – the buyer gets a full refund of what they paid from supplier
 Allowance – the buyer keeps the good but askes for a cost reduction from
supplier
 Accounted for by reducing the cost of inventory and either recording a
cash refund or reducing the liability owed to the supplier
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o Purchase Discounts
 A cash discount received for prompt payment of a purchase on account
 Reduces the cost of inventory
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This discount WILL NOT be applied to the trucking/shipping, unless the
shipping company offers a discount
Recording Inventory SALES
o FOB shipping point – the dale is recorded when the goods leave the seller’s
shipping department
o FOB destination – the sale is recorded when the goods reach their destination
(the customer)
 Unless otherwise stated, it is FOB shipping point meaning the buyer
covers the shipping cost
o Every merchandise sale has 2 components:
 Selling Price – recorded as an increase (credit) in Sales Revenue and debit
to cash or A/R
 Cost – Credit to Inventory and Debit to the expense account of Costs of
Goods Sold
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GROSS SALES = NET SALES – CGS
 NOT recorded into its own account, only shown on income
statement (difference between selling price and cost)
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NET SALES = SALES REVENUE – RETURNS AND ALLOWANCES OR
DISCOUNTS
o Sales Returns and Allowances
 Refunds and price reductions given to customers after goods have been
sold and found unsatisfactory
 Customer can return for full refund or ask for a reduction in selling price
known as an allowance
 When this happens, it is recorded under a contra-revenue (+xR, -SE)
account, which reduces Sales Revenue and keeps track of the value of
goods returned. Example:
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A sales return the results in issuing a store credit instead of a cash refund
is accounted for in the same way, except it’s a credit to Deferred Revenue
instead of a decrease in cash
 A sales allowances (i.e. a reduction in sales without the return of goods)
are the same too except the debit to inventory and credit to CGS is not
recorded
o Sales on Account and Sales Discounts
 Same as purchase discounts with the terms like “2/10 n/30”
 A company accounts for sales discounts either when the goods are first
sold (the net method) or later when payment is received (the gross
method)
 Net method is convenient when customer regularly take
advantage of discount, whereas gross method is more convenient
vice versa. The examples in the book use the gross method
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Then do this:
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Sales discounts are calculated after taking sales returns and allowance into
account
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Sales discounts ARE NOT reductions on selling price! Sales discounts
happen after initial sale has been made, and usually occur with
businesses. Normal consumers are not offered this and will only be able
to buy reduce priced items
o Summary:
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Multi-step Income Statement
o Presents important sub-totals, such as gross profits and CGS, to help distinguish
core operating results from other, less significant items that affect net income
o
Gross Profit Percentage
o The percentage of profit earned on each dollar of sales, after considering cost of
goods sold
o A higher ratio means that a greater profit is available to cover operating and
other expenses
o Formula:
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o Can be used to analyze changes in company’s operations, to compare companies
and determine whether a company is earning enough on each sale to cover
expenses
Bundle – when a company sells both a service and product
o To record revenue, figure out what percentage of the service to customer is a
service or product. Distribute the revenue and report it normally
Chapter 7:
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Primary goals of Inventory Management:
o Maintain sufficient quantity, ensure inventory quality and minimize the cost of
acquiring/carrying inventory.
Types of Inventory:
o Merchandising companies hold merchandise inventory (duh)
o Manufacturing companies hold:
 Raw Materials Inventory – plastics, steel, fabrics, etc.
 Work in Process (WIP) Inventory – goods in the process of being
manufactured
 Finished Goods Inventory – ready for sale
o Consignment Inventory – goods held on behalf of the owner, reported on the
balance sheet of the owner, not the company
o Goods in Transit – inventory items being transported, reported on the balance
sheet of the owner, not the company
Inventory Costing Methods
o Specific Identification – the cost of the item sold is the exact same price as the
actual cost paid for the item
 The question will ask for a specific sale, like half of the sale was from the
beginning inventory and the other half was from a different purchase.
Just take the number of units sold in the sale, multiply it by the percent
and multiply that answer by the unit cost (not sale price, the cost).
 Based on the physical flow of inventory, the other two are based on
assumptions
o First In, First Out (FIFO) – the oldest goods are sold first, the ending inventory is
the newer stuff.
o Weighted Average – weighted average cost per item is assigned
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Moving average is used with perpetual systems
Weighted average is used with periodic systems
First find the Total Cost of Goods Available for Sale – multiply the # of
units at each cost by the cost per unit and add them all together
 Ex. Item 1 Cost = $70, Item 2 = $75, Item 3 = $95
o Avg. Cost = ($70 +75 + 95) ÷ 3 = $80
o So if two items were sold, the CGS is $180, recorded on
Income Statement
 The EI is now $80, recorded on Balance Sheet
 Formula = Cost of Goods Available for Sale ÷ Number of Units Available
for Sale
o These methods are when a company uses a periodic inventory system, also
assume no shrinkage
o Financial Statement Effects
 When costs are rising
 FIFO produces: ↑ inventory value, ↓ CGS, ↑ NI, ↑ Income Tax
Expense
 Makes the balance sheet appear stronger, the lower CGS makes
the company look more profitable
 When costs are falling
 FIFO produces: ↓ inventory value, ↑ CGS, ↓ NI, ↓ Income Tax
Expense
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INVERSE RELATIONSHIP BETWENN EI AND CGS
These are not “real” economic effects because the inventory cost flow
assumption does not affect the number of units sold or held in EI
o When faced with increasing costs per unit, a company that uses FIFO will have a
higher income tax expense
Lower of Cost and Net Realizable Value (LC&NRV)
o The value of Inventory can fall below its original cost because:
 It can be replaced by identical goods at a lower cost
 It has become outdated or damaged
o LC&NRV requires inventory to be written down when its net realizable value or
current replacement cost falls below its original historical cost. Can be referred
to as lower of cost and market value
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o Provides conservative valuations and matches the decline in value to the period
it occurred, better matching the revenues and expenses of that period.
o Inventory write-down steps:
 Determine which cost is lower: historical cost or NRV
 Record under the LC&NRV column
 Multiply each item’s LC&NRV by the # of units (quantity) to find the Total
LC&NRV
 Total Recorded Cost (from unadjusted balance) – Total LC&NRV = Writedown
 LC&NRV AJE:
 Dr. Cost of Goods Sold (+E, -SE) XX ← Write down amount!

Cr. Inventory (-A) XX
Inventory Turnover Analysis:
o The process of buying and selling inventory, which is repeated over and over
during each accounting period for each line of products
o
o
o For merchandisers, inventory turnover refers to buying and selling goods
o For manufacturers, it refers to producing inventory and delivering to customers
o Often, the company with a lower gross profit percentage has a faster inventory
turnover
Chapter 8:
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Extending Credit
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o Large companies will extend credit (like A/R or N/R) to its customers (suppliers)
but not the induvial consumer
o Advantages:
 Increased revenue (gross profit) can be made by giving customers more
time to pay the amount owed
o Disadvantages:
 Increased wage costs – have to hire credit and collection department
employees
 Bad debt costs – amount owed not collected
 Delayed receipt of cash – 30-60 days till customer pays, so may need to
take a short-term loan to fund operations
o Often, the increased revenue is greater than the increase costs
Accounts Receivable – amounts owed to a business, arises from sale of goods or
services on credit
Bad Debt Expense – estimated amount of the period’s credit sales that customers will
fail to pay
When accounting for A/R and BDE:
o 1. Report A/R at the amount the company expect to collect (NRV)
o 2. Match the BDE to the accounting period the credit sale was made
 Same outcome: reduced A/R and NI by BDE
Record Bad Debts in the same period as the sale! – might need to do an estimate, can
be adjusted later
Allowance Method:
o Reduces A/R (and NI) for an estimated bad debt
o 2 Steps:
 1. Make an end-of-period adjustment to record the estimated bad debts
in the same period as the credit sales
 2. Remove (“write-off”) specific customer balances when they are known
to be uncollectable
o 1. Adjust for Estimated Bad Debts
 Reduce A/R using a contra-asset account called Allowance for Doubtful
Accounts – these are permanent, balance sheet accounts!
 Reduce Net Income using an expense called Bad Debt Expense – these
are temporary, income statement accounts!
 Dr. Bad Debt Expense (+E, -SE) XX

Cr. Allowance for Doubtful Accounts (+xA, -A) XX
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Accounts Receivable, Net of Allowance is NOT an account! It is a subtotal,
also known as Net Realizable Value!!
 Usually, companies will keep a track of their A/R and who owes what
internally (called a subsidiary account), and just put a total of that on the
external balance sheet
o 2. Remove (Write-Off) Specific Customer Balances
 When it becomes clear that the customer isn’t going to pay, then the
customer’s account is removed from the A/R. No need to make allowance
for it, so company removes the Allowance for Doubtful Accounts too.
 Write-off: removing the uncollectible account and a corresponding
amount from the allowance. DOES NOT affect income statement
 Dr. Allowance for Doubtful Accounts (-xA, +A) XX

Cr. Accounts Receivable (-A) XX
o Summary:
o
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Methods for Estimating Bad Debts
o Percentage of Credit Sales Method:
 This method estimates bad debts based on the historical percentage of
sales that lead to bad debt losses. Also called the income statement
approach.
 Bad Debt Expense x historical percentage of bad debt losses
 FORMULA: Credit Sales of the month * Bad Debt loss rate = Bad Debt
Expense of the month

o Aging of Accounts Receivable Method:
 Estimates uncollectable accounts based on the age of each account
receivable. Also called the balance sheet approach
 Focuses on estimating the ending balance in the Allowance for Doubtful
Accounts
 The older and more overdue an account receivable becomes, the less
likely it is to be collectable
 This method is generally more accurate
 Steps:
 1. Prepare an aged listing of account receivable
 2. Estimate bad debt loss percentages for each category – higher
percentages are applied to increasingly older receivables
 3. Compute the total estimate – from across all the aging
categories (the entire row of the estimate uncollectable)
o This is the DESIRED balance in the Allowance for Doubtful
Accounts, NOT the amount of the adjustment
o To determine the ADJUSTMENT, see the difference
between the current balance and the desired one and see
what needs to be debited or credited to get the desired
amount

o Revising Estimates
 Bad debt are estimates and may be different from actual
 If there is a difference, companies must revise them for the current
period by either lowering or raising estimates.
o Account Recoveries
 The customer that was written off actually pays
 Recovery - Collection of a previously written-off account, done in two
parts:
 1. Put receivable account back into books (opposite of write-off
transaction) – DOES NOT affect Net Income
 2. Record collection of amounts
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Note receivable – formal written contract (note) outlining the terms by which a
company will receive the amount owed
o Generally, charge interest from the day signed to collection
o Stronger legal claim, however, long to make, so less frequent
o Typically, when a company sells large dollar value items like cars, offers extended
payment periods, or lends money to individual or businesses.
Calculating Interest – I = prt
o P = principal, the amount of the N/R
o R = annual interest rate
o T = the time period, must match R
 Assume number of months out of 12
 In reality, Canada uses 365 days
Recording Notes Receivable and Interest Revenue:

o 1. Establishing the note
 Dr. Note Receivable (+A) XX

Cr. Cash (-A) XX
 Interest is not recorded when the note is established; it’s earned
over time
o 2. Accruing Interest Earned
 Under accrual basis accounting, interest revenue is recorded when it is
earned. Most companies will wait till they either receive a payment or it’s
the end of the accounting period.
 Use the interest formula to find the interest earned and make an AJE
 Dr. Interest Receivable (+A) XX

Cr. Interest Revenue (+R, +SE) XX
o 3. Recording Interest Received
 Find all the remaining interest revenue left to be earned and put it under
interest revenue, and credit the receivables
 Dr. Cash (+A) XX

Cr. Interest Receivable (-A) XX

Cr. Interest Revenue (+R, +SE) XX
o 4. Recording Principal Received
 Dr. Cash (+A) X-Principal-X

Cr. Note Receivable (-A) X-Principal-X
o Uncollectable Notes – make an Allowance for Doubtful Accounts against the
Notes Receivable
Receivables Turnover Analysis:
o Process of selling and collecting on account
o
o Managers, directors, investors and creditors can evaluate the effectiveness of a
company’s credit-granting and collection activities by using this

o
o Receivables Turnover Ratio determines the average
 Higher the ratio, the faster the collection, the shorter the operating cycle,
meaning more cash available for running the business
 Low turnover ratio suggests that the company is allowing too much time
for customers to pay
o Days to collect – measures the average number of days it takes
Speeding up Collectables:
o Factoring Receivables: An arrangement where receivables are sold to another
company (called a factor) for immediate cash (minus a factoring fee).
o Credit Card Sales: allows a company to receive cash quickly, reduces bad debts,
but the credit card companies charge a fee.
Chapter 9:

Long-lived Assets – resources owned by a business that enable it to produce the goods
or services that are sold to customers; “productive” assets
o Use over one or more years
o Not intended for resale
o Tangible Assets (Fixed Assets)
 Physical substance, can actually see/touch
 Property, Plant, and Equipment – like land, buildings, machinery, vehicles,
office equipment, and furniture
 Land improvements – something that improve the usefulness of the
land; includes sidewalks, pavement, landscaping, fencing, lighting, etc.
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These deteriorate over time, whereas Land never depreciates
(doesn’t lose its value)
Construction in progress – costs of constructing new buildings and
equipment. When the construction is finished, these costs are moved
into the building or equipment account they relate to.
Acquisition:
 All reasonable and necessary costs to acquire and prepare an
asset for use is recorded as a cost of the asset

o Intangible Assets
 Special rights; no physical substance
 Includes brand names, trademarks, and licensing rights
o Natural Resources
 When a company’s natural resource is depleted, they gain inventory but
have accumulated depletion (so it’s like depreciation, but there is no
expense)
 Ex. A timber company cuts down some wood
 Dr. Timber Inventory (+A) 100

Cr. Accumulated Depletion (+xA, -A) 100
o