Chapter 4 Terms Book Value: the diff between the cost of a depreciable asset and its related accumulated depreciation. Contra Asset Account: an account that is offset against an asset account on the balance sheet. Accrued revenues: revenues for services performed but not yet received in cash or recorded. Accrued expenses: expenses incurred but not yet paid in cash or recorded. Expense recognition principle: The principle that companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue. Revenue recognition principle: The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Quality of earnings: Indicates the level of full and transparent information that a company provides to users of its financial statements. Accrual-basis accounting: Accounting basis in which companies record, in the periods in which the events occur, transactions that change the companies’ financial statements, even if cash was not exchanged. Accruals: expenses or revenues that are recognized at a date earlier than the point when cash is exchanged. Deferrals: expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. Also known as prepaid expenses. Cash-basis accounting: Accounting basis in which a company records revenue only when it receives cash and an expense only when it pays cash. Adjustments: Changes made to accounts at the end of an accounting period to ensure that the revenue recognition and expense recognition principles are followed. Fiscal year: an accounting period that is one-year long. Unearned revenues: cash received and a liability recorded before services are performed. Periodicity assumption: an assumption that the economic life of a business can be divided into artificial time periods. Prepaid expenses (prepayments): expenses paid in cash before they are used or consumed. Earnings management: the planned timing of revenues, expenses, gains, and losses to reduce volatility in reported net income. Depreciation: the process of allocating the cost of an asset to expense over its useful life. Useful life: the length of service of a productive asset. Accrual Basis Accounting example. Adjustments for Supplies 6 months have passed from July 1 to December 31st. To determine the cost per month, divide $9840 by 24 months since they paid for a 2 year contract. Cost per month is 410. In December 31, they lost -2460 in prepaid insurance and was filed as an expense. Chapter 5 Internal Control: is a process designed to provide reasonable assurance regarding the achievement of company objectives related to operations, reporting, and compliance. Internal control systems have five primary components:1 1. A control environment. It is the responsibility of top management to make it clear that the organization values integrity and that unethical activity will not be tolerated. This component is often referred to as the “tone at the top.” 2. Risk assessment. Companies must identify and analyze the various factors that create risk for the business and must determine how to manage these risks. 3. Control activities. To reduce the occurrence of fraud, management must design policies and procedures to address the specific risks faced by the company. 4. Information and communication. The internal control system must capture and communicate all pertinent information both down and up the organization, as well as communicate information to appropriate external parties. 5. Monitoring. Internal control systems must be monitored periodically for their adequacy. Significant deficiencies need to be reported to top management and/or the board of directors. The six principles of control activities are as follows (see Decision Tools). Establishment of responsibility -An essential principle of internal control is to assign responsibility to specific employees Segregation of duties is indispensable in an internal control system. There are two common applications of this principle: 1. Different individuals should be responsible for related activities such as purchasing and sales. 2. The responsibility for recordkeeping for an asset should be separate from the physical custody of that asset. Documentation procedures 1. Whenever possible, companies should use prenumbered documents, and all documents should be accounted for. Prenumbering helps to prevent a transaction from being recorded more than once, or conversely, from not being recorded at all. 2. The control system should require that employees promptly forward source documents to the accounting department. This control measure helps to ensure timely recording of the transaction and contributes directly to the accuracy and reliability of the accounting records. Physical controls Independent internal verification 1. Companies should verify records periodically or on a surprise basis. 2. An employee who is independent of the personnel responsible for the information should make the verification. 3. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action. Human resource controls include the following: 1. Bond employees who handle cash. 2. Rotate employees’ duties and require employees to take vacations. 3. Conduct thorough background checks. A bank reconciliation is the process of comparing the bank’s balance with the company’s balance, and explaining the differences to make them agree. Bank Reconciliation Process Step 1 Deposits in transit (+). Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips for the current period. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit. Add these deposits to the balance per bank. Step 2 Outstanding checks (−). The process of determining outstanding checks is shown in Illustration 5.10. Compare the paid checks shown on the bank statement or the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation, and (b) checks issued by the company recorded as cash payments in the current period. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks. Deduct outstanding checks from the balance per bank. ILLUSTRATION 5.10 Determining outstanding checks at end of period Checks That Could Have Been Processed Checks That Were Checks Yet to Be Processed Processed Outstanding checks at beginning of period + Checks recorded in company’s books this period − Checks recorded on this period’s bank statement = Outstanding checks at end of period Step 3 Bank errors (+/−). Note any errors made by the bank that were discovered in the previous steps. For example, if the bank processed a deposit of $1,693 as $1,639 in error, the difference of $54 ($1,693 − $1,639) is added to the balance per bank on the bank reconciliation. All errors made by the bank are reconciling items in determining the adjusted cash balance per the bank. Reconciling Items per Books Reconciling items on the book side relate to amounts not yet recorded on the company’s books but recognized on the bank records. They include adjustments from deposits and other amounts added, payments and other amounts deducted, and company errors (if any). Step 4 Other deposits (+). Compare the other deposits on the bank statement with the company records. Any unrecorded amounts should be added to the balance per books. For example, if the bank statement shows electronic funds transfers from customers paying their accounts online, these amounts should be added to the balance per books on the bank reconciliation to update the company’s records unless they had previously been recorded by the company. Step 5 NSF checks and other payments (−). Similarly, any unrecorded NSF checks or other payments should be deducted from the balance per books. For example, if the bank statement shows service charges (such as debit and credit card fees and other bank service charges), this amount is deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records. Normally, the company will already have recorded electronic payments. However, if this has not been the case then these payments must be deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records. Step 6 Book errors (+/−). Note any errors made by the depositor that have been discovered in the previous steps. For example, say the company wrote check No. 443 to a supplier in the amount of $1,226 on April 12, but the accounting clerk recorded the check amount as $1,262. The error of $36 ($1,262 − $1,226) is added to the balance per books because the company reduced the balance per books by $36 too much when it recorded the check as $1,262 instead of $1,226. Only errors made by the company, not the bank, are included as reconciling items in determining the adjusted cash balance per books. Bank Reconciliation Adjustments Collection of Electronic Funds Transfer A payment of an account by a customer is recorded in the same way, whether the cash is received through the mail or electronically. The adjustment increases Cash and decreases Accounts Receivable $1,035. Book Error An examination of the cash disbursements records shows that check No. 443 was a payment on account to Andrea Company, a supplier. The correcting adjustment increases Cash and Accounts Payable $36. NSF Check As indicated earlier, an NSF check becomes an accounts receivable to the depositor. The adjustment increases Accounts Receivable and decreases Cash $425.60. Bank Charges Expense Fees for processing debit and credit card transactions normally increase the Bank Charges Expense account, as do bank service charges. We have chosen to combine and record these in a single adjustment, as the following shows, although they also could be recorded separately. The adjustment increases Bank Charge Expense and decreases Cash $150. After Laird records these adjustments, the Cash account will appear as in Illustration 5.12. The adjusted cash balance should agree with the adjusted cash balance per books in the bank reconciliation in Illustration 5.11. Reporting Cash Companies report cash in two different statements: 1. The balance sheet reports the amount of cash available at a given point in time. 2. The statement of cash flows shows the sources and uses of cash during a period of time. Restricted Cash A company may have restricted cash, cash that is not available for general use but rather is restricted for a special purpose. Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the company expects to use the restricted cash within the next year, it reports the amount as a current asset. When this is not the case, it reports the restricted funds as a noncurrent asset. Cash Budgeting Chapter 6 6.1 Merchandising Operations and Inventory Purchases The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses. 1. Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods. 2. Operating expenses are incurred in the process of earning sales revenue. Examples include advertising expense and rent expense. Note that operating expenses are a category of expenses, not a single line item on the income statement. Summary of Purchasing Transactions The following tabular summary shows the effect of Sauk Stereo’s previous transactions on Inventory: 1. Sauk Stereo originally purchased $3,800 worth of inventory on account for resale. 2. It paid $150 in freight charges. 3. It then returned $300 of goods. 4. It received a $70 discount off the balance owed because it paid within the discount period. This results in a balance in Inventory of $3,580. INCOME STATEMENT FROM SALES Multiple-Step Income Statement The multiple-step income statement has three important line items: gross profit, income from operations, and net income. They are determined as follows. 1. Subtract cost of goods sold from net sales to determine gross profit. 2. Deduct operating expenses from gross profit to determine income from operations. 3. Add or subtract the results of activities not related to operations to determine net income. Gross Profit Rate = Gross Profit / Net Sales x 100% Profit Margin= Net Income / Net Sales x 100% Example
