Accountings Summary OUTLINE

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1 Accountings Summary OUTLINE 1. Accounting and Business Environment 2. Recording Business Transaction 3. The Adjusting Process 4. Completing the Accounting Cycle 5. Merchandising Operations 6. Accounting for Merchandise Inventory 7. Accounting Information System 8. Internal Control and Cahs 9. Receivables 10. Property, Plan, and Equipment; and Good will and Intangible Assets 11. Current Liabilities and Payroll

2 Preface This is a summary of Accounting Fundamentals I, II at the class using the text book and powerpoint except Chapter 7, 9, 11 which aren t dealt at the class. Payroll was another course. There might be errors which I tried but couldn t find, so please take this on your risk. Table of Contents Part 1. The Basic Structure of Accounting... 5 Chapter 1. Accounting and Business Environment... 5 a. Accounting: Language of Business b. Business Forms c. Accounting Concepts d. Accounting Equation e. Financial Statements Chapter 2. Recording Business Transaction... 9 a. The Accounting Cycle b. Accounting Systems c. Chart of Accounts d. Double-Entry Accounting e. Expanding the Rules of Debit and Credit: Revenues and Expenses f. Normal Balance of an Account g. Source Document h. Recording Transaction in the Journal i. Posting (Transferring Information) from the Journal to the Ledger j. Trial Balance Chapter 3. The Adjusting Process a. The Time-Period Assumption b. Recognition Criteria for Revenues c. Recognition Criteria for Expenses d. Adjusting the Accounts Chapter 4. Completing the Accounting Cycle a. Accounting Work Sheet b. Permanent and Temporary Accounts c. Four Steps of Closing the Accounts d. Classifying Assets and Liabilities e. Accounting Ratios Chapter 5. Merchandising Operations Accounting Summary Page 2

3 a. Merchandising Company b. Inventory System c. Perpetual Inventory System d. Multi Level Income Statement in a Perpetual Inventory System e. Periodic Inventory System f. Multi Level Income Statement in a Periodic Inventory System Chapter 6. Accounting for Merchandise Inventory a. Inventory Costing Method b. Inventory Records, Journalize, and Calculate Gross Margin c. Accounting Concepts and Inventories d. NCNRV(lower-of-cost-and-net- realizable-value) rule e. Effects of Inventory Errors f. Ethical Issues Chapter 7. Accounting Information System a. Effective Accounting Information System(AIS) b. Computerized Accounting System c. Chart of Accounts Structure d. Processing Transactions e. Sales Journal f. Subsidiary Ledger g. The Cash Receipts Journal h. The Purchase Journal i. The Cash Payments Journal j. General Journal k. The Credit Memo Recording Sales Returns and Allowances l. The Debit Memo Recording Purchase Returns and Allowances Part 2 Accounting for Assets and Liabilities Chapter 8. Internal Control and Cash a. Internal Control b. Bank Account as a control device c. The Bank Reconciliation d. The Six Steps to reconcile a Bank Statement Chapter 9. Receivables a. Receivables b. Account for Uncollectible Accounts (Bad Debts) c. The Allowance Method d. Estimating Uncollectibles e. The Direct Write-Off Method f. Credit-Card Sales Accounting Summary Page 3

4 g. Debit-Card Sales h. Notes Receivable i. Reporting Receivables on the Balance Sheet: Actual Company Reports j. Using Accounting Information for Decision Making k. Discounting (Selling) a Note Receivable Chapter 10. Property, Plan, and Equipment; and Goodwill and Intangible Assets a. Tangible Long-term Asset PPE(Property, Plant, and Equipment) b. Lump-sum purchase of assets c. Betterments (Asset) vs. Repairs (Expense) d. Ethical Issues e. Amortization f. CCA(Capital Cost Allowance) g. Amortization for partial year h. Using Fully Amorted Asset i. Discarding or Selling Property, Plant, and Equipment j. Account for natural resources k. Future Removal and Site Restoration Costs l. Account for goodwill and intangible assets m. Specific Intangibles Chapter 11. Current Liabilities and Payroll a. Current Liabilities b. Goods and Services Tax, Harmonized Sales Tax, and Sales Tax Payable c. Goods and Services Tax (GST) d. Harmonized Sales Tax (HST) e. Provincial Sales Tax (PST) Accounting Summary Page 4

5 Part 1. The Basic Structure of Accounting Chapter 1. Accounting and Business Environment a. Accounting: Language of Business Accounting is an information system that: Measures business financial activities Processes that information into reports Communicates that information to decision makers Type Decisions Users Financial Accounting Should I invest in this business? Am I receiving an adequate return? Can we lend this company money? Managerial Accounting Is this product line profitable? Should we open a new branch? When should we order more inventory? b. Business Forms Investor Bank Manager & CEO Internal Control Type Sole proprietorship Partnership Details You are the sole owner, and fully responsible for all debts and obligations related to your business. All profits are yours to keep. Because you are personally liable, a creditor can make a claim against your personal assets as well as your business assets in order to satisfy any debts. Advantages: Easy and inexpensive to register. regulatory burden is generally light You have direct control of decision making. Minimal working capital required for start-up. Some tax advantages if your business is not doing well (for example, deducting your losses from your personal income, and a lower tax bracket when profits are low) All profits go to you directly Disadvantages: Unlimited liability (if you have business debts, claims can be made against your personal assets to pay them off) Income is taxable at your personal rate and, if your business is profitable, this could put you in a higher tax bracket Lack of continuity for your business if you are unavailable Non-incorporated business that is created between two or more people. In a partnership, your financial resources are combined with those of your business partner(s), and put into the business. You and your partner(s) would then share in the profits of the business according to any legal agreement you have drawn up. In a general partnership, each partner is jointly liable for the debts of the Accounting Summary Page 5

6 Corporation partnership. In a limited partnership, a person can contribute to the business without being involved in its operations. A limited liability partnership is usually only available to a group of professionals, such as lawyers, accountants or doctors. When establishing a partnership, you should have a partnership agreement in place. This is important because it establishes the terms of the partnership and can help you avoid disputes later on. Hiring a lawyer or other legal professional to help you draw up a partnership agreement will save you time and protect your interests. Advantages: Fairly easy and inexpensive to form a partnership Start-up costs are shared equally with you and your partner(s) Equal share in the management, profits and assets Tax advantage if income from the partnership is low or loses money (you and your partner(s) include your shares of the partnership in your individual tax returns) Disadvantages: There is no legal difference between you and your business Unlimited liability (if you have business debts, personal assets can be used to pay off the debt) Can be difficult to find a suitable partner Possible development of conflict between you and your partner(s) You are held financially responsible for business decisions made by your partner(s); for example, contracts that are broken Legal issues for small business Another type of business structure is a corporation. Incorporation can be done at the federal or provincial/territorial level. When you incorporate your business, it is considered to be a legal entity that is separate from its shareholders. As a shareholder of a corporation, you will not be personally liable for the debts, obligations or acts of the corporation. It is always wise to seek legal advice before incorporating. Advantages: Limited liability Ownership is transferable Continuous existence Separate legal entity Easier to raise capital than it might be with other business structures Possible tax advantage as taxes may be lower for an incorporated business Disadvantages: A corporation is closely regulated More expensive to set up a corporation than other business forms Extensive corporate records required, including documentation filed annually with the government Possible conflict between shareholders and directors You may be required to prove residency or citizenship of directors Accounting Summary Page 6

7 c. Accounting Concepts Develop common guidelines for how accountants measure, process, and communicate financial information, known as General Accepted Accounting Principles (GAAP). Canada has joined much of the developed world in adopting International Financial Reporting Standards (IFRS) as its GAAP for Publicly Accountable Enterprises. Assumption, Principles The Reliability Characteristic The Economic-Entity Consideration The Going-Concern Assumption The Stable-Monetary-Unit Assumption The Cost Principle of Measurement Cost/Benefit and Materiality Details In order to accounting information to be useful, it must be reliable Accurately represents the impact of the transaction Is free of error or bias Each entity is accounted for separately and distinctly from other entities (organizations and persons) We assume that an entity will remain in operation for the foreseeable future The dollar s purchasing power is relatively stable This allows accountants to ignore the effect of inflation in the accounting records Acquired assets and services should be recorded at their actual cost Also known as original or historical cost The benefits from the information produced should out-weigh the time, effort and cost to produce it Accounting Summary Page 7

8 d. Accounting Equation Equation Basic Net Income Owner s Equity Extended Details Assets = Liabilities + Owner's Equity Net Income = Revenues Expenses Owner's Equity = Owner's Capital Owner's Withdrawals + Revenues Expenses Assets = Liabilities + Owner's Capital Owner's Withdrawals +Revenues Expenses e. Financial Statements Financial statements are the formal reports of an entity s financial information The primary financial statements, in order of preparation, are: 1. Income statement presents a summary of the revenues and expenses of an entity for a period of time 2. Statement of owner s equity presents changes in OE for a period of time 3. Balance sheet (statement of financial position) lists all the assets, liabilities, and owner s equity of an entity as of a specific date 4. Cash flow statement reports the cash coming in and the cash going out during a period (covered in Chapter 17) Accounting Summary Page 8

9 Chapter 2. Recording Business Transaction a. The Accounting Cycle 1. Identify and analyze transactions 2. Record transactions in a journal 3. Post (copy) from the journal to the accounts in the ledger 4. Prepare the unadjusted trial balance 5. Journalize and post adjusting entries 6. Prepare the adjusted trial balance 7. Prepare the financial statements 8. Journalize and post the closing entries 9. Prepare the post-closing trial balance b. Accounting Systems ACCOUNT analyze the transaction to identify changes in accounts; for example, an account is required for Cash (bank account) transactions JOURNAL accountants record transactions first in a journal; chronological record of transactions LEDGER copy (post) the data to the ledger; like a binder, with each page in the binder representing one account TRIAL BALANCE a list of all the ledger accounts and their balances c. Chart of Accounts List of all accounts used by the entity. Account names are listed along with the account numbers. The numbering system often follows a general structure. Account numbers begin with: 1 = Assets 2 = Liabilities 3 = Owner s Equity 4 = Revenues 5 = Expenses d. Double-Entry Accounting Accounting uses the double-entry system. Every transaction affects at least two Accounts The owner invests $250,000 into a new business ASSETS = LIABILITIES + OWNER S EQUITY +250,000 +$250,000 e. Expanding the Rules of Debit and Credit: Revenues and Expenses Assets, Withdrawals, and Expenses An increase is recorded as debit (left side) A decrease is recorded as credit (right side) Accounting Summary Page 9

10 Liabilities, Capitals, and Revenues A decrease is recorded as debit (left side) An increase is recorded as credit (right side) Contra-accounts Contra-accounts behave exactly in opposite way to the respective normal accounts. f. Normal Balance of an Account The normal balance appears on the side of the account where increases are recorded Depending on the account, this could be a debit or credit The normal balances are: o Asset accounts = debit o Liability accounts = credit o Capital accounts = credit o Revenue accounts = credit o Expense accounts = debit o Withdrawal accounts = debit g. Source Document Source documents are the evidence of a transaction Bank deposit slip shows amount of money received by the business and deposited in the bank Purchase invoice Document that tells the business how much to pay and when to pay the vendor. Bank cheque Document that tells the amount and the date of cash payments. Sales invoice Document sent to the customer when a business sells goods or services and tells the business how much revenue to record h. Recording Transaction in the Journal Journalizing a transaction is the chronological record of the entity s transaction Process of journalizing transactions is as follows: Accounting Summary Page 10

11 Transaction: identify the transaction from the source documents Analysis: identify each account affected by the transaction Accounting Equation: apply the rules of debit and credit Journal Entry: record the transaction in the journal with an explanation or description i. Posting (Transferring Information) from the Journal to the Ledger Posting is the transferring of the data from the journal to the ledger The ledger tracks all transactions related to an account j. Trial Balance A trial balance summarizes the ledger by listing all accounts with their balances Assets first, followed by liabilities and then owner s equity, revenues and expenses A trial balance summarizes the ledger by listing all accounts with their balances Assets first, followed by liabilities and then owner s equity, revenues and expenses Accounting Summary Page 11

12 Chapter 3. The Adjusting Process a. The Time-Period Assumption Ensures that accounting information is reported at regular intervals Businesses need periodic (annual) reports on their progress. Fiscal year ends do not need to be the same as the calendar year end. Interim statements can be presented to support decision making: Monthly Quarterly Semi-annually b. Recognition Criteria for Revenues Revenue recognition states that revenue should be recognized when it is earned: Goods delivered or services completed; or Contractual agreements have been met Recognition criteria for revenues tell accountants: When to record revenue (it has been earned) The amount of revenue to record Record revenue equal to the cash value (not cash paid) of the goods or services (remember payment-in-kind) c. Recognition Criteria for Expenses Matching objective: a. Match expenses incurred with revenues earned during the accounting period (i.e. the cost of a product that has been sold); OR b. Match expenses incurred with appropriate time period (i.e. rent expense relates to a particular month) Definition of Expenses: cost of assets and services consumed when earning revenue. To match expenses against revenues means to subtract the related expenses from the revenue to compute net income (or net loss) d. Adjusting the Accounts Accrual-basis accounting requires adjusting entries at the end of the period in order to produce correct balances for the financial statements Accounting Summary Page 12

13 Prepaid expenses (or deferred expenses) are expenses paid in cash and recorded as assets prior to being used. o Debit Expense o Credit Prepaid Asset Unearned revenues (or deferred revenues) are revenues received in cash and recorded as liabilities prior to being earned. o Debit Unearned Revenue(Liability) o Credit Revenue Other adjusting entries include amortization of fixed assets, allowances for bad debts, and inventory adjustments. Amortization(depreciation) is the process of allocating the cost of property, plant, and equipment (PPE) to an expense account over its estimated useful life. Accumulated Amortization is a contra account to property, plant, and equipment assets. o Debit Amortization Expense o Credit Accumulated Amortization Asset Accrued expenses (also called accrued liabilities) are expenses already incurred but not yet paid or recorded. o Debit Expense o Credit Payable(Liability) Accrued revenues (also called accrued assets) are revenues already earned but not yet paid or recorded. o Debit Receivable o Credit Revenue Accounting Summary Page 13

14 Chapter 4. Completing the Accounting Cycle a. Accounting Work Sheet The difference between the Income Statement columns represents net income (or net loss) This amount must be reflected in the Balance Sheet, as it is part of the closing Capital balance b. Permanent and Temporary Accounts Permanent Permanent accounts, which includes Assets, Liabilities and Owner s Equity (the Capital account), are NOT closed at the end of the period. So, the ending balance of this period will be the beginning balance for next period. Temporary Revenues, expenses and withdrawals are set to zero after posting the closing entries. This allows measurement of each period s activities separately from other periods. These accounts are called temporary or nominal accounts c. Four Steps of Closing the Accounts Closing accounts occurs at the end of the period. Prepares the accounts for recording the transactions of the next period 1. Closing the revenue accounts transferring the credit balances in the revenue accounts to a clearing account called Income Summary. o Debit Revenue o Credit Income Summary 2. Closing the expense accounts transferring the debit balances in the expense accounts to a clearing account called Income Summary. o Debit Income Summary o Credit Expense 3. Closing the Income Summary account transferring the balance of the Income Summary account to the Capital account. Accounting Summary Page 14

15 a. A credit in the Income Summary account = net income Debit Income Summary Credit Capital b. A debit in the Income Summary account = net loss Debit Capital Credit Income Summary 4. Closing the Withdrawal account transferring the debit balance of the Withdrawal account to the Capital account. o Debit Capital o Credit Withdrawal d. Classifying Assets and Liabilities Assets and liabilities are classified in terms of their relative liquidity(how quickly an item can be converted to cash) Current assets are assets that are expected to be converted to cash, sold, or consumed during the next 12 months (or within the business s normal operating cycle if longer than a year) Cash, Accounts receivable Notes receivable, due within a year Supplies Prepaid expenses Inventory Long-term assets: Assets not classified as current Property, plant, and equipment (land, buildings, furniture and fixtures) Goodwill and intangibles Long-term investments Current liabilities are debts due to be paid within one year or within the operating cycle Accounts payable Notes payable, due within a year Salaries payable, Taxes payable, and Interest payable Unearned revenue Long-term liabilities: Liabilities not classified as current Long-term notes payable due after one year e. Accounting Ratios Decision makers use ratios computed from financial statements to assess financial position. Current ratio is a comparison of current assets to current liabilities, calculated by dividing your current assets by your current liabilities. Potential creditors use the current ratio to measure a company's liquidity or ability to pay off short-term debts. o Current Ratio = Total Current Assets Total Current Liabilities The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors. A high debt ratio indicates that a corporation has a high level of financial leverage. o Debt Ratio = Total Liabilities Total Assets Accounting Summary Page 15

16 Chapter 5. Merchandising Operations a. Merchandising Company A merchandising entity earns its revenue by selling products, called merchandise inventory or, simply, inventory. b. Inventory System Type Details Perpetual be debited when there is a purchase of goods (there is no Purchases account) be credited for the cost of the items sold (and the account Cost of Goods Sold will be debited) have its balance continuously or perpetually changing because of the above entries require a physical inventory to correct any errors in the Inventory account require a cost flow assumption (FIFO, LIFO, average) Periodic have a constant balance (the ending balance from the previous period) not include the cost of purchases (they are recorded in a Purchases account) be adjusted at the end of the accounting period (so the balance reports the costs actually in inventory) require a physical inventory at least once per year (and estimates within the year) require a cost flow assumption (FIFO, LIFO, average) require a calculation of the cost of goods sold (to be used on the income statement) c. Perpetual Inventory System Perpetual inventory is a method of accounting for inventory that records the sale or purchase of inventory immediately through the use of computerized point-of-sale(pos) systems and enterprise asset management software Purchasing Inventory Purchase by cash or on account Debit Inventory Credit Cash or Account Payable Discounts on Purchase Quantity Discount: No account for Quantity Discount Purchase Discount: Cash Discount within the discount period. Debit Account Payable Credit Cash Credit Inventory Returns and Allowance on Purchase Debit Credit Account Payable Inventory Accounting Summary Page 16

17 Transportation Cost in Perpetual Inventory System Legal Title Terms FOB Shipping Point = CIF Destination Who owns the goods in transit? The Buyer owns the goods while they are in transit, so the buyer pays the Freight FOB Destination The Seller owns the goods while they are in transit, so the seller pays the Freight Freight-in: The Buyer pays the Freight Cost Buyer Debit Inventory Buyer Credit Cash or Account Payable Freight-out: The Seller pays the Fright Cost Seller Debit Delivery Expense Seller Credit Cash or Account Payable Add Inventory = Purchase of Inventory + Fright in Purchase Return and Allowance Purchase Discount(Cash Discount) Sales = Selling Inventory Sales by cash or on account Debit Credit Debit Credit Discounts on Sales Cash or Account Receivable Sales Revenue Cost of Goods Sold Inventory Quantity Discount: No account Sales Discount: Cash Discount within the discount period. Debit Cash Debit Sales Discount Credit Account Receivable Returns on Sales Debit Sales Returns and Allowances Credit Account Receivable Debit Inventory Credit Cost of Goods Sold Allowance on Sale Debit Sales Returns and Allowances Credit Account Receivable Adjusting Inventory based on a physical count Adjusting Entry = Inventory balance actual inventory on hand Debit Cost of Goods Sold Credit Inventory Accounting Summary Page 17

18 d. Multi Level Income Statement in a Perpetual Inventory System Net, Sales Revenue = Sales Revenue Sales Discount Sales Return and Allowances Gross Margin = Net, Sales Revenue Cost of Goods Sold Operating Expense = Selling Expense + General and administrative expenses Income from Operation = Gross Margin Operating Expenses Multi-Level Net Income Statement in a Perpetual Inventory System Sales Revenue 1 Less: Sales Discount 2 Sales Return and Allowances(R&A) 3 Net, Sales Revenue 4 = Cost of Goods Sold(COGS) 5 Gross Margin 6 = 4 5 Operating Expenses Amortization Expense Insurance Expense Rent Expense Salaries Expense Supplies Expense Total Operating Expense 7 = sum(operating Expenses) Income from operations 8 = 6 7 Other Revenue and Expenses Interest Revenue 9 Interest Expense 10 Net Income = Gross Margin Gross Margin Percentage = Net, Sales Revenue Cost of Goods Sold Inventory Turnover = Average Inventory = Cost of Goods Sold (Begining Inventory + Ending Inventory) 2 Accounting Summary Page 18

19 e. Periodic Inventory System Periodic inventory is a system of inventory in which updates are made on a periodic basis. This differs from perpetual inventory systems, where updates are made as seen fit. In a periodic inventory system no effort is made to keep up-to-date records of either the inventory or the cost of goods sold. Inventory is NOT adjusted with each transaction. Purchasing inventory Purchase by cash or on account Debit Purchase(Expense) Credit Cash or Account Payable Discounts on Purchase Debit Account Payable Credit Cash Credit Purchase Discount Returns and Allowance on Purchase Debit Account Payable Credit Purchase Returns and Allowances Sales = Selling inventory Selling by cash or on account Debit Cash or Account Receivable Credit Sales Revenue Discounts on Sales Debit Cash Debit Sales Discount Credit Account Receivable Returns and Allowance on Sales Debit Sales Returns and Allowances Credit Account Receivable f. Multi Level Income Statement in a Periodic Inventory System Net, Sales Revenue = Sales Revenue Sales Discount Sales Return and Allowances Net Purchase = Purchases Purchase Discounts Purchase Returns and Allowances Cost of Goods Available = Beginning Inventory + Net, Purchases + Freight-in Cost of Goods Sold = Cost of Goods Available Ending Inventory Gross Margin = Net, Sales Revenue Cost of Goods Sold Operating Expense = Selling Expense + General and administrative expenses Income from Operation = Gross Margin Operating Expenses Accounting Summary Page 19

20 Multi-Level Net Income Statement in a Periodic Inventory System Sales Revenue 1 Less: Sales Discount 2 Sales Return and Allowances 3 Net, Sales Revenue 4 = Cost of Goods Sold: Beginning Inventory 5 Purchases 6 Less: Purchase Discounts 7 Purchase Returns and Allowances 8 Net, Purchases 9 = Freight-in 10 Cost of Goods available for sale 11 = Less: Ending Inventory 12 Cost of Goods Sold 13 = Gross Margin 14 = 4 13 Operating Expenses Advertising Expense Amortization Expense Insurance Expense Rent Expense Salaries Expense Supplies Expense Total Operating Expenses 15 = sum(operating Expenses) Income from operations 16 = Other Revenue and Expenses Interest Revenue 17 Interest Expense 18 Net Income 19 = Accounting Summary Page 20

21 Chapter 6. Accounting for Merchandise Inventory a. Inventory Costing Method Companies determine the number of units from perpetual inventory records (verified by a physical count) Ending Inventory = Number of units on hand X Unit Cost Cost of Goods Sold = Number of units sold X Unit cost (Unit Cost = Purchase Price Purchase Discount Quantity Discount + Freight-in + Duties + Insurance) What would ending inventory and cost of goods sold be if the cost of goods changed? Method Details SPECIFIC UNIT COST (=specific id method) FIRST-IN, FIRST-OUT (FIFO) WEIGHTED-AVERAGE COST Moving-Weighted-Average Cost Uses the specific cost of each unit of inventory for items that have a distinctive identity Cost of goods sold is based on the oldest purchases Cost of goods sold is based on an average cost for the period A new weighted-average cost per unit is calculated after each purchase. Ending Inventory and COGS are based on the most recent weighted-average cost per unit b. Inventory Records, Journalize, and Calculate Gross Margin Example 1. At Beginning of November, Inventory on Hand : 10 Units as $6 of Total Cost 2. Nov. 5: Purchased 60 units at Unit Cost $0.65 (Total Cost:$39) 3. Nov. 15: Sold 30 units at Unit Price $ Nov. 26: Purchased 70 Units at Unit Cost $0.70 (Total Cost:$49) 5. Nov. 30: Sold 90 units at Unit Price $4.00 Accounting Summary Page 21

22 Inventory Record under FIFO Purchase Cost of Goods Sold Inventory on Hand Notes Date Qty Unit Cost Total Cost Qty Unit Cost Total Cost Qty Unit Cost Total Cost Nov.1 10 $0.60 $6 Remaining 5 60 $0.65 $39 10 $0.60 $6 Carryover 60 $0.65 $39 Add New $0.60 $6 FIFO 20 $0.65 $13 40 $0.65 $26 Remaining $0.70 $49 40 $0.65 $26 Carryover 70 $0.70 $49 Add New $0.65 $26 FIFO 50 $0.70 $35 20 $0.70 $14 Remaining Bal 130 $ $80 20 $14 Carryover On Sales, must use the Oldest Items First. COGS = Beginning Inventory + Purchase Ending Inventory = = 80 Journal under FIFO Date Accounts and Explanation P.R Debit Credit Jun.5 Inventory Cash Purchased Inventory(60 X 0.65 = 39) 15 Cash Sales Revenue COGS Inventory Sales Revenue = 30 X 4 = 120 COGS: 10 X X 0.65 = Inventory Cash Purchased Inventory(70 X 0.70 = 49) 30 Cash Sales Revenue COGS Inventory Sales Revenue = 90 X 4 = 360 COGS: 40 X X 0.70 = 61 Gross Margin under FIFO Sales Revenue = = 480 COGS = = 80 Gross Margin = = 400 Accounting Summary Page 22

23 Inventory Record under Moving Weighted Average Cost Purchase Cost of Goods Sold Inventory on Hand Notes Date Qty Unit Cost Total Cost Qty Unit Cost Total Cost Qty Unit Cost Total Cost Nov.1 10 $0.60 $ $0.65 $39 70 $0.64 $44.80 ($6+$39)/(10+60) $0.64 $ $0.64 $ $0.70 $ $0.68 $74.80 ($25.60+$49)/(40+70) $0.68 $ $0.68 $13.60 Bal 130 $ $ $13.60 Calculate New Unit Cost only on Purchases of Inventory DO NOT Unit Cost Calculate on Sales COGS = Beginning Inventory + Purchase Ending Inventory = = Journal under Moving Weighted Average Cost Date Accounts and Explanation P.R Debit Credit Jun.5 Inventory Cash Purchased Inventory(60 X 0.65 = 39) 15 Cash Sales Revenue COGS Inventory Sales Revenue = 30 X 4 = 120 COGS: 30 X 0.64 = Inventory Cash Purchased Inventory(70 X 0.70 = 49) 30 Cash Sales Revenue COGS Inventory Sales Revenue = 90 X 4 = 360 COGS: 90 X 0.68 = Gross Margin under Moving Weighted Average Cost Sales Revenue = = 480 COGS = = Gross Margin = = Note When Unit cost increase, Income inflated under FIFO costing Method Accounting Summary Page 23

24 c. Accounting Concepts and Inventories Several accounting concepts have special relevance to inventories Consistency Disclosure Materiality Accounting conservatism businesses should use the same accounting methods and procedures from period to period Consistency helps investors compare a company s financial statements from one period to the next The company s financial statements should report enough information for readers to make knowledgeable decisions about the company disclosing: The method used to value inventory Different categories of inventory (raw materials vs. work in process vs. finished goods inventories) States that a company must perform strictly proper accounting only for items that are significant to the business s financial statements Information is significant, or material, when its presentation in the financial statements would influence a decision or cause someone to change a decision States that items should be reported at amounts that lead to the most cautious immediate results Conservatism could be interpreted as: Anticipate no gains, but provide for all probable losses. If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount. When there s a question, record an expense rather than an asset. d. NCNRV(lower-of-cost-and-net- realizable-value) rule If the net realizable value (selling price) falls below historical cost, the business must write down the value of its inventory. Item No. Qty Unit Cost Market Price Selling Cost Total Cost Total Market Value A B C D E F G H Given Given Given Given = Qty X Unit Cost = Qty X Market Price =Total Market Value Selling Cost Impairment reversal or Write Down =A X B = A X C = F D =E G =D - A(C-B) 10 $16 $20 $99 $160 $200 $101 $59 Journalize Cost of Goods Sold 59 Inventory 59 To Record Impairment of inventory Accounting Summary Page 24

25 e. Effects of Inventory Errors Income Statement Overstated Understated Sales Revenue Correct Correct Cost of Goods Sold Beginning Inventory Correct Correct Net Purchase Correct Correct Cost of goods available for sales Correct Correct Ending Inventory ERROR: Overstated ERROR: Understated Cost of Goods Sold Understated Overstated Gross Margin Overstated Understated Operating Expense Correct Correct Net Income Overstated Understated f. Ethical Issues Companies whose profits do not meet expectations can be tempted to cook the books to increase reported income There are two main schemes for using inventory to increase reported income: Overstate ending inventory Sales schemes, such as manipulating the timing of recognizing sales In virtually every area, accounting imposes a discipline that brings out the facts sooner or later Accounting Summary Page 25

26 Chapter 7. Accounting Information System a. Effective Accounting Information System(AIS) Features Control Compatibility Flexibility Reports that meet users needs A favourable cost / benefit relationship Details Owners and managers must control the business Internal controls are methods and procedures used to: Authorize transactions Ensure adherence to management policy Safeguard assets and records Prevent and detect error and fraud Provide security by limiting access to assets and records Ensure that information produced is relevant, accurate, and timely A system that works smoothly with: The business s operations The personnel The organizational structure Organizations evolve, so the system should be able to accommodate changes without needing a complete overhaul An effective system should produce reports that meet user s needs and preferences System that offers maximum benefit at a minimum cost b. Computerized Accounting System Components of a Computerized Accounting System = Hardware + Server + Software + Personnel Accounting Summary Page 26

27 c. Chart of Accounts Structure d. Processing Transactions In a manual system, credit sales, purchases on account, cash receipts, and cash payments are treated as four separate categories Enterprise Resource Planning (ERP) Systems, such as SAP, Oracle, and PeopleSoft, can integrate all company data into a single data warehouse. Special Journals in a Manual System The types of special journals depends on the nature of the business, but a few types are frequently seen in businesses that rely on manual accounting procedures: Special Journal Details Sales Journal. Cash Receipts Journal. Purchases Journal. Cash Payments (disbursement) Journal. record all sales a business makes to customers on account, which means no money changes hands between the company and the customer at the time of the sale. record cash sales, customer payments on account, or interest and dividend payments. show purchases a company makes on account. show any payment the business makes using a form of cash. These entries include purchases transactions or payments on debt. Accounting Summary Page 27

28 e. Sales Journal f. Subsidiary Ledger A subsidiary ledger is a file (or book) of individual accounts that make up a total for a general ledger account. It is often used to provide details on individual balances of: Customers (accounts receivable) Suppliers (accounts payable) Accounting Summary Page 28

29 g. The Cash Receipts Journal Accounting Summary Page 29

30 h. The Purchase Journal Accounting Summary Page 30

31 i. The Cash Payments Journal Accounting Summary Page 31

32 j. General Journal Special journals save much time in recording repetitive transactions and posting to ledgers, but some transactions do not fit into any of the special journals. Adjusting and closing entries Amortization Expiration of prepaid expenses Accrual of salaries payable at the end of the period Most companies use the general journal for sales returns and allowances, and purchase returns and allowances. The document issued by the seller for a credit to the customer s account receivable is the credit memo. A debit memo is the business document that states that the buyer no longer owes the seller for the amount of the returned purchases Payroll journals record all payroll transactions, including gross wages, taxes withheld, and other deductions, such as health insurance paid by the employee, leading to net pay, which is the amount shown on the employee s check. k. The Credit Memo Recording Sales Returns and Allowances Most companies use the general journal for sales returns and allowances, and purchase returns and allowances The document issued by the seller for a credit to the customer s account receivable is the credit memo The journal entry would debit Sales Returns and Allowances and credit Accounts Receivable There would also be a debit to Inventory and a credit to Cost of Goods Sold if the perpetual inventory system is used l. The Debit Memo Recording Purchase Returns and Allowances A debit memo is the business document that states that the buyer no longer owes the seller for the amount of the returned purchases The entry would require a debit to Accounts Payable and a credit to Inventory Accounting Summary Page 32

33 Part 2 Accounting for Assets and Liabilities Chapter 8. Internal Control and Cash a. Internal Control Internal control defined: consists of the process designed and put in place by management to provide reasonable assurance that the organization will achieve its objectives of reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations Internal control objectives are: Encouraging operational efficiency Preventing and detecting error and fraud Safeguarding assets and records. Providing accurate, reliable information Components Control procedures Risk assessment Information system Monitoring of controls Environmental controls b. Bank Account as a control device Details this is the tone at the top of the business. Owners and its managers must behave in a way that sets a good example for employees a company must identify its risks companies need accurate information to keep track of assets, and measure profits and losses companies hire both internal and external auditors to monitor company controls measures in place that help ensure that the business world runs honestly and efficiently Cash is the most liquid asset of an organization. Cash s liquidity can be considered a disadvantage because it is the most easily stolen asset. Cash on hand Petty cash Cash on deposit in bank and trust companies Cash equivalent (Treasury Bills) c. The Bank Reconciliation There are two records of the business s cash: The Cash account in the company s general ledger The bank statement, which tells the actual amount of cash the business has in the bank The Cash balance in the general ledger often differs from the bank statement. d. The Six Steps to reconcile a Bank Statement. 1. Identify closing balances from Bank Statement and General Ledger (Book) Cash Account. Review Bank Reconciliation from prior month for reconciling items to Bank side; if the items Accounting Summary Page 33

34 have still not cleared the bank, include them on your new Bank Reconciliation. Compare Bank Statement and Book details, crossing-out all items that can be matched 2. Adjust the Bank Statement Balance for: (a) leftover items on the Book Cash Account; and Outstanding Cheques Deposits in transit (b) Bank errors 3. Adjust the Book Cash Balance for: (a) leftover items on the Bank Statement; and ETF Payment and Collection NSF Cheque Interest Earned or Expense Bank Charge (b) Book errors 4. Compute Adjusted Bank Balance and Adjusted Book Balance The two balances should be equal 5. Make journalize entries for all reconciling items for the Book side. Correct all book errors. This will make the Book Cash Balance equal to the reconciled bank balance 6. Notify the bank of any errors the bank has made. Accounting Summary Page 34

35 Chapter 9. Receivables a. Receivables A receivable arises when a business (or person) sells goods or services to another party on credit. A receivable also arises when one person lends money to another. Each credit transaction involves two parties: The creditor, who sells something and obtains a receivable, which is an asset The debtor, who makes the purchase and has a payable, which is a liability Types Details Accounts receivable Notes receivable Other receivables amounts to be collected from customers when a business sells goods or services on credit; listed on the balance sheet as a current asset a more formal receivable that includes a written promise to pay at a specific date due within one year or one operating cycle are current assets miscellaneous category that may include loans to employees. usually long-term receivables, but they are current assets if receivable within one year or less b. Account for Uncollectible Accounts (Bad Debts) Selling on credit provides both a benefit and a cost: The benefit = selling to a wide range of customers The cost = unable to collect from some customers Uncollectable accounts create a cost or expense called bad-debt expense, uncollectible-account expense, or doubtful-account expense. Bad-debt expense is an operating expense There is no one indicator that an account has become delinquent and will not be paid Some clues would be: Receivable is past due Customer does not respond to company calls or attempts to collect Customer files for bankruptcy or has closed The customer cannot be located c. The Allowance Method The allowance method records uncollectable amounts based on estimates developed from past experience Bad-debt expense is matched in the same period as the sales revenue (matching objective) A contra account to Accounts Receivable is set up called Allowance for Doubtful Accounts the allowance is the amount of receivables that the business expects not to collect The allowance is subtracted from Accounts Receivable, and a net amount is determined Accounting Summary Page 35

36 d. Estimating Uncollectibles Method Percent-of-Sales Method Aging-of-Accounts- Receivable Method Percent-of-Accounts- Receivable Method Details Computes bad-debt expense as a percent of net credit sales Also called the income statement approach because it focuses on the amount of expense It ignores the current balance of the Allowance account It is based on prior experience of the business This method is also called the balance sheet approach because it focuses on accounts receivable Individual accounts receivable from specific customers are analyzed according to the length of time they have been outstanding This is another balance-sheet-based method using a percentage of total accounts receivable outstanding Accounting Summary Page 36

37 Writing Off Uncollectible Accounts When the credit department determines that an account is deemed uncollectible, it must be written off Since the Allowance for Doubtful Accounts is a contra-asset account, the write-off of uncollectible accounts has no effect on total assets, liabilities, or equity Recovery of Accounts Previously Written Off Two entries are required one to reinstate the account and the second to collect the cash e. The Direct Write-Off Method Using this method, an account is written off only when it becomes uncollectible. No allowance account is created. This method is acceptable only when uncollectible accounts are very low, and is not part of GAAP This method does not match the expense against the revenue, resulting in: The balance sheet being overstated The income statement being understated The direct write-off method is defective for two reasons: It does not set up an allowance for doubtful accounts It does not match the bad-debt expense against revenue. f. Credit-Card Sales Retailers accept credit cards from customers to increase revenues. The retailer receives the amount of the sale less a discount fee from the credit card company The discount fee is usually 1%-5% of the sale amount The retailer does not need to keep accounts receivable records, will not need to deal with uncollectibles, and receives no cash from the customer Accounting Summary Page 37

38 g. Debit-Card Sales The journal entry for the business is the same as if a credit card was used this includes a fee for usage. The bank transfers the purchase amount, less a fee, into the business s account from the customer s account. h. Notes Receivable A promissory note is a written promise to pay a specified sum of money at a particular future date. A note receivable may arise from a sale or may be given in settlement of an account receivable The maker pays the payee the maturity value The maturity value includes principal plus interest When the period is given in days, the maturity date is determined by counting the days from date of issue. In counting the days remaining for a note: Count the maturity date Omit the date the note was issued If a notes receivable is outstanding at the end of the accounting period, the interest earned on the note up to the year end must be accrued For a 12-month, 9 % interest, $6,000 note receivable issued Oct. 1, 2017, with a December 31, 2017 year-end, the entry is: On the note s maturity date of Sept. 30, 2018 the entry is: Accounting Summary Page 38

39 Dishonoured Notes Receivable If the maker of a note does not pay a notes receivable at maturity, the maker is said to dishonour or default on the note. The payee still has a claim against the note s maker, and transfers the amount (principal and interest) to Accounts Receivable. i. Reporting Receivables on the Balance Sheet: Actual Company Reports For companies reporting under ASPE, it is not necessary to present the allowance for doubtful accounts in the financial statements Companies can use a note to the financial statements to give more details j. Using Accounting Information for Decision Making The balance sheet lists assets in their order of relative liquidity: Cash (the most liquid asset) Short-term investments Current receivables Merchandise inventory k. Discounting (Selling) a Note Receivable If a payee of a note receivable needs cash before maturity of the note, the payee may sell the note To receive cash immediately, the seller of the note is willing to accept a lower price than the note s maturity value The practice is called discounting the note, and is based on present value calculations to record the discounting of the note Accounting Summary Page 39

40 When proceeds are less than the value of the note Accounting Summary Page 40

41 Chapter 10. Property, Plan, and Equipment; and Goodwill and Intangible Assets a. Tangible Long-term Asset PPE(Property, Plant, and Equipment) Property Land Land Improvement Plant(Buildings) Equipment Leasehold Improvement Details The cost of land includes the following: Purchase price Brokerage commission Survey and legal fees Any property taxes in arrears Cost for grading and clearing the land Cost for demolishing or removing unwanted building The cost of land is not amortized because it does not wear out Land improvements include: Lighting Signs Fences Paving Sprinkler systems Landscaping Cost of construction of a building includes: Architectural fees Building permits Contractors charges Payments for materials, labour, and overhead The cost of equipment and machinery include: Purchase price (less any discounts) Transportation charges Insurance while in transit Provincial sales tax (PST) Purchase commissions Installation costs Cost of testing the asset before it is used Another category of equipment is furniture and fixtures Computers are reported as equipment in some businesses Often times, a business will lease a building instead of own it; as a result, this is not an asset in their Balance Sheet Alterations to the leased assets may include: Painting Installation of special equipment These leasehold improvements are owned by the business and are considered assets Accounting Summary Page 41

42 b. Lump-sum purchase of assets A single price is paid for several assets purchased as a group Relative Fair Value Method c. Betterments (Asset) vs. Repairs (Expense) Betterments are debited to an asset because they: o Increase the capacity or efficiency of the asset, or o Extend the asset s useful life Repairs do not extend the asset s capacity or efficiency but merely maintain the asset in working order. For repairs, debit the Repairs and Maintenance expense account d. Ethical Issues When there are choices to be made in accounting such as whether a cost should be expensed or capitalized, or how to allocate costs using the relative-fair-value method, accountants may face an ethical dilemma For example, a company can capitalize a cost that should have been expensed, causing the current period s net income to be inflated Capitalize all costs that provide a future benefit for the business, and expense all other costs e. Amortization Amortization defined as the allocation of the cost of property, plant, and equipment less salvage value, or residual value, over its useful life. Amortization matches the asset s cost (expense) against the revenue earned by the asset Amortization is also called depreciation Amortization is based on: Cost Estimated useful life Estimated residual value Accounting Summary Page 42

43 Straight-line: used for an asset that generates revenue fairly evenly over time Cost Residual Value Annual Amortization Amount = Useful Life in Years UOP: best for assets that wear out because of physical use Unit Amortization Amount - Cost Residual Value Useful Life in units of production DDB: best for assets that produce more revenue in the early years Annual Amortization Amount = Net Value of asset X Useful Life in Years Last year amortization amount = Net Value of asset Residual Value Example of Amortization Purchased a Truck Cost : $65,000 Residual Value : $5,000 Useful life of Years : 5 Years Useful life of Units of Production : 400,000 km 2 Accounting Summary Page 43

44 Used Kms Straight Line ( )/5 = per year Unit of Production ( )/ = $0.15/km DDB 2/5 = 0.4 f. CCA(Capital Cost Allowance) The term used to describe amortization for Canada Revenue Agency is Capital Cost Allowance (CCA) CRA specifies the rates to be used for each class of asset A taxpayer may claim from zero to the maximum CCA Claiming the maximum CCA reduces taxable income and thus tax payable Accounting Summary Page 44

45 Half Year Rule - CRA allows the taxpayer to claim only 50 percent of the normal CCA rate in the year of acquisition. The CCA rate is applied to the balance in the asset class at the end of the year (Cost Accumulated CCA) Similar to the DDB method g. Amortization for partial year Record a full month s amortization on an asset bought on or before the 15th of the month. Record no amortization on assets purchased after the 15th of the month h. Using Fully Amorted Asset A fully amortized asset is one that has reached the end of its estimated useful life. No more amortization is recorded for the asset The asset may still be useful, and the company may continue using it No additional amortization is recorded. i. Discarding or Selling Property, Plant, and Equipment To record the disposal or sales of property, plant, and equipment: 1. Bring amortization up to date. Record partial year s amortization to update accumulated amortization. 2. Calculate whether there is a gain or loss 3. Remove the asset and related contra accounts: o Debit the asset s accumulated amortization account o Credit the asset account o Record any gains and losses o Record payment and /or trade-in (if applicable) j. Account for natural resources Natural resources are tangible capital assets that are often called wasting assets because they are used up in the process of production Examples of natural resources include: Iron ore, Coal, Gas, Oil, Timber Amortization (or depletion) is calculated using the units-of-production method k. Future Removal and Site Restoration Costs There is an increasing concern about the environment, and natural resource companies must restore the site location by removing equipment, buildings, and waste. Future removal and site restoration costs are estimated liabilities at the time the asset is acquired and are assessed at the end of each year. Accounting Summary Page 45

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