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Ryerson University
ACC 100
Anthony Chan

Chapter 6 Taking a physical inventory: Internal Control – Consists of policies and procedures to optimize resources, prevent and detect errors, safe guard assets, and enhance the accuracy and reliability of accounting records  Counting should be done by employees who do not have responsibility for the custody or record keeping  Each counter should check the validity of each inventory item  Second count by another employee or auditor  Pre-numbered inventory tags should be used Determining ownership of goods: Goods in transit  Goods in transit should be included in the inventory of the company that has legal title of the goods o FOB shipping point – Belongs to seller up until it is shipped o FOB destination – Belongs to sell until it reaches the destination  Consigned goods – Hold goods belonging to other parties and sell them, for a fee, without even taking ownership of the goods o Holder of the goods = consignee o Lender of the goods = consignor  Other Situation o Goods on approval - Belong to the store lending them out Like an employee taking home a stapler, included in inventory o Goods are sold but the seller is holding them, not included in inventory o Damaged good should NOT be included Inventory costing – A way of allocating the purchase cost to each item in inventory and each item that has been sold  Specific identification method o Tracks the actual physical flow of goods o Each item of inventory is marked, tagged or coded with its specific unit cost o Items still in inventory at the end of the year are specifically costed to determine the total cost of the ending inventory o Most practical when company sells limited number of items with high unit cost o Ideal method for determining costs o Reports ending inventory at actual cost and matches the actual cost of goods sold against sales revenue o Disadvantage is that management can manipulate net earnings o Expensive and Rare  Cost flow assumptions - Assume flows of costs may not be the same as the actually physical flow of goods o FIFO – First In First Out  First goods in are first goods sold  Generally good business practice to sell the older items first  Often matches the physical flow of goods  Commonly Used o Average  Assumes that the goods are homogenous or nondistinguishable  Uses weighted average unit cost  Formula: Cost of goods available for sale / Total Units available for sale  Commonly Used o LIFO – Last In First Out  Last goods in are the first to go out  Rarely matches with physical flow of goods  Illegal in Canada because of tax purposes, only used sometimes to harmonize with the US  Earnings can be manipulated with last minute purchasing  Rarely Used, used more in the USA  LIFO is best valuation because it matches current costs with current revenues since under LIFO, the cost of goods sold is assumed to be the cost of the most recently acquired goods Statement of earnings effect  Period of rising prices (Inflation) o FIFO – higher net earnings because the lower unit costs of the first units purchased are matched against revenues  Balance Sheet: am advantage is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost o Average – in between o LIFO – rising prices = lower net earnings/ most accurate  Balance Sheet: A major limitation is that in a period of inflation, the costs that are allocated to ending inventory may be significantly understated in terms of current cost of inventory  Period of falling prices o FIFO - lower net earnings/ most accurate o Average – In Between o LIFO - higher net earnings  Prices Stable o All 3 Assumptions will report the same results Period of rising prices FIFO LIFO Cost of goods sold Lowest Highest Gross profit/net earnings Highest Lowest Pre-tax cash flow Same Same Ending inventory Highest Lowest Inventory errors o Statement of earnings effect  If beginning inventory is understated then cost of goods sold will also be understated  Understating ending inventory will overstate cost of goods sold  An understatement in cost of goods sold will produce an overstatement in gross profit and net earnings  An overstatement in cost of goods sold will produce an understatement in gross profit and net earnings  An error on ending inventory of the current period will have a reverse effect on net earnings of the next period o Balance sheet effect  Overstated ending inventory will lead to overstated assets and shareholders’ equity  Understated ending inventory will lead to understated assets and shareholders’ equity Lower of Cost and Market (LCM) o Inventory decreases in value over time sometimes o Cash basis accounting no longer followed o When the value of inventory is lower than its cost, inventory is written down to its market value o Used because of conservatism o Used because it is least likely to overstate assets and net earnings o It can mean replacement cost or net realizable value o Debit loss due to decline in net realizable value o Used after specific identification or cost follow assumption has been used to determine cost o Credit merchandise inventory Dr. Loss to decline in Net Resizable value of inventory XXX Cr. Merchandise Inventory XXX - Decline in inventory Manufacturing goods o Finished goods o Work in process o Raw materials Inventory turnover o Measures the number of days it takes to sell inventory o A low turnover ratio means that the company has too much funds in inventory (High days in inventory), also means it has excessive carrying costs (interest, storage, tax) o A high turnover ratio means the company has little of its funds in the inventory (low days in inventory) Although minimal funds tied up in inventory suggests efficiency, to high an inventory ratio may indicate that the company is losing sale opportunities because of inventory shortages o Inventory turnover = Cost of goods sold/average inventory o Days in inventory = 365/inventory turnover Chapter 7 Internal control – Consists of all the related methods and measures adopted within a business to: 1. Optimize the use of resources 2. Prevent and detect errors and irregularities 3. Safeguard assets 4. Maintain reliable control systems Principles of Internal Control  Establishment of responsibility - Control is most effective when only one person is responsible for the task o Responsibility must also be assigned for the authorization and approval of transactions  Segregation of duties - The work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee o 1) The responsibility for related activities should be assigned to different individuals o 2) The responsibility for accounting for an asset should be separate from the responsibility for physical custody of that asset o When one individual is responsible for all the related activities, the potential for errors and irregularities is increased  Abuses are less likely to occur when the sales tasks are divided o The custodian of an asset is not likely to convert the asset to personal use if an another employee maintains the record which states that the asset should be on hand  Documentation procedures – Documents provide evident that transactions and event have occurred o Wherever possible, documents should be pre-numbered and all documents should be accounted for  Physical controls – Mechanical and electronic controls to safeguard assets and enhance the accuracy and reliability of the accounting records o Locks, passwords  Independent verification o Verification done on a periodic/surprise basis o Verification should be done by an employee who is independent of the personnel responsible for the information o discrepancies and exceptions should be reported to a management level that can take corrective action  Internal verification o Internal auditors – They are employees of the company who evaluate the effectiveness of the company’s system  External verification o External auditors – independent from the company, they are professional accountant hired by a company to report on whether or not the company’s financial statement fairly present is financial position and results of operations  Other controls o Bonding of employees who handle cash  Means having insurance protection against misappropriation of assets by dishonest employees o Rotating employee’s duties and requiring employees to take vacations Limitations of internal control  Provide reasonable assurance – signs, cameras  The cost of establishing control procedures should not be more than their expected benefit  Human element - Fatigue/collusion  Size of the business – in a small company it is hard to segregate duties, so managers have to take some duty Cash  Cash is coins, currency, cheques, money orders, and money on hand  If the bank will accept it as a deposit then it is cash  Debit-card transactions and bank credit card receipts such as VISA and MasterCard are considered cash. Non-bank credit cards are not considered cash.  Cash does not include post-dated cheques, stale dated (more than 6 months old) cheques, NSF cheques, Internal control of cash is more effective when cash receipts are deposited intact into the bank account on a daily basis. Also most effective when payments are made by cheque rather than in cash The use of a bank contributes significantly to good internal control over cash The banks files can be compared to the companies. Necessary for reconciliation Cheques paid and other debits  A Paid cheque (Bank stamped) is sometimes referred to as a cancelled cheque  Debit memorandums are issued for service charges by bank  RC = returned cheque when there’s NFS, there is a service charge  Credit memorandums are issued for things such as interest by bank Why bank’s records and company’s records rarely equal each other 1. Time lags that prevent one of the parties from recording the transaction in the same period as the other party 2. Errors by either party in recording transactions Outstanding cheques - Cheques recorded by a company that have no yet cleared (been paid by) the bank  Must be deducted from the balance per book Deposits in transit - Deposits recorded by the company that have not been recorded by the bank  Must be added to the balance per bank in the reconciliation process Reconciliation procedure  Reconciling items in the bank o Deposits in transit – added to the bank amount o Outstanding cheques – subtracted from the bank statement o Errors  Reconciling items per books o Bank memoranda – credit (added) debit (subtracted) o Errors What entries does the bank make?  The bank cannot correct your errors on its books and you cannot correct the banks errors on your books Restricted cash -Cash that has a restricted use should be recorded separately on the balance sheet Compensating balances - are the required minimum that companies need to maintain Too much cash on hand indicates management is not maximizing returns on assets 5 Principles of cash management 1. Increase the speed of collection on receivables 2. Keep inventory levels low 3. Delay payment of liabilities 4. Plan the timing of major expenditures 5. Invest idle cash The cash budget - shows anticipated cash flows, usually over one to two year period  Contains 3 sections o Cash receipts – includes expected receipts from the company’s main sources of revenue, such as cash sales and collections from customers on credit sales o Cash disbarments – expected payments for purchases of merchandise and operating expenses o Financing section – expected borrowings and the repayment of the borrowed funds plus interest  Data is obtained from other budgets and information provided by management  Accuracy of the cash budget depends on the accuracy of these assumption  Creditors find it critical in the companies ability to pay debts Chapter 8 Types of receivables 1. Accounts receivable – Amount owed by customers  Expected to be collected within 30 days  Needs to be recognized when the sales effort is substantially complete 2. Notes receivable – A written promise to repay a debt, it requires the debtor to pay interest and is for time periods of 30 days or longer 3. Other receivables – Include interest receivables, loans to officers, advances to employees, and recoverable sales taxes and income taxes Subsidiary Ledger – a group of accounts that share a common characteristic Like all receivable accounts  Helps the company organize and track individual customer balances  Rather than one general ledger where all A/R are kept, each company has its own  It is common to have subsidiary ledgers for accounts receivable, inventory, A/P  A/R is a control account for Subsidiary accounts receivable ledger  A control account is general ledger account that summarizes the subsidiary ledger data o At all times the control account balance must equal the total of all the individual customer receivable account balances in the subsidiary ledger  It posted twice, one in general ledger and the other in subsidiary o Subsidiary posts are done daily Interest Revenue  When customers don’t pay on time they receive interest  The seller recognizes interest revenue and increases the amount of A/R owed Valuing accounts receivable – Customer is unable to pay  Credit losses are debited to bad debts expense  Losses are considered normal and necessary risk of doing business on a credit basis  The key issue in valuing accounts receivable is when to recognize these credit losses  If the company waits until it knows for sure that the specific account will not be collected, it could end up recording the bad debt expense in a different period than when the revenue was recorded Net Realizable Value – The amount expected to be received in cash. It does not include amount that the company estimates it will not collect The Allowance method of accounting estimates uncollectible accounts at the end of the period (matching principle) 1. Recording estimated uncollectibles – estimates the amount of uncollectible accounts 2. Recording the write-off of an uncollectible account – actual collectibles are written off at the time the specific account is determined to be uncollectible 3. Recovery of an uncollectible account – when an account that was previously written off is later collected, the original write-off is reversed and the collection is recorded Recording estimated uncollectible Dr. Bad Debts Expense XXX Cr. Allowance for Doubtful Accounts XXX - To record the estimate of an uncollectable account  Bad debts expense is an operating expense  Allowance for doubtful accounts is a contra asset account o Because it is unknown which customer will pay o The estimate is just an estimate – it separates estimates from actual amounts Estimating the allowance  Percentage of receivables (aging of accounts receivable)  If credit balance in AFDA already then subtract the amount needed and place the result into it Like: 1000 in AFDA already, and estimate is 11,000 then you write in entry 10 ,000  If debit balance in AFDA already then add the amount needed and place the result into it Like: -1000 in AFDA already, and estimate is 11,000 then you write in entry 12,000 Recording the write off of an uncollected account Dr. Allowance for Doubt Accounts XXX Cr. A/R XXX - Writing off an account  Companies use various methods to collect past due accounts such as letters, collection agencies and legal action  When collecting seems unlikely, the account should be written off  Should be done by authorized management personnel to avoid premature write-offs  Write offs only effect the balance sheet  Net Realizable value in the balance sheet remains the same Recovery of an Uncollectible Account - Company collects after an account has been written off Dr. A/R XXX Dr. Cash XXX Cr. Allowance for doubtful Accounts XXX Cr. A/R XXX - To reverse write off - To collect the account Summary of Allowance Method 1. Uncollectible accounts receivable are recorded at the end of the period by debiting bad debts expense and crediting allowance for doubtful accounts. The amount to record can be determined by using a percentage of total receivables, or an aging schedule. 2. Actual uncollectibles, or write-offs, are then debited to allowance for doubtful accounts and credited to an accounts receivable account 3. Later, recoveries, if any, are recorded in two separate entries. The first reverses the write-off by debiting A/R and crediting Allowance for doubtful accounts. The second records the normal collection of the account by debiting Cash and crediting Accounts receivable. Notes receivable Promissory note - A written promise to pay specified amount of money on demand or at a definite time  When individuals and companies lend or borrow money  When the amount of the transaction
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