Financial Accounting Exam Notes.docx

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Accounting & Financial Management
AFM 123
Robert Sproule

Accounting Exam Notes Chapter 1-4 Types of Accounts: • Assets= resources owned by a business, things of value • Liabilities= claims against assets, existing debts and obligations • Owner’s Equity= ownership claim on total assets o Capital o Drawings o Revenues o Expenses • Investments increase owner’s equity -> can be cash or capital assets (ie. Computers) • Drawings are withdrawals of cash or other assets by the owner for personal use. Drawings decrease total owner’s equity • Revenues are the increase in owner’s equity resulting from business activities. May result from sale of merchandise, performance of services, rental property, or lending money. • Expenses are the decrease in owner’s equity that results from operating the business. They are the cost of assets consumed or services used in the process of earning revenue. Examples= utility expense, rent expense and supplies expense. Accrual Basis of Accounting • Accrual Basis adheres to -Revenue recognition principle -Matching principle • Revenue recorded when earned, NOT when cash received • Expense recorded when services or goods are used or consumed in the generation of revenue, NOT when cash paid Cash Basis of Accounting • Revenue recorded only when cash received • Expense recorded only when cash paid Adjusting Entries: • Required each time financial statements are prepared • Can be classified as: 1. Prepayments -Prepaid expenses -Unearned revenue 2. Accruals -accrued revenues -accrued expenses 3. Estimates -amortization (depreciation) Prepayments: 1. Prepaid expenses- paid in cash and recorded as assets before they are used/consumed 2. Unearned revenues- received in cash and recorded as liabilities before they are earned Accruals: 1. Accrued revenues- earned but not yet received in cash or recorded 2. Accrued expenses- incurred but not yet paid in cash or recorded Estimates: 1. Amortization- allocation of the cost of capital assets to expense over their useful lives Prepaid Expenses: • Have now used the expense recorded as an asset before adjustment: assets overstated, expenses understated • Entry. DR expense account CR Asset Account (Prepaid expense) • Ex: DR Insurance expense CR Prepaid Insurance • Others: supplies, rent, insurance, and property tax Unearned Revenues: • Opposite of prepaid expense • Unearned revenue on the books of one company is likely to be a prepaid expense on the books of another company • Ex: tuition received prior to the start of an academic session, airline tickets bought in advance • Why adjust? You have now earned revenue originally recorded as a liability DR Cash CR Unearned revenue • Before adjustment: liabilities overstated and revenue understated • Entry: DR Liability account CR Revenue account • Ex. DR Unearned revenue CR Service revenue • Other: rent, subscriptions, tuition Accrued Revenues: • Revenue has been earned but not yet recorded or paid in cash • Before the adjustment: assets understated, revenues understated • Entry: DR Asset account CR Revenue account • Ex. DR Accounts receivable CR Service revenue • Others: rent receivable, interest receivable Accrued Expenses: • Expenses have been incurred but not yet paid • Before adjustment: expenses understated, liabilities understated • Entry: DR Expense account CR Liability account • Ex. DR Advertising expense CR Accounts Payable • Others: rent payable, salaries payable, and interest payable Amortization: • Must allocate cost of any asset over its useful life as an expense • Before adjustment: asset overstated, expense understated • Entry: DR Amortization Expense CR Accumulated Amortization • Ex. DR Amortization Expense- Truck CR Accumulated Amortization- Truck • A contra account called Accumulated Amortization is CREDITED • On balance sheet: Original Cost of Asset Less: Accumulated Amortization Net book value (NBV) of the asset Adjusted Trial Balance: • After all adjustments have been journalized and posted • Shows the balances of all accounts are all adjustments • Proves the equality of total debit and credit balances in the ledger after all adjustments have been made • Financial statements can be prepared directly from the adjusted trial balance Purpose of Closing Entries: • Updates owner’s capital account • Prepares the temporary accounts for the next period by reducing their balance to zero • Temporary Accounts: Revenue Expense Drawings Closing Process: 1. Debit revenue account --- credit owner’s capital account 2. Debit owner’s capital---credit all expense accounts 3. Debit owner’s capital---credit drawings account Reversing Entries: • Made at the beginning of the accounting period • Exact opposite of the adjusting entry • Purpose  to simplify the recording of subsequent transactions related to an adjusting entry • It does not change the amounts reported on financial statements • Most often used for accruals • Rarely used for prepaids or unearned revenue • ONLY MADE AT THE BEGINNING OF THE PERIOD • Abnormal balances in expense or revenue accounts temporarily result • Expense accounts are subsequently debited for the full payment, and revenue accounts credited for the amount billed Balance Sheet Classifications: • Current Assets o cash or anything expected to be realized/sold/consumed within one year o listed in order of liquidity • Current Liabilities o obligations expected to be paid within one year • Long Term Investments o resources that can be realized in cash, but the conversion into cash is not expected within one year or operating cycle, whichever is longer o ex. Bonds, investments in land • Long Term Liabilities o obligations expected to be paid after one year • Capital Assets o can be tangible resources of a permanent nature that are used in business and not intended for sale o can be intangible such as patents/copyrights • Owner’s/partners’/shareholders’ equity o sole proprietorship = owner’s name, capital o partner’s= separate capital accounts o corporation= share capital and retained earnings Chapter 5-6 FOB • FOB Shipping Point: o BUYER PAYS for costs  Include shipping costs in MERCH INV as a DR o Goods delivered by seller o Entry:  DR Merch Inv XX CR Cash XX • FOB Destination: o SELLER PAYS costs  include in OPERATING EXP.  Freight out or Delivery expense - DR o Goods delivered by seller o Entry:  DR Delivery Expense XX CR Cash XX Freight Costs • “Goods in transit” = goods that are in the hands of the shipping company (Ex. UPS) • These goods should be included in the inventory of the party who has legal title over them FOB Perpetual Periodic Shipping Point DR Merchandise Inventory DR Freight-in CR Cash or A/P CR Cash or A/P Destination DR Freight out or Delivery Expense CR Cash or A/P Purchase Returns and Allowances • A purchaser may return their merchandise • Entry: o DR A/P CR Merch Inv Sales Returns VS Allowances • Sales returns: o Customer returns the goods to the seller for a credit or refund o Entry 1record return of sale  DR Sales Returns and Allowances XX CR Cash or A/P XX o Entry 2  Record the return to inventory  DR Merchandise Inventory XX CR COGS XX • Sales Allowances: o The seller allows a price reduction from the selling price Inventory Systems • Perpetual: o Detailed records of each inventory purchase and sale o COGS = calculated at the time of each sale • Periodic: o No detailed records maintained o COGS = calculated only at the end of each period o Misstates inventory during the period Perpetual System • Sale of Inventory o DR Merchandise Inventory CR Cash or A/P • Record when goods are received from the seller • Revenues are reported when earned in accordance with the revenue recognition principle o Entry 1  record the sale  Cash or A/P XXX Sales XXX o Entry 2  record the COGS  COGS XXX Merchandise Inv. XXX • Closing Entries: o Same types as a service company o 3 additional accounts need to be closed  Sales, Sales Returns and Allowances  DR to close  COGS  CR to close  Freight out  Cr to close o Merchandise inventory is an ASSET account and is NOT closed Periodic System • Consignee: o Holder of the good, does not own • Consignor: o Ships and owns the goods until actually sold to a customer o Include consigned goods in inventory • Closing entries  similar to perpetual except: o No entries have been made to the merchandise inventory account directly since the temporary purchases account is used with a periodic system o SO at the end of the year, entries must be made to ELIMANTE THE BEGINNING INVENTORY and to record this year’s new ending inventory o Entry 1:  DR Capital CR Merchandise Inventory o Entry 2:  DR Merchandise Inventory CR Capital Actual + Assumed Cost Flow Assumptions • Actual = physical flow of goods  sells limited # of high unit cost items • FIFO: o First goods purchased = first goods sold o Reflects actual flow of merchandise o Costs of the earliest goods purchased = the 1 to be recognized as COGS o most recent goods purchased are recognized as the ending inventory • LIFO: st o Last purchased = 1 out o Earliest goods purchased = ending inventory o Does not coincide with physical flow of inventory st o All goods purchased during the year = assumed to be available for the 1 sale, regardless of date of purchase • Average Cost: o Prices don’t differ very much o Assumes that goods available for sale = homogenous o Allocation of the cost = made on the basis of a weighted average unit cost o Cost = applied to the units sold to determine the COGS and to the units on hand to determine ending inventory o Weighted average = COG available ÷ total units available • In periods of rising prices + vice versa: o FIFO = highest net income o LIFO = lowest net income o Avg cost = middle • When prices = constant all yield the same result • FIFO = best balance sheet valuation  closest to current costs COGS • Calculations: o Beginning Inventory + COG purchased = COGA cost of goods available for sale o COGA – Ending Inventory = COGS o COGS = Beginning Inventory + COGS purchased – Ending Inventory o Apply unit costs to the total units on hand for each item of inventory Inventory error COGS Net Income Understate BI Understated Overstated Overstate BI Overstated Understated Understate EI Overstated Understated Overstate EI Understated Overstated Chapter 8 • Internal controls: o Policies+procedures within an organization to  Optimize its resources  Prevent and detect error and irregularities  Safeguard its assets  Maintain reliable control systems • Principles of internal controls: o Authorization o Segregation of duties o Documentation o Safeguarding of assets and records o Independent verification Chapter 9 • 3 primary ways accounting problems associated with A/R: o Recognizing o Valuing o Disposing 1. Recognizing A/R • Entry  sells merchandise on credit o A/R XX Sales XX • Recognizing with financing charges: o Charges are added to balance wrong o Entry:  A/R X Interest Revenue X 2. Valuing A/R • Receivables = current asset on balance sheet o Some = uncollectible o Record these losses as DR to Bad Debt Expense • State A/R at their net realizable value  net amount expected to be received in cash and excludes amounts that the company estimates they will not collet • 2 methods o Direct-write off (easier) o Allowance • Allowance for Doubtful accounts = CONTRAASSET account balance sheet • Bad debts expense = operating expense  income statement • Direct Write Off Method: o Loss is charged to bad debts expense o Ex: Carefoote Company writes off Lisa M.’s $X balance as uncollectible  Entry: • Bad Debt Expense XX A/P – Lisa M. XX • Allowance Method: o Required when bad debts are deemed to be material in amount o Uncollectible accounts are estimated and the expense account is matched against sales in the same accounting period in which the sale occurred  Entry: • Bad Debt Expense XX Allowance for doubtful accounts XX o Actual uncollectible accounts are written off  Entry: • Allowance for Doubtful accountsXX Bad Debts Expense XX o Recovering an A/R that has been written off  2 steps  1 step  reverse entry made to write off the account • Accounts Receivable XX Allowance for Doubtful Accounts XX  2 step  record the collection in usual manner • Cash XX A/R XX o 2 methods of estimation used for uncollectible accounts:  1  Percentage of Sales  2  percentage of receivables o Percentage of Sales Basis:  Determined by applying the % to sales base of the current period o Percentage of Receivables Basis:  Establishes a % relationship between the amount of AR and the required balance in the allowance account  To determine the required balance in the allowance account  apply the % to the AR balance  Adjusting entry amount = required balance – existing balance  Produces better estimate of net realizable value of receivables Credit Card Sales • 3 parties involved: o Credit card issuer o Retailer o Customer • Retailer pays credit card issuer % service fee of the sales price for their service • Bank (Credit) Card Sales o CASH SALES  DR Bank CR Sales o Cards = issued by banks o Ex: Customer spends $1000 using an RBC VISA… service fee= 3.5%  Cash 965 Credit Card Expense 35 Sales 1000 • Non-Bank (Credit) Card Sales o CREDIT sales not cash sales  DR A/R CR Sales o Ex: $500 using Amex… service fee that AMEX charges = 5%  A/R 475 Credit Card Expense 25 Sales 500 Chapter 10 Intangible Assets: • Do not possess physical substance • Intangible assets are: o Recorded at cost o Written off over useful life in a rational and systematic manner o At disposal, NBV is eliminated and gain or loss, if any, is recorded o NOT credited to an accumulated amortization account  the account is credited directly • Their life is limited by law • Must be reviewed when events or circumstances indicate that there may be a permanent decline in value: o In the event of a decline: the difference between the asset’s fair market value and net book value is recorded as an Impairment Loss o If the value increases, the value is NOT adjusted • Straight line method of amortization is commonly used Patents: • Exclusive right to manufacture, sell or control an invention for a 20 year period • The cost of the patent should be amortized over its 20 year legal life, or its useful life, whichever is shorter • Legal costs of protecting a patent are added to the patent account and amortized over the remaining life of the patent Copyrights: • Copyrights give the owner the exclusive right to reproduce and sell artistic or published work • They extend for the life of the creator Trade Marks/ Names: • If indefinite life, do not amortize • Test for impairment Franchises: • A contractual agreement under which the franchiser grants the franchisee the right: To sell certain products, render specific services, and use certain trademarks or names within a designated geographic area • If the life is indefinite, the cost is not amortized • Annual payments (of sales) are recorded as operating expenses Licenses: • Operating rights permit the enterprise to use public property in performing its service Goodwill: • Represents favorable attributes that relate to an exceptional business enterprise • Record only in an exchange transaction that involves the purchase of an ENTIRE business • Goodwill equals the excess cost over the fair market value of the net assets acquired • Goodwill is NOT written off as it has an unlimited useful life  must be tested regularly for impairment Research and Development Costs: • Research: planned investigation  costs are recorded as an EXPENSE when incurred • Development: use of findings  costs are capitalized if associated with a clearly defined product or process Intangible Asset Legal Life Amortization Period Amortized Patents 20 years Legal life Copyrights Life of creator plus 50 years Legal life Franchises/Licenses Contract Term Contract Term Other Contract Term Contract Term Unamortized Trademarks 15 years; renewable Franchises/ Licenses Indefinite Goodwill Indefinite Other Research Research EXPENSE Development CAPITALIZED (if criteria met) Chapter 13 6 Partnership Characteristics: 1. Association of Individuals: • Partnership: two or more people who do business together • Legal entity • Voluntary association may be based on a simple handshake 2. Division of Income • Shared equally unless specified • Net income is not taxed as a separate entity • Each share of income is recorded on the partner’s personal income tax return 3. Mutual Agency • Each partner acts for the partnership, therefore the action of one partner affects the other 4. Co-ownership of Property • Partnership assets are owned jointly • If the partnership is dissolved assets do not legally return to the original contributor • Each partner has a claim on total assets 5. Limited Life • Any change in ownership dissolves the partnership • Partnership dissolution occurs whenever a partner withdraws or a new partner is admitted • Voluntary and involuntary withdrawal: death, incapacitation, or mandatory retirement 6. Unlimited Liability • Each partner is jointly liable for all partnership liabilities • If one partner incurs liability, then the other is also responsible Advantages Disadvantages  Combining skills and resources of 2  Mutual agency individ
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