Financial Accounting Exam 2 Study Guide

Internal Controls

Policies and procedures designed to protect assets, ensure reliable accounting records, improve operations, and promote compliance with laws.

Who is ultimately responsible for internal controls?

Management is responsible for designing, implementing, and maintaining effective internal controls.

Fraud Triangle

Three conditions commonly associated with fraud: pressure, opportunity, and rationalization.

Fraud Triangle - Pressure

A financial or personal incentive that motivates someone to commit fraud, such as debt or unrealistic performance goals.

Fraud Triangle - Opportunity

A weakness in internal controls that allows someone to commit fraud without being easily detected.

Fraud Triangle - Rationalization

The justification a person uses to convince themselves that committing fraud is acceptable.

Control Activities

Specific policies and procedures used to prevent or detect errors, theft, and fraud.

Separation of Duties

Dividing authorization, recordkeeping, and custody of assets among different employees to reduce fraud risk.

Authorization Controls

Requiring designated employees to approve transactions before they occur.

Documentation Controls

Using invoices, receipts, and other records to provide evidence of transactions.

Physical Controls

Protecting assets through locks, safes, security cameras, passwords, and restricted access.

Independent Verification

Having someone who did not perform a transaction check its accuracy, such as reviewing a bank reconciliation.

Preventative Controls

Controls designed to stop mistakes or fraud before they occur, such as approval requirements and separation of duties.

Detective Controls

Controls designed to identify errors or fraud after they occur, such as audits and bank reconciliations.

Sarbanes-Oxley Act (SOX)

A 2002 federal law strengthening corporate financial reporting, internal control accountability, and auditor independence.

SOX Section 404

Requires public-company management to assess and report on internal control over financial reporting; certain companies also require auditor attestation.

Cash

Money available for immediate use, including currency, coins, checking accounts, and qualifying deposits. Asset; normal debit; permanent.

Cash Equivalents

Highly liquid short-term investments readily convertible to known cash amounts with insignificant value-change risk, generally maturing within three months of acquisition.

Cash and Cash Equivalents on Financial Statements

Reported together as current assets on the balance sheet, unless restrictions require different classification.

Accounts Receivable

Amounts customers owe from credit sales. Current asset; normal debit; permanent account.

Allowance for Uncollectible Accounts

Estimated receivables that will not be collected. Contra-asset; normal credit; permanent account.

Notes Receivable

Written promises to receive money, often with interest. Asset; normal debit; permanent account.

Inventory

Goods held for sale in normal business operations. Current asset; normal debit; permanent account.

Sales Revenue

Income earned from selling goods. Revenue account; normal credit; temporary account.

Sales Returns and Allowances

Reductions in sales for returned, defective, or damaged merchandise. Contra-revenue; normal debit; temporary account.

Sales Discounts

Reductions in sales revenue for customers who pay within discount terms. Contra-revenue; normal debit; temporary account.

Bad Debt Expense

Estimated cost of credit sales that will not be collected. Expense; normal debit; temporary account.

Cost of Goods Sold (COGS)

Cost of inventory sold to customers. Expense; normal debit; temporary account.

Permanent Accounts

Balance sheet accounts that carry balances into the next accounting period, including assets, liabilities, and equity.

Temporary Accounts

Revenue, expense, and dividend accounts that are closed at the end of the accounting period.

Normal Debit Balance

Assets, expenses, dividends, and contra-revenue accounts normally increase with debits.

Normal Credit Balance

Liabilities, equity, revenue, and contra-asset accounts normally increase with credits.

Net Sales Revenue Formula

Gross Sales Revenue - Sales Returns and Allowances - Sales Discounts = Net Sales Revenue.

Net Sales Calculation Example

Sales $50,000, returns $2,000, discounts $1,000: Net Sales = $47,000.

Allowance Method

Estimates uncollectible receivables and records bad debt expense in the period associated with the credit sales.

Journal Entry to Establish Allowance

Debit Bad Debt Expense; Credit Allowance for Uncollectible Accounts.

Journal Entry to Write Off Uncollectible Account

Debit Allowance for Uncollectible Accounts; Credit Accounts Receivable.

Does Writing Off a Receivable Create New Bad Debt Expense?

No. Under the allowance method, the expense was estimated previously.

Journal Entry to Recover a Written-Off Account

First debit Accounts Receivable and credit Allowance; then debit Cash and credit Accounts Receivable when collected.

Net Realizable Value of Accounts Receivable

Accounts Receivable - Allowance for Uncollectible Accounts = Estimated collectible amount.

Percentage of Sales Method

Estimates bad debt expense using a percentage of credit sales; focuses on the income statement.

Percentage of Receivables Method

Estimates the required ending allowance using a percentage of receivables; focuses on the balance sheet.

Aging of Receivables

Groups receivables by how long they are overdue and applies estimated uncollectible percentages to each group.

Adjusting the Allowance Account

Required ending credit balance minus existing credit balance equals adjustment; an existing debit balance increases the adjustment.

Multi-Step Income Statement

Income statement that separates operating and nonoperating items and calculates gross profit, operating income, and net income.

Benefit of Multi-Step Income Statement

Provides clearer information about gross profitability, operating performance, and other income or expenses.

Gross Profit Formula

Net Sales Revenue - Cost of Goods Sold = Gross Profit.

Gross Profit Percentage Formula

Gross Profit / Net Sales Revenue × 100 = Gross Profit Percentage.

Gross Profit Example

Net sales $80,000 and COGS $48,000: Gross Profit = $32,000.

Gross Profit Percentage Example

Gross profit $32,000 and net sales $80,000: Gross Profit % = 40%.

Operating Income Formula

Gross Profit - Operating Expenses = Operating Income.

Net Income Formula

Total Revenues and Gains - Total Expenses and Losses = Net Income.

Goods Available for Sale Formula

Beginning Inventory + Net Purchases = Goods Available for Sale.

Ending Inventory Formula

Goods Available for Sale - Cost of Goods Sold = Ending Inventory.

COGS Formula (Periodic System)

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold.

Inventory Calculation Example

Beginning inventory $10,000 + net purchases $30,000 - ending inventory $8,000 = COGS $32,000.

Four Inventory Cost Methods

Specific Identification, FIFO, LIFO, and Weighted Average.

Specific Identification

Tracks the actual purchase cost of each specific inventory item sold.

Specific Identification - Pros and Cons

Accurate for unique or expensive items but impractical for large quantities of similar products.

FIFO (First In, First Out)

Assumes the oldest inventory costs are assigned to COGS first, leaving newer costs in ending inventory.

FIFO - Pros and Cons

Often approximates physical flow and gives recent inventory costs on the balance sheet; during rising prices, typically produces higher reported income.

LIFO (Last In, First Out)

Assumes the newest inventory costs are assigned to COGS first, leaving older costs in ending inventory.

LIFO - Pros and Cons

During rising prices, generally produces higher COGS and lower taxable income; ending inventory may reflect outdated costs. Not allowed under IFRS.

Weighted Average Cost

Assigns inventory costs using an average unit cost; periodic average = total goods available cost / total units available.

Weighted Average - Pros and Cons

Smooths price fluctuations and is relatively simple; does not track exact individual item costs.

FIFO During Rising Prices

Typically results in lower COGS, higher ending inventory, and higher net income than LIFO.

LIFO During Rising Prices

Typically results in higher COGS, lower ending inventory, and lower net income than FIFO.

FIFO Calculation Example

Buy 10 units at $5 and 10 at $7; sell 12. FIFO COGS = (10 × $5) + (2 × $7) = $64.

LIFO Calculation Example

Buy 10 units at $5 and 10 at $7; sell 12. LIFO COGS = (10 × $7) + (2 × $5) = $80.

Weighted Average Calculation Example

Buy 10 units at $5 and 10 at $7. Average = $6/unit; selling 12 gives COGS $72.

Perpetual Inventory System

Updates inventory and COGS records continuously as purchases and sales occur.

Periodic Inventory System

Determines COGS and ending inventory at the end of the period using inventory counts and accounting calculations.

Perpetual vs. Periodic

Perpetual records COGS at each sale; periodic generally calculates COGS at period-end.

Merchandising Company

Purchases finished goods and resells them to customers without substantially changing the products.

Manufacturing Company

Produces finished goods using raw materials, labor, and manufacturing overhead.

Manufacturing Inventory Types

Raw Materials, Work in Process, and Finished Goods.

FOB Shipping Point

Ownership and risk generally transfer to the buyer when goods are delivered to the carrier; buyer generally pays freight.

FOB Destination (FOB Selling Destination)

Ownership and risk generally transfer when goods reach the buyer's destination; seller generally pays freight.

Journal Entry - Cash Sale (Perpetual)

Debit Cash; Credit Sales Revenue. Also debit COGS; Credit Inventory.

Journal Entry - Credit Sale (Perpetual)

Debit Accounts Receivable; Credit Sales Revenue. Also debit COGS; Credit Inventory.

Journal Entry - Purchase Inventory on Account (Perpetual)

Debit Inventory; Credit Accounts Payable.

Journal Entry - Pay Supplier

Debit Accounts Payable; Credit Cash.

Journal Entry - Customer Pays Receivable

Debit Cash; Credit Accounts Receivable.

Journal Entry - Sales Return (Perpetual)

Debit Sales Returns and Allowances; Credit Cash or Accounts Receivable. If resalable, debit Inventory; credit COGS.

Journal Entry - Sales Discount

Debit Cash for amount received; debit Sales Discounts for discount; credit Accounts Receivable for full balance.

Journal Entry - Record COGS (Perpetual)

Debit Cost of Goods Sold; Credit Inventory.

Journal Entry - Freight-In (Perpetual)

Debit Inventory; Credit Cash or Accounts Payable when freight is the buyer's inventory cost.

T-Accounts

Visual ledger accounts with debits on the left and credits on the right, used to track balances.

Posting to T-Accounts

Transfer each journal entry's debits and credits to the corresponding ledger accounts and calculate balances.

Closing Revenue Accounts

Debit revenue accounts and credit Income Summary, or use the direct closing approach to Retained Earnings.

Closing Expense Accounts

Credit expense accounts and debit Income Summary, or use the direct closing approach to Retained Earnings.

Closing Contra-Revenue Accounts

Credit Sales Returns and Allowances and Sales Discounts to bring them to zero; debit Income Summary under that closing method.

FIFO (First In, First Out)

Assumes the oldest inventory costs are sold first. During rising prices, results in lower COGS, higher ending inventory, and higher net income.

LIFO (Last In, First Out)

Assumes the newest inventory costs are sold first. During rising prices, results in higher COGS, lower ending inventory, and lower net income.