Accounting 101: Comprehensive Study Guide and Problem Set and Review Guide

ACCOUNTS RECEIVABLE AND UNCOLLECTIBLE ACCOUNTS

Accounts Receivable (A/R) Lifecycle

• Definition: Accounts receivable represent promises from customers for services or products provided on credit ($A/R = \text{Assets created by selling on credit}$).
• Accounting for A/R Balances:
  • The Subsidiary Ledger: Also known as the Accounts Receivable Ledger, it is used to maintain individual accounts for each customer to track their specific outstanding balances.
  • Balance Calculation Example:
    • Beginning Balance: $\$52,000$
    • Collections on account: $\$14,800$ (Decreases A/R)
    • Additional services on account: $\$12,500$ (Increases A/R)
    • Cash received for future services: $\$5,000$ (Recorded as Unearned Revenue, a liability; does not affect A/R)
    • Ending Balance: $"\$52,000 - \$14,800 + \$12,500 = \$49,700"$
• Credit Sales Entries:
  • Sale to customer (e.g., CompStore): $"\text{Debit Accounts Receivable - CompStore, Credit Sales}"$

Uncollectible Accounts (Bad Debts)

• Allowance Method: Follows the matching principle by estimating bad debts at the end of each period.
  • Percent of Sales Method: Estimates bad debt as a percentage of credit sales ($\$700,000 \times 3\% = \$21,000$).
  • Accounts Receivable Method: Estimates the Allowance for Doubtful Accounts balance via Aging of Receivables or a flat percentage of total A/R.
  • Aging Method Principle: The longer a receivable is past due, the lower the likelihood of collection.
  • Journal Entry for Write-off (Allowance Method):
    • $"\text{Debit Allowance for Doubtful Accounts, Credit Accounts Receivable}"$
    • Effect on total assets: No change (net realizable value remains the same).
  • Recovery of Write-off: Requires reversing the write-off and then recording the cash collection.
• Direct Write-off Method: Recording the expense only when specific accounts are deemed uncollectible (Not GAAP compliant for most large firms).
  • Entry: $"\text{Debit Bad Debt Expense, Credit Accounts Receivable}"$

INVENTORY SYSTEMS AND VALUATION

Inventory Systems

• Perpetual Inventory System: Continuously updates inventory and Cost of Goods Sold (COGS) with each purchase and sale.
  • Recording a sale: Requires two entries:
    1. $"\text{Debit Cash/A/R, Credit Sales}"$
    2. $"\text{Debit COGS, Credit Inventory}"$
• Periodic Inventory System: Records purchases in a temporary account and updates inventory only at the end of the period via a physical count.
  • Recording a purchase: $"\text{Debit Purchases, Credit Cash/A/P}"$
  • Recording a sale: $"\text{Debit Cash/A/R, Credit Sales}"$ (No COGS entry is made at the time of sale).
• COGS Equation (Periodic):
  • $\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

Inventory Costing Methods

• FIFO (First-In, First-Out): Assumes the oldest costs are transferred to COGS first; ending inventory is based on the most recent costs.
• LIFO (Last-In, First-Out): Assumes the most recent costs are transferred to COGS first; ending inventory is based on the oldest costs.
  • Tax Advantage: LIFO often results in higher COGS and lower net income during periods of rising prices, reducing taxable income.
• Weighted Average: Calculates a unit cost by dividing total cost of goods available for sale by total units available for sale.
  • $\text{Weighted Average Cost per Unit} = \frac{\text{Total Cost}}{\text{Total Units}}$
• Specific Identification: Identifies each item in ending inventory with a specific purchase and invoice.

Inventory Errors and Valuation Rules

• Inventory Shrinkage: Loss of inventory due to theft, damage, or bookkeeping errors. Identified when the physical count is less than the ledger balance.
• Lower of Cost or Market (LCM): Inventory must be reported at the lower of its historical cost or its current replacement cost (market value), supporting the Conservatism Principle.
• Impact of Errors:
  • Understated Ending Inventory: Leads to overstated COGS and understated Net Income.
  • Overstated Ending Inventory: Leads to understated COGS and overstated Net Income.

Shipping and Ownership

• FOB Shipping Point: Ownership transfers once the goods leave the seller's premises. The buyer pays freight-in ($\text{added to inventory cost}$).
• FOB Destination: Ownership transfers once goods arrive at the buyer's premises. The seller pays shipping/delivery expense.

INTERNAL CONTROL AND CASH MANAGEMENT

Principles of Internal Control

• Identity: Policies and procedures designed to protect assets, ensure reliable accounting, and promote efficiency.
• Limitations: Internal controls are NOT identical across companies; they must be tailored to specific needs.
• Key Principles:
  • Establishing clear responsibilities (assigned to one person).
  • Maintaining adequate records.
  • Using technology (e.g., cash registers, time clocks).
  • Separation of duties (e.g., two people present when opening mail involving cash).

Cash and Cash Equivalents

• Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known cash amounts and are near maturity (typically within 3 months).
• Cash Over and Short: An account used specifically to record discrepancies in the cash register where the physical cash does not match the recorded sales.
• Petty Cash: Used for small payments.
  • Reimbursement involves debiting various expense accounts and crediting Cash (not the Petty Cash account itself).

Bank Reconciliation

• Explains differences between the bank statement balance and the company's book balance.
• Adjustments to Bank Balance:
  • Add: Deposits in transit.
  • Deduct: Outstanding checks.
• Adjustments to Book Balance:
  • Add: Bank interest, EFT receipts.
  • Deduct: Bank service charges, NSF checks.
  • Example: A check written for $\$750$ but recorded as $\$768$ requires an addition of $\$18$ back to the book balance.

PLANT ASSETS, DEPRECIATION, AND INTANGIBLES

Plant Assets and Valuation

• Characteristics: Used in operations, have useful lives exceeding one accounting period.
• Cost Components: Includes invoice price, freight, assembly, and testing. It excludes financing/interest costs for natural resources.
• Lump-Sum Purchase: Total cost is allocated based on relative appraised (market) values.

Depreciation Methods

• Straight-Line: $\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$
• Double-Declining Balance (DDB): An accelerated method.
  • $\text{Rate} = 2 \times (\frac{1}{\text{Useful Life}})$
  • $\text{Expense} = \text{Beginning Book Value} \times \text{Rate}$
• Units-of-Production: Based on actual asset usage.

Natural Resources and Intangibles

• Depletion: The process of allocating the cost of natural resources (e.g., timber, oil) to the periods in which they are extracted.
• Amortization: The systematic allocation of the cost of intangible assets with limited lives (e.g., patents, copyrights).
• Goodwill and Trademarks: Intangibles with indefinite lives; not subject to amortization but tested for impairment.
• Book Value: The difference between the original cost and accumulated depreciation ($\text{Cost} - \text{Acc. Depr.}$).

Expenditures

• Revenue Expenditures: Ordinary repairs that maintain normal operating condition ($\text{Expensed on the Income Statement}$).
• Capital Expenditures: Extraordinary repairs or additions that extend the asset's life or capacity ($\text{Capitalized on the Balance Sheet}$).

LIABILITIES AND PAYROLL

Current and Long-Term Liabilities

• Known Liabilities: Measurable and certain obligations (e.g., A/P, Notes Payable).
• Liability Characteristics: Present obligations, resulting from past events, requiring future sacrifice of assets or services.
• Unearned Revenue: A liability created when cash is received in advance of providing service.

Notes Payable and Interest

• Interest Formula: $\text{Interest} = \text{Principal} \times \text{Annual Rate} \times \text{Time (in years)}$
• Example: A 60-day, $\$5,000$ note at $12\%$
  • $\text{Interest} = \$5,000 \times 0.12 \times (\frac{60}{360}) = \$100$
• Total Maturity Value: $\text{Principal} + \text{Interest}$

Bonds Payable

• Bond Indenture: The legal contract identifying the rights and obligations of the issuer and bondholders.
• Issuance Pricing:
  • At Par: Stated Rate $=$ Market Rate.
  • At Premium: Stated Rate $>$ Market Rate. (Difference is credited to Premium on Bonds Payable).
  • At Discount: Stated Rate $<$ Market Rate. (Difference is debited to Discount on Bonds Payable, a contra-liability).
• Interest Tax Deductibility: Unlike dividends, bond interest is tax-deductible for the corporation.

Payroll Accounting

• Gross Pay: Total earnings before deductions (Hours worked $\times$ Hourly rate $\pm$ Overtime).
  • $40\, \text{hours} \times \$25 = \$1,000$.
  • $6\, \text{overtime hours} \times \$37.50 = \$225$.
  • $\text{Total Gross} = \$1,225$.
• Net Pay: Gross pay minus all withholdings (Federal tax, Social Security, Medicare).

STOCKHOLDERS' EQUITY AND CORPORATIONS

Corporate Formation and Shares

• Characteristics: Separate legal entity, limited liability for owners, continuous life.
• Rights of Common Stockholders: Voting right, dividend right, liquidation right, and Preemptive Right (maintaining proportional ownership during new issuances).
• Authorized vs. Issued vs. Outstanding:
  • Authorized: Maximum shares allowed to be sold.
  • Issued: Shares actually sold.
  • Outstanding: Issued shares currently held by investors (Issued minus Treasury Stock).
• Par Value: An arbitrary value assigned per share by the corporate charter; represents the minimum legal capital.

Preferred Stock and Dividends

• Preferred Stock: Has priority over common stock for dividends and liquidation assets.
• Cumulative Preference: If dividends are missed, they accumulate and must be paid in the future before any common dividends.
• Issuance at Premium: Excess over par is recorded as "Paid-in Capital in Excess of Par Value."

Retained Earnings and Dividends

• Retained Earnings (RE): Cumulative net income minus net losses and cumulative dividends since inception.
  • $\text{Ending RE} = \text{Beginning RE} + \text{Net Income} - \text{Dividends}$
• Cash Dividends: Reduce both Assets and Equity (Retained Earnings).
• Stock Dividends: Transfer Retained Earnings to Paid-in Capital. They do NOT reduce total Equity or total Assets.

THE ACCOUNTING CYCLE AND FINANCIAL STATEMENTS

Accounting Principles and Assumptions

• Going-Concern Assumption: The business will continue to operate indefinitely rather than being closed or sold.
• Business Entity Assumption: A business is accounted for separately from its owner.
• Cost Principle: Assets are recorded at their actual historical cost, not current market value.
• Matching Principle (Expense Recognition): Record expenses in the same period as the revenues they generate.
• Accrual Basis Accounting: Recording revenues when earned and expenses when incurred, regardless of cash flow timing.

The Closing Process

• Temporary Accounts: Accounts that are closed to zero at year-end (Revenues, Expenses, Dividends/Withdrawals, Income Summary).
• Permanent Accounts: Not closed; balances carry forward (Assets, Liabilities, Capital/Equity).
• Income Summary: Used only during closing to summarize net income or loss before transferring the balance to RE/Capital.
• Post-Closing Trial Balance: Verifies that total debits equal credits after all temporary accounts have been closed. Only permanent accounts appear here.

Financial Statements

• Income Statement: Reports revenues and expenses for a period of time. Results in Net Income or Loss.
• Statement of Retained Earnings (or Owner's Equity): Explains changes in the owners' stake over a period of time.
• Balance Sheet: Lists assets, liabilities, and equity at a specific point in time.
• Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Equity}$