Accounting and Internal Controls Exam 3 Review

Essential Definitions and Block 2 Foundations

  • Internal Controls: Defined as a company's formal plan designed to accomplish two primary objectives:

    • Safeguard the company's assets.

    • Improve the accuracy and reliability of accounting information.

  • Separation of Duties: A critical internal control requirement where the following activities must be separated among different employees to prevent fraud and errors:

    • Authorizing transactions.

    • Recording transactions.

    • Maintaining control of related assets.

  • Multi-Step Income Statement: An income statement format that classifies and reports multiple levels of income or profitability (e.g., Gross Profit, Operating Income, and Net Income).

  • Residual (Salvage) Value: The specific amount a company expects to receive from selling or disposing of an asset at the conclusion of its service life.

  • Straight-Line Depreciation Calculation: A method that allocates an equal amount of depreciation expense to each year of the asset's service life.

  • Intangible Assets: Long-term assets that lack physical substance; their existence and value are often established based on a legal contract.

  • Net Accounts Receivable: The calculated difference between the total accounts receivable balance and the allowance for uncollectible accounts.

Internal Controls, Fraud, and the Sarbanes-Oxley Act

  • Performance Measures: The formal process through which managers at all organizational levels collect information regarding employee tasks and organizational performance. This performance is judged against pre-established criteria found in financial statements, budgets, plans, and goals.

    • Performance measures drive behavior but may result in unintentional consequences if they create excessive or misaligned motivation.

    • Well-designed internal controls and thought-out performance measures mitigate elements of the Fraud Triangle.

  • The Fraud Triangle: A framework identifying three factors that lead to fraud:

    • Opportunity: The situation that allows fraud to occur (minimized by internal controls).

    • Motivation: The pressure or incentive leading an individual to commit fraud.

    • Rationalization: The justification an individual provides for their fraudulent behavior.

  • Roles and Fraud Risk: Overlapping roles within a company (e.g., one person holding multiple positions) can significantly increase the risk of fraud.

  • Types of Fraud:

    • Misappropriation of Assets: Employees stealing assets (e.g., cash, accounts receivable, setting up fake employees, or submitting false expense reports).

    • Fraudulent Financial Reporting: Managers manipulating journal entries to make the company appear more profitable (overstating revenue or understating expenses) to deceive investors and creditors.

  • Sarbanes-Oxley Act of 2002 (SOX): Passed by Congress and applies to all financial statements filed with the SEC. It established rigorous guidelines for:

    • Internal control procedures.

    • Auditor-client relations.

  • Internal Control Framework (COSO):

    • Control Environment: Also known as the "Tone at the Top," this sets the ethical tone. It includes formal policies regarding management's philosophy and assignments of responsibility.

    • Risk Assessment: Identifying and analyzing internal and external risk factors and determining procedures to manage those risks.

    • Control Activities: Policies and procedures ensuring management's directives are executed.

    • Monitoring: Overseeing the internal control system to ensure it continues to function properly.

  • Types of Control Activities:

    • Preventative Controls: Designed to stop errors or fraud before they happen. Examples: Separation of duties, physical controls (safes/locks), proper authorization, and employee management.

    • Detective Controls: Designed to find errors or fraud that have already occurred. Examples: Reconciliations, performance reviews, and video surveillance.

Accounting for Accounts Receivable and Bad Debt

  • Accounts Receivable (A/R): Represents an asset where products or services have been provided, and cash is expected to be received later.

  • Contra Accounts: Accounts with a balance opposite to their related account. For example, Allowance for Uncollectible Accounts is a contra asset that reduces Accounts Receivable.

  • Calculating Net Sales/Revenue:

    • Net Sales=Sales−Returns−Discounts−Allowances \text{Net Sales}=\text{Sales}-\text{Returns}-\text{Discounts}-\text{Allowances }

    • Accounts such as Sales Returns, Sales Allowance, and Sales Discounts are all Contra Revenue accounts with a normal debit balance.

  • The Allowance Method: Used to estimate bad debt losses before they actually happen.

    • Adjusting Entry: Record at the end of the period.

      • Debit: Bad Debt Expense

      • Credit: Allowance for Uncollectible Accounts

    • Write-off Entry: When a specific account is deemed uncollectible.

      • Debit: Allowance for Uncollectible Accounts

      • Credit: Accounts Receivable

    • Crucial Rule: Write-offs do NOT affect total expenses or the net book value of accounts receivable, as the expense was already estimated and recorded.

  • Formulas for Receivables:

    • Bad Debt Expense=Target Allowance−Current Allowance\text{Bad Debt Expense} = \text{Target Allowance} - \text{Current Allowance}

    • Net Accounts Receivable=A/R−Allowance\text{Net Accounts Receivable} = \text{A/R} - \text{Allowance}

  • Valuation via Aging: An A/R aging method categorizes accounts based on how long they have been outstanding (e.g., Current, 30-60 days, 60-90 days, 90+ days) to estimate the necessary allowance.

Inventory Systems and Costing Methods

  • Inventory Flow Formula:

    • Beginning Inventory+Purchases=Cost of Goods Available for Sale\text{Beginning Inventory} + \text{Purchases} = \text{Cost of Goods Available for Sale}

    • Cost of Goods Available for Sale−Ending Inventory=Cost of Goods Sold (COGS)\text{Cost of Goods Available for Sale} - \text{Ending Inventory} = \text{Cost of Goods Sold (COGS)}

  • Costing Methods:

    • FIFO (First-In, First-Out): Assumes the oldest inventory items are sold first. During periods of rising prices, FIFO results in a lower COGS and a higher Net Income.

    • LIFO (Last-In, First-Out): Assumes the newest, most expensive inventory items are sold first. This results in a higher COGS and lower Net Income.

    • Weighted Average: Calculates a mean cost per unit based on all units available for sale.

  • Inventory Sales Process (Two-Step Entry):

    1. Record the revenue from the sale and the increase in assets (Cash or A/R).

    2. Record the Cost of Goods Sold (COGS) and the reduction in inventory (Asset).

Long-Term Assets and Depreciation

  • Straight-Line Depreciation Formula:

    • Depreciation Expense=Cost−SalvageLife\text{Depreciation Expense} = \frac{\text{Cost} - \text{Salvage}}{\text{Life}}

    • This results in an equal expense each year.

  • Activity-Based Depreciation: Expense is calculated based on the actual usage of the asset instead of the passage of time.

  • Double-Declining Balance: An accelerated method that records higher depreciation expense in the early years of an asset's life. Note: Salvage value is not used in the initial formula calculation but the asset is not depreciated below salvage value.

  • Book Value Formula:

    • Book Value=Cost−Accumulated Depreciation\text{Book Value} = \text{Cost} - \text{Accumulated Depreciation}

Financial Statements and Preparation

  • The Accounting Equation: Assets=Liabilities+Stockholders’ Equity\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}

  • Financial Statement Order:

    1. Income Statement: Reports Revenues minus Expenses to find Net Income.

    2. Statement of Stockholders' Equity: Calculates ending Retained Earnings.

      • Ending Retained Earnings=Beginning Retained Earnings+Net Income−Dividends\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}

    3. Balance Sheet: Reports Assets, Liabilities, and Stockholders' Equity as of a specific date.

  • Income Statement Structure (Multi-Step):

    • Sales

    • Less: COGS

    • Equals: Gross Profit

    • Less: Operating Expenses

    • Equals: Operating Income

    • +/- Other Items (Interest, Gains/Losses)

    • Equals: Net Income

  • Trial Balance Components: A list of all accounts and their balances. Total Debits must always equal Total Credits.

  • Closing Entries: Process of transferring temporary accounts (Revenues, Expenses, Dividends) to the permanent Retained Earnings account.

Stockholders' Equity and Corporate Accounts

  • Paid-in Capital: The total amount invested by stockholders in the corporation, including Common Stock, Preferred Stock, and Additional Paid-in Capital.

  • Earned Capital: The amount of earnings the corporation has retained (Retained Earnings).

  • Treasury Stock: The corporation’s own stock that has been reacquired.

  • Common Stock: The basic form of stock issued. The four primary rights of shareholders are:

    1. Right to vote.

    2. Right to receive dividends.

    3. Right to share in distribution (liquidation).

    4. Preemptive right.

  • Preferred Stock: Features advantages over common stock, such as receiving dividends first and preference in assets during liquidation. Shareholders usually earn a fixed dividend.