Exam 2: Equations and Other Info Flashcards
All about accrual-basis accounting
- Record economic events as they occur… assets at the time those resources are obtained, liabilities at the time those obligations occur, revenues at the time goods and services are provided to customers, and expenses at the time costs are used in running the company
- The intent is to provide accurate and timely information to financial statement users to make better decisions.
- Some costs, known as period costs, are more difficult to relate directly to a particular revenue activity, so we report those based on the period they occur (such as rent, advertising, or administrative salaries).
- Accrual-basis accounting is focused on the timing of transactions and events in the accounting cycle.
Similarities and differences between accrual-basis and cash-basis accounting
- Similarity:
– With both types, all revenues and expenses are eventually recorded for the same amount - Differences:
– The timing of when we record revenues and expenses is different (sometimes the timing is the same)
– Cash-basis accounting is not part of GAAP. All major companies use accrual-basis accounting to properly record revenues when goods and services are provided and record expenses in the period those costs have been used in company operations. Cash-basis accounting is not allowed for financial reporting purposes for most major companies.
When do you need adjusting entries?
When cash flows or obligations occur before the revenue-related or expense-related activity (prepayment) or when cash flows occur after the revenue-related or expense-related activity (accrual).
What are the categories of adjusting entries?
- Prepayments: prepaid expenses and deferred revenues
- Accurals: accrued expenses and accrued revenues
- Prepayments and accruals are opposites.
How do you do an adjusting entry for deferred revenue?
At the end of the reporting period, we determine the total amount of services provided and do a single adjusting entry to decrease the balance of Deferred Revenue to its remaining amount. We also recognize Service Revenue for the services provided during the period.
How do you do an adjusting entry for accrued expenses?
An adjusting entry is needed in the current period to record salaries payable (a liability) for the amount to be paid and to recognize salaries expense.
How do you do an adjusting entry for accrued revenues?
An adjusting entry is needed in the current period to record the amount receivable (an asset) and to recognize revenue, even though that cash won’t be received until a future period.
How do you do an adjusting entry for prepaid expenses?
- Common examples include the purchase of buildings, equipment, supplies, or prepaid rent. These payments are recorded as assets at the time of purchase.
- In the period these assets are used, an adjusting entry is needed to 1) decrease the asset’s balance to its remaining (unused) amount, and 2) recognize an expense for the cost of asset used.
All about depreciation
Depreciation is an estimate based on expected useful life and is an attempt to allocate the cost of the asset over its useful life. Depreciation is an internal calculation, and the book value doesn’t necessarily represent market value (what the asset could be sold for in the market).
All about deferred revenues
- Common examples include receiving cash in advance from customers for subscriptions, memberships, and gift cards.
- When a customer receives cash before providing services to customers, it owes the customer a service in return (this creates a liability).
- In the period those services are provided, the liability is settled, and adjusting entry is needed to 1) decrease the liability to its remaining amount owed, and 2) recognize revenue.
All about accrued expenses
- Common examples include the current cost of employee salaries, utilities, interest, and taxes that won’t be paid until the following period.
- Because the company has used these costs to operate the company in the current period and is obligated to pay them, an adjusting entry is needed to 1) record the liability to be paid, and 2) recognize the cost as an expense.
- There are 3 accrued expenses in the soccer example: employee salaries, utilities, and interest. Each represents costs used to operate the company during December, and the company is obligated to pay for these costs in the future.
All about accrued revenues
- Common examples include selling products and services to customers on account or being owed interest on amounts lent to others.
- Because the company has provided products and services in the current period and has the right to receive payment, an adjusting entry is needed to 1) record an asset for the amount expected to be received, and 2) recognize revenue.
Name 3 times when no adjustment is necessary.
- Transactions with owners do not involve the recognition of revenues or expenses.
- Transactions in which we receive cash at the same time we record revenue or in which we pay cash at the same time we record an expense do not require adjusting transactions (no timing differences).
Classified balance sheets separate assets and liabilities into what major categories?
Current assets and long-term assets // Current liabilities and long-term liabilities
How are current assets listed on a classified balance sheet?
Typically listed in order of liquidity…
- Cash is the most liquid of all assets, so it’s listed first.
- Accounts receivable (amounts owed by customers to the company) are generally collected within one month, so they are highly liquid assets and typically listed after cash.
- Prepaid expenses (such as supplies and prepaid rent) will not be converted to cash, but they are expected to be consumed within the next year, so they are included as current assets.
What are examples of current assets on a classified balance sheet?
-cash
- accounts receivable
- prepaid expenses (such as supplies and prepaid rent)
What are examples of long-term assets on a classified balance sheet?
- long-term investments
- property, plant, and equipment (such as land, buildings, equipment, machinery)
- intangible assets (such as patents, copyrights, trademarks, and franchises)
What are examples of current liabilities on a classified balance sheet?
- accounts payable
- deferred revenue
- salaries payable
- utilities payable
- interest payable
What is an example of a long-term liability on a classified balance sheet?
A loan that has a term longer than one year
How do you close revenue accounts?
Revenue accounts have credit balances, so we debit each revenue account for its balance and credit Retained Earnings for the total.
How do you close expense accounts?
Expense accounts have debit balances, so we credit each expense account for its balance and debit Retained Earnings for the total.
How do you close dividends accounts?
Dividends account has a debit balance, so we credit its balance and debit Retained Earnings for the same amount.
Which accounts should have a balance of $0 after closing entries?
All temporary accounts, so every revenue, expense, and dividend account. We start from scratch in measuring these the next period.
What is the ending balance of Retained Earnings after closing entries?
Ending Retained Earnings = Beginning Retained Earnings + net income - dividends
What two purposes do closing entries serve?
- To transfer the balances of temporary accounts (revenues, expenses, and dividends) to the Retained Earnings account
- To reduce the balances of these temporary accounts to zero to prepare them for measuring activity in the next period. Closing entries increase retained earnings by the amount of revenues for the period and decrease retained earnings by the amount of expenses and dividends for the period
Closing entries do not affect what?
- Closing entries do not affect the balances of permanent accounts (assets, liabilities, and permanent stockholders’ equity accounts) other than retained earnings. Permanent accounts carry a cumulative balance throughout the life of the company.
- Closing entries are not meant to reduce the balance of Retained Earnings to zero. Retained Earnings is a permanent account, representing the accumulation of all revenues, expenses, and dividends over the life of the company.
What are the two most common sources of occupational fraud?
- Number one is misuse of company resources (cash is the asset most commonly involved with fraudulent activity)
- Number two is financial statement manipulation
What are the 3 elements of the fraud triangle?
opportunity, motivation, and rationalization
How can a company minimize fraud?
At least one of the three elements of the fraud triangle must be eliminated
Which of the three elements of the fraud triangle do companies have the greatest ability to eliminate?
Opportunity
How can a company eliminate the opportunity for fraud?
By implementing internal controls
–> the quality of internal controls directly affects the quality of financial accounting
–> strong internal control systems allow greater reliance by investors on reported financial statements
Describe two of the highest-profile cases of accounting fraud in U.S. history.
- Enron used questionable accounting practices to avoid reporting billions in debt and losses in its financial statements.
- WorldCom misclassified certain expenditures to overstate assets and profitability by $11 billion.
- Both companies hoped to fool investors by overvaluing the company’s stock.
What are some common types of financial statement fraud?
Creating fictitious revenues, overstating assets, improperly valuing assets, hiding liabilities, and mismatching revenues and expenses
All about the SOX Act
- It established a variety of guidelines related to auditor–client relations and internal control procedures
- It applies to all companies that are required to file financial statements with the SEC
- It represents one of the greatest reforms in business practices in U.S. history.
What is the PCAOB?
- Part of the SOX Act
- Stands for Public Company Accounting Oversight Board
- they have the authority to establish standards dealing with auditing, quality control, ethics, independence, and other activities relating to the preparation of audited financial reports
- the board consists of five members who are appointed by the SEC
What are the two reasons a company must have internal controls?
- to safeguard the company’s assets
- to improve the accuracy and reliability of accounting information
What are the components of internal control? (Pyramid graphic)
Information and communication: A system should be in place to ensure that current transactions of the company are reflected in current reports. Employees should be aware of procedures in place to deal with any perceived internal control failures.
- Control environment: If employees notice unethical behavior or comments by management, they are more likely to behave in a similar manner, wasting the company’s resources
- Risk assessment of internal and external risks
- Control activities
- Monitoring: monitoring of internal controls needs to occur on an ongoing basis
What are the types of control activities?
- Preventive controls, which include
- separation of duties (prevents fraud)
- physical controls over assets and accounting records
- proper authorization to prevent improper use of company resources
- employee management (guidance, training)
- e-commerce controls - Detective controls, which include:
- reconciliations: management should periodically determine whether the amount of physical assets agree with accounting records
- performance reviews of employees and processes
- audits
Who takes final responsibility for the establishment and success of internal controls?
Top executives
Everyone in a company has an impact on the operation and effectiveness of internal controls, but the top executives are the ones who must take final responsibility for their establishment and success.
What does section 404 of SOX require?
Companies must document their internal controls and assess their adequacy, plus the company’s auditors provide an opinion on management’s assessment.
Which asset is the most susceptible to employee fraud?
Cash
What are the two reasons that numbers can be off in a bank reconciliation?
- Timing differences: the company records transactions either before or after the bank records the same transactions
- Examples: a company records an increase to cash immediately, but the bank doesn’t record it until it is later deposited; a bank’s service fees immediately reduce the bank’s record of the company’s balance of cash, but the company is not immediately aware of these fees - Errors: made by the company or its bank and may be accidental or intentional
- Accidental examples: a company mistakenly records a payment of $117 instead of $171; a bank improperly processes a deposit of $1,100 as $1,010
- Intentional example: a company records a daily deposit of $5,000 but an employee only depots $500 in the bank and pockets the rest
What are the three steps for bank reconciliation?
- Reconcile the bank’s cash balance
- Reconcile the company’s cash balance
- Update the company’s Cash account by recording items identified in step 2
Describe step 1 of bank reconciliation (reconcile the bank’s cash balance)
- Determine which cash transactions have been recorded by the company but not yet recorded by the bank.
- Deposits outstanding cause the bank’s balance to be LESS than the company’s balance of cash
- Checks outstanding cause the bank’s balance to be MORE than the company’s balance of cash
- We adjust the bank’s cash balance per bank statement by ADDING deposits outstanding and SUBTRACTING checks outstanding.
Describe step 2 of bank reconciliation (reconcile the company’s cash balance)
Use the general ledger to determine which cash transactions have been recorded by the bank but not yet recorded by the company.
Describe step 3 of bank reconciliation (update the company’s cash account)
these are amounts the company didn’t know until it examined the bank statement
- For reconciliation items that increase the company’s balance of cash, we debit Cash. For reconciliation items that decrease the company’s balance of cash, we credit Cash.
Common mistake: Do not update the Cash account for deposits outstanding, checks outstanding, or a bank error. The company does not need to adjust for these items related to reconciling the bank’s balance because they are already properly recorded in the company’s accounting records.
What does a company do if it cannot resolve a discrepancy between the two balances at the end of bank reconciliation (after they have investigated)?
Record the difference to either Miscellaneous Expense or Miscellaneous Revenue, depending on whether it has a debit or credit balance (ex: a company cannot account for $100 missing cash - debit Miscellaneous Expense and credit cash)
What statement do you need to update a bank’s cash balance in reconciliation AND list the items needed (and whether each item is + or - cash)
Use the bank statement
Timing differences:
* Deposits outstanding +
* Checks outstanding -
Errors:
* Bank errors +/-
What statement do you need to update a company’s cash balance in reconciliation AND list the items needed (and whether each item is + or - cash)
Use the general ledger
Timing differences:
* Notes received by bank +
* Interest received +
* Unrecorded payments -
* NSF checks from customers -
* Bank service fees -
Errors:
* Company errors +/-
If employees make purchases with a company credit card, how is it recorded?
They are typically not paid immediately, so it is a credit to Accounts Payable until paid. If the company’s accountant decides to pay the credit card balance at the time of reconciliation, it is a credit to Cash.
What two financial statements include cash and what do they show?
Balance sheet: shows only the final balance of cash
Statement of cash flows: shows cash receipts and payments during the period
What can investors learn from the statement of cash flows?
A company’s cash inflows and outflows related to:
1. operating activities - transactions involving revenues and expenses (the same activities reported in the income statement to calculate net income)
2. investing activities - cash investments in long-term assets (and selling those assets)
3. financing activities - activities involving liabilities and stockholders’ equity… transactions designed to raise cash or finance the business, such as borrowing cash from lenders, raising cash from stockholders… also includes cash outflows to repay debt and cash dividends to stockholders
What transactions do not involve an inflow or outflow of cash?
Transactions on account… so they are not included in the statement of cash flows
6 reasons why some companies hold onto more cash than other companies
- profitability - companies with higher profits tend to have more cash available
- growth - growing companies tend to have less cash available because their spending more on expansion
- reserves - companies sometimes hold onto more cash in anticipation of major purchases or debt payments
- volatility of operations - companies with more volatile operations tend to have more cash so they can repay debt and not enter bankruptcy
- foreign operations - something about taxes with international companies
- dividend policy - companies that pay higher dividends tend to have less cash available
