Week 7 - Preparing the financial statements and internal controls

Question 1

What is a method of preparing for financial statements?

Answer 1

1. If required, balance off and close ledger accounts at the period end
2. List all balances in the initial trial balance and check debit and credits are equal
3. Make adjustments to the trial balance for:
   - Closing inventory and inventory write-offs, COGS (week6)
   - Accruals and prepayments (week4)
   - Depreciation and amortisation (week5)
   - Bad debt write-offs and changes in the provision for doubtful debts (week 6)
   - Interest expense, new borrowings or repayment, and other provisions (week9)
   - New share issuance, and dividend payment (week9)
   - Errors and omissions
4. Prepare financial statements

Question 2

What are the main adjustments for COGS and opening and closing inventory?

Answer 2

adjust inventory to its end of year value and calculate COGS (pay attention to any written-down in the closing inventory)

Journals
Debit: Cost of sales XXX
Credit: OB Inventory XXX
Debit: Cost of sale XXX
Credit: Purchases XXX
Debit: Closing Balance Inventory XXX
Credit: Cost of sales XXX

OR

COGS = Opening Inventory + Purchases - Closing Inventory

Question 3

What are the main adjustments for accruals?

Answer 3

• Expense with accruals:
  Calculate how much expense (I/S) has been incurred over the year, starting from the cash payment in the trial balance, decreases (credit) the expense by the amount of opening accrual, and increases (debit) the expense by the amount of closing accrual.
• Create (credit) a (closing) accrual as a liability in the B/S

Journal
Debit: OB Accruals XXX
Credit: Expense (I/S) XXX
Debit: Expense (I/S) XXX
Credit: CB Accruals (B/S) XXX

Directly working out:
Expense (I/S) = CB Accruals (B/S) + Cash payment - OB Accruals

Question 4

What are the main adjustments for prepayments?

Answer 4

• Expense with prepayments: calculate how much expense has been incurred over the year, starting from the cash payment in a trial balance, increase (debit) the expense by the amount of opening prepayments, and decrease (credit) the expense by the amount of closing prepayments
• Create (debit) a (closing) prepayment as an asset in the B/S

Journal
Debit: Expense (I/S) XXX
Credit: OB Prepayment (/S) XXX
Debit: CB Prepayment (B/S) XXX
Credit: Expense (I/S) XXX

Directly working out:
Expense (I/S) = OB Prepayments + Cash Payments - CB Prepayments

Question 5

What are the main adjustments for depreciation (accumulated depreciation)?

Answer 5

• Calculate this year’s depreciation expense and include it in the Income Statement
• Add this year’s depreciation to accumulated depreciation brought forward and include the total in the Balance Sheet

Journal
Debit: Depreciation expense (I/S) XXX
Credit: Accumulated depreciation (B/S) XXX

Adjustments for disposal of non-current assets:
- Remove the disposed assets’ cost and accumulated depreciation

Question 6

What are the main adjustments for credit loss, allowance/provision for doubtful debts?

Answer 6

Adjustment for trade receivables:
1. Credit loss/ bad debts expense
Debit: Credit loss/ Bad debts expense (I/S) XXX
Credit: Receivables (B/S) XXX

2. Allowance for credit loss/ provision for doubtful debts in the year
   - Two provisions: Specific allowance and/ or general allowance
   - The change in allowance for credit loss is included to the I/S (debit for an increase in the provision, credit for a decrease)
   - Total allowance for credit loss is shown below the trade receivables in B/S to reduce the trade receivables

Journals:
If the allowance for credit loss has increased from last year
Debit: Change in allowance for credit loss (I/S) XXX
Credit: Allowance for credit loss (B/S) XXX
If the allowance for credit loss has decreased from last year
Debit: Allowance for credit loss (B/S) XXX
Credit: Change in allowance for credit loss (I/S) XXX

Question 7

What is specific allowance?

Answer 7

an allowance operation we set for a specific customer or specific trade receivables or we have a general allowance

Question 8

Where are adjustments to trial balance made?

Answer 8

• You can use journals to record the adjustments and post these to a final trial balance
• You can use T accounts
• For simple adjustments, use direct calculations

Question 9

Why are internal controls required?

Answer 9

1. to prevent managers/ employees from misappropriating cash and other assets from the organisation (fraud)
   2, to identify errors in recording transactions and amounts
2. to provide evidence to external stakeholders that the company is well governed

Question 10

What are 5 examples of fraud/ theft

Answer 10

1. Supplier fraud
2. Fake employee
3. Theft
4. Customer fraud
5. Collusion

Question 11

What is supplier fraud?

Answer 11

employee creates a fake supplier and arranges for the invoices to be paid

Question 12

What is a fake employee?

Answer 12

when an employee leaves, another staff member tells payroll that the employee’s bank details have changed and arranges for salary to be paid into their own account

Question 13

What is theft?

Answer 13

taking petty cash, stealing inventory or stationary etc

Question 14

What is customer fraud?

Answer 14

customers fail to pay for goods or pay using stolen credit cards or cheques

Question 15

What is collusion?

Answer 15

where employees act together to defraud employer

Question 16

What is the internal control and the separation of responsibility?

Answer 16

a self-checking mechanism
an accounting system control

no one person is responsible for the whole transaction, eg:
1. Initiating transactions
2. Recording of transactions
3. Custody of assets
For example, a sales executive or an inventory custody person cannot record cash, authorise credit notes, or write-off bad debts

Question 17

What is a major external control/ monitoring on companies?

Answer 17

use of external auditors

Question 18

What does an auditor do?

Answer 18

scrutinise accounts, records, controls to report an opinion on whether the accounts show a true and fair view

Question 19

What do auditors not guarantee?

Answer 19

that the accounts are correct or that no fraud has occured

Question 20

What must auditors be?

Answer 20

an expert, a registered auditor, and external auditors must be independent of the company

Question 21

What is the purpose bank reconciliations?

Answer 21

it is a method for internal control
the purpose is to check whether the cash book balance is correct by comparing it to the bank statement

Question 22

Why are the cash book balances often different?

Answer 22

because of timing etc and need to be reconciled

Question 23

What is a bank reconciliation a part of>

Answer 23

not part of the double enry system but must be prepared as part of preparing the financial statements

Question 24

Why should the bank reconciliation always be prepared by someone different to the person who pays cash/ payments into the bank and writes cheques?

Answer 24

so it can act as a control

Question 25

Which one is correct if the cash book balance doesnt equal the bank statement balance?

Answer 25

1. There are timing differences of payments and receipts
   eg if there are items in the cash book but not the bank statement
2. Bank charges/ items notified to the bank
   eg items in the bank statement but not in the cash book
3. Timing differences vs correction of errors
   - Final differences between the cash book and bank statement should always reflect timing differences

Question 26

What are differences arising between the cash book and bank statements?

Answer 26

corrections and adjustments to the cash book (the bank statement is correct, the cash book isnt)
- payments made into or from the bank directly, eg by direct debit but havent been entered into the cash book yet
- dishonoured (bounced) cheques
- bank interest and charges not yet entered in the cash book

Question 27

What are the corrections and adjustments to the cash book (the bank statement is correct, the cash book isnt)?

Answer 27

1. payments made into or from the bank directly, eg by direct debit but havent been entered into the cash book yet
2. dishonoured (bounced) cheques
3. bank interest and charges not yet entered in the cash book

Question 28

What are dishonoured (bounced) cheques?

Answer 28

receipts recorded in the cash book but returned unpaid by customers bank