BUS103 Study Guide
| Site: | Saylor Academy |
| Course: | BUS103: Introduction to Financial Accounting |
| Book: | BUS103 Study Guide |
| Printed by: | Guest user |
| Date: | Tuesday, May 21, 2024, 6:20 AM |
Table of contents
- Navigating this Study Guide
- Unit 1: Accounting Environment, Decision-Making, and Theory
- Unit 2: Recording Business Transactions
- Unit 3: Adjusting Entries
- Unit 4: Completing the Accounting Cycle
- Unit 5: Financial Reporting and Financial Statement Analysis
- Unit 6: Accounting for Inventory
- Unit 7: Accounting for Receivables and Payables
- Unit 8: Accounting for Property, Plant, and Equipment
- Unit 9: Long-Term Liabilities and Stockholders' Equity
- Unit 10: Statement of Cash Flows
Navigating this Study Guide
Study Guide Structure
In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit.
Beneath each learning outcome are:
- questions for you to answer independently;
- a brief summary of the learning outcome topic; and
- and resources related to the learning outcome.
At the end of each unit, there is also a list of suggested vocabulary words.
How to Use this Study Guide
- Review the entire course by reading the learning outcome summaries and suggested resources.
- Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.
By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.
Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!
Unit 1: Accounting Environment, Decision-Making, and Theory
1a. Define the basic accounting equation
- What is the basic accounting equation?
- What is the definition of assets, liabilities, and owners' equity?
1b. Apply the accounting equation to illustrate the impact of business transactions
- How can you use the accounting equation to analyze business transactions?
- What is the impact on the accounting equation of common business activities?
- How can the activities of a business impact the owners' equity?
Knowing the basic accounting equation also allows you to understand better the rules of debits and credits. If a company increases its assets without increasing liabilities, the owners' equity will increase. If a company increases liabilities without increasing asset value, then owners' equity will decrease. Financial managers can project the impact on the accounting equation of various business strategies and make financial decisions that will lead to the maximization of shareholder wealth.
To review, see Accounting and its Use in Business Decisions.
1c. Compare and contrast the basic forms of business organizations
- What are the main forms of business organization?
- What are the advantages and disadvantages of a sole proprietorship?
- What are the advantages and disadvantages of a partnership?
- What are the advantages and disadvantages of a corporation?
To review, see Accounting and its Use in Business Decisions.
1d. Explain GAAP rules and their importance in the study of accounting
- What does GAAP stand for?
- What organization oversees the creation of GAAP rules?
- Why is it important to study GAAP rules?
Companies are required to follow GAAP rules, so understanding them and their implementation is a critical component of financial management. Understanding GAAP rules also helps the manager understand how their company is judged and measured against other companies.
To review, see GAAP Principles and Concepts.
1e. Explain the difference between financial and managerial accounting
- What is the difference between financial and managerial accounting?
- Do managers have to use both financial and managerial accounting?
- Why is it important for managers to understand both?
| Managerial Accounting | Financial Accounting | |
|---|---|---|
| Users | Inside the organization | Outside the organization |
| Accounting rules | None | U.S. Generally Accepted Accounting Principles (U.S. GAAP) |
| Time horizon | Future projections (sometimes historical if in detail) | Historical information |
| Level of detail | Often presents segments of an organization (e.g., products, divisions, departments) | Presents overall company information in accordance with U.S. GAAP |
| Performance measures | Financial and nonfinancial | Primarily financial |
Financial accounting provides historical financial information for external users that conforms to GAAP rules. It is required for financial reporting. Managerial accounting provides detailed financial and non-financial information for internal users. It is important for managers to use managerial accounting data to make good decisions, plan for the future, and control their operations.
To review, see Financial vs. Managerial Accounting.
1f. Summarize the foundational principles of accounting used in analyzing transactions
- What are the major underlying assumptions that guide the system of accounting?
- Do you understand how the fundamental accounting principles govern the reporting that companies in the U.S. must do?
- What are the basic principles that govern how accounting information is reported?
- business entity
- going concern
- money measurement
- stable dollar
- periodicity
- cost principle
- revenue recognition principle
- matching principle
- gain and loss recognition principle
- full disclosure principle
To review, see Accounting Theory.
1g. Explain how to detect fraud risk in the accounting function
- What is the fraud triangle, and how is it used to detect fraud risk?
- How does perceived opportunity create the potential for fraud?
- How can rationalization lead to fraud?
- What pressures might create incentives for someone to commit fraud?
To review, see Fraud, Internal Controls, and Cash.
1h. Discuss management responsibilities for monitoring the effectiveness of internal control systems in an organization
- How does SOX govern management responsibility for internal controls?
- What is the responsibility of management in ensuring the integrity of financial reports?
Unit 1 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- assets
- basic accounting equation
- corporation
- FASB
- financial accounting
- fraud triangle
- GAAP
- incentive
- internal control
- liabilities
- managerial accounting
- owners' equity
- partnership
- perceived opportunity
- rationalization
- Sarbanes Oxley Act
- sole proprietorship
Unit 2: Recording Business Transactions
2a. Illustrate the rules of debits and credits, and which accounts they increase or decrease
- What do the terms debit and credit represent?
- What accounts increase or decrease with a debit or a credit?
The term debit means the left side of the t-account, while credit refers to the right side of the t-account. The American accounting system is a double-entry system, where every entry must have equal debits and credits. Debits and credits are the building blocks of our accounting system. Assets increase by debits and decrease by credits. Liabilities and stockholders' equity decrease by debits and increase by credits. Revenues increase with a credit and decrease with a debit. Expenses increase by debits and decrease by credits. Debits must always equal credits for every transaction.
To review, see Recording Business Transactions and More on the Rules of Debits and Credits.
2b. Explain the steps in the accounting cycle
- What are the eight steps in the accounting cycle?
- What is the goal of the accounting cycle?
The accounting cycle is the series of steps performed during every accounting period. The eight steps in the accounting cycle are:
- Analyze transactions by examining source documents.
- Journalize transactions in the journal.
- Post journal entries to the accounts in the ledger.
- Prepare a trial balance of the accounts and complete the worksheet (includes adjusting entries).
- Prepare financial statements.
- Journalize and post adjusting entries.
- Journalize and post closing entries.
- Prepare a post-closing trial balance.
The goal of the accounting cycle is to produce financial statements for the company.
To review, see The Accounting Cycle.
2c. Perform double entry accounting for basic business transactions
- What is the double entry system for analyzing business transactions?
- How does the basic accounting equation help you understand and apply the rules of double entry accounting?
- How is a t-account used to analyze transactions?
The double entry system is the backbone of financial accounting. Double entry accounting requires that every business transaction be recorded with at least one debit and one credit, and the sum of the debits must equal the sum of the credits. The transaction must always balance. How the balancing occurs can be understood by looking back at the basic balance sheet equation. Since Assets = Liabilities + Owner's Equity, the transaction must be recorded in a manner that continues to balance. Since a debit increases an asset, a credit must increase a liability or equity account since they are on opposite sides of the basic accounting equation.
Knowing which side of the equation the account falls on allows you to know if they are increased or decreased with a debit or a credit. T-accounts help you apply the double-entry system. Entries on the left are debits, and entries on the right are credits. By utilizing t-accounts to analyze business transactions, you can more easily see what account should be debited and what account should be credited, and easily check that debits=credits and your accounting equation remains in balance.
To review, see Recording Business Transactions.
2d. Prepare a trial balance
- What is the purpose of a trial balance?
- What are the steps required to prepare a trial balance?
A trial balance is usually prepared once all of the business transactions are recorded for the period. The purpose of the trial balance is to test if the total debits equal the total credits for all the transactions recorded. The accounting manager is checking their work by completing a trial balance. To prepare a trial balance, you first list all the accounts with a balance and enter debit balances in the left column and credit balances on the right. The left and right columns are then summed, and the totals are compared to check for equality. If the totals are not equal, the manager goes back and re-checks that the balances were entered correctly, that the math was correct, and that nothing was left off the statement.
The trial balance is useful for finding some errors but will not show if a transaction is completely left off or if errors of the same amount are made on both the debit and credit sides. The trial balance is an important check before moving on to adjusting entries and financial statement preparation.
To review, see Accounting Cycle Step 4: Unadjusted Trial Balance.
Unit 2 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- accounting cycle
- credit
- debit
- double-entry system
- t-account
- trial balance
Unit 3: Adjusting Entries
3a. Identify why adjusting entries are necessary
- What is the difference between cash accounting and accrual accounting?
- Why does a company that uses accrual accounting have to make adjusting entries?
- What would be the result if adjusting entries were not made?
Companies that use cash-basis accounting record business transactions only when cash is paid out or received. Most organizations use accrual-basis accounting, which records transactions according to the GAAP rules for revenue recognition and matching. This results in revenues and expenses sometimes being recorded in a different period than when the associated cash is received or paid.
Accrual accounting also creates the need to make adjusting entries. Adjusting entries are necessary because the accounting period ends on a particular date, and all relevant revenues and expenses must be recorded even if the cash hasn't changed hands. Adjusting entries never involves the cash account. Failure to record adjusting entries at the end of an accounting period results in inaccurate income statements and balance sheets.
To review, see Adjustments for Financial Reporting and Cash vs. Accrual Accounting.
3b. Distinguish among various types of adjusting entries
- What are the major types of adjusting entries?
- What is the difference between a deferral and an accrual?
There are five main categories of adjusting entries:
- Prepaid expenses – adjusting is necessary to show the portion of the asset that has been consumed during the period, such as prepaid rent or prepaid insurance.
- Depreciation – adjusting entry required to show the decline in the value of a plant asset.
- Accrued Expense – expenses that are incurred but not recorded, such as wages or interest.
- Accrued revenue – this is revenue that has been earned but not yet billed,
- Unearned revenue – adjustment is required to show that cash has been received, but the associated revenue has not been earned yet.
A deferral is money paid or received before the expense or revenue should be recognized. Deferred expenses involve payments made in advance, such as for rent or insurance, which will only become an expense with the passage of time, to adhere to the matching principle. Deferred revenue happens when a company receives money in advance of earning it.
An accrual is when the expense or revenue needs to be recognized before the money is paid or received. Accrued expenses are when it is necessary to record the expense and liability in the accounting period before payment is made, such as a utility bill that won't be invoiced until next month even though the utility was used. Accrued Revenue is the reporting of revenue that we earned, but before processing the invoice or receiving the money.
To review, see Adjustments for Financial Reporting.
3c. Apply the revenue recognition and matching principles to transaction analysis
- What is the revenue recognition principle?
- What is the matching principle?
The revenue recognition principle requires that to record revenue, a company must show that the revenue was earned and that collection of the payment is reasonably assured. A company earns revenue by delivering the product or service. The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. In other words, you must match the recognition of the expense with the revenue that it helped generate.
Adjusting entries are used to ensure that the revenue recognition and matching principles are followed. For example, let's say a roofing company took a deposit from a customer for a roof that they would install in the coming months. When the deposit was received, the company had not yet provided a product or service. As such, that cash represented a liability, as the company owed the customer a roof. At the time of deposit, cash would be debited, and the liability, unearned revenue, would be credited. Once the roof was installed, the company could remove (debit) the liability unearned revenue and credit their revenue account.
To review, see Adjustments for Financial Reporting.
3d. Interpret economic transactions and create appropriate adjusting entries
- What adjustment is needed when a company has paid rent in advance?
- What adjustment is required to show the loss in value of a plant asset?
- What adjustment is needed when a company completes a service that the client had prepaid for?
It is important to practice the various adjusting entries.
If a company paid for rent in advance, it must make an adjustment to show that some of the value of that prepayment has been used up. The entry would be a Debit to Rent Expense and a credit to Prepaid Rent.
Depreciation is how a loss in value of a plant asset is recorded. After calculating the appropriate amount of loss, the adjusting entry involves debiting Depreciation Expense and crediting the contra-asset account Accumulated Depreciation.
When a company completes a service, it has earned the revenue. Since the cash was previously received, the original entry would have debited cash and credited unearned revenue. Now that the revenue has been earned, the adjusting entry is to debit Unearned Revenue and credit Revenue.
To review, see Adjustments for Financial Reporting.
3e. Prepare an adjusted trial balance
- When is the adjusted trial balance created?
- What is the adjusted trial balance used for?
After adjusting entries have been recorded and posted, an adjusted trial balance is prepared by listing all the accounts and their balances. If the adjusting entries were posted correctly, then the total debits will equal the total credits. The adjusted trial balance is another check for accuracy after the adjusting entries are completed. The financial statements are prepared using the adjusted trial balance. Some account balances will not change between the trial balance and the adjusted trial balance. Those affected by the adjusting entries will change. It is important to remember that the fact that the adjusted trial balance has equal debits and credits does not mean it is error-free. If an adjusting entry is not made, the totals will still balance, but the statement will be incorrect.
To review, see Completing the Accounting Cycle.
Unit 3 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- accrual
- accrual-basis accounting
- adjusted trial balance
- adjusting entry
- cash-basis accounting
- deferral
- matching principle
- revenue recognition principle
Unit 4: Completing the Accounting Cycle
4a. Explain the closing process for the accounting cycle
- What are the steps required to complete the closing process?
- How does the Income Summary account relate to the income statement?
The closing process is when entries are made to reduce all temporary accounts to a zero balance at the end of each accounting period. This is accomplished by debiting or crediting the balances in the revenue and expense accounts and making a corresponding debit or credit to the Income Summary Account. This temporary clearing house account is used to organize the closing process. The balance in Income Summary and the balance in the Dividends accounts are closed to the Retained Earnings account. When the closing process is complete, the accounts have a zero balance and are ready to receive new entries in the next accounting period.
The Income Summary account is only used during the closing process to facilitate and summarize the appropriate entries. The balance of the Income Summary Account will translate to the Net Income or Loss on the Income Statement.
To review, see Completing the Accounting Cycle.
4b. Perform the necessary closing entries
- What accounts get closed at the end of the cycle?
- What are the entries required to complete the closing process?
At the end of the accounting period, the revenue, expense, and dividend accounts are closed, not the asset liability, capital stock, or retained earnings accounts. Accounts that are closed are called temporary accounts, whereas those that are not are called permanent accounts.
The closing process has four steps:
- Debit the revenue accounts and credit Income Summary.
- Credit the expense accounts and debit Income Summary.
- Close the balance in the Income Summary to the capital account.
- Credit dividends (or owner's draw) and debit the capital account.
To review, see Adjusting and Closing Entries.
4c. Describe the process for preparing a post-closing trial balance
- What is the post-closing trial balance?
- How is the post-closing trial balance different from the adjusted trial balance?
The post-closing trial balance is a trial balance completed after all the closing entries have been posted. Once the closing entries are completed, the revenue, expense, and dividend accounts should all have zero balances. Record all the balances on the post-closing worksheet in the proper debit or credit column. Only the permanent accounts (asset, liability, capital stock, and retained earnings) should have balances that will appear on the post-closing trial balance. The total debits should equal the total credits as a check that the closing process was completed accurately.
The post-closing trial balance is different from the adjusted trial balance because it does not have any temporary accounts as they were closed. It has the updated retained earnings balance after the net income or net loss is determined.
To review, see Completing the Accounting Cycle.
4d. Create an income statement and balance sheet from the adjusted trial balance
- What statements do the adjusted trial balance accounts appear on?
- In what order are the financial statements prepared?
The adjusted balances for revenues and expenses will appear on the income statement and will result in the determination of the net income or net loss for the period. The permanent accounts of assets, liabilities, and equity appear on the balance sheet. The income statement is prepared first to determine the net income or net loss. The statement of retained earnings must be prepared before the balance sheet to show the changes in the equity account as a result of dividends and retained earnings. Finally, the balance sheet is prepared.
To review, see Completing the Accounting Cycle.
Unit 4 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- closing process
- Income Summary
- post-closing trial balance
Unit 5: Financial Reporting and Financial Statement Analysis
5a. Conduct horizontal and vertical analyses of a company's financial statements
- What are the benefits of analyzing financial statements using horizontal and vertical analyses?
- What type of analysis allows you to compare a company with other companies of different sizes?
Many stakeholders look to a company's financial statements to determine its current value and health and attempt to predict its future performance. Since the financials of a company change over time and companies are of different sizes, comparisons can be difficult. Analysts use horizontal and vertical analyses to more easily compare a company over time and to its competitors. A horizontal analysis refers to calculating the total changes and percent changes in various financial statement items over multiple periods. To evaluate the performance of the company, an analyst would look at how each item has changed over time and compare those results with the percentages from other companies. This allows comparisons to be useful, even if the companies are of different sizes. A horizontal analysis provides valuable trend data and highlights trends that management needs to pay attention to.
Vertical analysis is when you take a financial statement and calculate all the items on it as a percentage of a significant total. For example, on the income statement, all line items would be expressed as a percentage of sales. This allows the analyst to see trends in terms of the relationships of financial statement accounts to each other (for example, if administrative costs as a percentage of sales are increasing). Most often, balance sheet items are expressed as a percentage of total assets.
When financial statements are shown as percentages of a line item, they are known as common-size statements.
To review, see:
- Analysis and Interpretation of Financial Statements
- Vertical Analysis
- Common Size Financial Statements
- Horizontal Analysis
5b. Calculate key ratios from financial statement data including liquidity, profitability, efficiency, and leverage ratios
- Why are financial ratios needed to analyze a company's financial health?
- What are the main categories of financial ratios?
A financial ratio is a relationship between financial statement amounts. Financial ratios help examine the relationship among financial statement numbers and help show the trends with those numbers over time. When you utilize a formula to calculate a ratio, you are able to express a relationship as a percentage and are then able to compare the ratio over time and across companies. For example, a company may have Net Income of $1.2 billion; how do you know if that is good? If you know that $1.2b is a 5.4% net profit margin, you can compare that percentage to the company over time and to other companies to judge the performance of the company. Without ratios, stakeholders aren't able to make comparisons about a company over time or against other companies.
Financial ratios are generally broken down into the categories of liquidity, profitability, efficiency, and leverage ratios, although you can consider many more categories. Liquidity ratios analyze a company's ability to pay its short-term debt. Profitability ratios look at the overall financial return the company generates on its sales. Efficiency ratios examine how well a company manages various assets, such as inventory and accounts receivable. Leverage ratios analyze the amount of debt a company has, typically in comparison to assets or equity.
To review, see Analysis and Interpretation of Financial Statements and Calculating Financial Ratios.
5c. Analyze competitor and industry data for financial comparisons
- Where can analysts get competitor or industry data to make comparisons?
- Why is it important to utilize industry-specific averages?
Once financial ratios are calculated, they must be compared over time and to industry standards and competitors to provide meaningful conclusions. Industry information can be found in a variety of sources: databases including Den & Bradstreet, Hoovers, and IBIS World, industry associations and research sources, and by studying public financial information and sources. When comparing company data utilizing these sources, it is important that the various calculations are consistent. An analyst should look at the underlying formula used to calculate averages and ratios to ensure that they are reported the same. It is also important to understand the context of the ratios – economic events, company events, and others – that will affect the industry or a particular company.
It is important to utilize industry-specific averages, as acceptable standards vary by industry. What is considered poor performance in one industry (such as a low profit margin in a luxury goods manufacturer) may be normal in another industry (such as big-box retail). Even within an industry, variations may exist due to unique geographical issues, business systems, or market strategies.
To review, see Analysis and Interpretation of Financial Statements.
5d. Interpret results of financial analyses to make decisions
- What ratios are most important to which stakeholders when analyzing financial statements?
- What are some of the potential pitfalls when using the results of financial analyses to make decisions?
- What other sources of information should management consider when making decisions based on their financial analysis?
Stakeholders will focus on different categories of financial ratios based on the reason for their analysis. Lenders, who are most concerned with the ability to be repaid, often look most closely at liquidity ratios. Investors hone in on profitability ratios. In addition to being concerned with all ratios, a company's management looks very closely at efficiency ratios, and the Board looks very closely at overall leverage.
When using financial analyses to make decisions, it is important to understand the potential pitfalls. One is that a company's financial statements do not contain all the relevant information needed about the company. A great financial analysis typically leaves the analyst with many questions to ask management and others – about upcoming projects, customer loyalty, employee retention, etc. It also is sometimes difficult to find direct comparisons for the ratios. Benchmarking is difficult when companies are conglomerates (composed of many different divisions) or are in a new industry. Analysts must also remember that all the ratios have been calculated using historical data. Historical data does not always predict future results.
When making decisions based on their financial analyses, management must go beyond the numbers to look at what the individuals responsible for those numbers say about them and their plans for the future. While quantitative data is critically important, we must remember that qualitative data provides an additional layer of value to our analysis.
To review, see Analysis and Interpretation of Financial Statements.
Unit 5 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- common-size statement
- conglomerates
- efficiency ratios
- financial ratio
- horizontal analysis
- leverage ratios
- liquidity ratios
- profitability ratios
- vertical analysis
Unit 6: Accounting for Inventory
6a. Describe the effects of a company's choice of valuation method on its financial statements
- What are the four main methods of costing inventory?
- How does the choice of inventory valuation method impact a company's income statement?
- How does the choice of inventory valuation method impact a company's balance sheet?
There are four main methods of valuing a company's inventory:
- Specific identification: This involves attaching the actual cost to an identified unit or project. This is typically used for large, unique items.
- FIFO (First in, First out): This method assigns the cost of the earliest items purchased to the goods sold.
- LIFO (Last in, First out): This method assigns the cost of the latest items purchased to the goods sold.
- Weighted average: This method assigns costs based on a weighted average unit cost.
The choice of inventory method will directly impact a firm's financial statements. In inflationary times, FIFO will result in a lower COGS and therefore a higher Net income, while LIFO would result in a lower Net Income. Likewise, in inflationary times, the units on the balance sheet would be at a higher dollar amount under FIFO than LIFO. This difference will impact many of the ratios calculated, which makes knowing any differences in inventory valuation methods important when comparing a company to its competitors.
To review, see Inventory Valuation Methods.
6b. Calculate COGS and ending inventory value under the various inventory costing methods
- How do you calculate COGS and ending inventory under the FIFO method?
- How do you calculate COGS and ending inventory under the LIFO method?
- How do you calculate COGS and ending inventory under the Weighted Average method?
- How do you calculate COGS and ending inventory under the Specific Identification method?
To calculate the COGS under FIFO, complete the following steps:
- Determine the number of units sold.
- Use the costs of any units that were in the beginning inventory for the units sold.
- If more were sold than existed in the beginning inventory, find the cost of the earliest purchases and count those for the cost of the units sold.
- Whatever units are left (the newest purchases) will be the value of your ending inventory.
To calculate the COGS under LIFO, complete the following steps:
- Determine the number of units sold.
- Use the costs of the most recent purchases as the cost of the units sold.
- Keep going backward to earlier purchases until all units sold have an associated cost.
- Whatever units are left (the oldest purchases/beginning inventory) will be the value of your ending inventory.
To calculate the COGS under Weighted Average, complete the following steps:
- Determine the number of units sold
- Calculate the weighted average cost of all the units in beginning inventory and purchased during the period.
- Multiply the number of units sold by the weighted average to get the COGS
- Multiply the units left by the weighted average to get the value of the ending inventory.
To calculate the COGS under Specific Identification, complete the following steps:
- Determine the number of units sold
- Determine which units were sold and look up the exact cost information on them. Use this as your COGS.
- Look up the cost of the exact units not sold – this is the value of your ending inventory.
To review, see:
6c. Calculate the inventory turnover ratio
- How would a company calculate its inventory turnover ratio?
- What does inventory turnover show about a company's operations?
The inventory turnover ratio is defined as COGS/average inventory. A company would take the total COGS for the period being analyzed and divide it by the average inventory. Average inventory is calculated by taking the beginning inventory plus the ending inventory and dividing by 2. This helps smooth out fluctuations in inventory levels at the beginning or end of a period.
The turnover ratio measures how efficiently the firm is managing and selling its inventory and is a measure of liquidity. Generally, the quicker a firm sells its inventory, the faster it generates cash for other uses. A low turnover rate may indicate the firm's products are not desired by customers, the firm is holding too much inventory, or that marketing efforts are not working. A high turnover rate may indicate that customers are very interested in the products but could also indicate a lack of inventory that could be exploited by competitors. Generally speaking, a firm wants to have just enough inventory to cover all the demands of the customers, but not much more, as unsold inventory ties up cash that could be used elsewhere and runs the risk of damage or obsolescence, decreasing its value.
To review, see Reporting and Analyzing Inventories.
6d. Produce journal entries for the flow of goods in inventory for merchandising and manufacturing companies
- How are inventory transactions recorded in a merchandising company?
- How are inventory transactions recorded in a manufacturing company?
A merchandising company is a company that purchases products to resell to customers. When a company purchases products to resell, the accounting transaction is:
|
(debit) Purchases |
$$ |
|
|
(credit) Accounts Payable |
$$ |
This is recorded at the cost paid.
|
(debit) Accounts Receivable |
$$ |
|
|
(credit) Sales |
|
$$ |
|
(debit) COGS |
$$ |
|
|
(credit) Merchandise Inventory |
|
$$ |
This amount will depend on the inventory valuation method that is being used.
A manufacturing company makes finished products from purchased materials using labor and overhead. For manufacturing companies, the transactions would be:
|
(debit) Raw Materials |
$$ |
|
|
(credit) Accounts Payable |
|
$$ |
|
(debit) Work in Process |
$$ |
|
|
(credit) Raw Materials |
|
$$ |
|
(debit) Finished Goods Inventory |
$$ |
|
|
(credit) Work in Process |
|
$$ |
|
(debit) Accounts Receivable |
$$ |
|
|
(credit) Sales |
|
$$ |
|
(debit) COGS |
$$ |
|
|
(credit) Finished Goods Inventory |
|
$$ |
To review, see Measuring and Reporting Inventories and Understanding Inventory.
6e. Describe appropriate internal controls to safeguard inventory
- What methods can a company put in place to safeguard its inventory?
- Why do companies have to count their physical inventory if they use a perpetual inventory system that tracks purchases and sales automatically?
Companies will routinely check their inventory counts in the computer against physical counts to ensure accuracy. Even the best inventory tracking system cannot show when inventory is stolen, damaged, or misplaced, so routine physical counts are essential. The internal audit department routinely confirms reported inventory levels with physical counts as well. When discrepancies exist, management must determine if they have an issue with their systems, their quality, or potential fraud by employees or outsiders.
Use of bar codes, secure facilities, employee training, camera systems, spot checks, and other methods have all been used by companies to protect their investment in inventory.
To review, see Controlling Inventory.
Unit 6 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- FIFO
- inventory turnover ratio
- LIFO
- manufacturing company
- merchandising company
- specific identification
- weighted average
Unit 7: Accounting for Receivables and Payables
7a. Perform the accounting entries to record and write-off accounts receivable
- How are sales on credit recorded by the company?
- What entry must a company make when a customer is unable to pay the amount due?
Accounts receivable are amounts that customers owe a company for goods and services sold on account. When a company sells its goods or services and bills the customer later, they are said to have extended credit to the customer. The initial accounting entry for this transaction would be:
|
(debit) Accounts Receivable |
$$ |
|
|
(credit) Sales |
|
$$ |
|
(debit) Allowance for Bad Debts |
$$ |
|
|
(credit) Accounts Receivable |
|
$$ |
Since we know that not all customers will be able to pay us, we set up an allowance account, which is a contra-asset account, to reflect this fact. A contra-asset account reduces the amount of the asset it is associated with (in this case, accounts receivable), so that the actual total we expect is shown.
To review, see Receivables and Payables.
7b. Calculate the accounts receivable turnover ratio and the average collection period
- How is the accounts receivable turnover ratio calculated?
- How is the average collection period calculated?
- What factors influence these ratios?
The average collection period is calculated by taking 365/accounts receivable turnover ratio. It translates the a/r turnover ratio into the number of days to collect. In general, a lower number is desired. The faster a firm collects its receivables, the more liquid they are and the higher the quality of its accounts receivable.
To review, see Receivables and Payables.
7c. Describe sources of short term financing for a company
- What are some scenarios that would cause a company to need short-term financing?
- What are the main sources of short-term financing for a company?
Companies generally can utilize trade credit from suppliers (accounts payable) for some short-term needs. They may also choose to issue an interest-bearing note or utilize their line of credit if they have one established at their bank.
To review, see Receivables and Payables.
7d. Construct journal entries for notes receivable and payable
- How are notes receivable recorded?
- How are notes payable recorded?
|
(debit) Notes Receivable |
$$ |
|
|
(credit) Sales |
|
$$ |
|
(debit) Interest receivable |
$$ |
|
|
(credit) Interest Revenue |
|
$$ |
When the note is paid off with interest, the transaction is:
(debit) Cash
(credit) Interest receivable
(credit) Notes receivable
(credit) Interest revenue
A note payable occurs when we agree to borrow money short-term, with a note, usually with interest. It is essentially the opposite transaction of the note receivable.
|
(debit) Cash |
$$ |
|
|
(credit) Note Payable |
|
$$ |
|
(debit) Interest Expense |
$$ |
|
|
(credit) Interest Payable |
|
$$ |
|
(debit) Notes Payable |
$$ |
|
|---|---|---|
|
(debt) Interest Payable |
$ | |
|
(debit) Interest Expense |
$ | |
|
(credit) Cash |
$ $ $ $ |
7e. Calculate estimated bad debts
- Why must companies estimate their bad debts?
- How are bad debts estimated?
The only method that satisfies the matching principle is the allowance method. This requires the company to estimate their uncollectible accounts, usually by aging their accounts receivable or using the percentage of sales method.
Using the aging method, each account receivable is categorized by the number of days it has been outstanding. Percentages estimated to be uncollectible (from past experience) are determined and calculated for each category. The total is then the appropriate balance in the Allowance for Bad Debts accounts, and the adjusting entry is made to make the total in the account equal to that balance.
The percentage of sales method is a much simpler calculation. The amount of sales on credit is simply multiplied by the expected % that will be uncollectible (based on history). That amount is then added to the balance in the Allowance for Bad Debts Account.
To review, see Receivables and Payables.
7f. Perform the accounting entries to record and adjust bad debts expense
- How are the journal entries for bad debts made using the aging of receivables method?
- How are the journal entries for bad debts made using the percent of credit sales method?
Bad debts expense estimate from the aging schedule: $50,000
Current balance in Allowance for Bad Debts: $40,000
|
(debit) Bad debts expense |
$10,000 |
|
|
(credit) Allowance for bad debts |
|
$10,000 (bringing total to 50,000) |
|
(debit) Bad Debts Expense |
$1,000 |
|
|
(credit) Allowance for Bad Debts |
|
$1,000 |
To review, see Receivables and Payables.
Unit 7 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- accounts receivable
- accounts receivable turnover
- aging accounts receivable
- allowance method
- average collection period
- contra-asset account
- note payable
- note receivable
- percentage of sales method
Unit 8: Accounting for Property, Plant, and Equipment
8a. Distinguish between tangible and intangible assets
- What is the difference between a tangible and intangible asset?
- How is the accounting different for a tangible vs. intangible asset?
Tangible assets have physical characteristics that we can see and touch – things like buildings, equipment, and vehicles. Intangible assets have no physical characteristics but have value due to the privileges and rights they convey to the owner, such as patents and copyrights. The accounting treatment for tangible assets differs from the treatment for intangible assets. Tangible assets tend to be depreciated, whereas intangible assets are either amortized or checked periodically for impairment.
To review, see Property, Plant, and Equipment.
8b. produce journal entries for the acquisition, depreciation, and disposal of fixed assets
- How is the cost determined for the journal entry for the acquisition of fixed assets?
- How is the depreciation of fixed assets recorded?
- What entries must be made when fixed assets are disposed of?
Fixed assets are recorded at historical cost. Even if the market value of the asset changes over time, the acquisition cost is still reflected on the balance sheet. The acquisition cost is the amount of cash or cash equivalents given up to acquire and place the asset in operating condition at its proper location. Once the appropriate cost is determined, the acquisition would be recorded as:
(debit) Plant Asset Name
(credit) Cash or Payable
Plant assets are depreciated in accordance with the matching principle. Depreciation is
the amount of plan asset cost allocated to each accounting period benefiting from the plant asset's use. Once depreciation is calculated, the entry to record it is:
(debit) Depreciation Expense $$
(credit) Accumulated Depreciation – Plant Asset name $$
When a fixed asset is disposed of, all the accounts associated with the asset must be closed, and a potential gain or loss on the asset recognized. The entry is as follows:
(debit) Cash
(debit) Accumulated depreciation
(credit) Equipment
(credit) or (debit) Gain or Loss on Sale
To review, see Property, Plant, and Equipment and Plant Asset Disposals.
8c. Calculate depreciation expense using the various methods of depreciation
- What are the main methods for calculating depreciation expense?
- How do companies choose which depreciation method to use?
The main methods for calculating depreciation expense are:
- Straight-line method: an equal amount is charged to each accounting period.
- Depreciation = (asset cost-estimated salvage value)/# of accounting periods for useful life
- Units-of-production method: assigns an equal amount of depreciation to each unit of product manufactured or service rendered.
- Depreciation = (asst cost – estimated salvage value)/units of production during useful life of asset
- This answer is then multiplied by the number of goods/service produced in period
- Double-declining method: an accelerated depreciation method that increases the amount charged in the earlier years.
- Depreciation = 2 x (straight-line rate) x (asset cost-accumulated depreciation)
Depreciation = 2 x (straight-line rate) x (asset cost-accumulated depreciation)
Companies should use the depreciation method that reflects most closely allocated costs according to the benefit received from the asset. Many companies use accelerated depreciation to minimize their tax liability. Others use the straight-line method because of its ease of use.
To review, see:
8d. Explain the difference between book value and market value
- How is the book value of an asset calculated?
- How is market value determined?
The book value of an asset is its cost less its accumulated depreciation. The cost on the "books" is the historical cost at acquisition, which we then subtract the accumulated depreciation from. The market value of an asset is determined according to what it could be sold or traded for on the current market. Book value and market value are usually not the same. In some instances, an asset is worth more than its book value, and when it is sold, a gain will be realized. When an asset is sold for less than its book value, a loss will be realized.
To review, see Plant Asset Disposals.
Unit 8 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- book value
- depreciation
- double-declining method
- intangible asset
- market value
- straight-line method
- tangible asset
- units-of-production method
Unit 9: Long-Term Liabilities and Stockholders' Equity
9a. Describe the difference between bonds and capital stock
- What is a bond?
- What does stock represent?
- How do stocks and bonds differ?
A bond is a long-term debt, or liability, owed by the company that issues it. Bonds have a face value, which is the principal amount payable at maturity, or the due date, and a stated interest rate, payable at regular periods, typically semiannually, until the maturity date. A bond-holder is a creditor of the company that issued the bond.
A share of stock is a unit of ownership in a corporation. Investors purchase stock hoping that the share price will appreciate in value and/or that they will be paid dividends. Dividends are a payment to shareholders of the profits from the corporation's business. Stockholders, as owners of the company, can vote on major issues affecting the corporation and select managers to act in their interest.
Bonds differ from stock in several important ways:
- A bond is a liability, while a share of stock represents an ownership interest in the company.
- Bonds have maturity dates, while stocks do not.
- Bonds typically require periodic interest payments by contractual obligation. Stocks may pay dividends but are under no legal obligation to do so.
- The company can deduct the interest paid to bondholders but not dividends paid to stockholders.
To review, see Valuing Long-Term Bonds, and Stockholders' Equity: Classes of Capital Stock.
9b. describe par value, discount, and premium as they relate to bonds
- What does par value represent in relation to bonds?
- Why do bonds sell at a premium or discount?
A bond's par value is its face value, or stated amount due at maturity. Most often, corporate bonds are issued with $1,000 par values. When a corporation issues a $1,000 par value bond, they are promising to pay the creditor that $1,000 back on the maturity date and typically make regular interest payments each period between the issue date and maturity date.
When bonds are issued, they typically have a fixed interest payment associated with the bond. That interest rate may or may not be attractive in the marketplace, depending on what other bonds are paying and what is happening to interest rates in general. Since the bond's interest rate is fixed, the only factor that can change to account for this change in attractiveness is the bond's price. A bond that sells above face/par value is said to sell at a premium. A bond that sells below face/par value is said to sell at a discount.
To review, see Valuing Long-Term Bonds.
9c. Explain how interest rates affect bond prices
- What is the relationship between interest rates and bond prices?
- How are bond prices determined?
A bond is sold at face value, a discount, or a premium. The price at which a bond is sold depends on the market rate of interest and how it compares to the contract rate of interest. When interest rates in the market go up, since the interest rate the bond is paying is fixed, the bond will look less attractive. The bond must sell at a discount to entice buyers when it is less attractive. When interest rates in the market decrease, the fixed rate on the bond will look relatively more attractive. Investors will want the bond that pays the higher rate and will bid up the price. The bond will sell at a premium. Thus, interest rates and bond prices are inversely related: when rates increase, prices decrease, and when rates decrease, prices increase.
Bond prices are determined by taking the present value of the cash flows associated with the bond. These cash flows include the repayment of principal at maturity and the periodic interest payments. The present value is calculated using the current market rate on similar bonds as the discount rate. Thus:
Price(bond) = PV principal repayment at maturity + PV periodic interest payments
To review, see Valuing Long-Term Bonds.
9d. Prepare accounting entries for bonds issued at par, a discount, or a premium
- What is the accounting entry for a bond issued at par?
- What is the accounting entry for a bond issued at a discount?
- What is the accounting entry for a bond issued at a premium?
A bond issued at par value is a straightforward entry:
|
(debit) Cash |
$ $ $ |
|
|
(credit) Bonds Payable |
|
$ $ $ |
|
(debit) Cash |
$ $ |
|
|
(debit) Discount on Bonds Payable |
$ |
|
|
(credit) Bonds Payable |
|
$ $ $ |
This shows that the full amount is due (bonds payable) at maturity, but less cash is received up front.
|
(debit) Cash |
$ $ $ |
|
|
(credit) Premium on Bonds Payable |
$ |
|
|
(credit) Bonds Payable |
|
$ $ |
This shows that more cash is received than what the company will owe at maturity.
To review, see Valuing Long-Term Bonds.
9e. Contrast common stock and preferred stock
- What are the main differences between preferred and common stock?
- Why do companies issue preferred stock?
- the right to vote on major corporate issues, including the election of the board of directors
- a preemptive right to purchase additional shares whenever stock is issued by the corporation
- right to receive cash dividends if they are paid
- residual claim on corporate assets
To review, see Stockholders' Equity: Classes of Capital Stock.
9f. Prepare a statement of shareholders' equity
- What does a statement of stockholder's equity show?
- Where does the information from the stockholder's equity statement appear on the balance sheet?
Each column reports a beginning balance and then reports transactions that affect the beginning balance. Finally, the ending balances are totaled to arrive at a total amount of stockholders' equity.
The accounts from the stockholder's equity statement are transferred in summary form to the equity section of the balance sheet.
To review, see Stockholders' Equity: Classes of Capital Stock.
9g. Develop accounting entries for paid-in capital, cash dividends, stock dividends, stock splits, and retained earnings appropriations
- What is paid-in capital?
- Are retained earnings the same as profits?
- How do cash dividends and stock dividends differ?
- What is a stock split?
Retained earnings are also listed under the Stockholders' Equity section of the balance sheet and represent all the earnings that have accumulated in the business to date and have not been paid out as dividends. When retained earnings and cash are sufficient, and the retained earnings have not been appropriated (set aside) for another use, a corporation's board of directors may decide to share the retained earnings with shareholders in the form of a dividend payment. If they do that, then profits and retained earnings will not be the same.
A cash dividend is the most common form of dividend payment and is paid out of retained earnings, which decreases a corporation's cash. Rather than declare a cash dividend, a corporation may elect to declare a stock dividend that distributes additional shares of stock to common stockholders. A stock dividend also decreases retained earnings but does not decrease cash.
A corporation's board of directors may also vote to declare a stock split which decreases the par value of stock and increases the number of common shares. A stock split will divide each share of stock into two or more shares. For instance, a 4:1 (4 for 1) stock split will turn one share of stock into four shares and simultaneously divide the par value by four. To further illustrate, one share of stock with a par value of $40 that is split 4:1 will now equal four shares of stock with a par value of $10 each.
Dividends are declared by a corporation's board of directors after a review of the retained earnings and cash of the corporation and a vote.
To practice, name the three significant dates associated with the payment of dividends. Know the journal entries associated with each of the significant dates.
To review, see Stockholders' Equity: Classes of Capital Stock.
Unit 9 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- bond
- common stock
- discount
- dividend
- face value
- maturity
- paid-in capital
- par value
- preemptive right
- preferred stock
- premium
- retained earnings
- statement of stockholders' equity
- stock
- stock dividend
- stock split
Unit 10: Statement of Cash Flows
10a. Distinguish the types of business transactions that are included in operating, investing, and financing activities
- What business activities fall under the operating sections of the cash flow statement?
- What business activities fall under the investing section of the cash flow statement?
- What business activities fall under the financing section of the cash flow statement?
Inflows and outflows of cash are reported in three different sections of the statement of cash flows. Operating activities are those transactions and events that enter into the calculation of net income. Investing activities are transactions and events that involve the purchase and sale of securities and property, plant and equipment. Financing activities are transactions and events involving equity and debt financing.
List the cash inflows and cash outflows for each of the following sections of the statement of cash flows: operating activities, investing activities, and financing activities.
|
|
Cash Inflows |
Cash Outflows |
|
Operating Activities |
|
|
|
Investing Activities |
|
|
|
Financing Activities |
|
|
You will find examples of the cash inflows and outflows included within each category in Operating Activities, Financing Activities, and Investing Activities.
10b. Summarize the difference between the indirect and direct methods of preparing the statement of cash flows
- How is the operating activities section prepared using the indirect method?
- How is the operating activities section prepared using the direct method?
The direct method analyzes all the operating expenses to determine what cash was actually spent in the period and only counts cash sales. The indirect method starts with accrual-based net income and then adjusts it for items that affected net income but did not involve cash.
To review, see Calculating Cash Flows.
10c. Prepare a cash flow statement
- What is the check figure when preparing a cash flow statement?
- What are the steps required to prepare a cash flow statement?
The steps to prepare a cash flow statement are:
- Calculate the change in cash for the period.
- Using the indirect method, convert the accrual-based net income to cash basis by:
- adding back any non-cash items on the income statement
- adjusting the current asset and current liability accounts for changes in cash
- adjusting gains and losses
- Analyze cash flow effects of investing activities
- Analyze cash flow effects of financing activities
- Total all sections and balance to change in cash for the period (#1 above)
Unit 10 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- direct method
- financing activities
- indirect method
- investing activities
- operating activities