PRINCIPLES OF ACCOUNTING REVISION

Transcription

1 PRINCIPLES OF ACCOUNTING REVISION Exam format open book 2 hours No multiple choice question. Question 1 FIFO, LIFO stock valuation (20 marks) Question 2 Depreciation (20 marks) Question 3 Bank reconciliation (20 marks) Question 4 Adjusting entries and financial statements (40 marks) All questions will be similar to the following exercises and include some theory. Question 4 will not cover any theoretical part. Review lecture notes for those topics. In the lecture notes of each topic except for the topic on adjustments and financial statements, there is example which is similar to the below practice questions. Review carefully the format and preparation of financial statements. Question 1 Stock valuation The following information is available during the year: Jan 1 Beginning inventory 100 units at $60 each Feb 26 Sale 75 units at $112 each Apr 10 Purchase 155 units at $65 each Jun 18 Sale 135 units at $112 each Oct 5 Purchase 200 units at $72 each Dec 20 Sale 175 units at $112 each The firm uses the perpetual inventory system. Required: i. Determine the total cost of the ending inventory and cost of goods sold and gross profit according to FIFO and LIFO ii. Because of imperfections, an item of inventory cannot be sold at its normal selling price. How should this item be valued for the financial statement purposes and the treatment is justified by which accounting principle? Suggested answer i. Determine the total cost of the ending inventory and cost of goods sold and gross profit according to FIFO and LIFO Cost of goods available for sales = 100* * *72 = 30,475 Sales revenue = ( ) * 112 = 43,120 FIFO COGS = 75* * * * *72 = 25,435 Gross profit = 43,120 25,435 = 17,685 Ending inventory = 30,475 25,435 = 5,040 LIFO COGS = 75* * *72 = 25,875 Gross profit = 43,120 25,875 = 17,245 Ending inventory = 30,475 25,875 = 4,600 ii. Because of imperfections, an item of inventory cannot be sold at its normal selling price. How should this item be valued for the financial statement purposes and the treatment is justified by which accounting principle? 1

2 Inventory should be valued at lower of cost or market. The treatment is justified by conservatism principle. Question 2 Depreciation Tory Ltd purchased a new machine on 1 October 2007 at a cost of $95,000. The company paid also $1,000 to the supplier for transportation and installation costs. The company estimated that the machine has a residual value of $12,000. The machine is expected to be used for 70,000 working hours during its 5-year life. Each year $500 is spent on the maintenance of the machine. Assume a 31 December year end. Required: i. Calculate the depreciation expense, accumulated depreciation and net book value for the year 2007 and 2008 under a. straight line method b. reducing balance method using double the straight line rate c. the units of production method assuming the machine usage was 1,700 and 6,800 hours for the year 2007 and 2008 respectively ii. On 31 December 2008, the company sold the machine for $80,000 cash. Journalise the entry to record the disposal of the machine assuming the company uses straight line method for depreciation. iii. Distinguish between the accounting for capital expenditures and revenue expenditures Suggested answer i. Calculate the depreciation expense, accumulated depreciation and net book value for the year 2007 and 2008 under a. straight line method Depreciation exp = (95,000+1,000-12,000)/5 = 16, Depreciation exp = 16,800*3/12 = 4,200 Accumulated depreciation = 4,200 Net book value = 96,000 4,200 = 91, Depreciation exp = 16,800 Accumulated depreciation = 4, ,800 = 21,000 Net book value = 96,000 21,000 = 75,000 b. reducing balance method using double the straight line rate Depreciation rate = 1*2/5 = 40% 2007 Depreciation exp = 96,000*40% *3/12 = 9,600 Accumulated depreciation = 9,600 Net book value = 96,000 9,600 = 86, Depreciation exp = 86,400*40% = 34,560 Accumulated depreciation = 9, ,560 = 44,160 Net book value = 96,000 44,160 = 51,840 c. the units of production method assuming the machine usage was 1,700 and 6,800 hours for the year 2007 and 2008 respectively Depreciation expense per hour = (96,000-12,000)/70,000 = $1.2 per hour 2007 Depreciation exp = 1.2* 1,700 = 2,040 Accumulated depreciation = 2,040 Net book value = 96,000 2,040 = 93, Depreciation exp = 1.2 * 6,800 = 8,160 Accumulated depreciation = 2, ,160 = 10,200 Net book value = 96,000 10,200 = 85,800 ii. On 31 December 2008, the company sold the machine for $80,000 cash. Journalise the entry to record the disposal of the machine assuming the company uses straight line method for depreciation. 2

3 31 Dec 08 Net book value (straight line) = 75,000 Gain on disposal = 80,000 75,000 = 5,000 Dr Cash 80,000 Dr Accumulated depreciation 21,000 Cr Machinery 96,000 Cr Gain on disposal 5,000 Question 3 Bank reconciliation The cash account for FMT at 1 Oct, 20X8, indicated a balance of $10, During October, the total cash deposited was $39,146.38, and cheques written totaled $42, The bank statement indicated a balance of $10, on 31 October. Comparing the bank statement, the cancelled cheques, and the accompanying memoranda with the records revealed the following reconciling items: i. Cheques outstanding totaled $11, ii. A deposit of $8,773.34, representing receipts of October, 31, had been made too late to appear on the bank statement. iii. The bank had collected for FMT $3,710 on a note left for collection. The face of the note was $3,500. iv. A cheque for $380 returned with the statement had been incorrectly charged by the bank as $830. v. A cheque for $419 had been incorrectly recorded by FMT as $149. The cheque was for the payment of an obligation to Latrobe on account. vi. Bank service charges for October amounted to $40. vii. A cheque for $1,129.5 from Baist Co. was returned by the bank because of insufficient funds. Required: i. Prepare a bank reconciliation as of 31 October 20X8 ii. Prepare necessary entries in the firm s accounting records Bank reconciliation Statement at 31 Oct 20X8 Balance per bank statement 10, Add: Deposits in transit 8, Less: Unpresented cheques 11, Add error correction Correct balance 9, Updated cash book Balance per cash book (10,676,67+39, ,918.4) 6, Add note collected 3, Add interest on note Less bank charge Less NSF cheques 1, Less error correction Correct balance 9, Details Dr Cr 1 Cash 3, Note Receivable 3, Interest revenue Collection of note receivable and interest 3

4 2 Miscalleneous expense Cash Payment for bank charge 3 Account Receivable 1, Cash 1, Recovered A/R due to returned cheque 4 Account Payable Cash Error correction Question 4 Adjusting entries and financial statements HANOI LTD Trial balance as of 31 December 20X8 Debit Credit Cash 6,035 Accounts receivable 80,230 Accounts payable 40,710 Advertising expense 7,875 Office expense 3,585 Share capital (100,000 shares issued, $1 par) 225,000 Delivery vehicle (at cost) 40,000 Accumulated depreciation - delivery vehicle 10,000 Rent expense 12,500 Prepaid insurance 2,625 Interest expense 3,120 Land 35,000 Building 100,000 Accumulated depreciation - building 4,550 Utility expense 5,075 Unearned revenue 3,980 Allowance for doubtful accounts (1 January 20X8) 975 Inventory 94,250 Cost of goods sold 115,370 Salary expense 35,260 Sales 215,500 Retained earnings (1 January 20X8) 28,585 Maintenance expense 3,375 Loan 15,000 Total 544, ,300 4

5 Additional information 1. Interest expense accrued $ Depreciation for the current year to be 20% p.a on cost for delivery vehicle and 5% p.a. on cost for building 3. Unexpired insurance $ Aging analysis of accounts receivable at 31 December 20X8 revealed that the Allowance for doubtful accounts should have balance of $4, The balance of Unearned revenue includes $980 received in December for goods to be delivered in February 20X9 6. Declare a dividend to shareholders of $10,000 for the current year. Required: i. Prepare necessary journal entries given the above additional information ii. Prepare Income Statement and Statement of Owner s equity for the year ended 31 December 20X8 as well as Balance Sheet as of 31 December 20X8. Suggested answer Adjusting entries Details Dr Cr 1 Interest expense 325 Interest payable 325 Adjust for accrued interest expense 2 Depreciation expense 5,000 Accumulated depreciation-building 5,000 Depreciation exp = 100,000*5% Depreciation of building Depreciation expense 8,000 Accumulated depreciation-vehicle 8,000 Depreciation exp = 40,000*20% Depreciation of vehicle 3 Insurance expense 2,195 Prepaid insurance 2,195 Adjust for insurance expired ( ) 4 Bad debt expense 3,150 Allowance for doubtful debts 3,150 Adjust for bad debt exp (4, ) 5 Unearned revenue 3,000 Sales revenue 3,000 Adjust for revenue earned (3, ) 6 Retained earnings 10,000 Dividends payable 10,000 Dividends declared 5

6 HANOI LTD Income Statement for the year ended 31 December 20X8 Sales revenue (215,500+3,000) 218,500 less Cost of sales 115,370 Gross profit 103,130 less Operating expenses Advertising expense 7,875 Office expense 3,585 Rent expense 12,500 Interest expense (3, ) 3,445 Utility expense 5,075 Salary expense 35,260 Maintenance expense 3,375 Depreciation expense (5,000+8,000) 13,000 Insurance expense 2,195 Bad debt expense 3,150 89,460 Net profit 13,670 HANOI LTD Statement of Shareholders' equity for the year ended 31 December 20X8 Shareholders' equity Share capital (100,000 shares issued, $1 par) 225,000 Retained earnings Retained earnings (1 January 20X8) 28,585 Net income for the year 20X8 13,670 Dividends (10,000) Retained earnings (31 December 20X8) 32,255 Shareholders' equity as at 31 December 20X8 257,255 6

7 HANOI LTD Balance Sheet as of 31 December 20X8 Current assets Cash 6,035 Accounts receivable 80,230 less Allowance for doubtful accounts (4,125) 76,105 Prepaid insurance 430 Inventory 94,250 Total current assets 176,820 Non-current assets Land 35,000 Building 100,000 Accumulated depreciation - building (9,550) 90,450 Delivery vehicle (at cost) 40,000 Accumulated depreciation - delivery vehicle (18,000) 22,000 Total non-current assets 147,450 Total assets 324,270 Current liabilities Accounts payable 40,710 Unearned revenue (3,980-3,000) 980 Interest payable 325 Dividends payable 10,000 Total current liabilities 52,015 Non-current liabilities Loan 15,000 Shareholders' equity Share capital 225,000 Retained Earnings 32, ,255 Total liabilities & shareholders' equity 324,270 7

8 Question 5 Adjusting entries and financial statements (One more question on this topic) Presented below are the unadjusted trial balance as of 31 December 2005 of Grant Advertising Agency Ltd Grant Advertising Agency Ltd Unadjusted Trial Balance as at 31 December 2005 Debit ($) Credit ($) Cash 11,000 Accounts Receivable 20,000 Supplies 8,400 Prepaid insurance 3,350 Printing Equipment 60,000 Accumulated depreciation 28,000 Accounts Payable 5,000 Note payable (due in 6 months) 5,000 Advertising Revenue Received in advance 7,000 Share capital 20,000 Retained Earnings 5,500 Dividends 12,000 Advertising revenue 58,600 Salaries expense 10,000 Interest expense 350 Rent expense 4,000 Total 129, ,100 Other data: 1. Insurance expired during the year $ Unused supplies on hand as at 31 December $5, Printing equipment is depreciated for 8 years with residual value of $4, The interest rate on notes payable is 12%, (The note was signed on 1 Oct 05) 5. $1,400 of the Advertising Revenue Received in Advance was earned during the year ended 31 Dec Salaries of $1,300 are unpaid at 31 Dec 2005 Required: (a) Journalise the annual adjusting entries on 31 December 2005 (b) Prepare the Income Statement for the month ended 31 December 2005 and the classified Balance Sheet as at 31 December Suggested answer (a) Adjusting entries No Accounts Dr Cr 1 Insurance exp 850 Prepaid insurance 850 Adjusted for insurance expired 2 Supplies exp 3,400 Supplies (8,400-5,000) 3,400 8

9 Adjusted for supplies used 3 Depreciation exp 7,000 Accumulated depreciation 7,000 Adjusted for depreciation of printing equipment (60,000-4,000)/8 4 Interest exp 150 Interest payable 150 Adjusted for interest 5,000*0.12*3/12 5 Advertising Rev received in advance 1,400 Advertising revenue 1,400 Adjusted for revenue earned 6 Salary exp 1,300 Salary payable 1,300 Adjusted for unpaid salary (b) Financial Statements Grant Advertising Agency Ltd Income Statement for the year ended 31 December 2005 Advertising revenue (58, ,400) 60,000 Less operating expense Salary expense (10, ,300) 11,300 Interest expense ( ) 500 Depreciation expense 7,000 Insurance expense 850 Supplies expense 3,400 Rent expense 4,000 Utility expense 6,500 33,550 Net income 26,450 RE = Beginning RE + Net income - Dividends = 5, ,450-12,000 = 19,950 9

10 Grant Advertising Agency Ltd Classified Balance Sheet as of 31 December 2005 Current assets Cash 8,000 Account receivable 16,500 Supplies 5,000 Prepaid insurance 2,500 32,000 Non-current assets Printing equipment 60,000 Less accumulated depreciation (35,000) 25,000 Total assets 57,000 Current liabilities Account Payable 5,000 Advertising revenue received in advance 5,600 Salary payable 1,300 Interest payable 150 Note payable 5,000 Total current liabilities 17,050 Owners' equity Capital 20,000 Retained earnings 19,950 39,950 Total liabilities and owners' equity 57,000 10

11 PRINCIPLES OF ACCOUNTING Lecture 1 Introduction to Accounting 1 Lecture Outline Objective of Accounting The users of accounting information Financial accounting vs management accounting Regulating accounting Types of business organisations Accounting concepts and principles The financial statements Accounting equation 2 Accounting for business transaction Objective of Accounting Users of accounting information Providing information about the financial performance and status of organisations Accounting is the process of identifying, measuring and communicating economic information to various users Key product of accounting: Financial statements Accounting information is of interest to people who have some stake in the organization Owners/Managers Investors Lenders/Creditors dit Government Employees Customers 3 4 Financial vs management accounting Financial accounting focuses on information for people outside the firm Management accounting focuses on information for internal decision makers of a business GAAP (Decision 15) Accounting standards IAS VAS Regulating accounting 5 6

12 Types of Business Accounting concepts & principles Sole Proprietorships Small businesses owned by one person. Legally, the business is not separate from its owner Partnerships Unincorporated business owned by one or more persons. The partners agree on how much capital each will contribute and how much each may withdraw as salaries, interest or as a share of profit. Companies Incorporated under the laws. Ownership is represented by shares. Stockholders enjoy limited liability 7 Entity concept Reliability principle Cost principle Going concern concept Monetary unit concept 8 The four basic financial statements The Balance Sheet The Balance Sheet Income Statement Statement of Owner s Equity Statement of Cash Flows The Balance Sheet is the report of financial position of an accounting entity at a particular point in time List the company assets (in order of liquidity) and liabilities ( in order of maturity) and stockholders equities To prove the accounting equation 9 10 Elements of Balance Sheet Basic Accounting Equation Assets are economic resources owned by the entity Liabilities and stockholders equities are source of financing or claims against the company s economic resources Liabilities: claims to business assets by creditors Shareholders equities: claims to business assets by owners/shareholders 11 ASSETS = LIABILITIES + SHs EQUITIES Cash Bank loans Share capital Inventory Accounts payable Retained Earning 12

13 Income Statement Accountant s primary measure of performance of a business or Revenue less Expenses during the accounting gperiod. NET INCOME = REVENUES - EXPENSES REVENUES AND EXPENSES Revenues are amounts earned by delivering goods or services to customers. Revenues increase owner s equity. Expenses decrease owner s equity that occurs from using assets or increasing liabilities in the course of delivering goods or services to customers Statement of Owner s Equity Summary of the changes in an entity s owner s equity during a specific period. Statement of Cash flows Receipts and Payments of cash during the accounting period 3 primary categories: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Transaction 1: Starting the business Luikhart invested $60,000 in the business ASSETS = LIABILITIES + OWNER S EQUITY Cash Capital + 60,000 = + 60,000 Transaction 2: Purchase of land Paid $55,000 cash for land ASSETS = LIABILITIES + OWNER S EQUITY Cash + Land Capital +60, ,000-55, ,

14 Transaction 3: Purchase of supplies Purchased supplies for $2,000 on account ASSETS = LIABILITIES + OWNER S EQUITY Cash + Land+ Supplies = A/P Capital +60,000 = +60,000-55, ,000 +2,000 = +2,000 Transaction 4: Earning service revenue Earned service revenue of 7,000, receiving cash ASSETS = LIABILITIES + OWNER S EQUITY Cash + Land+ Supplies = A/P Capital +60,000 = +60,000-55, ,000 +2,000 = +2,000 +7,000 +7, Transaction 5: Paid for expenses Paid cash expenses totalled 2,700 including salaries 1,400; rent 1,000; utilities 300 ASSETS = LIABILITIES + OWNER S EQUITY Cash + Land+ Supplies = A/P Capital +60,000 = +60,000-55, ,000 +2,000 = +2,000 +7,000 +7,000-2,700-2, Transaction 6: Payment on account Paid 1,500 on account ASSETS = LIABILITIES + OWNER S EQUITY Cash + Land+ Supplies = A/P Capital +60,000 = +60,000-55, ,000 +2,000 = +2,000 +7,000 = +7,000-2,700 = -2,700-1,500 = -1,500 7,800 55,000 2,000 = , Ken Luikhart MD Income Statement For the month ended Jul Service revenue 7,000 Less expenses Salaries 1,400 Rent 1,000 Utitlies 300 2,700 Net income 4, Ken Luikhart MD Balance Sheet as of 31 Jul Assets Liabilities Cash 7,800 A/P 500 Land 55,000 Owner s equity Supplies 2,000 Capital 64,300 Total assets 64,800 Total L&OE 64,800 24

15 Tutorial S1-3 S1-4 E1-4 E1-8 E1-10 P1-1A P1-2A 25

16 Outline Principles of Accounting Lecture 3 Financial Statements and Adjusting entries Accrual versus cash-basis accounting Accounting period principle Revenue recognition Matching principle Prepaids Accruals 1 2 Accrual vs cash-basis accounting Cash basis accounting Revenue and expenses recognised when the cash is received or paid Accrual accounting Revenue recognised when goods/services are provided (revenue is earned) Expenses recognised when assets consumed or liabilities incurred (expense is incurred) Accrual vs cash-basis illustrated Illustration for painting business 3 4 Accounting period assumption Economic life of a business is divided into artificial time periods for reporting purpose The basic accounting period is one year. 5 Revenue recognition Revenue recognition criteria: It is probable that the inflow or enhancement has occurred; The inflow or enhancement can be reliably measured Tests used to determine revenue recognition: Agreement to provide goods or services; Cash must be received or claim to cash must exist Goods must be delivered or services rendered; It must be possible to estimate the collectability of debts or returns of the goods sold 6 1

17 Expense recognition Adjusting entries Expense recognition criteria: The consumption or loss of future economic benefits Is probable Can be reliably measured. Recognition technique: matching principle Association of revenue of a period with all the expenses necessary to generate that revenue 7 Adjusting entries are the journal entries made at the end of a period for a company to reflect the accrual basis of accounting. Adjusting entries assign revenues to the period when they are earned and expenses to the period when they are incurred. Adjusting entries also update asset and liability accounts. 8 Prepayments Prepayments Amounts paid in cash recorded as assets until used (prepaid expense) Revenue received from customers and recorded as a liability until services performed/ goods delivered (unearned revenue or revenue received in advance) 9 10 Prepaid expense Example: Insurance paid for 1 year in advance $600 Insurance for October $600/12 = $50 Unearned revenue Eg: $1,200 received 2 October for advertising services to be completed 31 December Services worth $400 were performed during the month of Oct

18 Depreciation Depreciation Allocation of the cost of the asset to expense over its useful life Example: Office equipment is purchased for $5,000. Estimated useful life of 10 years Estimated residual value of $200 Depreciation of office equipment = (5, )/10 $480 p.a. or $40 monthly Journal entry Ledger account Accruals Accruals Amounts not yet received and recorded for which goods/services have been provided (accrued revenue) Amounts not yet paid or recorded for goods/services already received (accrued expense) Accrued expense Accrued expense Accrued Salaries Example: Salaries outstanding for October $1,200 (3 days x $400) Journal Ledger

19 Accrued revenue Example: Commission revenue earned, not yet received or recorded $ Summary of adjusting entries Type Situation Entry during period Entry at end of period Prepaid Cash paid before exp is Asset Expense expense incurred. Cash Asset Unearned revenue Accrued expense Accrued revenue Cash received before revenue earned Expense incurred before cash is paid Revenue earned before cash is received Cash Liability No entry No entry Liability Revenue Expense Liability Asset Revenue 20 Adjusted trial balance Tutorial Prepared after all adjusting entries have been journalised and posted Used to prove the equity of total debit balances and total credit balances after the adjusting entries have been made Provides the basis for the preparation of financial Statements S3-5 S3-6 S3-7 S3-8 S3-9 E3-7 E3-8 E3-15 P3-5A

20 Outline PRINCIPLES OF ACCOUNTING Lecture 6 Inventory Inventory valuation and income measurement Inventory costing method under perpetual inventory Specific identification Weighted average First-in, First-out (FIFO) Last-in, First-out (LIFO) Accounting principles and inventories Other inventory issues 1 2 Inventory valuation and income measurement Valuation is the major problem in accounting for inventories. The amount recorded as the cost of inventory determines the amount recognised as cost of goods sold on the income statement Errors in inventory valuation will result in misstatements in the cost of goods sold and as a result the net income shown in the income statement. 3 Inventory costing methods under perpetual inventory system 4 costing methods can be used for inventory: Specific identification First in First out (FIFO) Last in First out (LIFO) Weighted average. 4 Specific identification Specific identification: assumes that the business is able to identify the specific units and their costs in the inventory at the end of the period. Used for high-unit-cost inventory items that can be identified clearly from the time of purchase to the time of sale. FIFO First-in, First-out (FIFO) Cost of the first item purchased is assigned to the first items sold., ending inventory cost is determined from the prices of the most recent purchases So,, inventory is valued at the most recent purchase prices 5 6 1

21 Average cost Last-in, First-out (LIFO) The last items purchased are assigned to the cost of the first items sold, the ending inventory cost is determined from the prices of the earliest purchases So, ending inventory is valued at oldest purchase prices Average cost is determined by dividing the cost of goods available for sale by the number of units available. With this method, a new average cost per unit after each purchase is computed. 7 8 Example for inventory costing FIFO Purchases Sales Balances Date Details Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost 1 JanBalance , AprPurchase , , AugPurchase , ,800 Units sold on Sep 10 Ending Inventory Cost of goods sold 550 units 10 SepSale , NovPurchase , , LIFO Average cost Purchases Sales Balances Date Details Unit Total Unit Total Unit Total Qty Qty Qty cost cost cost cost cost cost 1 JanBalance , AprPurchase , , AugPurchase , , SepSale , NovPurchase , , Purchases Sales Balances Date Details Unit Total Unit Total Unit Total Qty Qty Qty cost cost cost cost cost cost 1 JanBalance , AprPurchase , , AugPurchase , , SepSale , NovPurchase , ,

22 Financial statement effects Dubbo Electronics Income Statement FIFO LIFO Average cost Sales revenue 11,500 11,500 11,500 Cost of goods sold 6,200 6,300 6,233 Gross profit 5,300 5,200 5,267 Operating expenses 2,000 2,000 2,000 Profit before tax 3,300 3,200 3,267 Income tax (30%) Profit after tax 2,310 2,240 2, Selecting an inventory costing method Most managers choose accounting methods based on two factors: Net income effects: managers prefer to report higher earnings for their companies Income tax effects: managers prefer to pay the least amount of taxes allowed by law as late as possible-the least-latest rule Managers can have both objectives by choosing one accounting method for external financial statements and a different method for preparing its tax return 14 Financial Statement Effects of Inventory Methods Normal Financial Statement Effects of Increasing Costs FIFO LIFO Cost of goods sold on income statement Lower Higher Net Income Higher Lower Income Taxes Higher Lower Inventory on balance sheet Higher Lower Normal Financial Statement Effects of Decreasing Costs FIFO LIFO Cost of goods sold on income statement Higher Lower Net Income Lower Higher Income Taxes Lower Higher Inventory on balance sheet Lower Higher 15 Accounting principles & Inventories Consistency principle Disclosure principle Materiality concept Conservatism principle 16 Other inventory issues Lower of cost or market The lower of cost or market rule (LCM) Effects of inventory errors Estimating inventory amounts 17 Why LCM? Because inventory can become economically obsolete and can no longer be sold at regular price. LCM is applied regardless of which inventory valuation method is used to determine cost. At the end of each accounting period, the original cost, as determined using one of the costing methods, is compared with the market price of the inventory. 18 3

23 Lower of cost or market If Cost < Market: ending inventory stays at Cost. If Cost > Market: ending inventory is reduced to Market price Eg: Holding loss: the cost of Pentium chips hold by Dell is $250,000 and replacement value is $200,000, the accountant would make the following entry: Dec 31 Dr Cost of goods sold $50,000 Cr Inventory $50,000 Assets = Liabilities + Owner s equity - 50,000-50, Lower of cost or market The departure from the cost basis is normally justified on the basis of conservatism. Conservatism s is a prudent reaction to uncertainties to try to insure that uncertainties and risks inherent in business are adequately considered. LCM could be applied and reported for the entire inventory, or individual item of inventory or groups of inventory. 20 Effects of inventory errors Estimating inventory Period 1 Period 2 Cost of Gross profit & goods sold net income Cost of goods sold Gross profit & net income Inventory error Period 1 Ending inventory overstated Understated Overstated Overstated Understated Period 1 Ending inventory understated Overstated Understated Understated Overstated The gross profit method provides a way to estimate inventory. Beginning inventory + Purchases = Cost of goods available for sale - Ending inventory = Cost of goods sold Practice problem Practice problem Steward Distributing company uses a periodic inventory system. The following data are available for the year: Date Transaction No of units Unit cost Total 1/1 Beginning g inventory 500 $1.00 $500 2/5 Purchase 350 $1.10 $385 4/12 Sale 550 7/17 Sale 200 9/23 Purchase 400 $1.30 $520 11/5 Sale 300 $1,405 a/ Compute the cost of goods sold, assuming using the average costing method b/ Compute the dollar amount of ending inventory, assuming the FIFO costing method c/ Compute the dollar amount of ending inventory, assuming the LIFO costing method

24 Tutorial E6-1 E6-3 E6-4 E6-5 E6-11 P6-1A P6-2A P6-3A P6-6A 25 5

25 Lecture Outline PRINCIPLES OF ACCOUNTING Lecture 9 Internal controls and Bank reconciliation Internal control Principles of internal control Limitations of internal control Bank statements Bank reconciliation Internal control over cash Cash and cash equivalents 1 2 Internal control Processes used to provide effective and efficient operations, and compliance with laws, regulations and internal policies Why? Safeguard assets Enhance accuracy and reliability of accounting records Encourage compliance with prescribed managerial policies and government regulations Promote operational efficiency 3 Principles of internal control Assignment of responsibility to individuals for a given task ensure staff are appropriately qualified Segregation of duties 2 elements Separation of operations from accounting Separation of the custody of assets from accounting Documentation procedures Pre-numbered documents so that they can all be accounted for 4 Principles of internal control Physical, mechanical and electronic controls To ensure the assets are safeguarded Independent verification Internal and external audit Other controls Mandatory vacations Job rotation Limitations of internal control Cost/benefit analysis Cost must be outweighed by the benefits to be derived Human element Errors because of carelessness or fatigue Collusion Two or more people actively collude Size of business Difficult to apply principles of internal control in a small business 5 6 1