FIN621Current Midterm Paper Fall 2013 Midterm Papers Questions

FIN621 Midterm Papers

GAAP:People and organizations make decisions based on financial information prepared by accountants. That is why it is important for people and organizations to understand the ways in which accounting information is measured. To ensure consistency, rules are established that business people can use to make sure they are comparing oranges to oranges.

For example, assume a store sells goods. Should the store's accountant record the sale at the moment the goods are shipped (accrual accounting) or at the time cash for these goods is received (cash accounting)?

Whether the store owner applies accrual or cash accounting is not important to interested parties, as long as the owner follows a rule requiring him to disclose the chosen accounting method for the reporting purposes.

Accounting rules such as these are grouped together and called Generally Accepted Accounting Principles (GAAP).

Generally Accepted Accounting Principles:

Entity principle/ separate entity principle: According to this principle, a business is treated as a separate entity from the owner. The owner’s private expenditure/spending are not recorded in the books of the business entity. For example money received as prize by a person have no effect on the books of accounts because no business transaction is involved.

Cost principle:according to this principle an asset on the balance sheet is recorded based on its nominal or original cost when acquired by the company.

Going-concern assumption:The 'going concern' concept in accounting is an assumption that the business will continue to exist for the foreseeable future. This assumption is also closely related to cost principle as without the 'going concern' concept, accountants would have to record all assets at current price instead of historical cost.

Objectivity principle:definite, factual basis for assets valuation; measuring transactions objectively. An accounting principle according to which information that is supplied in a company's financial statement must be supported by actual and real evidence and should not be based on personal feeling or opinion.

Stable currency principle:The currency remains more or less stable and rate of inflation is almost zero.

Adequate disclosure concept:facts necessary for proper interpretation of statements; “subsequent events”, lawsuits against the business, assets pledged as securities/collaterals, contingent liabilities etc; reflected in Notes.

 

Closing the books: permanent and temporary accounts

At the end of an accounting period, all accounts are prepared for the next period. In this regard, it is important to distinguish between permanent and temporary accounts. Balance sheet accounts (i.e., assets, liabilities, and equity) have a continual nature; therefore, they are not closed after each period. That's why they are called permanent accounts.

Permanent accounts are balance sheet accounts. They are not closed after each period. Their balances are carried forward into the next period. Permanent accounts are also called real accounts.

In contrast, revenue, expense, and distribution accounts are used to collect information about a single accounting period. At the end of a period, amounts in revenue, expense, and distribution accounts are transferred to the Retained Earnings account. Accordingly, the revenue, expense, and distribution accounts must have zero balances after closing the books at the end of one accounting period and at the beginning of the next period.

Temporary accounts are closed at the end of each period. These are mostly income statement accounts, except for a distribution account that is an equity statement account. Temporary accounts are also called nominal accounts.

Cash inflow, Outflow & its categories:

Cash inflows are sources of cash; for example, payments from customers, capital acquisitions, etc.

Cash outflows are uses of cash; for example, payments to vendors, paying off bank loans, etc.

The statement classifies cash inflows and outflows into three categories:

Operating activities explain: cash generated through revenue and cash spent for expenses.

Investing activities: include cash received or spent on productive assets and investments in the debt or equity of other companies.

Financing activities: describe cash transactions associated with resource providers (i.e., owners and lenders.)

ACCOUNTING EQUATION

ASSETS = LIABILITIES + OWNER’S EQUITY

Balance Sheet is based on Accounting Equation. It is in fact, a detailed statement of the Equation. The Equation in a way shows, utilization of Funds and Sources of Funds. In other words, it shows what a business OWNS and what it OWES. Alternately, the Accounting Equation or Balance Sheet is a description of Total Assets of a business against the claimants of these Assets. Therefore, this Equation shows financial position on a specific date. The three titles in the Equation are Elements of Balance Sheet. Similarly Elements of Income Statement would be Revenues & Expenses and their net affects Owner’s equity.

Within the Elements, there would be sub-elements, for example, the Element or Account “Assets” would consist of cash, Accounts Receivable, Land, and Building etc. Each financial transaction affects two or more elements or sub-elements of the Accounting Equation. Therefore, we can say that each financial transaction affects Balance Sheet i.e. financial position of the business.

Steps in Accounting Cycle

1-Analyzing financial transaction.The purpose is to see which two (or more) Accounts (or sub-Accounts) are affected by a particular financial transaction.

2-Recording (chronologically) in journal which is called “book of original entry”.this step is also called journalizing. Its practical illustration is given below.

3- Posting in ledger which means transferring debits and credits from journal to ledger account. This is also called ledgerising or classification.

4-Preparing trial balance, this is done to prove the equality of debits and credits in the ledger

5-Making adjusting Entries

Long & Current Liabilities:

Long Term Liabilities:These are the liabilities that will become payable after a period of more than one year of the balance sheet date. For example, if business has taken a loan from bank or any third person and it is payable after three years, it will be treated as a long term liability for the business.

Current Liabilities:These are the obligations of the business that are payable within twelve months of the balance sheet date. Creditors and all accrued expenses are the examples of current liabilities of the business because business is expected to pay these back within one accounting period.

Balance Sheet

It is a position statement that shows the standing of the organization in Monetary Terms at a Specific Time.

Unlike Profit and Loss that shows the performance of the entity over a period of time, the Balance Sheet shows the Financial State of Affairs of the entity at a given date. Balance sheet is the summarized analysis in a ‘T’ form of all assets and liabilities of the entity, with liabilities listed on left hand side and assets on right hand side. Asset is any owned physical object (tangible asset) or a right (intangible asset) having economic value to the owner. Liability is an obligation of the business to deliver goods or to provide a benefit in future.

Income, Expenditure, and Profit & Loss

Incomeis the value of goods and services earned from the operation of the business. It includes both cash & credit. For example, if a business entity deals in garments. What it earns from the sale of garments, is its income. If somebody is rendering services, what he earned from rendering services is his income.

Expensesare the resources and the efforts made to earn the income, translated in monetary terms. It includes both expenses, i.e., paid and to be paid (payable). Consider the above mentioned example, if any sum is spent in running the garments business effectively or in provision of services, is termed as expense.

Profit is the excess of income over expenses in a specified accounting period.

Profit= Income-expenses

Classification of Expenses:

The most commonly used groupings of expenses are as follows:

Cost of goods sold (CGS) is the cost incurred in purchasing or manufacturing the product, which an organization is selling plus any other expense incurred in bringing the product in saleable condition. Cost of goods sold contains the following heads of accounts: 1-Purchase of raw material/goods;2-Wages paid to employees for manufacturing of goods;3-Any tax/freight is paid on purchases;4-Any expense incurred on carriage/transportation of purchased items.

Administrative expensesare the expenses incurred in running a business effectively. Main components of this group are:

1-Payment of utility bills;2-Payment of rent;3-Salaries of employees;4-General office expenses;5-Repair & maintenance of office equipment & vehicles.

Selling expensesare the expenses incurred directly in connection with the sale of goods. This head contains:

1-Transportation/carriage of goods sold;2-Tax/freight paid on sale;3-o If the expense head ‘salaries’ includes salaries of sales staff then it will be excluded from salaries & appear under the heading of ‘selling expenses’.

Financial expensesare the interest paid on bank loan & charges deducted by bank on entity’s bank accounts. It includes:1-Mark up on loan;2-Bank charges

Income & Expenditure Vs Profit & Loss Account

1-These are two similar terms. Only difference between these two terms is that income & expenditure account is prepared for non profit oriented organizations, e.g. Trusts, NGO’s, whereas profit & loss account is prepared in profit oriented organizations, e.g. Limited companies, Partnership firms etc.

2-In case of Income and Expenditure account, Surplus/ Deficit is to be found and in case of Profit and loss account, profit or loss is to be found.

Income Statement and Net Income

Income Statement summarizes operating results of a business by matching revenues with expenses over the same accounting period.

Net income is the increase in owner’s equity resulting from profitable operations of a business. This is accompanied by increase in total assets, (but not necessarily cash) or decrease in total liabilities. It may happen that a profitable business may also run short of cash, because the profit that it earns is tied up in other assets i.e. Accounts Receivables, fixed assets etc or else, it was used in paying out its obligations like Accounts Payable etc. Net loss is the corresponding decrease in owner’s equity.

Closing the Owner’s Drawing Account

Withdrawals of cash or other assets by the owner are not considered an expense of the business and, therefore, are not a factor in determining the net income for the period. Since drawings by the owner do not constitute an expense, the owner’s drawing account is closed not into the Income Summary account but directly to the owner’s capital account.

Revenue, Expense and Drawing (by owner) change owner’s equity. These are temporary capital accounts. To make these Accounts ready for recording events of next accounting periods, we take the following steps:-

-Close (transfer) Revenue Accounts to Income Summary Account.

-Close (transfer) Expense Accounts to Income Summary Account.

-Close (transfer) Income Summary Account to Owner’s Equity Account or Capital Account.

-Close Drawing Account directly to Capital Account.

Owners Capital Account ( Dr.)

Drawings Account (Cr.)

Steps in Accounting Cycle:

The accounting procedures in the accounting cycle may be summarized as follows

1-Journalize Transactions;2-Post to Ledger Accounts;3-Prepare A Trial Balance;4-End of Period Adjustments;5-Prepare an Adjusted Trial Balance;6-Prepare Financial statements;7-Journalize and Post Closing Entries;8-Prepare an After Closing Trial Balance

 

Meaning, Functions Of Perpetual Inventory System

Meaning of perpetual inventory system:Perpetual inventory system is also known as "Automatic Inventory System". Perpetual inventory system is a technique of controlling stock items by maintaining store record in a manner such that stock balances at any point of time are readily available. The terms 'Perpetual Inventory' refer to the system of record-keeping and a continuous physical verification of stocks, with reference to store records.

Functions Of Perpetual Inventory System:The main functions of perpetual inventory system are as follows.
1-Recording store receipts and issues to determine the stock in hand at any time, in quantity or value or both, without the need for physical counting of the stock.
2-Continuous verification of the physical stock with reference to the balance recorded in the store record is convenient for the management.

Periodic Inventory System:

The periodic inventory system only updates the ending inventory balance when you conduct a physical inventory count. Since physical inventory counts are time-consuming, few companies do them more than once a quarter or year. In the meantime, the inventory account in the accounting system continues to show the cost of the inventory that was recorded as of the last physical inventory count.

Under the periodic inventory system, all purchases made between physical inventory counts are recorded in a purchases account. When a physical inventory count is done, you then shift the balance in the purchases account into the inventory account, which in turn is adjusted to match the cost of the ending inventory.

The calculation of the cost of goods sold under the periodic inventory system is:

Beginning inventory + Purchases = Cost of goods available for sale

Cost of goods available for sale – Ending inventory = Cost of goods sold

For example, Milagro Corporation has beginning inventory of $100,000, has paid $170,000 for purchases, and its physical inventory count reveals an ending inventory cost of $80,000. The calculation of its cost of goods sold is:

$100,000 Beginning inventory + $170,000 Purchases - $80,000 Ending inventory

= $190,000 Cost of goods sold

Advantages Of Perpetual Inventory System

Perpetual inventory system provides an opportunity to verify the physical stock of materials.
1-Perpetual inventory system helps in rapid stock checking which, in turn, helps in the preparation of interim accounts.
2-A moral check on the store staff to maintain proper stock records.
3-The investment in materials and supplies may be kept at the lowest point.
4-It is not necessary to stop the production so as to carry out a complete physical stocktaking.
5-Perpetual inventory system helps to avoid deterioration, obsolescence etc.
6-Perpetual inventory system helps to discover or find out discrepancies and errors and remedial action can be taken quickly.
7-Timely replenishment of stock is facilitated by means of recording the level specified in the bin card.

Periodic System:Primaryuse of the periodic inventory system occurred prior to the introduction of point-of-sale scanners and computers. Companies such as drug and hardware stores that sold lots of small merchandise found it easier to update their inventory balances periodically instead of trying to account for every item sold on a daily basis. The periodic inventory system allows a company to record sales of merchandise in a special account. When merchandise gets sold, the company records the revenue but does not record a cost of goods sold (CoGS) entry.

Perpetual System:The introduction of point-of-sale systems and computers greatly advanced the use of the the perpetual inventory system. Perpetual inventory records each sale of merchandise and places an entry in the company’s inventory account. This system also immediately reduces sold inventory from stock and adds inventory back to stock when a customer returns merchandise.