This chapter describes the necessity for and features of internal control, defines cash, and identifies procedures for controlling cash receipts and disbursements. It covers preparing a bank reconciliation, using a petty cash fund, and analyzing results with the quick ratio, a measure of short-term liquidity.
Internal control over cash
Because cash is the asset most easily misused, businesses rely on internal control procedures, such as separating the duties of handling cash from recording it, to safeguard both receipts and disbursements. The chapter describes what management seeks to achieve through effective control of cash, and the specific procedures used for both incoming customer payments and outgoing payments to suppliers and employees.
The bank reconciliation
A bank reconciliation compares a company’s own cash records to the bank statement and explains any differences, such as outstanding checks or deposits still in transit, arriving at one true, reconciled cash balance. The chapter works through preparing this reconciliation step by step and the journal entries needed for items it reveals, such as bank service fees the company had not yet recorded.
Petty cash and the quick ratio
A petty cash fund is a small, controlled amount of cash kept on hand for minor expenses that would be impractical to pay by check, and the chapter explains how it is established, used, and periodically replenished. It also introduces the quick ratio, which measures a company’s ability to meet short-term obligations using only its most liquid assets, cash chief among them.
This chapter explains how inventory errors affect financial statement items, which costs belong in inventory, and how to calculate the cost of ending inventory and cost of goods sold under the four major inventory costing methods, using both periodic and perpetual procedures, along with net realizable value and the lower-of-cost-or-market rule.
Inventory errors and inventoriable costs
An error in counting or valuing ending inventory flows directly into cost of goods sold and net income, and because ending inventory of one period becomes beginning inventory of the next, the error affects two periods’ statements before it finally corrects itself. The chapter also identifies which costs, beyond the purchase price alone, properly belong in the inventory figure reported on the balance sheet.
The four costing methods for measuring and reporting inventories
Specific identification, first-in first-out, last-in first-out, and weighted average each assign cost to units sold and units remaining in inventory differently, and can produce materially different reported income and inventory values from the exact same underlying purchases. The chapter works through calculating cost of ending inventory and cost of goods sold under each of these four methods in turn.
Net realizable value and lower-of-cost-or-market
Inventory is not always carried at its originally recorded cost. When net realizable value falls below cost, the lower-of-cost-or-market rule requires writing the inventory down, so the balance sheet does not overstate an asset whose value has genuinely declined since purchase. The chapter shows how this adjustment is calculated, applied, and recorded in the accounts.
This chapter covers journal entries for sales and purchase transactions involving merchandise, the distinction between perpetual and periodic inventory procedures, freight terms, and how cost of goods sold is determined. It concludes with preparing a classified income statement and analyzing the gross margin percentage the business achieves on its merchandise.
Recording sales and purchases of merchandise
Sales transactions are recorded with entries that recognize revenue and, under the perpetual method, remove the sold goods from inventory at the same time. Purchase transactions record merchandise coming into the business, together with any purchase discounts or returns that affect the final recorded cost of the goods bought, which later flows through into cost of goods sold.
Perpetual versus periodic procedures, and freight
Perpetual inventory procedure updates the inventory account with every purchase and sale, while periodic procedure determines cost of goods sold only at the end of the period through a physical count. Freight terms determine who bears shipping cost and exactly when title to the goods transfers, both of which affect how transportation costs on merchandising transactions are ultimately recorded in the accounts.
Cost of goods sold and the classified income statement
Cost of goods sold is calculated by combining beginning inventory, net purchases, and ending inventory, and it is typically the largest single expense on a merchandising company’s income statement. The chapter shows how to present this figure within a classified income statement, and introduces the gross margin percentage as a way to analyze how efficiently the business is pricing and selling its goods.
This chapter surveys the underlying assumptions, major principles, and modifying conventions that govern accounting practice, and describes the conceptual framework project of the Financial Accounting Standards Board. It also discusses what a company’s own summary of significant accounting policies typically covers in its published annual report.
Assumptions and principles in accounting theory
Accounting rests on underlying assumptions, such as treating the business as a separate entity and assuming it will continue operating, and on major principles that guide how transactions are measured and recorded, including matching revenues with the expenses that produced them. Together these form the conceptual basis for the more detailed accounting rules applied to individual transactions day to day.
Modifying conventions
Alongside the formal principles, a set of modifying conventions, or practical constraints, shape how strictly those principles are actually applied, including considerations of materiality and conservatism in everyday practice. These conventions exist because rigid application of every principle to every transaction, however small, would not always produce useful or cost-effective financial reporting for a business.
The conceptual framework and disclosure
The Financial Accounting Standards Board’s conceptual framework project sets out the objectives and qualitative characteristics that financial reporting should meet. In practice, a company communicates the specific choices it has made, among the acceptable alternatives that theory and principle allow, through a summary of significant accounting policies included in its annual report, so readers can judge one company against another.
This chapter summarizes the full accounting cycle for a service company, from preparing a work sheet through adjusting and closing entries to a post-closing trial balance. It also covers preparing a classified balance sheet and analyzing results using the current ratio, tying the cycle’s mechanical steps to the statements they ultimately produce.
The work sheet
A work sheet brings together the unadjusted trial balance, the period’s adjustments, and the resulting adjusted figures in one place, making it easier to prepare the income statement, statement of retained earnings, and balance sheet without error. It is a working tool rather than a formal financial statement, but it organizes the numbers that those statements are ultimately built from, step by step.
Adjusting, closing, and completing the accounting cycle
Adjusting entries update the accounts before statements are prepared, while closing entries transfer the balances of temporary accounts, revenues, expenses, and dividends, into retained earnings so the books are ready for the next period. A post-closing trial balance is then prepared to confirm that only permanent balance sheet accounts remain open and that total debits still equal total credits before the cycle begins again.
The classified balance sheet and the current ratio
A classified balance sheet groups assets and liabilities into current and long-term categories, making the statement considerably easier to analyze. The current ratio, current assets divided by current liabilities, is introduced as a way to assess a company’s short-term ability to meet its obligations, drawing directly on the figures organized in this classified presentation of the balance sheet.
