Slide 1 Accounting for Sales Chapter 6, Part 2 Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 1 Slide 1 Hello, I'm Susanne Garret, and this is Introduction to Financial Accounting. This is Session 7 of this course, and this is a continuation of our study of Chapter 6. In this session, we will be examining further some topics relating to cash, accounts receivable, and sales specifically. We are going to look at the last three objectives, that is in this chapter having to do with assessing the level of accounts receivable, discussing more in detail what proper internal control procedures 1would be, and finally, looking at a bank reconciliation. So this, again, is a continuation of Chapter 6, and we'll be looking specifically at Pages 249 through 259 in your text. Slide 2 Credit Sales and Accounts Receivable Most sales create Accounts Receivable Both costs and benefits Potential uncollectible accounts – bad debt expense Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 2 Slide 2 As you may recall from our prior session, we discussed several aspects of having credit sells, including the possibility of having uncollectible accounts receivable, or bad debt. Now, we explored how to account for bad debt and how to calculate estimates and so forth. However, how much should a credit -- a company give in terms of credit to various customers? How much accounts receivable is appropriate? And how much of an allowance or bad debt should we have? Now some people might naturally respond that the ideal situation is to not have any bad debt at all. However, for most companies their philosophy is that a small amount of bad debt is actually good, and the reason why is that by taking some risks and having uncollectible accounts, we are also expanding the amount of sells in total that we will be receiving because we are allowing people to buy with credit. This would expand our customer base, as we discussed before. And the hope is to find that balance which maximizes the overall profit to the company. Meaning increasing accounts receivable and sells to a point where it lists the bad expense to the highest point possible. We want to maximize our net profits. So let's examine some tools that we could use to assess our level of accounts receivable and match this using some financial ratios. Slide 3 Assessing the Level of Accounts Receivable One measure: Accounts receivable turnover = Credit Sales / Average A/R Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 3 Slide 3 One measure of assessing the level of accounts receivable in a company is to use what's called the accounts receivable turnover ratio. This is a way of measuring how fast accounts receivable is turned into cash. This is a calculation of an indication of how many times each year the accounts receivable is converted into cash. It is calculated by taking the total amount of credit sells for the year and dividing it by the average level of accounts receivable. We have used this concept of averaging of an amount before in our prior discussions. And we would apply the same way here by looking at the beginning balance of accounts receivable for the period and the ending balance and then dividing by two or multiplying by five, in order to have an average of those balances. In examining the result, a higher turnover would indicate that a company is turning its accounts receivable into cash faster than a company who is turning over a low, a lower number. So in general, companies would feel that the higher the turnover, the better. Slide 4 Assessing the Level of Accounts Receivable - Example Suppose credit sales for Compuport in 20X8 were $1 million and beginning and ending accounts receivable were $115,000 and $112,000, respectively Accounts receivable turnover = $1,000,000 / 0.5 ($115,000 + $112,000) = 8.81 Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 4 Slide 4 Let's look at an example by using this turnover ratio, by looking once again at our company from the book, Compuport. In this case, let's assume they have $1 million in sells, and we're given its beginning and ending balances of accounts receivable for this same year. So our accounts receivable turnover would be calculated by taking the $1 million on the top part of our ratio and dividing it by the average of $115,000 and the $112,000. Again, that average could be calculated in a couple of different ways. You can see here that I'm taking half, or .05, of the sum of these two numbers. The resulting turnover calculation is 8.81. Again, this is meaning that, in essence, the turnover of our accounts receivable is happening approximately 8.8 times in a year. Now this doesn't mean that it happens all at once. This is just an average number of what is happening. Slide 5 Assessing the Level of Accounts Receivable Second method: Average collection period = 365 // Average collection period = 365 Accounts receivable turnover Accounts receivable turnover Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 5 Slide 5 Another method we can use to assess the level of accounts receivable is the days to collect accounts receivable or the average collection period. This ratio is found by taking 365 days and dividing it by the accounts receivable turnover. In the case of Compuport from before, we would have already calculated our accounts receivable turnover, and so this is simply another way of looking at this same financial information, but it is a measurement in days. In other words, how many days does it take us on average to convert our accounts receivable into cash. So our resulting number from this calculation will be in days. Now if we did do the calculation from Compuport, we would take 365 and divide it by 8.81 and we would get a result of 41.4 days. Now this may seem long. In some companies, it is rather short. A lot will depend on the specific credit policy they have in place and what their goal is of how fast they want their accounts receivable to turn into cash. If you look at Exhibit 6.3 in your textbook, and that's on Page 250, you can see a comparison of accounts receivable turnover ratios average collection periods for several different industries. Note that they are quite different in some cases and this is the case in a lot of different industries. These expectations and their normal collection periods can vary quite a bit. Slide 6 Management of Cash Major internal control procedures Separation of duties Record and deposit cash receipts immediately Use serially numbered checks, Require proper authorization Reconcile bank accounts monthly Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 6 Slide 6 In our last session, we discussed that cash management is very important because of a variety of things, including the fact that we want to make sure that we're not opening ourselves up for someone to steal or embezzle our funds. Cash is something easy to take away. Relate it to this: We need to have procedures in place that try to prohibit or at least convince people that it would be too difficult, too risky, to try to take funds from the company. Some major internal procedures we talked about before that affect cash are things such as separation of duties, the issue of deposits, and recording funds as fast as possible, to use numbered checks, to require proper authorization to the issuing of checks, and to do monthly bank reconciliations. We are going to explore this further in detail. Slide 7 Overview of Internal Control Internal control Administrative Accounting Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 7 Slide 7 We've used the term internal control. Let's talk about that a little bit in detail. First, what exactly is internal control? Well it should be some sort of system of checks and balances that a company has in place so that the management can ensure accurate financial records and ensure that employees and others are dissuaded from trying to take money, embezzle funds, or even take other assets of the company. Now, we're specifically talking about cash in this chapter, but let's talk about two different types of internal controls that a company probably has in place. There are administrative controls and then there are accounting controls. Administrative controls could be things such as budgeting procedures, reports on performance, procedures for how to determine how much credit to give to customers. These are things that help us to, again, manage planning and control of our day-to-day operations. Accounting controls are things like ensuring that we have proper authorization before the issue of a check so that the person who is writing the check is not the same person who signs the check. This is an example of separation of duties and a good internal control procedure, and it has to do with our accounting system. Some other things about recording could be an example of an accounting internal control. In other words, we are trying to safeguard our accounting system and what we record so that we can ensure our financial statements and our records are accurate. Slide 8 The Accounting System Repetitive transactions: Cash disbursements Cash receipts Purchase of goods and services, including employee payroll Sales or other rendering of goods and services Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 8 Slide 8 Looking specifically at our accounting system. The accounting system, again, can be quite automated and handle a number of repetitive tasks or transactions, such as the ones listed here, numerous cash disbursements. We may be receiving cash on a daily basis, purchasing goods and services, and this includes making payments to employees through our payroll efforts. We could be doing numerous sells, multiple sells in a single day, in some types of companies. All of these should be handled well if you have a good accounting system in place. If we have many repetitive tasks, we want to try to automate these as best as possible, which will serve us to reduce the number of errors and probably the amount of time, effort and cost in accounting for these things. Well-designed and well-run accounting systems are definitely positive contributions to the organization. And we could look at inventory controls as an example, and ordering systems. If a company is constantly needing to replenish the goods that it turns around and sells to their customers, they may expand their accounting system to allow for an interactive way for our inventory control system to contact our suppliers directly to inform them when our inventory level is getting low and to automatically place a new order with our normal supplier. Slide 9 Checklist of Internal Control Reliable personnel with clear responsibilities Separation of duties Proper authorization Adequate documents Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 9 Slide 9 In a good accounting system, we would need to have good internal controls. Some of the areas of internal controls that a manager might use to check and safeguard our cash and payroll and related information could include some of the following: First of all, having a reliable personnel with clear responsibilities that include the second bullet there, separation of duties. We have people who have good responsibilities, know what they are doing, plus have a separation of their duties, such as having two people open up deposits at a bank instead of just one, having the person who creates a deposit slip check in with a second person to verify the amount before it is actually taken to the bank, and the person preparing checks to be written not have the authority to sign the actual checks. Another area is proper authorization. For instance, someone should be approving how much credit is given to various customers. This could be a situation where we're watching that a customer who is not really a customer or a friend of someone who works in the credit department might get too much credit extended and become a major uncollectible account in the future. Another safeguard in this area would be the approval of overtime in advance or the approval of large expenditures for such things as capital assets. Lastly, we want to make sure that we have accurate documentation of our decisions and transactions. We want to have what's called source documents to refer back to, to clearly see who requested certain transactions, and in most cases, who approved these transactions in advance, in case there are any questions later, and make sure that these documents are tamper proof and are safeguarded for future reference. Slide 10 Checklist of Internal Control (continued) Proper procedures Physical safeguards Vacations and rotation of duties Independent check Cost-benefit analysis Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 10 Slide 10 Continuing our discussion on the checklist, our internal controls, we have a number of other areas that we would want management to consider in creating a good internal control system. One area is have proper procedures in place. If we have good standardized procedures regarding things such as dividing up duties, who does which part of a process and who needs to approve it. This routine is replicated potentially many times daily, weekly, monthly, in an organization, and repetition and expectation of what's happening would minimize the possibility of someone tampering with this process. Another area is to place physical safeguards where appropriate. In safeguarding our assets, we would want to ensure that we have good physical safeguards in place for important assets, valuable assets, as well as those assets that can easily walk off, as we say. Meaning, that could easily be taken by either customers or employees and not be noticed right away. Things like good lighting at night. Using safes and locks would be examples of this. Another area would be ensuring that vacations are taken and perhaps even having rotation of duties. For example, many banks promote that you must take two weeks in a row of vacation each year. The thought being if you only take one week, perhaps if you are embezzling funds, it wouldn't be noticed, but if you miss two weeks in a row, your absence and someone else doing your job would allow the company to see that something wrong was taking place. Rotation of duties would have the same affect. Someone else will periodically do the exact same responsibility you have now and they could be examining those things that you've done, written down, tampered with, that might not be appropriate. Next we suggest that you have an internal check, meaning that an independent person verifies what has been done in key job areas, again, to verify that there is no embezzlement or other misdoings going on. Then, finally, the cost benefits. We do recognize that some internal control procedures can be quite costly. So we need to verify that the cost of an internal control procedure is not more than the benefit that you would get from it. A good example, yes, something like a pencil can easily walk out the door by a customer or an employee, but how available is a pencil? It would not make sense to have an expensive internal control procedure in place for that type of asset. It would cost more to do that than the actual cost of losing a few pencils. The goal of internal control is really not to prevent all of fraud from happening. It's to minimize the possibility and the temptation because of these procedures. Slide 11 Management’s Responsibility Management bears the primary responsibility for a company’s financial statements The audit committee oversees the Internal accounting controls Financial statements Financial affairs of the corporation Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 11 Slide 11. It is really management's responsibility to see that the company's financial statements are accurate and prepared well. This means that they need to have those appropriate procedures in place for internal control for preparation. Many companies have what's called an audit committee that is separate from management, and it often reports not to management of any level but to the board of directors. And this audit committee oversees the internal controls of a company and that the financial statements and the general financial affairs of the organization are being done in an appropriate way. This audit committee, as I said, ideally is independent of management and is an example of an independent check that we just discussed. If they do not report to management, then they cannot have any fear in examining and reporting any misdoings that they find. Slide 12 Bank Reconciliation Two sections: Company books Bank statement Goal: Equal adjusted balances Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 12 Slide 12. Next, I wanted to talk about what's in your appendix of your chapter, which is about bank reconciliations. Bank reconciliation, as you've seen mentioned, is an important part of internal controls. Though many bank reconciliations these days are done by a computer, there still needs to be someone examining them and knowing what they should look like and verifying their accuracy and their interpretation. We are going to examine bank reconciliations that can easily be done by hand for any size organization or even you, as an individual. Usually a bank reconciliation has two sections. One is looking at the company books and the second section is looking at the bank statement. The goal of a bank reconciliation is to adjust each of these amounts to a matching adjusted balance that would then accurately reflect the true cash balance that should be recorded on our balance sheet. Let's look at this more in detail. Slide 13 Adjustments to Company Books’ Balance Bank service charges Bad customer checks - NSF Collections Errors Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 13 Slide 13. Let's first examine the normal first section of the bank reconciliation, which is about the company book balance. Normally we would see adjustments to the company books about such things as bank service charges, customer checks that were returned for insufficient funds, we often shortcut this name as NSF, standing for nonsufficient funds checks, another possibility that a bank may collect money on our behalf. In other words, in some situations, a bank is actually collecting the cash from a customer of ours and depositing it directly into the checking account, but the company has not been notified as of yet. Lastly, we may have errors that need to be corrected on our books, as opposed to what actually happened at the bank. These types of adjustments usually need a journal entry to be made in the company books because these are things that have yet to be recorded in your accounting books, in your journal, but should be because they are transactions that have already occurred. Slide 14 Adjustments to Bank Balance Outstanding checks Deposits in transit Errors Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 14 Slide 14. Next, let's look at the second section of bank reconciliation, which is about the bank statement balance. When the bank issues it's statement, normally for a company it is dated the end of month. There may be checks that the company has written and recorded on its books that the bank has not processed yet. Perhaps who we've written it to has not cashed it yet. These would be called outstanding checks and would need to be deducted from the bank balance. There also may be deposits and transactions in it. For example, a deposit may have been made on that last day of the month and taken to the bank, but if it was taken too late in the day, it would not be on the bank statement. Yet, we have accurately recorded it as a deposit into our cash account and have taken it to the bank as of the end of month. This, again, would simply be a timing issue and our adjustment would be to add this amount to the bank balance. There also could be errors on the bank end of things, though not very often, but they may need to be made to adjust the bank balance to its final adjusted balance. Slide 15 Exercise 1 Look at Exercise 6-51, page 265. Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 15 Slide 15. Let's put into practice some of the things that we have discussed. Take a look at Exercise 6-51 (K), which is on Page 265 of your text. This is an exercise designed to calculate those financial ratios to measure the level of accounts receivable. So take a moment and look at this exercise and try it on your own before advancing to the next slide. Slide 16 Solution to Exercise 1 6-51 Dollar amounts are in millions. Vulcan’s accounts receivable turnover is: $2,700÷ [0.5 x ($334 + $343)] = 7.98 The average collection period is: 365 ÷ 7.98 = 45.74 days Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 16 Slide 16. In solving exercise 51, we can eliminate the millions of dollars since all of our dollar values are there, and you can see that if we want to examine and calculate the accounts receivable turnover, we can do this by dividing $2,700 by the average of accounts receivable, which is one-half of our two accounts receivable balances, $334 and $343. The resulting turnover value is 7.98, or about eight times. To calculate the average collection period, we would take that result and divide it into 365. In other words, we want to take 365 days and divide it by 7.98 times. The result is 45.75 days, or almost seven days, as being the average period or almost 46 days as being the average collection period for Vulcan. Slide 17 Exercise 2 Look at Exercise 6-54, page 266. Let’s do a simple two-part bank reconciliation and the journal entries related to the adjustments. Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 17 Slide 17 Now let's check ourselves in the area of a bank reconciliation. If you look at exercise 6-54 on Page 266 of your text, you can see that we have some similar bank reconciliation information given for this company. Let's do that bank reconciliation and the corresponding journal entries for this exercise. Please try do this on your own before advancing to the next slide to see how I would do it on the board. Slide 18 Exercise 2 Balances as of July 31: books - $47,000; bank statement - $32,880. Cash receipts on July 31 of $9,000 not on bank statement. Bank service charge was $120. NSF checks totaled $11,000. Outstanding checks = $6,000. Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 18 Slide 18 All right, let's try to create our bank reconciliation and our corresponding journal entries. The normal beginning of a bank reconciliation, as we reviewed earlier, starts with the balance per books. In this case, in our example, we are given that the book balance was $47,000. So that's where we will begin. Now in the given information, did you identify any of that as being necessary to affect our book balance? Well you should have recognized that there weren't any additions that we need to make, but there is two things that would need to be deducted from our book balance. Those would be the bank service charge and the nonsufficient fund checks. So we need to record those as deductions, bank charges, and our nonsufficient fund checks, and those amounts were $120 and $11,000, for a total deduction of $11,100, and now we can get our adjusted book balance by subtracting, and we should see that this is $35,880. This is the balance that we hope we now get when we examine our bank statement and adjust its balance. We were given that our balance from the bank statement on that same date, July 31st, was $32,880. So that was given information. Now what adjustments do we need to make in the bank balance? If you look through the remainder of the given information, you should see that we have a deposit that had been recorded on your books dated July 31, but the bank had not put it on our account yet. So this would be an addition for an adjustment here of the deposit amount on 7/31, and that amount was $9,000. This increases our bank balance to $41,880, but we have some deductions. We also were given information about outstanding checks. These would be payments that our books would already reflect but had not cleared at the bank yet. So we need to deduct outstanding checks, and we were given that this amount was $6,000. So this is a subtraction, and we do get a balance of $35,880, which matches what we had for our book balance. This would be called an adjusted bank balance, which should match our adjusted book balance. So that completes part one of this exercise. The second part asks us to do journal entries. Now in examining what we did in our bank reconciliation, which of these things would still need to be recorded in your journal? In other words, what things have not yet been recorded that we now know we need to do? It should make sense that these would be the things we need to do to adjust our book balance. The other things have already been recorded. So in this example, we are looking at a bank service charge and our insufficient fund check as far as adjustments that need to be made. We would need to put an accounts receivable back on our books because now we do have a customer that owes us money that we had previously removed from accounts receivable because we thought that they had paid it. So that's a debit of $11,000. The bank service charge would be some sort of expense account, perhaps just titled bank charges, and that's our $120. These would both be debits. The corresponding credit would be to cash, $11,120. This is a credit to cash because these were charges that reduced our balance in our books. So now we would be reflecting this reduced balance. Another way to look at it is this: If we examine our cash account before we had done the bank reconciliation, we had $47,000 in our books. By doing this journal entry, we reduce our cash balance by crediting it $11,120 and our new balance is the $35,880. That matches what we got on our bank reconciliation and it also is the correct amount that this company should now use on its balance sheet. Slide 19 Exercise 2 1. Bank Reconciliation - July 31 Balance per books $47,000 Deduct: Bank service charge $ 120 NSF checks 11,000 11,120 Corrected balance per books $35,880 Balance per bank $32,880 Add: Deposit in transit 9,000 Subtotal $41,880 Deduct: Outstanding checks 6,000 Corrected balance per bank $35,880 2. Patient receivables 11,000 Bank service charge expense 120 Cash in bank 11,120 Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 19 Slide 19. Here is the final formal version of what we just did on the board. Note that the journal entry in Part 2 is once again to record the deductions in cash that we had as actual transactions, by July 31. We had not recorded these yet in the book, so this journal entry is necessary. None of the rest of the adjustments that we did as part of being the banking reconciliation need to be adjusted on your books. They have already been recorded. I have previously mentioned the possibility of errors occurring and that we have not seen one in practice of our examples. I wanted to give you one here that might have happened for this company. For example, if a company had written a specific check for $491 to one of their suppliers and then had deposited it in the bank. When the bank receives the check back to deduct it from the checking account, they would see that the check was actually written out for $419, not $491. There was a transposition error and, yes, this would be an error that needs to be corrected. If the company has actually recorded it incorrectly in their books as $491 dollars, but the check was actually made out for $419, then we would have an error and we would, in this case, need to adjust our books to reduce the amount of the actual payment that was made to this supplier. If we actually did owe the higher amount, this would also result in another check needing to be written to the supplier to complete our payment. Slide 20 Starbucks Analyzing Starbucks’ Financial Statements Problem 6-82, Part 2, page 277 Use Appendix, pages A-1 through A-33 Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 20 Slide 20 It's once again time to take a look at Starbucks. Let's look at problem 6-82, Part 2, which is on Page 277. We already completed Part 1 in an earlier session. Please try to complete Part 2 before going on to the next slide. Slide 21 Solution to Starbucks 2. Average Collection Period = 365 days ÷ Accounts receivable turnover = 365 days ÷ [Credit Sales ÷ Average Accounts Receivable] = 365 ÷ [$4,075,522 ÷ (0.5($114,448 + $97,573))] = 365 ÷ [($4,075,522 ÷ $106,101.5] = 365 ÷ 38.4 = 9.5 days Introduction to Financial Accounting Suzanne Thornton Garrett, MBA, PMP 21 Slide 21. Now let's solve our Starbucks problem and look at Part 2 in trying to calculate the average collection period and the accounts receivable turnover for Starbucks. Remember that our average collection period is determined by taking 365 and dividing the accounts receivable turnover. So we need to calculate accounts receivable turnover, which is the credit sells divided by the average accounts receivable. For Starbucks, we can see that you need to pull the credit sells information and then the beginning accounts receivable balance, the ending accounts receivable balance for our year and, in this case, adding those two up and then dividing by two or multiplying by .05, and that is our denominator for the calculation of the accounts receivable turnover. So your accounts receivable turnover becomes 38.4 and our average collection period, or our days on average to collect accounts receivable, is 9.5 days. Now this amount is quite different than some examples we have looked at in the past, but it should make sense with Starbucks being the type of organization it is that it would have a fast turnover. Can you think of an industry that it might make sense that they have a slow turnover? Typically it's companies that have large, more expensive goods that they are selling to clients. Perhaps a piano seller is going to have a very long turnover period or a large collection period. Starbucks, in emphasizing coffee and small, inexpensive items, would have a small turnover, typically. This is the end of Session 7 and hopefully through this session you now have a good idea of how to assess the level of accounts receivable, understand a bit more about internal control procedures, particularly as it pertains to cash, and how to do a basic bank reconciliation.
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