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Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page iKey Accounting PrinciplesVolume 2ByNeville Joffe

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page iiCopyright 2008 AME Learning Inc.All rights reserved. This publication and the online program are protected by federal and internationalcopyright and patent laws. No part of this publication may be reproduced or transmitted in any form orby any means, electronic or mechanical, including photo-copying, recording or by any information storageand retrieval system, without prior written permission of the publisher.ISBN: 978-0-9733051-8-0PREFACEKey Accounting Principles Volume 2Author: Neville JoffePublisher: AME Learning Inc.Project Coordinator: Anand KaratCover Design: Gordon PalmerTypesetting: Krista Donnelly and Gordon PalmerOnline course design & production: AME multimedia teamOnline course quality testing: Creative Learn Inc.Printed and bound in CanadaThis book is written to provide accurate information on the covered topics.It is not meant to take the place of professional advice.For more information contact:AME Learning Inc.306-9251 Yonge StreetRichmond Hill, ON Canada L4C 9T3Phone: 905.731.2408Fax: 905.731.8120Toll-free: 1.888.401.3881E-mail: [email protected] our website at: www.amelearning.comii

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page iiiAcknowledgement:Contributors:1. Penny Parker, CGA, Fanshawe College2. Dennis Wilson, CA, Centennial College3. Ranjhani Raghunathan, Seneca CollegeEditors1. Dennis Furlan2. Suraiya HollingsReviewersRobert VanSomeren, Red Deer College2.Patty Mackenzie, Fanshawe College3.John Trembley, Fanshawe College4.Shauna Roch, Fanshawe College5.Elizabeth Yih-Hutchison, Fanshawe College6.David Moreland, Fanshawe College7. Thea Standish, Fanshawe College8. Kelly Wilson, Fanshawe CollegePREFACE1.9. Matthew Meikle, Fanshawe College10. Meghan Williams, York University11. Karen Baker, Loyalist College12. Treena Burns, Seneca College13. Justin Joffe, Harvard Business School14. Kerry Hendricks, Fanshawe Collegeiii

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page ivAbout the AuthorNeville Joffe, founder of AME Learning Inc., wasinvolvedfor over twenty years in theorganizational transformation and restructuring oflarge and small businesses internationally. It wasthrough this experience that he first recognizedthe benefits of educating employees about thefinancial implications of their actions. He realizedthat people with non-financial backgrounds lackeda shared frame of reference to tackle day-to-dayfinancial issues related to their responsibilities.This motivated him to create a unique hands-onsystem to teach accounting and financialmanagement, which he patented and called theAME Learning System.The success of this system was phenomenal and Neville has since trained over 25,000 nonfinance managers, senior executives, sales professionals and operators of Fortune 1000companies throughout the world, for more than a decade. Measurable results of the programhave been amazing. AME Learning is recognized as a world leader in its industry, winningnumerous awards, including the prestigious Otter Award from the Canadian Society forTraining & Development for the best training program in the country.PREFACEOver the years, employees in numerous organizations have remarked: “I wish I had learnedaccounting like this in college”. The next step was to extend this patented system of teachingaccounting to educational institutions. With over 5 years of research and development,coupled with surveys conducted on numerous professors and students, AME Learning launcheda blended introductory accounting course eight years ago. The success of the Accounting 1course led to the development of this Accounting 2 blended course.Traditional methods of teaching accounting concepts lean more toward teaching themechanics of accounting, but AME focuses on the logic of accounting principles, usingpatented pedagogical tools that bring the subject to life, simplifying the topic and making iteasier to understand. Students have consistently commented that they find the courseremarkably easy to follow, using the numerous interactive tools that supplement the textbookand workbook.Professors on the other hand have described this methodology as “refreshing”, “intriguing”,“amazing”, “never thought it could be this simple”, “inspiring to see that someone haschanged the rules of teaching accounting” and “you have broken the mould - the way thissubject has been taught”!ivNeville envisions that in the foreseeable future the perception of accounting will change,from a subject that is typically considered ‘intimidating and boring’ to one that is inspiring,exciting and useful as a crucial life skill.

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page vBrief Table of ContentsAccounting information aid expenses and other assets6.Capital assets: tangible assets7.Capital assets: intangible assets8.Current liabilities9.Long-term liabilities10.Accounting for partnerships11.Corporations12.Cash flow statement13.Financial statement analysis14.Introduction to International Financial Reporting StandardsPREFACE1.v

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page viDetailed Table of ContentsChapter 1: Accounting information systems. . . . . . . . . . . . . . . . . . . . . . . . . 111. An integrated approach to learning accounting . . . . . . . . . . . . . . . . . . . .112. How accountants follow a paper trail . . . . . . . . . . . . . . . . . . . . . . . . . .113. How accountants deal with information today . . . . . . . . . . . . . . . . . . . .14Chapter 2: Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17PREFACE1. The role of short-term investments . . . . . . . . . . . . . . . . .a. What are short-term investments . . . . . . . . . . . . . . . . .b. Short-term investments and the balance sheet . . . . . . . .c. Types of short-term investments . . . . . . . . . . . . . . . . . .2. Debt investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . .a. The nature of debt expenses . . . . . . . . . . . . . . . . . . . .b. Traditional loans and how they are recorded . . . . . . . . .c. Bond purchases and how they are recorded . . . . . . . . . .3. Equity investments . . . . . . . . . . . . . . . . . . . . . . . . . . . .a. The nature of equity investments . . . . . . . . . . . . . . . . .b. Share purchases and how they are recorded . . . . . . . . . .c. Dividend payments and how they are recorded . . . . . . . .d. Changes in the value of shares and how they are recordede. Selling equity and how this is recorded . . . . . . . . . . . . .4. Controls for short-term investments . . . . . . . . . . . . . . . . .a. Types of controls needed for short-term investments . . . .b. Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .c. Integrity of information and bookkeeping . . . . . . . . . . . .d. Physical safekeeping . . . . . . . . . . . . . . . . . . . . . . . . .e. Managerial safekeeping . . . . . . . . . . . . . . . . . . . . . . . .d. Setting company objectives . . . . . . . . . . . . . . . . . . . . .5. Ethics related to short-term investments . . . . . . . . . . . . . 2.33.33.34.34.34Chapter 3: Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381. The importance of accounts receivable . . . . . . . . . . . .2. Controlling accounts receivable using subsidiary ledgers3. Accounting for bad debts . . . . . . . . . . . . . . . . . . . . .a. The direct approach . . . . . . . . . . . . . . . . . . . . . . .b. The allowance approach . . . . . . . . . . . . . . . . . . . .c. Reverse bad debt expense . . . . . . . . . . . . . . . . . . .4. Approaches to estimating bad debt . . . . . . . . . . . . . .a. Income statement approach (Percentage of Sales) . . .b. Balance sheet approach (Percentage of Receivables) .vi.38.39.41.42.42.44.47.48.49

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page 6.61Chapter 4: Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651. Inventory: A different kind of asset . . . . . . . . . . . . . . . . . . . . . . . . . . .652. Methods of measuring inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66a. Perpetual vs. periodic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66b. Four methods for valuing inventory . . . . . . . . . . . . . . . . . . . . . . . . . .66c. Applying inventory systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .67d. Using specific identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68e. Using average cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69f. Using First-In-First-Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70g. Using Last-In-First-Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70h. Why does the choice of inventory system matter? . . . . . . . . . . . . . . . .713. The lower of cost or market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .724. The impact of inventory errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73a. The impact of cost of goods sold on gross profit . . . . . . . . . . . . . . . . .74b. The impact of inventory errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . .745. Methods of estimating inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76a. The gross profit method of estimating inventory . . . . . . . . . . . . . . . . .77b. The retail method of estimating inventory . . . . . . . . . . . . . . . . . . . . .806. Recording and presenting inventory data . . . . . . . . . . . . . . . . . . . . . . . .81a. Purchase of inventory for resale . . . . . . . . . . . . . . . . . . . . . . . . . . . .82b. Sale of inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82PREFACE5. Managing accounts receivable information using reports6. The accounts receivable subsidiary ledger . . . . . . . . . .a. Alternative presentation formats . . . . . . . . . . . . . .7. Measuring the effectiveness of collections using ratios . .a. Day sales ouststanding ratio (DSO) . . . . . . . . . . . . .b. Accounts receivable turnover ratio (ART) . . . . . . . . .8. Accounts receivable controls . . . . . . . . . . . . . . . . . . .a. Credit controls . . . . . . . . . . . . . . . . . . . . . . . . . .b. Credit approval . . . . . . . . . . . . . . . . . . . . . . . . . .c. Credit information . . . . . . . . . . . . . . . . . . . . . . . .d. Terms of sale . . . . . . . . . . . . . . . . . . . . . . . . . . .e. Credit Policy . . . . . . . . . . . . . . . . . . . . . . . . . . .9. Converting accounts receivable into cash . . . . . . . . . .a. Setting firm terms of credit . . . . . . . . . . . . . . . . . .b. The promissory note . . . . . . . . . . . . . . . . . . . . . .c. Notes receivable . . . . . . . . . . . . . . . . . . . . . . . .10. An ethical approach to accounts receivable . . . . . . . . .vii

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page viii7. Controls related to inventory . . . . . . . . . . . . . . . . . . . . . . . . . . .a. Recording in the general ledger and subsidiary ledger . . . . . . . .b. General ledger . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .c. Subsidiary ledger accounts . . . . . . . . . . . . . . . . . . . . . . . . . .d. A control when posting to the journal . . . . . . . . . . . . . . . . . . .e. General principles regarding inventory controls . . . . . . . . . . . .f. Reliability and integrity of information . . . . . . . . . . . . . . . . . .g. Compliance with plans, policies, procedures, regulations and lawsh. Safeguarding inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . .i. The economical and efficient use of resources . . . . . . . . . . . . .j. Inventory objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. An ethical approach to inventory estimation and valuation . . . . . . .a. Impact on financial statements . . . . . . . . . . . . . . . . . . . . . . .b. Who commits fraud and why? . . . . . . . . . . . . . . . . . . . . . . . . .9. Measuring inventory turnover using financial ratios . . . . . . . . . . . .a. Inventory turnover ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . .b. Day sales on hand ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5PREFACEChapter 5: Prepaid expenses and other assets. . . . . . . . . . . . . . . . . . . . . . . 991. Assets not to be forgotten . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .992. Prepaid expenses, the matching principle and materiality . . . . . . . . . . . .99a. Finding a place for miscellaneous assets . . . . . . . . . . . . . . . . . . . . .1023. Recording transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1024. Controls for prepaid expenses and other current assets . . . . . . . . . . . . .1035. Ethics related to prepaid expenses and sundry assets . . . . . . . . . . . . . . .104Chapter 6: Tangible fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1071. Capital assets: the big picture . . . . . . . . . . . . . . . . . . . . . . . . .2. The acquisition of capital assets: plant, property and equipment . . .a. How to define a capital asset . . . . . . . . . . . . . . . . . . . . . . . . .3. Recording total costs of capital assets . . . . . . . . . . . . . . . . . . . . .a. What about a lump sum purchase of capital assets? . . . . . . . . . .4. What if changes are made to a capital asset? . . . . . . . . . . . . . . . .5. The basic concept of amortization . . . . . . . . . . . . . . . . . . . . . . .a. Residual value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .b. Actual salvage value when disposing of an asset . . . . . . . . . . . .6.Three methods of amortization . . . . . . . . . . . . . . . . . . . . . . . . . . .a. Straight-line method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .b. The declining-balance method (double-declining-balance 7.118.121

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page ix7.8.9.10.11.c. The units-of-production method . . . . . . . . .Amortization for partial years . . . . . . . . . . . .Disposal, revision, and amortization . . . . . . . .a. Revising amortization . . . . . . . . . . . . . . . .Controls related to capital assets . . . . . . . . . .An ethical approach to capital assets . . . . . . .Capital assets, total assets, and financial ratios.124.126.128.133.134.136.138Chapter 7: Intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142A not so tangible company asset.Accounting for goodwill . . . . . . . . . . . . . . . . . . . . . . . . .Some assets are not naturally intangible . . . . . . . . . . . . . .Protecting unique inventions: the patent . . . . . . . . . . . . . .Protecting artistic creations: the copyright . . . . . . . . . . . . .Protecting a symbol or name: the trademark and trade nameLeasing instead of owning capital assets . . . . . . . . . . . . . .Controls related to intangible assets . . . . . . . . . . . . . . . . .An ethical approach to intangible assets . . . . . . . . . . . . . .142.143.147.150.151.152.153.153.154Chapter 8: Current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1561.2.3.4.5.6.7.8.9.10.11.On the other side of the balance sheet . . . . . . . . . . . .How the liabilities side of the balance sheet works . . . . .Getting billed: accounts payable and reporting proceduresAccruals when matching expenses . . . . . . . . . . . . . . . .a. Current liabilities are paid using current assets . . . . . .Accruals when matching revenues . . . . . . . . . . . . . . . . .The flip-side of a promissory note: notes payable . . . . . .When shareholders loan the company money . . . . . . . . .Estimated and contingent liabilities . . . . . . . . . . . . . . .a. Estimated liabilities . . . . . . . . . . . . . . . . . . . . . . . .b. Contingent liabilities . . . . . . . . . . . . . . . . . . . . . . .Controls related to current liabilities . . . . . . . . . . . . . .An ethical approach to current liabilities . . . . . . . . . . . .Current liabilities and financial ratios . . . . . . . . . . . . . 79.180PREFACE1.2.3.4.5.6.7.8.9.Chapter 9: Long-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1851. A matter of focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1852. From current liabilities to long-term liabilities . . . . . . . . . . . . . . . . . . .1863. Taking the initiative - the bond issue . . . . . . . . . . . . . . . . . . . . . . . . . .187ix

Preface - Vicky:*Preface.qxd 23/12/08 3:43 PM Page xa.Issuing bonds at par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .188b.Issuing bonds at a discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .191c.Issuing bonds at a premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195d.Retiring bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1984. The time value of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .200a.Time value of money and long-term liabilities . . . . . . . . . . . . . . . . . .2035. Controls related to long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . .2056. An ethical approach to long-term liabilities . . . . . . . . . . . . . . . . . . . . .205Chapter 10: Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2081.2.3.4.5.6.7.Characteristics of proprietorships and partnershipsWhat changes with partnership . . . . . . . . . . . . .How to divide up the profits . . . . . . . . . . . . . . .Why limited partnerships were invented . . . . . . .Why limited liability partnerships were invented . .How to add and withdraw partners . . . . . . . . . . .How to liquidate a partnership . . . . . . . . . . . . . .208.209.210.214.215.215.220Chapter 11: Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224PREFACE1.2.3.4.5.6.7.8.9.10.The professionalization of ownership structure . . . . . . . . . . . . .The corporate structure: separating management from ownershipFinancial statements and shareholders’ equity . . . . . . . . . . . . .Issuing shares for money and more . . . . . . . . . . . . . .

1. Accounting information systems 2. Investments 3. Receivables 4. Inventory 5. Prepaid expenses and other assets 6. Capital assets: tangible assets 7. Capital assets: intangible assets 8. Current liabilities 9. Long-term liabilities 10. Accounting for partnerships 11. Corporations 12. Cash flow statement 13. Financial statement analysis 14.