Assignment Type:Individual Project Deliverable Length: 2 pages
Points Possible:125 Due Date:3/2/2013 11:59:59 PM CT
You are an accountant at a local CPA firm that is auditing the accounting records of ABC Company. You have been asked to educate the accounting department about the limitations of the internal control system in preparation for an upcoming audit. During your audit, you have identified that because of a weak internal control system, an adjusting entry for prepaid insurance was not recorded for the first 3 months of the year at $500 per month.
· Identify the limitations of the internal control system. Provide at least 3 limitations.
· Provide at least 2 examples of internal control procedures, and explain how these procedures can be implemented.
· Identify symptoms of a lack of internal control.
· Explain the impact of the missing journal entry on the financial statements of the company.
The Accounting Equation
The Importance of the Accounting Equation
The accounting equation, the transactions behind it, and the rules for its use are to business
like the scoring, rules, and regulations are to a game of baseball. If each baseball team played
by different rules and scored the game differently, no one would know which team is the best
or, for that matter, understand what was going on as they watched the game being played.
Without the use of the accounting equation, businesses could not be compared to each other
and owners and investors would not be able to determine the profit or loss of a company.
The Accounting Equation
The accounting equation on the surface looks very simple: Assets = Liabilities + Owner’s
Equity. However, like in the game of baseball, there are many rules and plays (transactions)
that occur before the home run is scored, or the accounting equation is finalized for a business.
The assets of a business include all the company’s resources. Examples are land, building,
manufacturing equipment, office equipment and furniture, and inventory. A company’s liabilities
are what it owes to creditors. This could be money the company borrowed to buy equipment or
money it owes for the purchase of supplies and inventory. These liabilities are subtracted from
the owner’s equity to arrive at the VALUE or assets of the business. The owner’s equity
includes the cash the owner puts into the business, the assets that are transferred into the
business, and the net income (income after all expenses are accounted for) that remains in the
business. Both sides of the accounting equation must be equal.
The Rules
The rules or guidelines for tracking business activities were developed over many years of
business practice. Rules were developed and regulatory agencies were created to continue to
develop, regulate, and publish the rules by which the game of business would be played. The
rules are called the Generally Accepted Accounting Principles and the regulatory agency is the
Financial Accounting Standards Board (FASB).
The Transactions and Chart of Accounts
The transactions record the plays or activities of the business. All transactions are either debits
or credits to an account. An example is a company that buys a piece of manufacturing
equipment costing $10,000 and uses cash. What has it done? It has traded one asset for
another (cash for equipment). The cash account is reduced by $10,000 (as a credit) and the
equipment account is increased by $10,000 (as a debit). All transactions are two sided. Each
must have a debit and a credit.
It takes many accounts to organize and control a business. This list of accounts is called the
chart of accounts. Some examples are assets (which include cash, inventory, capital
equipment, supplies, and accounts receivable) and liabilities (which include accounts payable,
wages payable, and long-term loans). In the evaluation (audit) and control of a business, one
of the most important reviews is to analyze each transaction for each account to make sure
that each transaction has an offsetting posting (debit and credit). Once all transactions are
correctly posted to each account, a summary of all accounts must be posted to reports or
forms. This shows the performance of the business. Types of Forms/Reports
The most widely used reports are the income statement, balance sheet, and the statement of
cash flows. The income statement is a report of the activity of a business through time
(month/year). The balance sheet is a snapshot of the business at a single point in time (monthend, year-end) and reports the values of the accounting equation. The statement of cash flows
is a report of the availability of cash and use of cash through time – usually monthly
Special Income Statement Items
Generally accepted accounting principles (GAAP) require that the following irregular items
(items that do not happen frequently in the regular course of business) be listed separately in
the income statement:
Discontinued operations
Extraordinary items
Unusual gains and losses
Changes in accounting principles
Changes in estimates Discontinued Operations
Discontinued operations occur when the results of operations and cash flows of a segment of
an entity are eliminated and are no longer considered part of continuing operations and the
company no longer participates in that segment of the operation. If either of these conditions
is not met, an entity cannot separately disclose the transaction as a discontinued operation.
When an organization decides to dispose of a segment of its operations, certain aspects of the
transaction must be reported separately, and disclosures must be presented in the financial
statement notes. On the income statement, a separate category for the gain or loss
calculations from the disposal of the assets of that segment of the entity must be included.
Also, the results of operations for the disposed business segment are reported in discontinued
operations section.
Extraordinary Items
Extraordinary items are material transactions that are unusual in nature and occur
infrequently. All characteristics must exist for an item to be classified as an extraordinary
item on the income statement. If the transaction does meet the one or more of the criteria for
extraordinary itemsmaterial, unusual, and infrequent then the item is shown net of tax
below the discontinued operations sections of the income statement. An earthquake in the Midwest would be considered material, unusual, and infrequent for that area, so it would
qualify as an extraordinary item.
Unusual Gains and Losses
Material gains and losses that are either unusual or occur infrequently (but not both) cannot
be included as an extraordinary item and are instead considered unusual gains and losses.
These transactions are presented with the normal revenue and expense income statement
sections. If the transaction is material, then the items are disclosed separately on the income
statement; however, if the transaction is immaterial, then the items are combined with other
items on the income statement. An example of a transaction that was included as an unusual
gain or loss because it did not qualify as an extraordinary item was Hurricane Katrina. The
FASB ruled that because that area of the country is prone to hurricanes, it was not unusual
for a hurricane to occur. Therefore, any losses were classified as unusual but not
extraordinary. This was a shock to many organizations.
Changes in Accounting Principles
A change in accounting principle occurs when an organization adopts a new accounting
principle that is different from the one previously used such as changing from LIFO to FIFO
or straight-line depreciation to double declining balance. A company calculates the change in
accounting principle by making a retrospective adjustment to the financial statements. This
basically means restating the financial statements. The retroactive adjustment restates the
previous years’ financial statements on using the newly adopted principle. The company also
records the cumulative effect of the change for prior periods as an adjustment to beginning
retained earnings of the earliest year presented in the financial statements. Most companies
will release 2 years of financial information in their annual report, but there is not a set
amount of years that must be disclosed when a change in accounting principle occurs.
Detailed information of the change in the accounting principle is also disclosed in the notes
to the financial statements. It is extremely important for accountants and users of financial
information to understand the transaction that the financial statements and notes be used in
conjunction with each other.
Changes in Estimates
When accountants prepare the financial statements of an entity, many estimates are used in
all phases of preparationsuch as the estimated useful life that is used in the calculation of
depreciation. Adjustments that occur because of the use of estimates are used in the
determination of income for the current period, and future periods and are not treated as
changes in the accounting principle on the income statement. Therefore, it is extremely
important to understand the difference between a change in accounting principle and a
change in the accounting estimate, as they are handled differently on the income statement.
In addition, changes in estimates are not considered errors such as prior period adjustments
(that would be recorded in the statement of retained earnings or extraordinary item