Week 8 · Chapter

Chapter 8 — Midterm Review & Exam

Financial Accounting Free sample edition

The module's primary reading · ~30–40 minutes · Objective 1 (explain the purpose of financial accounting, its users, the forms of business organization, the roles of GAAP, the FASB, the SEC, and IFRS, and the ethical principles that guide accountants) to Objective 5 (account for merchandising operations and inventory: record purchases and sales in a perpetual system, compute cost of goods sold and gross profit, and apply FIFO, LIFO, and weighted-average costing and the lower of cost and net realizable value) reviewed, Objective 6 (describe internal control and its components, and account for cash, including the bank reconciliation, and for receivables, including the allowance method and notes receivable) introduced · Read it early this week, before the practice set and the discussion and well before the midterm.

In plain language

This chapter helps you review the first seven weeks before the midterm. Instead of rereading everything, you ask each topic for the one distinction it asks you to keep (a line between two ideas that are easy to mix up, such as an asset and an expense). You rerun each distinction on figures you have already worked for the bicycle shop, so the review adds no new numbers. Then you meet one new idea: internal control (the everyday rules a business follows so its cash, its goods, and its records stay safe and right). You finish by seeing why even good controls give confidence, not a guarantee.

Why you already care about this

Picture the bicycle shop (illustrative) a few weeks into its life. Its two founders want a bank loan, and the lender asks for the Month 1 statements. The statements say the shop earned $1,400 of net income on $5,850 of service revenue. Its first bicycle sale brought in $2,460 of gross profit. The lender's question is simple: can I trust these numbers?

Two things decide the answer. The first is whether every figure was put in the right place: an asset kept apart from an expense, revenue counted when it was earned, and the right cost sent to cost of goods sold. That is what you have learned for seven weeks, one distinction at a time. The second is whether the shop has habits that keep its cash and its records from going wrong in the first place. That is this week's new topic.

You will meet the same pair of questions anywhere money is counted: at a food bank tracking donations, at a clinic ordering supplies, or at a public company whose report thousands of investors read.

By the end of this chapter you will be able to:

tell an asset, a liability, and an expense apart on the running case's entries;
read a debit and a credit by side and by normal balance, and say what a balanced trial balance does not prove;
separate the cash basis from the accrual basis, and revenue from cash received;
sort the six month-end adjustments into deferrals and accruals;
tell temporary accounts from permanent accounts, and close each correctly;
compare perpetual and periodic systems, and FIFO and LIFO, by their effects;
define internal control, name its five components, and match each to a bicycle-shop example;
date COSO's framework and the Sarbanes-Oxley Act, and explain why controls give reasonable, not absolute, assurance.

Carry this line with you: one topic, one distinction — then check the books.

Where we are

Already covered: Week 1 set the rules and the rule makers. Week 2 built the accounting equation. Week 3 recorded transactions with debits and credits. Week 4 adjusted the books with deferrals and accruals. Week 5 prepared the statements and closed the books. Week 6 added merchandising, and Week 7 costed inventory four ways.
This week: a review of Weeks 1 to 7 by distinction, one light new topic (internal control, its five components, COSO's framework, the Sarbanes-Oxley Act, and its limits), and then the midterm.
How they connect: every distinction you review decides where a figure lands, and internal control is how a business keeps those figures trustworthy.
Where we're going next: Week 9, Cash and the Bank Reconciliation, opens the course's second half and takes one of internal control's components, control activities, and points it at cash.

The midterm checks Objectives 1 to 5 as taught in Weeks 1 to 7, and you take it without AI help. Internal control is new this week and returns in Week 9. Every worked example below reruns a figure from Datasets A to D, the running case's month, its month-end, its bicycle sale, and its helmet layers. If a figure surprises you, go back to the week that built it.

1. Ask whether a cost is still useful or still owed: asset, liability, and expense

Think about a new phone and the monthly plan that runs it. The phone keeps working for years. The month of service is gone once the month ends. You paid for both, yet they are different kinds of cost.

A distinction is a line between two ideas that are easy to mix up, such as an asset and an expense, that a topic asks you to keep straight before you record or report anything. Weeks 2 and 4 asked for two of them.

Recall the definitions. An asset is a resource the business controls that is expected to provide future benefits. An expense is the cost of resources used up to earn revenue. A liability is an obligation to transfer resources to others. So ask two questions about any cost: is it still useful, and is it still owed?

Worked example — the shop's equipment, rent, supplies, and wages. You rerun four transactions and three adjustments, asking your two questions each time.

Transaction 2: the shop pays $12,000 cash for repair equipment. Debit Equipment 12,000; credit Cash 12,000. The work stands will serve for years, so Equipment is an asset. Total assets do not change: Cash falls by $12,000 as Equipment rises by $12,000.
Transaction 8: the shop pays $1,500 rent for the month. Debit Rent Expense 1,500; credit Cash 1,500. The month is used up, so the cost is an expense.
Adjustment (c): the equipment's cost reaches expense a little at a time. It lasts 60 months with no residual value, so depreciation is 12,000 ÷ 60 = $200 a month. Its book value at the end of Month 1 is 12,000 − 200 = $11,800.
Transaction 3: the shop buys $900 of supplies on account. Debit Supplies 900; credit Accounts Payable 900. The supplies are an asset, the amount owed is a liability, and no expense exists yet.
Adjustment (a): a count finds $350 of supplies on hand, so 900 − 350 = $550 was used. Only now does $550 become Supplies Expense.
Adjustment (e): the mechanic earned $400 of wages that the shop has not paid. Debit Wages Expense 400; credit Wages Payable 400. One entry records both an expense (the work was used this month) and a liability (the pay is still owed). Wages Expense for the month is 1,600 + 400 = $2,000.

In words: the shop's $12,000 of equipment is an asset that turns into expense at $200 a month, while its $1,500 of rent was expense the moment the month was used.

Misconception check. Students often think that buying equipment, or buying supplies on account, is an expense because money is involved. Paying for something is not the same as using it up. The cure: ask whether the cost will still help next month. If it will, it is an asset; if the business still owes for it, there is a liability too.

2. Read a debit and a credit by side, not by direction

Picture a scoreboard with two columns, one for each team. A point in the left column is not "good" or "bad" until you know which team that column belongs to. Debits and credits work the same way.

Recall from Week 3: a debit is an entry on the left side of an account, and a credit is an entry on the right side. Neither means increase or decrease on its own. What a debit does depends on the account's normal balance. Assets, expenses, and dividends increase with debits. Liabilities, common stock, retained earnings, and revenues increase with credits.

Worked example — footing the unadjusted trial balance. You add the debit column and the credit column of the running case's unadjusted trial balance.

The bicycle shop's unadjusted trial balance at the end of Month 1, in dollars (Dataset A, illustrative)
Account	Debit	Credit
Cash	$17,100
Accounts Receivable	$800
Supplies	$900
Prepaid Insurance	$2,400
Equipment	$12,000
Accounts Payable		$300
Unearned Revenue		$1,200
Common Stock		$30,000
Dividends	$500
Service Revenue		$5,300
Rent Expense	$1,500
Wages Expense	$1,600
Totals	$36,800	$36,800

The debits are 17,100 + 800 + 900 + 2,400 + 12,000 + 500 + 1,500 + 1,600 = $36,800. The credits are 300 + 1,200 + 30,000 + 5,300 = $36,800. The two sides match.

In words: the trial balance shows that the shop's debits equal its credits, and that is all it shows.

Here is the honesty note that goes with every trial balance. Suppose the shop forgot to record the $1,000 it collected on Day 25. Both Cash and Accounts Receivable would be wrong, and the trial balance would still balance, because the missing entry had a debit and a credit of the same size.

Misconception check. Students often think a debit always means "increase" and a balanced trial balance proves the books are right. A debit decreases a liability or a revenue, and an omitted entry, a duplicated entry, or a posting to the wrong account of the same type all leave the totals equal. The cure: read the side first, then the account's normal balance, and treat a balanced trial balance as one check, not proof.

3. Record revenue when it is earned: cash basis versus accrual basis

Suppose you buy a concert ticket months before the show. The venue has your money, but it has not put on the concert yet. If the show were canceled, it would owe you a refund. Has the venue earned your money? Not yet.

Recall from Week 4: under the cash basis, revenue is recorded when cash is received and an expense when cash is paid. Under the accrual basis, revenue is recorded when it is earned and an expense when it is incurred, whenever the cash moves. GAAP requires accrual-basis statements. A close cousin is the Week 2 distinction between revenue and cash received: the two can happen on different days.

Worked example — the cycling club's advance, and a delivery company's account. You follow each receipt of cash and each piece of work to the day it happened.

Transaction 5: a cycling club pays $1,200 in advance for tune-ups the shop has not yet performed. Debit Cash 1,200; credit Unearned Revenue 1,200. The cash basis would call the $1,200 revenue on Day 6. The accrual basis records a liability, because the shop owes the work.
Adjustment (d): by the end of Month 1 the shop has performed one quarter of the tune-ups. It has earned 1,200 ÷ 4 = $300. Debit Unearned Revenue 300; credit Service Revenue 300. Unearned Revenue is left at 1,200 − 300 = $900.
Transaction 7: the shop does $1,800 of repairs for a delivery company on account. Debit Accounts Receivable 1,800; credit Service Revenue 1,800. That is revenue on Day 18 with no cash.
Transaction 10: the delivery company pays $1,000 of its account. Debit Cash 1,000; credit Accounts Receivable 1,000. That is cash on Day 25 with no revenue. Accounts Receivable is left at 1,800 − 1,000 = $800.
The month's revenue: Service Revenue is 3,500 + 1,800 = $5,300 before the adjustments and 5,300 + 300 + 250 = $5,850 after them.

In words: the shop's $5,850 of revenue counts the work it did in Month 1, not the cash it happened to collect.

Misconception check. Students often think revenue is earned when the cash arrives, so a collection from a customer is revenue and an advance is income. Revenue follows the work. The cure: for every cash receipt, ask what the shop did to earn it, and when. If the work is still owed, the cash is a liability; if the work was done earlier, the revenue is already on the books.

4. Sort the six adjustments: deferral versus accrual

Think of two bills at home. You pay a streaming service for a year in advance, and you use it a month at a time. Your electric bill arrives after you have already used the power. In the first case the cash moved first. In the second it moves later.

Recall from Week 4: a deferral is an adjustment for an amount where the cash moved first, such as a prepaid expense or unearned revenue. An accrual is an adjustment for an amount where the cash moves later, such as accrued revenue or an accrued expense. Every accrual or deferral adjusting entry changes one income statement account and one balance sheet account, and never Cash.

Worked example — the shop's six adjustments, sorted. You ask of each one whether the cash moved before or after the month-end.

The bicycle shop's six month-end adjustments sorted by kind, in dollars (Dataset B, illustrative)
Adjustment	What happened	Kind	Amount
(a)	Supplies used	Deferral (prepaid expense)	$550
(b)	Insurance expired	Deferral (prepaid expense)	$200
(c)	Depreciation	Deferral (of the equipment's cost)	$200
(d)	Unearned revenue earned	Deferral (unearned revenue)	$300
(e)	Wages accrued	Accrual (accrued expense)	$400
(f)	Revenue accrued	Accrual (accrued revenue)	$250

Adjustment (b) comes from the $2,400, 12-month insurance policy: 2,400 ÷ 12 = $200 for one month. Count the rows: 4 deferrals + 2 accruals = 6 adjustments. Scan the accounts in each entry, and you will not find Cash in any of them.

After the six adjustments, the adjusted trial balance reaches $37,650 on each side. Adjustments (c), (e), and (f) each open a new balance on both sides, so 36,800 + 200 + 400 + 250 = $37,650. The other three move amounts between accounts on the same side.

In words: four of the shop's adjustments use up or earn something paid for in advance, and two record something earned or used before any cash moved.

Misconception check. Students often think an adjusting entry fixes the Cash account, since the cash is "where the money is". The cash already moved, or has not moved yet; the adjustment only puts revenue or expense in the right month. The cure: if an accrual or deferral adjustment you write touches Cash, stop and rewrite it.

5. Close what is temporary, carry what is permanent

Think of a basketball league. Each team's wins and losses reset to zero when a new season starts, while a player's career totals keep growing. One record starts fresh; the other carries forward.

Recall from Week 5: temporary accounts (revenues, expenses, and dividends) collect one period's activity and are closed to Retained Earnings at the end of the period. Permanent accounts (assets, liabilities, and equity accounts) carry their balances into the next period. A dividend is a distribution to the owners, not an expense, so it never appears on the income statement.

Worked example — the Month 1 statements and closing. You prepare your figures in order, then close only what measures the month.

Expenses: 2,000 + 1,500 + 550 + 200 + 200 = $4,450.
Net income: 5,850 − 4,450 = $1,400.
Retained earnings at the end of Month 1: 0 + 1,400 − 500 = $900.
The four closing entries close Service Revenue and the five expenses into Income Summary, close Income Summary's $1,400 to Retained Earnings, and close Dividends straight to Retained Earnings.
The post-closing trial balance lists only permanent accounts, at $32,700 on each side.

In words: the shop earned $1,400 in Month 1, paid $500 of it to its owners, and carries $900 of retained earnings into Month 2.

Misconception check. Students often think closing entries close the balance sheet, or that Dividends is closed to Income Summary like an expense. Closing touches only the temporary accounts, and Dividends goes straight to Retained Earnings because it is not part of net income. The cure: before you close an account, ask whether it measures one period or carries forward.

6. Compare inventory systems and cost flows: perpetual versus periodic, FIFO versus LIFO

At a campus café, one cashier rings up each muffin and the register updates the count at once. Another café counts its muffin trays only at closing. Both learn how many muffins sold; they learn it at different times.

Recall from Week 6: in a perpetual inventory system, Inventory and Cost of Goods Sold are updated with every purchase and sale. In a periodic inventory system, cost of goods sold is found from a count at the end of the period. Recall from Week 7: FIFO counts the oldest unit costs as sold first, and LIFO counts the newest first. The methods are compared by their effects and never ranked. IFRS does not allow LIFO, as the SEC stated in 2008; U.S. GAAP permits it.

Worked example — the bicycle sale, perpetual. You record cost of goods sold at the moment of each sale.

The 10 bicycles cost 4,000 + 180 − 80 = $4,100, or 4,100 ÷ 10 = $410 each.
Sales of 6 bicycles at $820: 6 × $820 = $4,920.
Cost of goods sold, recorded with each sale: 6 × $410 = $2,460.
Gross profit: 4,920 − 2,460 = $2,460, and 2,460 ÷ 4,920 = 0.50, a gross margin of 50 percent.
Inventory left: 4 × $410 = $1,640.

Worked example — the helmets, periodic, by FIFO and LIFO. You find cost of goods sold after the count, under each method.

Cost of goods available for sale: 600 + 1,320 + 1,440 = $3,360.
FIFO cost of goods sold is $2,280, so FIFO ending inventory is 3,360 − 2,280 = $1,080.
LIFO cost of goods sold is $2,430, so LIFO ending inventory is 3,360 − 2,430 = $930.
The gap: 2,430 − 2,280 = $150 more cost of goods sold under LIFO.

In words: when helmet costs rise, LIFO sends the newest, costliest helmets to cost of goods sold, so the shop reports $150 more cost of goods sold than under FIFO from the same $3,360.

Misconception check. Students often think FIFO and LIFO describe which helmets leave the shelf first, and that LIFO lowers cost of goods sold when costs rise. Both methods describe which costs count as sold, and when costs rise, LIFO's figure is the higher one, $2,430 against $2,280. The cure: say "costs, not helmets", then check which layer is newest.

7. Protect the books: internal control and its five components

A neighborhood club holds a bake sale. One member sells, and a second member counts the cash box with the seller at the end. Each sale gets a slip, and the treasurer checks that the slips match the cash. Nobody thinks the seller is dishonest. The habits protect the seller as much as the money.

That is the idea behind internal control: the set of policies and procedures a business uses to protect its assets, keep its records reliable, run efficiently, and follow the law.

The U.S. Government Accountability Office (GAO) publishes a guide to internal control called the Green Book: the U.S. Government Accountability Office's Standards for Internal Control in the Federal Government, which sets out the five components of internal control in adapting the COSO framework. Section 8 meets COSO.

The components of internal control are the five parts that together make up an internal control system: the control environment, risk assessment, control activities, information and communication, and monitoring. Each one has its own job:

Control environment — the component of internal control that forms its foundation: the discipline, structure, and example set by the people who run a business, which shape how seriously everyone else treats its rules.
Risk assessment — the component of internal control in which a business identifies and analyzes what could stop it from meeting its goals, such as an asset going missing or a sale going unrecorded, so it can decide how to respond.
Control activities — the everyday actions built into the work to deal with those risks. Week 9 takes this component apart.
Information and communication — the component of internal control that covers the quality information a business records and shares, and the channels people use to pass it on, so that everyone can do their part in the system.
Monitoring — the component of internal control in which a business checks over time whether its controls are working and promptly follows up on any problem a review finds.

Worked example — the five components at the bicycle shop (Dataset E, illustrative). You match each component to one thing the shop does.

The five components of internal control, each with an illustrative bicycle-shop example (Dataset E)
Component	Bicycle-shop example (illustrative)
Control environment	The two founders follow the shop's own rules, so every repair gets a ticket, theirs included
Risk assessment	The founders list what could go wrong, such as walk-in cash that never reaches the books or a bicycle leaving the stockroom unsold
Control activities	Prenumbered repair tickets with every number accounted for, and a locked stockroom for bicycles and a safe for cash
Information and communication	The repair tickets carry each sale into the books, and the mechanic knows whom to tell when a ticket number is missing
Monitoring	A founder reviews each monthly bank reconciliation, prepared by someone who does not handle cash, and follows up on any difference

That is 5 components. Dataset E also lists 6 common categories of control activities, and Week 9 applies all six to cash.

In words: the shop's controls start with the founders' own example, aim at the risks they listed, run through tickets and locks, travel on the repair tickets, and get checked every month.

Pause and choose one of these to think through, whichever you prefer:

(a) Think of a place you have worked, volunteered, or shopped. Name one habit there that protects cash or goods, and say which of the five components it belongs to.
(b) Imagine the bicycle shop skips the control environment: the founders write rules but ignore them. Describe in one or two sentences what might happen to the other four components.

Misconception check. Students often think internal control is a list of locks and passwords, so it means only control activities. Locks are one component of five. Without a control environment, a risk assessment, good information, and monitoring, the locks guard the wrong things or stop being used. The cure: name all five components before you judge any one control.

8. Follow the sources: COSO's framework and the Sarbanes-Oxley Act

Building codes let any inspector judge any house by the same rules. Internal control has shared rules too, and two sources matter for this course.

The first is COSO: the Committee of Sponsoring Organizations of the Treadway Commission, which issued Internal Control—Integrated Framework in 1992 and refreshed it in 2013. Its five components are the ones you met in Section 7, and the GAO's Green Book adapts them. Name the 2013 refresh in words; the year to remember is 1992.

The second is a U.S. law. Congress enacted the Sarbanes-Oxley Act of 2002, Public Law 107-204, to protect investors by improving the accuracy and reliability of corporate disclosures. Among other things, the Act requires management of public companies to report on internal control over financial reporting.

That last phrase has its own meaning. Internal control over financial reporting is the controls a company relies on to make its financial statements reliable, which the management of a public company must report on under the Sarbanes-Oxley Act of 2002.

Worked example — does the Act's reporting rule reach the bicycle shop? You walk the question in steps.

Who must report on internal control over financial reporting? Management of public companies.
Is the bicycle shop public? No. It is a corporation owned by its two founders, and its shares are not sold to the public.
So the Act's reporting rule does not require the shop to file that report.
Does the shop still gain from controls? Yes. Its lender reads its statements, and the five components protect the shop's own cash and bicycles.

In words: the Sarbanes-Oxley Act's reporting rule is aimed at public companies, while the ideas behind it help any business whose numbers someone relies on.

Misconception check. Students often think the Sarbanes-Oxley Act applies in full to every business, so a small private shop must file the same reports as a public company. The Act's internal control reporting is required of the management of public companies. The cure: ask whether the business is public before you say what the Act requires of it, and say "the Act requires" only for what it requires.

9. Know the limit: reasonable assurance, not absolute

A seatbelt lowers the risk of injury in a crash. Nobody claims it makes a crash harmless. Internal control works the same way.

Reasonable assurance is the level of confidence internal control can give: a high degree of confidence, never a guarantee, because people make mistakes and controls can be defeated. Internal control gives reasonable, not absolute, assurance.

One way controls fail is collusion: two or more people working together in secret to get around a control, such as two employees agreeing to hide a missing check, which can defeat segregation of duties, a control that Week 9 names and studies in detail. The Green Book adds that management itself can override a control.

Worked example — where the shop's controls stop. You test two of Dataset E's controls against the limit.

The person who opens the mail and lists the checks is not the person who records receivables. One person's mistake shows up in the other's work.
Now suppose those two people agree to hide a check together. The split no longer catches it. That is collusion.
A tired clerk could also skip a repair ticket number by accident. Controls lower the chance; they do not remove it.

In words: the shop's controls make a missing dollar much more likely to be noticed, but they cannot promise that no dollar ever goes missing.

That is the limitation to state honestly whenever you describe a control. It is also why splitting duties is not an insult to employees. It protects the honest person whose work is checked, because a problem elsewhere cannot be pinned on them.

Misconception check. Students often think internal control guarantees that no fraud occurs, and that segregation of duties means the owner distrusts the staff. Controls give reasonable, not absolute, assurance, and splitting duties protects honest employees as well as the cash. The cure: describe what a control makes likely, never what it makes impossible.

Key terms

distinction — A line between two ideas that are easy to mix up, such as an asset and an expense, that a topic asks you to keep straight before you record or report anything. (first used: 1. Ask whether a cost is still useful or still owed: asset, liability, and expense)
internal control — The set of policies and procedures a business uses to protect its assets, keep its records reliable, run efficiently, and follow the law. (first used: 7. Protect the books: internal control and its five components)
Green Book — The U.S. Government Accountability Office's Standards for Internal Control in the Federal Government, which sets out the five components of internal control in adapting the COSO framework. (first used: 7. Protect the books: internal control and its five components)
components of internal control — The five parts that together make up an internal control system: the control environment, risk assessment, control activities, information and communication, and monitoring. (first used: 7. Protect the books: internal control and its five components)
control environment — The component of internal control that forms its foundation: the discipline, structure, and example set by the people who run a business, which shape how seriously everyone else treats its rules. (first used: 7. Protect the books: internal control and its five components)
risk assessment — The component of internal control in which a business identifies and analyzes what could stop it from meeting its goals, such as an asset going missing or a sale going unrecorded, so it can decide how to respond. (first used: 7. Protect the books: internal control and its five components)
information and communication — The component of internal control that covers the quality information a business records and shares, and the channels people use to pass it on, so that everyone can do their part in the system. (first used: 7. Protect the books: internal control and its five components)
monitoring — The component of internal control in which a business checks over time whether its controls are working and promptly follows up on any problem a review finds. (first used: 7. Protect the books: internal control and its five components)
COSO — The Committee of Sponsoring Organizations of the Treadway Commission, which issued Internal Control—Integrated Framework in 1992 and refreshed it in 2013. (first used: 8. Follow the sources: COSO's framework and the Sarbanes-Oxley Act)
Sarbanes-Oxley Act of 2002 — A U.S. law, Public Law 107-204, passed to protect investors by improving the accuracy and reliability of corporate disclosures; among other things, it requires management of public companies to report on internal control over financial reporting. (first used: 8. Follow the sources: COSO's framework and the Sarbanes-Oxley Act)
internal control over financial reporting — The controls a company relies on to make its financial statements reliable, which the management of a public company must report on under the Sarbanes-Oxley Act of 2002. (first used: 8. Follow the sources: COSO's framework and the Sarbanes-Oxley Act)
reasonable assurance — The level of confidence internal control can give: a high degree of confidence, never a guarantee, because people make mistakes and controls can be defeated. (first used: 9. Know the limit: reasonable assurance, not absolute)
collusion — Two or more people working together in secret to get around a control, such as two employees agreeing to hide a missing check, which can defeat segregation of duties. (first used: 9. Know the limit: reasonable assurance, not absolute)

Summary

Each topic asks for one distinction; name it before you record anything.
A cost still useful is an asset; a cost used up is an expense; an amount still owed is a liability.
A debit is the left side and a credit the right side; neither means increase on its own.
A balanced trial balance, $36,800 on each side, is one check, not proof.
Revenue follows the work, not the cash: the club's $1,200 advance is a liability until earned.
The six adjustments are 4 deferrals and 2 accruals, and none touches Cash.
Net income of $1,400 less $500 of dividends leaves $900 of retained earnings.
Temporary accounts close; permanent accounts carry forward, at $32,700 on each side.
Perpetual records cost of goods sold with each sale; periodic finds it from a count.
LIFO gives $150 more helmet cost of goods sold than FIFO when costs rise; neither is ranked.
Internal control has five components: control environment, risk assessment, control activities, information and communication, and monitoring.
COSO issued its framework in 1992; the Sarbanes-Oxley Act was enacted in 2002.
Internal control gives reasonable, not absolute, assurance; collusion can defeat it.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A food truck pays $3,000 cash for a new griddle and $140 cash for one week of parking. Sort each payment into an asset or an expense, and write the debit and the credit for each.
A tutoring business receives $600 in advance for 6 sessions. By the end of the month it has taught 2 of them. Under the accrual basis, how much revenue has it earned, how much does it still owe, and is the month-end adjustment a deferral or an accrual?
A dog-grooming service starts the year with $1,000 of retained earnings. Its revenue for the year is $4,200, its expenses are $2,900, and it pays $400 of dividends. Compute net income and ending retained earnings, and name the accounts that are closed.
At a farmers' market stall, one helper takes the cash, writes the sales log, and counts the cash box at the end of the day. Name the weakness, name one component of internal control it falls under, and explain why fixing it still would not give absolute assurance.

Answers (worked reasoning — read after attempting)

The griddle will cook for years, so it is an asset: debit Equipment 3,000, credit Cash 3,000. The week of parking is used up when the week ends, so it is an expense: debit Parking Expense 140, credit Cash 140. Both entries balance, and only the parking reduces this period's income.
Each session is worth 600 ÷ 6 = $100. Two sessions are done, so the business has earned 2 × $100 = $200 of revenue. It still owes 600 − 200 = $400 of sessions, which stays in Unearned Revenue as a liability. The cash came first, so the adjustment is a deferral: debit Unearned Revenue 200, credit Service Revenue 200.
Net income is 4,200 − 2,900 = $1,300. Ending retained earnings is 1,000 + 1,300 − 400 = $1,900. The revenue, expense, and dividends accounts are temporary, so they are closed; the dividends go straight to Retained Earnings, not through net income.
One person handles the cash and keeps its record, so a mistake or a missing bill would show up nowhere else. The fix is a control activity (a second person counts the box or checks the log), and checking that the fix keeps happening is monitoring. Even with the duties split, the two people could collude, or both could make the same mistake, so the stall gets reasonable, not absolute, assurance.

Next up in this module: the lecture, the Readings & Resources page, the practice set, the discussion, and the midterm; next week the bank reconciliation method puts control activities to work on cash.

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