Lecture: Midterm Review & Exam
Lecture script · about 15–20 minutes spoken · Week 8
Opening
Picture the owner of a small bike shop sitting across from a loan officer. The officer slides the shop's statements back across the desk and asks one question: can I trust these numbers? A nurse manager signing off on a clinic's supply count faces the same question. So does an auditor reading a public company's report. Every one of them is leaning on a handful of distinctions, and on habits that keep the records behind those distinctions honest.
Here's where we are. In Weeks 1 through 7 you built a whole set of books for the bicycle shop. That shop is illustrative, a made-up business we follow through the course. You analyzed its first month's transactions, recorded them with debits and credits, adjusted them at the month's end, prepared its statements, closed its books, sold its first bicycles, and costed its helmets four ways.
That's a lot to review. So in this lecture I'll ask each topic for one thing: the distinction it wants you to keep. We'll rerun each one on figures you've already worked, with no new numbers. Then we'll meet one light new topic, internal control. After that comes the midterm, which you take without AI help, and then Week 9, Cash and the Bank Reconciliation.
1. Still useful, or still owed?
Think about a phone and its monthly plan. The phone keeps working for years. The month of service is gone when the month ends. You paid for both, but they're different kinds of cost.
That's the first distinction, and 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. For any cost, ask two questions. Is it still useful? Is it still owed?
The shop paid $12,000 for repair equipment. The work stands will serve for years, so Equipment is an asset. Its cost reaches expense a little at a time, through depreciation of $200 a month. The shop also paid $1,500 rent for the month. That month is used up, so rent is an expense. Then it bought $900 of supplies on account. That's an asset, Supplies, and a liability, Accounts Payable, with no expense at all yet. Only when the count found $350 left did $550 of use become Supplies Expense.
Pause and try this. The mechanic earned $400 of wages the shop hasn't paid yet. Is that an expense, a liability, or both?
Ask your two questions, one at a time.
Here's the answer. Both. The work was used this month, so it's Wages Expense, and the pay is still owed, so it's Wages Payable, in one balanced entry.
2. Sides, not directions
Think of a scoreboard with two columns. A point in the left column isn't good or bad until you know which team owns that column. Debits and credits work the same way.
A debit is an entry on the left side of an account, and a credit is an entry on the right side. Neither one means increase or decrease on its own. Assets, expenses, and dividends grow with debits. Liabilities, common stock, retained earnings, and revenues grow with credits.
The shop's unadjusted trial balance listed every account and came to $36,800 on each side. That tells you the debits equal the credits. It tells you nothing more.
Pause and try this. Suppose the shop forgot to record the $1,000 a customer paid on its account. Would the trial balance still balance?
Think about the size of the missing debit and the missing credit.
Here's the answer. Yes, it would still balance. The missing entry had a $1,000 debit and a $1,000 credit, so leaving it out lowers both sides by the same amount.
3. Revenue follows the work
Imagine buying a concert ticket months ahead. The venue has your money, but it hasn't put on the show. If the show were canceled, it would owe you a refund.
Under the cash basis, revenue is recorded when cash is received. Under the accrual basis, revenue is recorded when it's earned and an expense when it's incurred, whenever the cash moves. GAAP requires accrual-basis statements.
A cycling club paid the shop $1,200 in advance for tune-ups. Under the accrual basis, that's Unearned Revenue, a liability, because the shop owes the work. By the month's end the shop had done one quarter of the tune-ups, so it had earned $300, and it still owed $900. The same idea splits revenue from cash received. The shop did $1,800 of repairs on account for a delivery company, which was revenue with no cash. Later it collected $1,000 of that, which was cash with no revenue.
Pause and try this. The day the delivery company paid its $1,000, did the shop's revenue go up?
Find the day the work was done.
Here's the answer. No. The revenue was recorded when the repairs were done, and the payment only swapped Accounts Receivable for Cash.
4. Did the cash move first, or later?
Here's a pair from home. You pay a streaming service for a year up front and use it a month at a time. Your electric bill shows up after you've already used the power.
A deferral is an adjustment where the cash moved first, like a prepaid expense or unearned revenue. An accrual is an adjustment where the cash moves later, like accrued revenue or an accrued expense. And every one of these adjustments touches one income statement account and one balance sheet account, never Cash.
The shop had six adjustments. Four were deferrals: $550 of supplies used, $200 of insurance expired, $200 of depreciation, and $300 of unearned revenue earned. Two were accruals: $400 of wages accrued and $250 of revenue the shop had earned but not yet billed. After them, the adjusted trial balance reached $37,650 on each side.
Pause and try this. The $250 of finished but unbilled repairs: deferral or accrual?
Ask when the cash will move.
Here's the answer. Accrual. The work is done, and the cash comes later, after the shop bills the delivery company.
5. What resets, and what carries forward
Think about a basketball league. Every team's wins reset when a new season starts. A player's career totals keep growing.
Temporary accounts, the revenues, expenses, and dividends, collect one period's activity and get closed to Retained Earnings. Permanent accounts, the assets, liabilities, and equity accounts, carry their balances forward. A dividend is a distribution to the owners, not an expense.
The shop's revenue was $5,850 and its expenses were $4,450, so net income was $1,400. It paid $500 of dividends, so it carried $900 of retained earnings into Month 2. After closing, the post-closing trial balance held only permanent accounts, at $32,700 on each side.
Pause and try this. When the shop closes its books, does Dividends go into Income Summary?
Remember what net income measures.
Here's the answer. No. Dividends go straight to Retained Earnings, because they aren't part of earning net income at all.
6. When cost of goods sold is found, and which costs it uses
Picture two campus cafés. One rings up each muffin and the register updates the count at once. The other counts its trays only at closing.
In a perpetual inventory system, Inventory and Cost of Goods Sold are updated with every sale. In a periodic inventory system, cost of goods sold comes from a count at the end. The bicycles were perpetual: each cost $410, so the 6 sold carried $2,460 of cost of goods sold, recorded with each sale, against $4,920 of sales. That's a gross margin of 50 percent.
The helmets were periodic. The shop had $3,360 of helmets available. FIFO counts the oldest costs as sold first and gave cost of goods sold of $2,280. LIFO counts the newest first and gave $2,430, which is $150 more. We compare those effects and never rank them. And remember that IFRS does not allow LIFO, as the SEC stated in 2008, while U.S. GAAP permits it.
Pause and try this. Helmet costs were rising. Which method sent the higher cost to cost of goods sold?
Ask which layer was newest.
Here's the answer. LIFO, at $2,430, because the newest helmets were the costliest, and LIFO counts them as sold first.
7. Protecting the books
Now for the new topic. Picture a neighborhood club's bake sale. One member sells, and a second member counts the cash box with the seller at the end. Nobody thinks the seller is dishonest. The habit protects the seller as much as the money.
That's 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's guide, the Green Book, sets out its five components. The control environment is the foundation, the example set by the people in charge. Risk assessment asks what could go wrong. Control activities are the everyday actions that deal with those risks. Information and communication carries good information to the people who need it. Monitoring checks over time that the controls still work.
At the bicycle shop, the founders follow their own rules, so every repair gets a ticket, theirs included. They've listed what could go wrong, like walk-in cash that never reaches the books. The tickets are prenumbered, and the bicycles sit in a locked stockroom. The tickets carry each sale into the books, and the mechanic knows whom to tell about a missing number. And a founder reviews each monthly bank reconciliation and follows up on any difference.
Pause and try this. A founder reviewing the monthly bank reconciliation: which of the five components is that?
Ask whether it's doing the work or checking the work.
Here's the answer. Monitoring. It's a check over time that the other controls are still working, with a follow-up when something looks off.
8. Where the rules come from
Building codes let any inspector judge any house by the same rules. Internal control has shared rules too.
COSO, the Committee of Sponsoring Organizations of the Treadway Commission, issued its framework in 1992 and refreshed it in 2013. The year to remember is 1992. Then came a law. Congress enacted the Sarbanes-Oxley Act of 2002 to protect investors by improving the accuracy and reliability of corporate disclosures. Among other things, it requires the management of public companies to report on internal control over financial reporting, the controls a company relies on to make its statements reliable.
Pause and try this. The bicycle shop is owned by its two founders, and its shares aren't sold to the public. Must it file the Act's internal control report?
Ask who the report is required of.
Here's the answer. No. That report is required of public companies, though the same ideas still protect the shop's own cash and bicycles.
9. The limit
A seatbelt lowers the risk of injury in a crash. Nobody says it makes a crash harmless. Internal control works the same way.
Internal control gives reasonable assurance: a high degree of confidence, never a guarantee, because people make mistakes and controls can be defeated. One way they're defeated is collusion, two or more people working together in secret to get around a control. At the shop, the person who opens the mail and lists the checks isn't the person who records receivables. One person's mistake shows up in the other's work. But if those two agree to hide a check together, the split no longer catches it.
Pause and try this. Does splitting duties mean the founders distrust their staff?
Think about who is protected when work gets checked.
Here's the answer. No. Splitting duties protects honest employees as well as the cash, because a problem elsewhere can't be pinned on them.
Closing
Let's pull it together. A cost still useful is an asset, a cost used up is an expense, and an amount still owed is a liability. A debit is the left side and a credit the right, and a balanced trial balance at $36,800 is one check, not proof. Revenue follows the work, so the club's $1,200 was a liability until the shop earned it. The six adjustments were four deferrals and two accruals, and none touched Cash. Temporary accounts close, so $1,400 of net income less $500 of dividends left $900 of retained earnings. Perpetual systems record cost of goods sold with each sale, periodic systems find it from a count, and LIFO gave $150 more helmet cost than FIFO. Internal control has five components, it rests on COSO's 1992 framework and the Sarbanes-Oxley Act of 2002, and it gives reasonable, not absolute, assurance.
Next in this module, look over the Readings and Resources page, work through the practice set, join the discussion, and then sit the midterm. Next week, in Cash and the Bank Reconciliation, the third component, control activities, goes to work on the shop's cash.
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