2. Copyright © John Wiley & Sons Canada, Ltd.3:
THE ACCOUNTING INFORMATION SYSTEM
After studying this chapter, you should be able to:
Understand basic accounting terminology.
Explain double-entry rules.
Explain how transactions affect the accounting equation.
Identify the steps in the accounting cycle and the steps in the recording process.
Explain the reasons for and prepare adjusting entries.
Explain how the type of ownership structure affects the financial statements.
Prepare closing entries and consider other matters relating to the closing process.
Prepare a 10-column work sheet and financial statements.
After studying Appendix 3A, you should be able to:
Identify adjusting entries that may be reversed.
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3. The Accounting Information System
Basic terminology
Debits and credits
Accounting equation
Accounting Cycle and the Recording Process
Identifying and recording transactions and other events
Journalizing
Posting
Trial balance
Adjusting entries
Adjusting Entries
Adjusting entries for prepayments
Adjusting entries for accruals
Adjusting entries for estimated items
Financial Statements and Ownership Structure
Closing Process
Preparing closing entries
Reversing entries
The accounting cycle summarized
Using a Worksheet
Adjustments entered
Work sheet columns
Preparing financial statements from a work sheet
Closing entries
Monthly statements, yearly closing
Appendix 3A- Using Reversing Entries
Accruals
Prepayments
Summary of reversing entries
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4. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Event: The cause of changes of assets, liabilities, and equity
Transaction: A transfer or exchange between two or more entities or parties
Account: Where transactions are recorded
A separate account is used for each asset, liability, revenue, expense, gain, loss and capital (owner’s equity)
LO1
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5. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Permanent accounts (or “real” accounts)
Asset, liability, and equity accounts
Appear on the balance sheet
Permanent accounts are not closed at year end
Temporary accounts (or “nominal” accounts)
Revenue, expense, and dividend accounts
Revenue and expenses are on the income statement; dividends are on the statement of changes in shareholders equity.
Temporary accounts are closed at year end
LO1
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6. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Journalizing and Posting
A Journal is a book of original entry for all transactions
The General Journal is a chronological listing of transactions expressed as debits and credits to particular accounts (known as a journal entries)
Special Journals are used to summarize transactions with common characteristics (e.g. cash receipts, sales, purchases)
Posting: when the transaction information entered in the journal is transferred to the ledger accounts
LO1
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7. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Ledger
Book (or electronic database) containing all accounts
Each account has a separate page
General ledger contains all asset, liability, and all equity related accounts (capital, revenue, and expenses)
Subsidiary ledger contains details related to a specific general ledger account (example: accounts receivable subsidiary ledger)
LO1
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8. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Trial balance
Listing of all accounts and their balances from the general ledger at a given point in time
Objective: prove the mathematical equality of debits and credits after posting (i.e. to ensure general ledger is in balance)
Typically prepared after end of period adjustments (called Adjusted Trial Balance) and possibly after closing entries (called Post- closing Trial Balance)
LO1
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9. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Adjusting entries
Entries made at the end of an accounting period
Brings all accounts up to date on an accrual accounting basis
Seven classifications of adjusting entries:
Prepayment Accruals Estimated Items
1. Prepaid Expenses Accrued Revenues 5. Bad Debts
2. Unearned Revenues 4. Accrued Expenses 6. Unrealized Holding Gain or Loss
7. Unrealized Holding Gain or Loss - OCI
LO1
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10. Copyright © John Wiley & Sons Canada, Ltd.
Basic Terminology
Financial statements
Final summaries of the accounting data for a specific time period
Four statements:
Statement of Financial Position (or Balance Sheet under ASPE) - shows financial condition at a specific date
Statement of Comprehensive Income (or Income Statement under ASPE) - measures the results of operations during a period of time
Statement of Cash Flows - shows sources and uses of cash
Statement of Changes in Shareholders’ Equity (Statement of Retained Earnings under ASPE)
LO1
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11. Copyright © John Wiley & Sons Canada, Ltd.
Debits and Credits
Credit (Cr.)
To record or enter an
amount on the right side
of a general ledger
account
Debit (Dr.) To record or enter an amount on the left side of a general ledger account
This system of recording transactions is referred to as the double-entry accounting system; the two-sided effect of each transaction is recorded in appropriate accounts
When a transaction is “in balance”, the debits equal the credits
Debits and credits do not mean “increases” and “decreases”
LO2
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12. The Accounting Equation
Assets = Liabilities + Shareholders’ Equity*
*Shareholder’s Equity = Common Shares + Retained Earnings – Dividends + Revenues - Expenses
LO3
Assets = Liabilities + Common Shares + Retained Earnings – Dividends + Revenues - Expenses
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13. The Rules of Debit and Credit
To increase the balance of any account, record the amount in the normal balance column
To decrease the balance of any account, record the amount in the column opposite to its normal balance
When any transaction is correctly recorded, the accounting equation will remain in balance
LO2, LO3
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14. The Rules of Debit and Credit
Decrease
Increase
Expenses
Revenue
Shareholders’ Equity
Liabilities
Assets
Credit
Debit
Account
LO2, LO3
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15. The Accounting Cycle: Steps
Analyse the transaction
Journalize the transaction
Post the transaction to general ledger (and sub- ledgers) accounts
Prepare the (unadjusted) trial balance
Prepare necessary adjusting journal entries
Prepare the (adjusted) trial balance
Prepare financial statements
Prepare closing journal entries for the year
Prepare post-closing trial balance (optional)
Prepare reversing entries (optional)
LO4
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16. Recording a Transaction: Shares are issued for $3,000 cash
Assets = Liabilities + Shareholders’ Equity
+ $3,000
To record this transaction as a journal entry (in General Journal):
Dr. Cash $3,000
Cr. Common Shares $3,000
These amounts are then posted to the general ledger
LO4
Common Shares
Cash
3,000
3,000
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17. Preparation of Trial Balance
PIONEER ADVERTISING AGENCY INC. at October 31, 2014
Account Debit Credit
Cash
Cash 80,000
Accounts Receivable 72,000
Advertising Supplies 25,000
Prepaid Insurance ,000
Fair Value Investments 10,000
Office Equipment 50,000
Notes Payable ,000
Accounts Payable ,000
Unearned Service Revenue 12,000
Common Shares 100,000
Dividends 5,000
Service Revenue 100,000
Salaries Expense 40,000
Rent Expense 9,000
TOTALS , ,000
80,000
Notes Payable
50,000
LO4
Dividends
5,000
Revenue
100,000
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18. Preparation of Trial Balance
From the previous example, we can see that the trial balance is “in balance”
However, the trial balance only proves the mathematical accuracy of the ledger
Errors may still exist such as the following:
Transaction not journalized
Correct journal entry not posted
Journal entry posted twice
Incorrect accounts used in either the journal entry or posting
Offsetting errors made during recording
LO4
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19. Adjusting Journal Entries
Adjusting entries ensure that revenue recognition and matching are followed within the period
Reasons for adjusting entries include:
To record those events that are not journalized daily
To record those costs, which expire with time and are therefore not recorded
To record item previously unrecorded
Adjusting entries are required each time financial statements are prepared
LO5
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20. Adjusting Entries for Prepayments
Prepaid Expenses
Prepayments made in cash and recorded as assets before item is used
Unearned Revenues
Revenue received in cash and recorded as liabilities before being earned
LO5
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21. Adjusting Entries for Prepayments
Prepaid expenses expire either with the passage of time (e.g. rent and insurance) or by being used and consumed (e.g. supplies)
Example: Company paid $6,000 for one year insurance when coverage begins October 1 and debited Prepaid Insurance for $6,000.
Adjust Prepaid Insurance on Dec. 31:
Dr Insurance Expense 1,500
Cr Prepaid Insurance 1,500
($6,000/12 * 3)
LO5
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22. Adjusting Entries for Prepayments
When payment is received from customers for services (or goods) that will be provided in a future accounting period, a liability (unearned revenue) is recognized
e.g. Rent, magazine subscriptions, deposits
Example: Company received $12,000 for four months’ advertising services that begins Oct. 1. $12,000 was credited to unearned revenue
Adjustment required on December 31:
Dr Unearned Revenue 9,000
Cr Service Revenue 9,000
($12,000/4 * 3)
LO5
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23. Adjusting Entries for Accruals
Accrued Revenues
Revenues earned but not yet received in cash and not recorded
Accrued Expenses
Expenses incurred but not yet paid in cash and not recorded
LO5
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24. Adjusting Journal Entries
Expenses must be accrued when they are incurred; also revenues must be recorded as earned
Accruals required: interest expense, salaries expense, bad debts expense, interest earned
Example: assume on January 5, a company pays $20,000 for salaries which includes $10,000 of salaries for December
Adjustment required on December 31:
Dr Salaries Expense 10,000
Cr Salaries Payable ,000
LO5
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25. Adjusting Entries for Estimated Items
Bad Debts
Expenses relating to impaired accounts receivable estimated in the period and relating to revenue that has been earned
Investments – Fair Value Adjustments
For certain categories of investments, an unrealized gain or loss must be recorded in the statement of comprehensive income
Adjustment made either through:
Net Income, or
Other Comprehensive Income
LO5
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26. Financial Statements and Ownership Structure
LO6
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27. Financial Statements and Ownership Structure
LO6
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28. Copyright © John Wiley & Sons Canada, Ltd.
Closing Entries
Closing entries are made to close all nominal accounts (revenue and expense accounts) for the year
The balances in these accounts are transferred to a clearing account (Income Summary)
The balance in Income Summary represents net income or net loss for the period
Real (or permanent) accounts are not closed
The Dividends account is closed to retained earnings
LO7
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29. Copyright © John Wiley & Sons Canada, Ltd.
Closing Entries
The following closing entries are made (assume net income and other comprehensive income for the year): 1. Income Summary $$$ Expense Accounts (individually) $$$ 2. Revenue Accounts (individually) $$$ Income Summary $$$ 3. Income Summary $$$ Retained Earnings $$$ 4. Retained Earnings $$$ Dividends $$$ 5. OCI Accounts (individually) $$$ Accumulated OCI $$$
LO7
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30. Retained Earnings: Closing Entries
Income Summary
Ret. Earnings
Dividends
Expense
Revenue 4 3 1 2
LO7
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31. Closing Entries: Inventory
In a periodic inventory system, closing entries are made to record cost of goods sold and ending inventory
In a perpetual inventory system, such entries are not required
LO7
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32. Periodic Inventory: Closing Entry
Collegiate Apparel Shop has the following balances at year end. The company uses a periodic inventory system.
Beginning Inventory $ 30,000
Purchases (gross) $200,000
Transportation-In $ 6,000
Purchases Returns $ 1,000
Purchase Discounts $ 3,000
Ending Inventory $ 26,000
LO7
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33. Periodic Inventory: Closing Entry
First Step: Determine Cost of Goods Sold
Beginning Inventory $ 30,000
Purchases $200,000
Less: Purchase returns $1,000
Purchase discounts 3, ,000
Net Purchases ,000
Plus: Transportation-In ,000
Cost of Goods Purchased ,000
Cost of Goods Available for Sale ,000
Less: Ending Inventory ,000
Cost of Goods Sold $206,000
LO7
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34. Periodic Inventory: Closing Entry
Account
Dr.
Cr.
Cost of Goods Sold
Inventory (Ending) Purchases Returns
Purchase Discounts
$ 206,000
$ 26,000
$ 1,000
$ 3,000
$ 200,000
$ 6,000
$ 30,000
LO7
Purchases (Gross)
Transportation-in
Inventory (Beginning)
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35. Copyright © John Wiley & Sons Canada, Ltd.
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