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. Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 3. 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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

The Rules of Debit and Credit Decrease Increase Expenses Revenue Shareholders’ Equity Liabilities Assets Credit Debit Account LO2, LO3 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 6,000 Fair Value Investments 10,000 Office Equipment 50,000 Notes Payable 50,000 Accounts Payable 35,000 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 297,000 297,000 80,000 Notes Payable 50,000 LO4 Dividends 5,000 Revenue 100,000 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 10,000 LO5 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

Financial Statements and Ownership Structure LO6 Copyright © John Wiley & Sons Canada, Ltd.

Financial Statements and Ownership Structure LO6 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

Retained Earnings: Closing Entries Income Summary Ret. Earnings Dividends Expense Revenue 4 3 1 2 LO7 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 Copyright © John Wiley & Sons Canada, Ltd.

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 4,000 Net Purchases 196,000 Plus: Transportation-In 6,000 Cost of Goods Purchased 202,000 Cost of Goods Available for Sale 232,000 Less: Ending Inventory 26,000 Cost of Goods Sold $206,000 LO7 Copyright © John Wiley & Sons Canada, Ltd.

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) Copyright © John Wiley & Sons Canada, Ltd.

Copyright © John Wiley & Sons Canada, Ltd. Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright © John Wiley & Sons Canada, Ltd.