1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 3 The Accounting Information System Chapter 3 The Accounting Information System

2. 2 The Accounting Information System Accounting Information System Basic terminology Debits and credits Accounting equation Financial statements and ownership structure Using a Worksheet Adjustments entered Work sheet columns Preparing financial statements from a work sheet Closing entries Monthly statements, yearly closing Accounting Cycle Identifying and recording Journalizing Posting Trial balance Adjusting entries Adjusted trial balance Closing Post-closing trial balance Reversing entries The accounting cycle Appendix 3A- Using Reversing Entries Accruals Prepayments Summary of reversing entries

3. 3 The Accounting Information System Accounting Information System Basic terminology Debits and credits Accounting equation Financial statements and ownership structure Using a Worksheet Adjustments entered Work sheet columns Preparing financial statements from a work sheet Closing entries Monthly statements, yearly closing Accounting Cycle Identifying and recording Journalizing Posting Trial balance Adjusting entries Adjusted trial balance Closing Post-closing trial balance Reversing entries The accounting cycle Appendix 3A- Using Reversing Entries Accruals Prepayments Summary of reversing entries

4. 4 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)

5. 5 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 equity statement Temporary accounts are closed at year end

6. 6 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 entry) 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 general ledger

7. 7 Basic Terminology Ledger Book (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)

8. 8 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) Prepared after end of period adjustments (called Adjusted Trial Balance) and possibly after closing entries (called Post-closing Trial Balance)

9. 9 Basic Terminology Adjusting entries Entries made at the end of an accounting period Brings all accounts up to date on an accrual accounting basis Ensures that revenue recognition principle are followed and that proper matching occurs Four classifications of adjusting entries: Prepayment Accruals 1. Prepaid expenses 2. Accrued revenues 3. Unearned revenues 4. Accrued expenses

10. 10 Basic Terminology Financial statements Final summaries of the accounting data for a specific time period Four statements: Balance Sheet - shows financial condition at a specific date Income Statement - measures the results of operations during a period of time Statement of Cash Flows - shows sources and uses of cash Statement of Retained Earnings Optional: Statement of Comprehensive Income (or as part of Income Statement)

11. 11 Debits and Credits Debit (Dr.) To record or enter an amount on the left side of a general ledger account Credit (Cr.) To record or enter an amount on the right 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”

12. 12 The Accounting Equation Assets = Liabilities + Capital + Retained Earnings* Assets = Liabilities + Shareholders’ Equity *Retained Earnings = Revenues – Expenses – Dividends Assets = Liabilities + Capital + Revenues – Expenses – Dividends

13. 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

14. 14 The Rules of Debit and Credit DecreaseIncreaseExpenses IncreaseDecreaseRevenue IncreaseDecreaseShareholders’ Equity IncreaseDecreaseLiabilities DecreaseIncreaseAssets CreditDebitAccount

15. Financial Statements and Ownership Structure 15

16. 16 The Accounting Information System Accounting Information System Basic terminology Debits and credits Accounting equation Financial statements and ownership structure Using a Worksheet Adjustments entered Work sheet columns Preparing financial statements from a work sheet Closing entries Monthly statements, yearly closing Accounting Cycle Identifying and recording Journalizing Posting Trial balance Adjusting entries Adjusted trial balance Closing Post-closing trial balance Reversing entries The accounting cycle Appendix 3A- Using Reversing Entries Accruals Prepayments Summary of reversing entries

17. 17 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)

18. 18 Recording a Transaction: Shares are issued for $3,000 cash Assets = Liabilities + Shareholders’ Equity 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 Cash Common Shares 3,0003,000

19. 19 Preparation of Trial Balance PIONEER ADVERTISING AGENCY INC. at October 31, 2010 Cash 80,000 Revenue 100,000 Dividends 5,000 Notes Payable 50,000 AccountDebitCredit Cash80,000 Accounts Receivable72,000 Advertising Supplies25,000 Prepaid Insurance 6,000 Office Equipment50,000 Notes Payable 50,000 Accounts Payable 25,000 Unearned Service Revenue 12,000 Common Shares100,000 Dividends 5,000 Service Revenue100,000 Salaries Expense40,000 Rent Expense 9,000 TOTALS 287,000287,000

20. 20 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: 1.Transaction not recorded 2.Journal entry not posted 3.Journal entry posted twice 4.Incorrect accounts used in either the journal or posting 5.Offsetting errors made during recording

21. 21 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

22. 22 Adjusting Entries PrepaymentsAccruals 1. Prepayments made in cash and recorded as assets before item is used (Prepaid Expenses) 2. Revenue received in cash and recorded as liabilities before being earned (Unearned Revenue) 3. Revenues earned but not yet received in cash and not recorded (Accrued Revenues) 4. Expenses incurred but not yet paid in cash and not recorded (Accrued Expenses )

23. 23 Adjusting Journal Entries 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 Adjust for Prepaid Insurance on Dec. 31: Dr Insurance Expense 1,500 Cr Prepaid Insurance 1,500 ($6,000/12 * 3)

24. 24 Adjusting Journal Entries 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 Revenue9,000 ($12,000/4 * 3)

25. 25 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

26. 26 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

27. 27 Closing Entries $$$ Dividends $$$4. Retained Earnings $$$Retained Earnings $$$3. Income Summary $$$ Income Summary $$$2. Revenue Accounts (Individually) $$$ Expense Accounts (Individually) $$$1. Income Summary The following closing entries are made (assume net income for the year):

28. 28 Scheme of Closing Entries 4 3 12 Income Summary Ret. Earnings Dividends ExpenseRevenue

29. 29 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

30. 30 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

31. 31 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

32. 32 Periodic Inventory: Closing Entry Cost of Goods Sold Inventory (Ending) Purchases Returns Purchase Discounts $ 206,000 $ 26,000 $ 1,000 $ 3,000 Purchases (Gross) Transportation-in Inventory (Beginning) $ 200,000 $ 6,000 $ 30,000 AccountDr.Cr.

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