INTERMEDIATE ACCOUNTING TENTH CANADIAN EDITION Kieso • Weygandt • Warfield • Young • Wiecek • McConomy CHAPTER 3 The Accounting Information System Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto CHAPTER 3: THE ACCOUNTING INFORMATION SYSTEM After studying this chapter, you should be able to: LEARNING OBJECTIVES: • 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. 2 The Accounting Information System Accounting Cycle and the Recording Process • Basic terminology • Identifying and • Debits and recording credits transactions • Accounting and other equation events Accounting Information System Adjusting Entries Financial Statements and • Adjusting Ownership entries for prepayments Structure Closing Process • Adjusting entries for accruals • Reversing entries • Adjusting entries for estimated • Journalizing items • Preparing closing entries • The accounting cycle summarized • Posting • Trial balance Appendix 3AUsing Reversing • Adjustments Entries entered Using a Worksheet • Work sheet columns • Preparing financial statements from a work sheet • Accruals • Prepayments • Summary of reversing entries • Closing entries • Monthly statements, yearly closing • Adjusting entries Copyright © John Wiley & Sons Canada, Ltd. 3 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) Copyright © John Wiley & Sons Canada, Ltd. 4 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 Copyright © John Wiley & Sons Canada, Ltd. 5 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 Copyright © John Wiley & Sons Canada, Ltd. 6 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) Copyright © John Wiley & Sons Canada, Ltd. 7 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 Postclosing Trial Balance) Copyright © John Wiley & Sons Canada, Ltd. 8 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 Copyright © John Wiley & Sons Canada, Ltd. 9 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) Copyright © John Wiley & Sons Canada, Ltd. 10 Debits and Credits Credit (Cr.) Debit (Dr.) To record or enter an To record or enter an amount on the right side amount on the left side of a general ledger of a general ledger account 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” Copyright © John Wiley & Sons Canada, Ltd. 11 The Accounting Equation Assets = Liabilities + Shareholders’ Equity* *Shareholder’s Equity = Common Shares + Retained Earnings – Dividends + Revenues - Expenses Assets = Liabilities + Common Shares + Retained Earnings – Dividends + Revenues - Expenses Copyright © John Wiley & Sons Canada, Ltd. 12 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 Copyright © John Wiley & Sons Canada, Ltd. 13 The Rules of Debit and Credit Account Debit Credit Assets Increase Decrease Liabilities Decrease Increase Shareholders’ Equity Decrease Increase Revenue Decrease Increase Expenses Increase Decrease Copyright © John Wiley & Sons Canada, Ltd. 14 The Accounting Cycle: Steps 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Analyse the transaction Journalize the transaction Post the transaction to general ledger (and subledgers) 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) Copyright © John Wiley & Sons Canada, Ltd. 15 Recording a Transaction: Shares are issued for $3,000 cash Assets = Liabilities + Shareholders’ Equity + $3,000 + $3,000 To record this transaction as a journal entry (in General Journal): Dr. Cash Cr. $3,000 Common Shares $3,000 These amounts are then posted to the general ledger Cash 3,000 Copyright © John Wiley & Sons Canada, Ltd. Common Shares 3,000 16 Preparation of Trial Balance PIONEER ADVERTISING AGENCY INC. at October 31, 2014 Account Cash 80,000 Notes Payable 50,000 Dividends 5,000 Revenue 100,000 Debit 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 Accounts Payable Unearned Service Revenue Common Shares Dividends 5,000 Service Revenue Salaries Expense 40,000 Rent Expense 9,000 TOTALS 297,000 Copyright © John Wiley & Sons Canada, Ltd. Credit 50,000 35,000 12,000 100,000 100,000 297,000 17 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. 2. 3. 4. Transaction not journalized Correct journal entry not posted Journal entry posted twice Incorrect accounts used in either the journal entry or posting 5. Offsetting errors made during recording Copyright © John Wiley & Sons Canada, Ltd. 18 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 Copyright © John Wiley & Sons Canada, Ltd. 19 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 Copyright © John Wiley & Sons Canada, Ltd. 20 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) Copyright © John Wiley & Sons Canada, Ltd. 21 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 ($12,000/4 * 3) 9,000 Copyright © John Wiley & Sons Canada, Ltd. 22 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 Copyright © John Wiley & Sons Canada, Ltd. 23 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 Copyright © John Wiley & Sons Canada, Ltd. 24 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 Copyright © John Wiley & Sons Canada, Ltd. 25 Financial Statements and Ownership Structure Copyright © John Wiley & Sons Canada, Ltd. 26 Financial Statements and Ownership Structure Copyright © John Wiley & Sons Canada, Ltd. 27 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 Copyright © John Wiley & Sons Canada, Ltd. 28 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) $$$ Accumulated OCI $$$ Copyright © John Wiley & Sons Canada, Ltd. 29 Retained Earnings: Closing Entries Ret. Earnings Dividends Income Summary 4 3 Expense Revenue 1 Copyright © John Wiley & Sons Canada, Ltd. 2 30 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 Copyright © John Wiley & Sons Canada, Ltd. 31 Periodic Inventory: Closing Entry Collegiate Apparel Shop has the following balances at year end. The company uses a periodic inventory system. Beginning Inventory Purchases (gross) Transportation-In Purchases Returns Purchase Discounts Ending Inventory $ 30,000 $200,000 $ 6,000 $ 1,000 $ 3,000 $ 26,000 Copyright © John Wiley & Sons Canada, Ltd. 32 Periodic Inventory: Closing Entry First Step: Determine Cost of Goods Sold Beginning Inventory 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 Cost of Goods Available for Sale Less: Ending Inventory Cost of Goods Sold Copyright © John Wiley & Sons Canada, Ltd. $ 30,000 202,000 232,000 26,000 $206,000 33 Periodic Inventory: Closing Entry Account Cost of Goods Sold Inventory (Ending) Purchases Returns Purchase Discounts Dr. Cr. $ 206,000 $ 26,000 $ 1,000 $ 3,000 Purchases (Gross) Transportation-in Inventory (Beginning) Copyright © John Wiley & Sons Canada, Ltd. $ 200,000 $ 6,000 $ 30,000 34 COPYRIGHT Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. 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