Chapter 3: The Accounting Information System

Learning Objectives: Understand basic accounting terminology. Explain double-entry rules. Identify steps in the accounting cycle. Record transactions in journals, post to ledger accounts, and prepare a trial balance. Explain the reasons for preparing adjusting entries. Prepare financial statement from the adjusted trial balance. Prepare closing entries.

Learning Objective:

Explain the difference between cash and accrual accounting

Cash basis Accounting

Cash Basis Accounting
Revenue is recognized when cash

is received.
Expenses are recognized when

cash is paid.

Accrual Basis Accounting

Income Measurement

Companies should recognize revenue

When it is realized or realizable, and When it is earned.

Expenses are matched to revenues.

Net income = Revenues - Expenses

Cash Basis vs. Accrual Basis Accounting

Which method would you want to use if you were asked to make predictions about future years operating performance?

Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than does information about current cash receipts and payments. ( SFAC No. 1)

Accrual earnings is a more accurate measure of the economic value added during the period than is operating cash flow

Conversion from Accrual basis to Cash Basis

Revenues
- Increase in current assets (e.g., Accounts receivable ) + Decrease in current assets + Increase in current liabilities (e.g., unearned revenue) - Decrease in current liabilities Other adjustments = Cash receipts from customers

Conversion from Accrual basis to Cash Basis

Expenses on an accrual basis

+ Increase in current assets (e.g., Prepaid expense ) - Decrease in current assets + Increase in current liabilities (e.g., accrued liabilities) - Decrease in current liabilities Other adjustments = Cash paid for operating expenses

Conversion from Accrual basis to Cash Basis

Indirect method ( chapter 23):

Net income ( Revenues- Expenses)

+ Non cash items + or Double counted items + or - Current assets or current liabilities adjustment ( use DIAL) = Cash flows from operating activities

Learning Objective:

Analyze routine economic events transactionsand record their effects on a companys financial position using the accounting equation format.

If the normal balance for an account is a debit, then the account is increased by a debit and decreased by a credit.

If the normal balance for an account is a credit, then the account is increased by a credit and decreased by a debit.

Contra Accounts have normal balances that are the opposite of their parent accounts.

The Accounting Cycle

Identification and Measurement of Transactions and Other Events
Journalization General Journal Cash Receipts Journal Cash Disbursements Journal Purchases Journal Sales Journal Other Special Journals Posting General Ledger (usually monthly) Subsidiary Ledger (usually daily)

Reversing Entries (optional)

Post-closing trial-balance (optional)

Closing (temporary accounts) Statement Preparation Income Statement Retained Earnings Balance Sheet Cash Flows

Trial balance preparation

Work Sheet (optional)

Adjustments Accruals Prepayments Estimated Items

Adjusted Trial Balance

Identifying and Recording

Event: a happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal. Transaction: an external event involving a transfer or exchange between two or more entities. What to record: as many events as possible that affect the financial position of the enterprise are recorded.

Journalizing
Transactions

are initially recorded in a journal, sometimes referred to as the book of original entry. A general journal is merely a chronological listing of transactions expressed in terms of debits and credits to particular accounts.
No distinction is made in a general journal concerning the type of transaction involved. In addition to a general journal, specialized journals are used to accumulate transactions possessing common characteristics.

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General Journal Entries

On July 1, 2006, the owners invest $60,000 in a new business, Dress Right Clothing Corporation.
GENERAL JOURNAL
Date Description Post. Ref.

Page
Debit

1
Credit

July 1 Cash Common Stock

60,000 60,000

Account numbers are references for posting to the General Ledger.

Special Journals ( FYI)

Special journals are used to capture the dual effect of repetitive types of transactions in debit/credit form.
Special journals simplify the recording process in the following ways: 1. 2. Journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats. Individual transactions are not posted to the general ledger accounts but are accumulated in the special journals and a summary posting is made on a periodic basis. The responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them.

3.

Lets look at some special journals.

Sales Journal
Sales journals record all credit sales. Every entry in the sales journal has the same effect on the accounts; the sales revenue account is credited and the accounts receivable control account is debited.
SALES JOURNAL
Accounts Receivable Subsidiary Account No. 5 9 18 22 29 801 812 813 803 805 Sales Invoice Number 10-221 10-222 10-223 10-224 10-225 Page 1 Cr. Sales Revenue (400) Dr. Accounts Receivable (110) 1,500 200 825 120 650 3,295

Date 2006 Aug.

Customer Name Leland High School Mr. John Smith Greystone School Ms. Barbara Jones Hart Middle School

Other columns capture information needed for updating the accounts receivable subsidiary ledger.

Sales Journal
SALES JOURNAL
Accounts Receivable Subsidiary Account No. 5 9 18 22 29 801 812 813 803 805 Sales Invoice Number 10-221 10-222 10-223 10-224 10-225 Page 1 Cr. Sales Revenue (400) Dr. Accounts Receivable (110) 1,500 200 825 120 650 3,295 Date 2006 Aug. Leland High School Mr. John Smith Greystone School Ms. Barbara Jones Hart Middle School Customer Name

Accounts Receivable Bal. 7/31 2,000 Aug. 31 SJ1 3,295 Bal. 5,295 Leland High School Aug. 5 SJ1 1,500 Bal. 1,500

Sales Revenue Beg. bal. 3,295 Aug. 31 SJ1 3,295 Bal.

801

Accounts Receivable Subsidiary Ledger

Cash Receipts Journal

Cash receipts journals record all cash receipts, regardless of the source. Every entry in the cash receipts journal produces a debit to the cash account with the credit to various other accounts.
CASH RECEIPTS JOURNAL
Dr. Cash (100) 500 Cr. Accounts Receivable (110) Cr. Sales Revenue (400) 500 Notes payable (220) Page 1 Explanation or Account Name Cr. Other Other Accounts

Date 2006 Aug.

7 Cash sale

11 Borrowed cash 17 Leland High School 20 Cash sale 25 Mr. John Smith

10,000 750 300 200 11,750 200 950 800 750 300

10,000

10,000

Cash Receipts Journal

CASH RECEIPTS JOURNAL
Dr. Cash (100) 500 Cr. Accounts Receivable (110) Cr. Sales Revenue (400) 500 Notes payable (220) Page 1 Date 2006 Aug. 7 Cash sale Explanation or Account Name Cr. Other Other Accounts

11 Borrowed cash 17 Leland High School 20 Cash sale 25 Mr. John Smith

10,000 750 300 200 11,750 200 950 800 750 300

10,000

10,000

Accounts Receivable Subsidiary Ledger

Aug. 5 SJ1 Bal.

Leland High School 801 1,500 750 Aug. 17 CR1 750

General Ledger:
The general ledger is a collection of accounts and contains a separate page for each account.
GENERAL LEDGER Account:
Post. Ref.

Acct. No.

##
Balance

Date

Item

Debit

Credit

DR (CR)

The T account is a shorthand used by accountants to analyze transactions. It is not part of the bookkeeping system.

Subsidiary Ledgers
Subsidiary ledgers contain a group of subsidiary accounts associated with particular general ledger control accounts. Subsidiary ledgers are commonly used for accounts
receivable, accounts payable, plant and equipment, and investments. Ex: there will be a subsidiary ledger for accounts receivable that keeps track of the increases and decreases in the accounts receivable balance for each of the companys customers purchasing goods and services on credit.

Posting Journal Entries

GENERAL JOURNAL
Date Description Post. Ref.

Page
Debit

1
Credit

July 1 Cash Common Stock

100

60,000 60,000

GENERAL LEDGER Account: Cash

Post. Ref. J1

Acct. No.

100

Date July 1

Item

Debit 60,000

Credit

Balance 60,000

Trial Balance

A trial balance is a list of all open accounts in the general ledger and their balances. An entity may prepare a trial balance at any time in the accounting cycle. A trial balance prepared after posting has been completed serves to check the mechanical accuracy of the posting process and provides a listing of accounts to be used in preparing financial statements.

After recording all entries for the period, Dress Rights Trial Balance would be as follows:
Dress Right Clothing Corporation Unadjusted Trial Balance July 31, 2006 Account Title Cash Accounts receivable Supplies Prepaid rent Inventory Furniture and fixtures Accounts payable Notes payable Unearned rent revenue Common stock Retained earnings Sales revenue Cost of goods sold Salaries expense Total Debits $ 68,500 2,000 2,000 24,000 38,000 12,000 $ Credits

35,000 40,000 1,000 60,000 38,500

A Trial Balance is a listing of all accounts and their balances at a point in time.

1,000 22,000 5,000 $ 174,500

$ 174,500

Debits = Credits

The Reasons for Preparing adjusting entries

Some

events are not journalized daily because it is not practical. (e.g., wages expense) Some costs are not journalized during the accounting period because these costs expire with the passage of time. (e.g., rent expense) Some items may be unrecorded. (e.g., utility
expense)

Adjusting Entries
To obtain an accurate statement:

At the end of accounting periods to bring all accounts up to date on an accrual accounting basis Necessary to achieve a proper matching of revenues and expenses

Affect

at least one real account (asset, liability, or equity account) and one nominal account (revenue or expense account)

Adjusting Entries

(1) Deferrals (Prepaid Exp.) (Unearned Rev.)

(2) Accruals

(3) Estimates

Transactions where cash is paid or received before a related expense or revenue is recognized. Transactions where cash is paid or received after a related expense or revenue is recognized.

Bad debt expense

(1) Adjusting Journal entries for Prepaid expense

Payment of cash that is recorded as an asset because service or benefit will be received in the future.
Cash Payment
BEFORE

Expense Recorded

Prepayments often occur in regard to:

insurance supplies advertising rent maintenance on equipment fixed assets

(1) Adjusting Entries for Prepaid Expenses

Insurance. On Oct. 4th, Pioneer paid $6,000 for a one-year
fire insurance policy, beginning October 1. Show the entry to record the purchase of the insurance. Oct. 4 Prepaid insurance 6,000

Cash
Prepaid Insurance Debit Credit Debit Cash

6,000

Credit

6,000

6,000

(1) Adjusting Entries for Prepaid Expenses

Insurance. An analysis of the policy reveals that $500
($6,000 / 12) of insurance expires each month. Thus, Pioneer makes the following adjusting entry. Oct. 31 Insurance expense 500

Prepaid insurance
Prepaid Insurance Debit Credit Insurance Expense Debit Credit

500

6,000
5,500

500

500

(1) Adjusting Entries for Unearned Revenues

For Dress Right Corporation, the only unearned revenue in the trial balance is unearned rent revenue. On July 16 Dress Right received $1,000 in advance for the first two months rent. First, lets prepare the entry for July 16.
GENERAL JOURNAL
Date July 16 Cash Unearned Rent Revenue
Liability Account

Page 25
Post. Ref. Debit 1,000 1,000 Credit

Description

(1) Adjusting Entries for Unearned Revenues

For Dress Right Corporation, the only unearned revenue in the trial balance is unearned rent revenue. On July 16 Dress Right received $1,000 in advance for the first two months rent. Now, lets prepare the adjusting entry for July 31.
GENERAL JOURNAL
Date Description Rent Revenue Post. Ref.

Page 30
Debit 250 250 Credit

July 31 Unearned Rent Revenue

Alternative Approach to Record Prepayments

Prepaid Expenses Record initial cash payments as follows: Expense Cash $$$ $$$ Unearned Revenue Record initial cash receipts as follows: Cash $$$ Revenue $$$

Adjusting Entry Record the amount for the prepaid expense as follows:
Prepaid expense Expense $$ $$

Adjusting Entry Record the amount for the unearned liability as follows:
Revenue $$ Unearned revenue $$

Class Practice Problems

Gomez Company received $9,600 on April 1, 2004 for one year's rent in advance and recorded the transaction with a credit to a nominal account. The December 31, 2004 adjusting entry is a. debit Rent Revenue and credit Unearned Rent, $2,400. b. debit Rent Revenue and credit Unearned Rent, $7,200. c. debit Unearned Rent and credit Rent Revenue, $2,400. d. debit Unearned Rent and credit Rent Revenue, $7,200.

(1) Special Type of Prepayment adjusting entry:

Depreciation
The adjusting entry for depreciation is a specific type of a prepayment adjusting entry

Depreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives.
Straight-Line Depreciation Expense Asset Cost - Salvage Value

=
Useful Life

Depreciation
Recall the Furniture and Fixtures for $12,000 listed on Dress Rights unadjusted trial balance. Assume the following:
Asset Cost $ 12,000 Salvage Value Useful Life 60 months

Lets calculate the depreciation expense for the month ended July 31, 2006.

Depreciation
Recall the Furniture and Fixtures for $12,000 listed on Dress Rights unadjusted trial balance. Assume the following:
Asset Cost $ 12,000 Salvage Value Useful Life 60 months
2006 Depreciation Expense $12,000 - $0

=
60 months

$200

Now, prepare the adjusting entry for July 31, 2006.

Depreciation
GENERAL JOURNAL
Date Description PR Debit 200 200 July 31 Depreciation Expense Accumulated Depr. Furniture & Fixtures
To record depreci a ti on

Page 2
Credit

Contra Asset

Lets see how the accounts would look after posting!

Depreciation
After posting, the accounts look like this:
Furniture and Fixtures Beg. bal. 12,000 Bal. 12,000 Depreciation Expense Beg. bal. 200 Bal. 200

Accumulated Depreciation Beg. bal. 200 200 Bal.

(2) Accrued Liabilities

Last pay date 7/20/06 Next pay date 8/2/06 7/31/06 Month end Record adjusting journal entry.

7/1/06

On July 31, 2006, the employees have earned salaries of $5,500.

GENERAL JOURNAL
Date Description Salaries Payable Post. Ref.

Page 30
Debit 5,500 5,500 Credit

July 31 Salaries Expense

(2) Accrued Receivables

Assume that Dress Right loaned another corporation $30,000 at the beginning of August. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. First, lets determine the amount of interest to accrue at August 31, 2006.

PRT
$30,000 .08
1/ 12

Interest = $200

(2) Accrued Receivables

Assume that Dress Right loaned another corporation $30,000 at the beginning of August. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months.
Now, lets prepare the adjusting entry for August 31, GENERAL JOURNAL Page 30 2006. Post.
Date Description Interest Revenue Ref. Debit 200 200 Credit Aug. 31 Interest Receivable

(2) Accrued Receivables

After posting, the accounts look like this:
Interest Receivable Beg. bal. 200 Bal. 200

Interest Revenue Beg. bal. 200 200 Bal.

(3)Estimates:

An estimated item is a function of future events and developments

The estimate of bad debt expense at the end of the period is an example of an adjusting entry that requires an estimate. Assume that Dress Rights management determines that of the $2,000 of accounts receivable recorded at July 31, 2006, only $1,500 will ultimately be collected. Prepare the adjusting entry for July 31, 2006.
GENERAL JOURNAL
Date Description Post. Ref.

Page 30
Debit 500 500 Credit

July 31 Bad Debt Expense Allowance for Uncollectible Accounts

Adjusted Trial Balance

After adjusting entries are recorded and posted, an adjusted trial balance is prepared. This trial balance serves as a basis for the preparation of the financial statements discussed in the next two chapters.

DRESS RIGHT CLOTHING CORPORATION Adjusted Trial Balance July 31, 2006 Account Title Debits Credits Cash $ 68,500 Accounts receivable 2,000 Allowance for uncollectible accounts $ 500 Supplies 1,200 Prepaid rent 22,000 Inventory 38,000 Furniture and fixtures 12,000 Accumulated depr.-furniture & fixtures 200 Accounts payable 35,000 Note payable 40,000 Unearned rent revenue 750 Salaries payable 5,500 Interest payable 333 Common stock 60,000 Retained earnings 1,000 Sales revenue 38,500 Rent revenue 250 Cost of goods sold 22,000 Salaries expense 10,500 Supplies expense 800 Rent expense 2,000 Depreciation expense 200 Interest expense 333 Bad debt expense 500 Totals $ 181,033 $ 181,033

This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted.
Dress Right will use these balances to prepare the financial statements.

Learning Objective:

Describe the four basic financial statements.

Dress Right Clothing Corporation Income Statement For Month Ended July 31, 2006 Sales revenue $ Cost of goods sold Gross profit Other expenses: Salaries $ 10,500 Supplies 800 Rent 2,000 Depreciation 200 Bad debt 500 Total operating expenses Operating income Other income (expense): Rent revenue 250 Interest expense (333) Net income $

38,500 22,000 16,500

14,000 2,500

(83) 2,417

The income statement summarizes the results of operating activities of the company.

Dress Right Clothing Corporation Balance Sheet At July 31, 2006 Assets Current assets: Cash Accounts receivable Less: Allowance for uncollectible accounts Supplies Inventory Prepaid rent Total current assets Property and equipment: Furniture and fixtures Less: Accumulated depreciation Total assets $ $ 2,000 500 68,500 1,500 1,200 38,000 22,000 131,200

12,000 200 $

11,800 143,000

The balance sheet presents the financial position of the company on a particular date.

Dress Right Clothing Corporation Balance Sheet At July 31, 2006 Liabilities and Shareholders' Equity Current liabilities: Accounts payable $ Salaries payable Unearned rent revenue Interest payable Note payable Total current liabilities Long-term liabilities: Note payable Shareholders' equity: Common stock $ 60,000 Retained earnings 1,417 Total shareholders' equity Total liabilities and shareholders' equity $

35,000 5,500 750 333 10,000 51,583 30,000

61,417 143,000

The balance sheet presents the financial position of the company on a particular date.

Dress Right Clothing Corporation Statement of Cash Flows For the Month of July 2006 Cash flows from operating activities: Cash inflows: From customers $ From rent Cash outflows: For rent For supplies To suppliers for merchandise To employees Net cash used by operating activities Cash flows from investing activities: Purchase of furniture and fixtures Cash flows from financing activities: Issue of capital stock $ Increase in notes payable Payment of cash dividend Net cash provided by financing activities Net increase in cash

36,500 1,000 (24,000) (2,000) (25,000) (5,000) $ (18,500) (12,000) 60,000 40,000 (1,000) $ 99,000 68,500

The statement of cash flows discloses the changes in cash during a period.

Dress Right Clothing Corporation Statement of Shareholders' Equity For the Month of July 2006 Common Retained Stock Earnings $ $ 60,000 2,417 (1,000) $ 60,000 $ 1,417 Total Shareholders' Equity $ 60,000 2,417 (1,000) $ 61,417

Balance at July 1, 2006 Issue of capital stock Net income for July 2006 Less: Dividends Balance at July 31, 2006

The statement of shareholders equity presents the changes in permanent shareholder accounts.

Example on the link between financial statements

The following information are given: Common Stocks ( 1/1/2010) $1000 Preferred Stocks (1/1/2010) $500 Retained Earnings (12/31/2010) $2000 Additional paid-in-capital ( 1/1/2010) $500 The firm issued $1,200 value of common stocks in year 2010, and declared a dividend of $100.
What is the ending balance of Shareholders Equity?

Links between statement of R/E and statement of Stockholders Equity (S/E)

Statement of S/E: SEBegin + New issue stocks + Net Income (NI) - Dividends SEEnd

Contributed or Paid-in capital( beginning) + Additional paid-in-capital ( beginning) + R/E( beginning) + New issue stock during this time period + NI Dividends = SE (ending)

Statement of Retained Earnings (R/E):

Ending retained earnings balance

REBegin + NI

= REEnd

In conclusion: Contributed/paid-in capital (beginning) + Additional paid-in-capital ( beginning)+ New issue stock during this time period (I) + RE (ending) = SE( ending)

Learning Objective:

Explain the closing process

The Closing Process

Resets revenue, expense and dividend account balances to zero at the end of the period.

Identify accounts for closing.

Closing steps:
Close Revenue accounts to Income Summary. Close Expense accounts to Income Summary. Close Income Summary account to Retained Earnings.

Record and post closing entries.

Prepare post-closing trial balance.

Temporary and Permanent Accounts

Revenues Expenses Liabilities Assets Shareholders Equity

Dividends

Temporary Accounts

Permanent Accounts

Income Summary

The closing process applies only to temporary accounts.

Close Revenue Accounts to Income Summary

GENERAL JOURNAL
Date July 31 Sales Revenue Rent Revenue Income Summary Description Post. Ref. Debit 38,500 250 38,750

Page 34
Credit

Now, lets look at the ledger accounts after posting this closing entry.

 Close Expense Accounts to Income Summary

GENERAL JOURNAL
Date Description Cost of goods sold Salaries expense Supplies expense Rent expense Depreciation expense Interest expense Bad debts expense Post. Ref. Debit 36,333 22,000 10,500 800 2,000 200 333 500

Page 34
Credit

July 31 Income Summary

Now, lets look at the ledger accounts after posting this closing entry.

(3) Close Dividends to Income Summary

At date of declaration ( refer to page #758)

Retained earnings 100 Dividends payable

100

Alternatively, ( refer to Page #93) Dividends 100 Dividends payable 100 Then, closing entry: Retained earnings 100 Dividends 100

At date of payment:

Dividends payable Cash

100 100

DRESS RIGHT CLOTHING CORPORATION Adjusted Trial Balance July 31, 2006 Account Title Debits Credits Cash $ 68,500 Accounts receivable 2,000 Allowance for uncollectible accounts $ 500 Supplies 1,200 Prepaid rent 22,000 Inventory 38,000 Furniture and fixtures 12,000 Accumulated depr.-furniture & fixtures 200 Accounts payable 35,000 Note payable 40,000 Unearned rent revenue 750 Salaries payable 5,500 Interest payable 333 Common stock 60,000 Retained earnings 1,000 Sales revenue 38,500 Rent revenue 250 Cost of goods sold 22,000 Salaries expense 10,500 Supplies expense 800 Rent expense 2,000 Depreciation expense 200 Interest expense 333 Bad debt expense 500 Totals $ 181,033 $ 181,033

Close Income Summary to Retained Earnings.

Close Income Summary to Retained Earnings

GENERAL JOURNAL
Date Description Retained Earnings Post. Ref. Debit 2,417 2,417

Page 34
Credit

July 31 Income Summary

Now, lets look at the ledger accounts after posting this closing entry.

Closing Entries: Periodic vs. Perpetual Inventory System

In

a periodic inventory system, closing entries are made to record cost of goods sold and ending inventory.
Inventory purchases are recorded as incurred. Inventory and cost of goods sold determined at the end of each period through physical count.

In

a perpetual inventory system, such entries are not required.

Up-to-date record in inventory account. Cost of goods sold computed for each sale.

FYI: Closing Entries (perpetual inventory)

Income Summary COGS Selling Exp General & Admin. Exp Interest Exp 289,000 206,000 25,000 40,600 4,400

Income Tax Exp

13,000

FYI: Periodic Inventory System

Inventory (ending) Purchase Discounts Purchase Returns and Allowances XX Cost of Goods Sold XXX Inventory (beginning) Purchases Transportation-In
Income Summary COGS XXX XXX

Dr. XX XX

Cr.

XX XXX X

Post-Closing Trial Balance

DRESS RIGHT CLOTHING CORPORATION Post-Closing Trial Balance July 31, 2006 Account Title Debits Credits Cash $ 68,500 Accounts receivable 2,000 Allowance for uncollectible accounts $ 500 Supplies 1,200 Prepaid rent 22,000 Inventory 38,000 Furniture and fixtures 12,000 Accumulated depr.-furniture & fixtures 200 Accounts payable 35,000 Note payable 40,000 Unearned rent revenue 750 Salaries payable 5,500 Interest payable 333 Common stock 60,000 Retained earnings 1,417 Totals $ 143,700 $ 143,700

Lists permanent accounts and their balances.

Total debits equal total credits.

Reversing Entries: This is an optional step

A company may make a reversing entry at the beginning of the next accounting period.
1. All accruals should be reversed.
2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue

account should be reversed.

3. Adjusting entries for depreciation and bad debts are not reversed.
Again: Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.

USING REVERSING ENTRIES

Illustration of Reversing EntriesAccruals

USING REVERSING ENTRIES

Illustration of Reversing EntriesDeferrals