CHAPTER 3: THE ACCOUNTING INFORMATION SYSTEM
BASIC TERMINOLOGY
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.
ACCOUNT
A systematic arrangement that shows the effect of transactions and other
events on a specific element (asset, liability, and so on).
Companies keep a separate account for each asset, liability, revenue, and
expense, and for capital (stockholders' equity).
Because the format of an account often resembles the letter T, it is
sometimes referred to as a T-account.
Real (Permanent) Accounts
o Asset, liability, and equity accounts that appear on the balance sheet
o They are called permanent because they’re not “closed” at the end of
a reporting period
Nominal (Temporary) Accounts
o Revenue, expense, and dividend accounts; except for dividends, they
appear on the income statement.
o They are called temporary because companies periodically close
these accounts.
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LEDGER
The book (or computer printouts) containing the accounts. A general ledger is a
collection of all the asset, liability, stockholders' equity, revenue, and expense
accounts. A subsidiary ledger contains the details related to a given general ledger
account.
JOURNAL
The “book of original entry” where the company initially records transactions and
selected other events. Various amounts are transferred from the book of original
entry, the journal, to the ledger. Entering transaction data in the journal is known as
Journalizing.
POSTING
The process of transferring the essential facts and figures from the book of
original entry to the ledger accounts.
TRIAL BALANCE
The list of all open accounts in the ledger and their balances.
Adjusted Trial Balance
The trial balance taken immediately after all adjustments have been posted
Post (after) Closing Balance
o A trial balance taken immediately after closing entries have been
posted.
o Companies may prepare a trial balance at any time.
CLOSING ENTRIES
The formal process by which the enterprise reduces all nominal accounts to zero
and determines and transfers the net income or net loss to a stockholders' equity
account. Also known as “closing the ledger,” “closing the books,” or merely
“closing.”
ADJUSTING ENTRIES
Entries made at the end of an accounting period to bring all accounts up to date on
an accrual basis, so that the company can prepare correct financial statements.
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FINANCIAL STATEMENTS
Statements that reflect the collection, tabulation, and final summarization of the
accounting data. Four statements are involved:
(1) The Balance Sheet
o Shows the financial condition of the enterprise at the end of a period.
o A snapshot of the enterprise’s financial condition, taken a given point
in time
(2) The Income Statement
o Measures the results of operations during the period.
o Measures financial performance from for a specified reporting period
(3) The Statement of Cash Flows
o Reports the cash provided and used by operating, investing, and
financing activities during the period.
(4) The Statement of Retained Earnings
o Reconciles the balance of the retained earnings account from the
beginning to the end of the period.
DEBITS AND CREDITS
Debit (Dr.) and Credit (Cr.) mean left and right, respectively.
The terms do not mean increase or decrease.
Describe where a company makes entries in the recording process.
o When a company enters an amount on the left side of an account,
it debits the account.
o When it makes an entry on the right side, it credits the account.
o When comparing the totals of the two sides, an account shows a debit
(credit) balance if the total of the debit (credit) amounts exceeds the
credits (debits).
o The positioning of debits on the left and credits on the right is simply
an accounting custom. We could function just as well if we reversed
the sides. However, the United States adopted the custom, now the
rule, of having debits on the left side of an account and credits on the
right side, similar to the custom of driving on the right-hand side of
the road. This rule applies to all accounts
DOUBLE-ENTRY ACCOUNTING SYSTEM
The dual (two-sided) recording of each transaction in appropriate accounts.
Balancing—if every transaction is recorded with equal debits and credits,
then the sum of all the debits to the accounts must equal the sum of all the
credits.
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The basic guidelines for an accounting system.
Increases to all asset and expense accounts occur on the left (or debit side)
and decreases on the right (or credit side).
Conversely, increases to all liability and revenue accounts occur on the right
(or credit side) and decreases on the left (or debit side).
A company increases stockholders' equity accounts, such as Common Stock
and Retained Earnings, on the credit side, but increases Dividends on the
debit side.
The Accounting Equation
In a double-entry system, for every debit there must be a credit, and vice versa
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FINANCIAL STATEMENTS AND OWNERSHIP STRUCTURE
EFFECTS OF TRANSACTIONS ON EQUITY ACCOUNTS
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THE ACCOUNTING CYCLE
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ADJUSTING ENTRIES
Revenue recognition principle requires revenue to be recognized in the
period in which it is earned
Expense recognition principle requires expenses to be recognized in the
period in which they are incurred.
The matching principles requires revenues to be matched to the expenses
incurred to generate the revenues.
PRACTICAL REALITIES
Cash may be received prior to or after the associated revenue is earned.
Cash may be paid out prior to or after the related expense is incurred.
Some events are not recorded daily because it would be inefficient—e.g. the
use of supplies and employee wages/salaries.
Some costs are unrecorded during the accounting period because these costs
expire with the passage of time—not a result of recurring daily transactions.
(e.g., building and equipment depreciation, rent and insurance).
Some items may be unrecorded—e.g. a utility service bill that will not be
received until the next accounting period.
To ensure the revenue and expense recognition principles work, companies make
adjusting entries. Adjusting entries make it possible to:
Report on the balance sheet the appropriate (not overstated or understated)
assets, liabilities and stockholders’ equity at the balance sheet date.
Report on the income statement the appropriate revenues and expenses—
thus not overstating/understating the resultant income.
To prepare financial statements, an accountant must analyze each account in the
trial balance to determine whether it is complete and up-to-date.
This requires understanding the firm’s operations and accounts interrelationships
Preparing adjusting entries requires a skilled accountant—not a book keeper.
To gather the adjustment data, the accountant may need to make inventory counts
of merchandise, supplies and repair parts; and to prepare supporting schedules of
insurance policies, rental agreements, and other contractual commitments.
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Companies often prepare adjustments after the balance sheet date. However, they
date the entries as of the balance sheet date.
TYPES OF ADJUSTING ENTRIES
(1) DEFERRALS (Cash precedes revenue/expense)
a. PREPAID EXPENSES –ASSETS
Cash is paid out before the expense is incurred—e.g., supplies,
prepaid rent, insurance, royalties, fees, tuition.
Debit assets, to indicate the future benefit
Prepaid expenses expire with passage of time (e.g., rent) or by
consumption (e.g., supplies)
It is impractical to daily record the expiration of prepaid expenses
Rather, make an adjusting entry at the end of a reporting period.
Prior to making the adjusting entry, assets are overstated and expenses
understated
An adjusting entry debits/increases the expense (e.g., rent or supplies
expense) and credits/decreases the asset (i.e., the prepaid expense) to
reflect appropriate amounts.
Example 1
On October 31, Tenantskev Inc., the tenant, pays the next twelve months’ worth of
rent amounting to $12,000 to Landlordsky enterprises, the landlord. Both firms
have a December 31 fiscal year-end.
a) Show the journal entry/entries that Tenantskev Inc. makes on October 31 to
record this transaction.
b) Show the adjusting entry/entries that Tenantskev Inc. makes on December
31 when preparing the financial statements.
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b. UNEARNED REVENUES—LIABILITIES
Cash is received before the revenue is earned, generating an
obligation (liability) to supply goods/services to customers—e.g., rent
revenue, insurance revenue, air fare, royalties/fees revenue.
Credit liability, to indicate the increase in obligation/liability
Unearned revenue is earned with the passage of time (e.g., rent) or by
fulfilling contractual obligations by supplying the goods/services (e.g.,
air fare, tuition).
It is impractical to daily record the fulfillment of the performance
obligation.
Companies make an adjusting entry at the end of a reporting period.
Prior to making an adjusting entry, the liability is overstated and
revenue is understated
An adjusting entry debits/decreases the unearned revenue (liability)
and credits/increases a revenue account—for the revenue that is now
earned, to reflect the appropriate amounts.
Example 1 (Continued)
c) Show the journal entry/entries that Landlordsky enterprises made to record
the transaction on October 31.
d) Show the adjusting entry/entries that Landlordsky enterprises made on
December 31 when preparing financial statements.
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(2) ACCRUALS (Cash follows revenues/expenses)
a. ACCRUED EXPENSES
Expense may be incurred, but unrecorded at reporting date
Expense may be accrued by the passage of time (e.g., interest
expense) or by the consumption of goods/services (e.g., salaries,
wages, taxes, rent—not prepaid)
Companies don’t record wage/interest expense daily
Companies don’t receive bills/invoices for incomplete work/orders
An adjusting entry is needed to record the appropriate liability as of
the report date.
Prior to making an adjusting entry, both the liability and expense are
understated.
The adjusting entry for accrued expenses debits (increases) an
expense account and credits (increases) a liability account.
Example 2
Assume that Castle National Bank agrees to lend $100,000 on March 1, 2014, to
Landscape Co. in exchange for a $100,000, 6%, 4-month note.
a) Show the journal entry/entries that Landscape Co. makes to record this
transaction on March 1.
b) Assume Landscape Co. prepares financial statements semiannually. Show
the adjusting entry/entries they make pertaining to this note, at June 30.
c) At Maturity (July 1) Landscape Co. must pay the face value of the note
(principal) and accrued interest. Make this journal entry.
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b. ACCRUED REVENUES-ASSETS
Revenue may be earned, but unrecorded at reporting date.
Revenue may be accrued by the passage of time (e.g., interest
revenue) or provision of goods/services (e.g., unbilled or uncollected
consultation/advertising services, un-invoiced goods)
Companies don’t record interest revenue daily.
Companies don’t often bill, invoice incomplete service.
An adjusting entry is needed to record the appropriate receivable as of
the report date.
Prior to making the adjusting entry total assets are understated and
revenue is also understated.
An adjusting entry for accrued revenues debits (increases) an asset
account (receivable) and credits (increases) a revenue account.
Example 2 (Continued)
d) Show the journal entry/entries that Castle National Bank makes to record
this transaction on March 1.
e) Assume Castle National Bank prepares financial statements semiannually.
Show the adjusting entry/entries they make pertaining to this note, at June
30.
f) Show the journal entry that Castle National Bank makes at Maturity (July 1)
to record receipt of the face value of the note plus accrued interest.
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THE APPROPRIATE ADJUSTING ENTRY OFTENTIMES DEPENDS ON
HOW THE PREVIOUS TRANACTION WAS RECORDED.
EXAMPLE 3
Yorktown Attorneys, a busy law firm, purchases supplies worth $942 in cash. The
firm has 2 acceptable alternatives of recording this transaction.
(1) Record supplies as a prepaid expense (an asset) when purchased
Prepaid supplies $942
Cash $942
Suppose the firm takes an inventory count at the end of the reporting period
and discovers the value of supplies left over is $612. The appropriate
adjusting entry is:
Supplies expense $330
Supplies $330
(2) Record supplies as an expense, when purchased
Supplies expense $942
Cash $942
Recall, the value of supplies left over at the end of reporting period is $612.
Thus, the initial journal entry “over-expensed” supplies by $612, the amount
of unused supplies. Accordingly, the appropriate adjusting entry will “un-
expense” supplies expense with a credit of $612, and an equal debit to
prepaid supplies.
Prepaid supplies $612
Supplies expense $612
Note, either way, after the adjusting entries, we end up with the same
amount for both supplies expense and prepaid supplies.
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Example 2 Example 1
Prepaid Supplies Prepaid Supplies
0 942
612 Adjusting entry 330
612 612
Same Ending Balance
Supplies expense Supplies expense
942
612 Adjusting entry 330
330 330
Same Ending Balance
ADJUSTED TRIAL BALANCE
A trial balance prepared from the ledger accounts after journalizing and
posting all adjusting entries.
The purpose of an adjusted trial balance is to prove the equality of the
total debit balances and the total credit balances in the ledger after all
adjustments.
Since the accounts contain all data needed for financial statements, the adjusted
trial balance is the primary basis for the preparation of
financial statements.
CLOSING
Reduces the balance of nominal (temporary) accounts to zero in order to
prepare the accounts for the next period's transactions.
Transfers all of the revenue and expense account balances (income statement
items) to a clearing or suspense account called Income Summary. The
Income Summary account matches revenues and expenses.
The Income Summary clearing account is used only at the end of each
accounting period and it represents the net income or net loss for the period.
The income summary amount (the net income or net loss) is then transferred
to a stockholders' equity account. (For a corporation, the stockholders' equity
account is retained earnings; for proprietorships, it is a capital account.)
Companies post all such closing entries to the appropriate general ledger
accounts.
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Dividends are NOT an expense. Dividends are directly closed to
retained earnings.
CLOSING ENTRIES ILLUSTRATION
GENERAL JOURNAL J3
Date Account Titles and Explanation Debit Credi
t
Closing Entries
(1)
Oct. Service Revenue 106,0
31 00
Income Summary 106,0
00
(To close revenue account)
(2)
31 Income Summary 73,00
0
Supplies Expense 15,00
0
Depreciation Expense 400
Insurance Expense 500
Salaries and Wages Expense 46,00
0
Rent Expense 9,000
Interest Expense 500
Bad Debt Expense 1,600
(To close expense accounts)
(3)
31 Income Summary 33,00
0
Retained Earnings 33,00
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GENERAL JOURNAL J3
Date Account Titles and Explanation Debit Credi
t
(To close net income to retained
earnings)
(4)
31 Retained Earnings 5,000
Dividends 5,000
(To close dividends to retained
earnings)
POST-CLOSING TRIAL BALANCE
Recall that a trial balance is prepared after entering the regular transactions
of the period
A second trial balance (the adjusted trial balance) occurs after posting the
adjusting entries.
A company may take a third trial balance, called the post-closing trial
balance, after posting the closing entries.
The purpose of the post-closing trial balance is to prove the equality of the
permanent account balances that the company carries forward into the
next accounting period.
Since all temporary accounts will have zero balances, the post-closing trial
balance will contain only permanent (real)—balance sheet—accounts.
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