Chapter Two

Summary of the Accounting process

Relevant Facts Concerning IFRS
International companies use the same set of procedures and records to keep track of
transaction data. Thus, the material in Chapter 2 dealing with the account, general rules of
debit and credit, and steps in the recording process the journal, ledger, and chart of accounts is
the same under both GAAP and IFRS. Transaction analysis is the same under IFRS and
GAAP but, as you will see in later chapters; different standards sometimes impact how
transactions are recorded. Rules for accounting for specific events sometimes differ across
countries. For example, European companies rely less on historical cost and more on fair
value than U.S. companies. Despite the differences, the double-entry accounting system is the
basis of accounting systems worldwide. A trial balance under IFRS follows the same format.
In FASB, dollar signs are typically used only in the trial balance and the financial statements.
The same practice is followed under IFRS, using the currency of the country in which the
reporting company is [Link] controls are a system of checks and balances
designed to prevent and detect fraud and errors. While most companies have these systems in
place, many have never completely documented them nor had an independent auditor attest to
their effectiveness.

Learning Objectives

At the end of this chapter, learners should be able to:

1. Understand basic accounting terminology.

2. Explain double-entry rules.
3. Identify steps in the accounting cycle.
4. Record transactions in journals, post to ledger accounts, and prepare a trial balance.
5. Explain the reasons for preparing adjusting entries.
6. Prepare financial statement from the adjusted trial balance.
7. Prepare closing entries.
Introduction
Maintaining a set of accounting records is not optional. Regulators require that businesses
prepare and retain a set of records and documents that can be audited. The Accounting and
Auditing Board of Ethiopia (AABE), for example, requires public interest entities to “make
and keep books, records, and accounts, which, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets.” But beyond these two reasons, a
company that fails to keep an accurate record of its business transactions may lose revenue
and is more likely to operate [Link] reason accurate records are not provided is
because of economic crime or corruption. It is clear that economic crime remains a persistent
and difficult problem for many companies.
The top four economic crimes are asset misappropriation, accounting fraud, bribery and
corruption, and cybercrime. Cybercrime is a new phenomenon as new types of fraud are
emerging in this [Link] phones and tablet devices, social media, and cloud computing all
offer companies interesting business opportunities but can also lead to risks related to the
disclosure of sensitive and confidential [Link] some of these cases, such as money laundering
or infringement of intellectual property, a sound system of internal controls focused on
financial accounting and reporting may not work. Nonetheless, many believe that effective
internal control sends a message that a company is serious about finding not only economic
crime but also errors or misstatements. As a result, many companies are taking a proactive
look as to how they can better prevent both economic crime as well as basic errors in their
systems.
As the opening story indicates, a reliable information system is a necessity for all companies.
The purpose of this chapter is to explain and illustrate the features of an accounting
information system. The content and organization of this chapter are as follows.

An accounting information system collects and processes transaction data and then
disseminates the financial information to interested parties. Accounting information systems
vary widely from one business to another. Various factors shape these systems: the nature of
the business and the transactions in which it engages, the size of the firm, the volume of data
to be handled, and the informational demands that management and others require.
A good accounting information system helps management answer such questions as:
  .How much and what kind of debt is outstanding?
 Were sales higher this period than last?
 What assets do we have?
 What were our cash inflows and outflows?
 Did we make a profit last period?
 Are any of our product lines or divisions operating at a loss?
 Can we safely increase our dividends to shareholders?
 Is our rate of return on net assets increasing?
Management can answer many other questions with the data provided by an efficient
accounting system. A well-devised accounting information system benefits every type of
company.
Basic Terminology
Financial accounting rests on a set of concepts for identifying, recording, classifying, and
interpreting transactions and other events relating to enterprises. You therefore need to
understand the basic terminology employed in collecting accounting data.
 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.
The first objective of any accounting system is to identify the economic events that can be
expressed in financial terms by the system. Economic events cause changes in the financial
position of a company.
 External events involve an exchange between the company and another entity.
Examples are purchasing merchandise inventory for cash and borrowing cash
from a bank.
 Internal events do not involve an exchange transaction but do affect the
company’s financial position. Examples are the depreciation of machinery and
the use of supplies.
The accounting equation underlies the process used to capture the effects of economic events.
Assets equal liabilities plus owners’ equity. Each event, or transaction, has a dual effect on
the accounting equation.
 Transaction: A business transaction is an economic event or condition that directly
changes an entity’s financial condition or directly affects its results of operations. It is 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
 Real Account: Permanent accounts (assets, liabilities, paid-in capital and retained
earnings) represent the basic financial position elements of the accounting equation. Real
(permanent) accounts are asset, liability, and equity accounts; they appear on the balance
sheet
 Nominal Account: Temporary accounts (revenues, gains, expenses and losses) keep track
of the changes in the retained earnings component of shareholders’ equity. Nominal
(temporary) accounts are revenue, expense, and dividend accounts; except for dividends,
they appear on the income statement. Companies periodically close nominal accounts;
they do not close real accounts.
 Ledger: The book (or computer printouts) containing the accounts. A general ledger is a
collection of all the asset, liability, owners’ 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 chronologically. 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. The trial
balance taken immediately after all adjustments have been posted is called an adjusted
trialbalance. A trial balance taken immediately after closing entries have been posted is
called a post-closing (or after-closing) trial balance. Companies may prepare a trial
balance at any time.
 Chart of accounts: a list of all statement of financial position (balance sheet) and Profit
and loss account (income statement) accounts.
 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.
 Financial Statements: Statements that reflect the collection, tabulation, and final
summarization of the accounting data. Four statements are involved: (1) A statement of
financial position shows the financial condition of the enterprise at the end of a period.
 (2) The income statement measures the results of operations during the period. (3) The
statement of cash flows reports the cash provided and used by operating, investing, and
financing activities during the period. (4) The statement of retained earnings reconciles
the balance of the retained earnings account from the beginning to the end of the period.
 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 an owners’
equity account. Also known as “closing the ledger,” “closing the books,” or merely
“closing.”

2.1. Identifying and Recording Transactions and Other Events

The first step in the accounting cycle is analysis of transactions and selected other events. The
first problem is to determine what to record. Although GAAP provides guidelines, no simple
rules exist that state which events a company should record. Although changes in a
company’s personnel or managerial policies may be important, the company should not
record these items in the accounts. On the other hand, a company should record all cash sales
or purchases no matter how small.
Illustration below shows the steps in the accounting cycle. A company normally uses these
accounting procedures to record transactions and prepare financial statements.

When the steps have been completed, the sequence starts over again in the next accounting
period.
Assets are probable economic benefits controlled by a particular entity as a result of a
pasttransaction or event. Do human resources of a company meet this definition?
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------
What to Record? An item should be recognized in the financial statements if it is an element,
is measurable, and is relevant and a faithful representation.
Events are of two types. (1) External events involve interaction between an entity and its
environment, such as a transaction with another entity, a change in the price of a good or
service that an entity buys or sells, a flood or earthquake, or an improvement in technology by
a competitor. (2) Internalevents occur within an entity, such as using buildings and
machinery in operations, ortransferring or consuming raw materials in production processes.
Many events have both external and internal elements. For example, hiring an employee,
which involves an exchange of salary for labor, is an external event. Using the services of
labor is part of production, an internal event. Further, an entity may initiate and control
events, such as the purchase of merchandise or use of a machine. Or, events may be beyond
its control, such as an interest rate change, theft, or a tax hike.
Transactions are types of external events. They may be an exchange between two entities
where each receives and sacrifices value, such as purchases and sales of goods or services. Or,
transactions may be transfers in one direction only. For example, an entity may incur a
liability without directly receiving value in exchange, such as charitable contributions. Other
examples include investments by owners, distributions to owners, payment of taxes, gifts,
casualty losses, and thefts.
In short, a company records as many events as possible that affect its financial position.
As discussed earlier in the case of human resources, it omits some events becauseof tradition
and others because of complicated measurement problems. Recently,however, the accounting
profession shows more receptiveness to accepting the challengeof measuring and reporting
events previously viewed as too complex and immeasurable.
1. Journalizing
A company records in accounts those transactions and events that affect its assets, liabilities,
and equities. The general ledger contains all the asset, liability, and stockholders’ equity
accounts. An account shows the effect of transactions on particular asset, liability, equity,
revenue, and expenseaccounts. In practice, companies do not record transactions and selected
other events originallyin the ledger. A transaction affects two or more accounts, each of which
is on a different page in the ledger. Therefore, in order to have a complete record of each
transaction or other event in one place, a company uses a journal (also called “the book of
original entry”). In its simplest form, a general journal chronologically lists transactions and
other events, expressed in terms of debits and credits to accounts.
Illustration below shows the technique of journalizing, using the first transactions for a given
company. This transaction was:
September 1 Stockholders invested $15,000 cash in the corporation in exchange for shares of
[Link] J1 indicates this entry is on the first page of the general journal.

Each general journal entry consists of four parts: (1) the accounts and amounts to be debited
(Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an explanation. A
company enters debits first, followed by the credits (slightly indented). The explanation
begins below the name of the last account to be credited and may take one or more lines. A
company completes the “Ref.” column at the time it posts the accounts.
In some cases, a company uses special journals in addition to the general journal. Special
journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales,
purchases, cash payments). As a result, using them reduces bookkeeping time.

2.2. Posting transactions and other events

Transferring journal entries to the ledger accounts is called posting. Posting involves the
following steps.
1. In the ledger, in the appropriate columns of the account(s) debited, enter the date,
journal page, and debit amount shown in the journal.
2. In the reference column of the journal, write the account number to which the debit
amount was posted.
3. In the ledger, in the appropriate columns of the account(s) credited, enter the date,
journal page, and credit amount shown in the journal.
 4. In the reference column of the journal, write the account number to which the credit
amount was posted.
Illustration below diagrams these four steps, using the first journal entry of a company. The
illustration shows the general ledger accounts in standard account form. Some companies
call this form the three-column form of account because it has three money columns debit,
credit, and balance. The balance in the account is determined after each transaction. The
explanation space and reference columns provide special information about the transaction.
The boxed numbers indicate the sequence of the steps.
The numbers in the “Ref.” column of the general journal refer to the ledger accounts to which
a company posts the respective items. For example, the “101” placed in the column to the
right of “Cash” indicates that the company posted this $15,000 item to Account No. 101 in the
ledger.
The posting of the general journal is completed when a company records all of theposting
reference numbers opposite the account titles in the journal. Thus, the number in the posting
reference column serves two purposes. (1) It indicates the ledger account number of the
account involved. (2) It indicates the completion of posting for the particular item. Each
company selects its own numbering system for its ledger [Link] begin numbering
with asset accounts and then follow with liabilities, owners’ equity, revenue, and expense
accounts, in that order.
The ledger accounts in Illustration below show the accounts after completion of the posting
process. The reference J1 (General Journal, page 1) indicates the source of the data transferred
to the ledger account.
An Expanded Example
To show an expanded example of the basic steps in the recording process, we use theOctober
transactions of Pioneer Advertising Agency Inc. Pioneer’s accounting period is a month.
Illustrations below show the journal entry and posting of each [Link] simplicity, we
use a T-account form instead of the standard account [Link] the transaction analyses
carefully.
The purpose of transaction analysis is (1) to identify the type of account involved,and (2) to
determine whether a debit or a credit is required. You should always performthis type of
analysis before preparing a journal entry. Doing so will help you understandthe journal entries
discussed in this chapter as well as more complex journal entries inlater chapters. Keep in
mind that every journal entry affects one or more of the followingitems: assets, liabilities,
stockholders’ equity, revenues, or expenses.
1. October 1: Shareholders invest $100,000 cash in an advertising venture to be known
as Pioneer Advertising Agency Inc.
2. October 1: Pioneer Advertising purchases office equipment costing $50,000 by
signing a 3-month, 12%, $50,000 note payable.

3. October 2: Pioneer Advertising receives a $12,000 cash advance from KC, a client,
for advertising services that are expected to be completed by December 31.

5. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October.

6. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that
will expire next year on September 30.

7. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated

3-month supply of advertising materials from Aero Supply.
[Link] 9: Pioneer Advertising signs a contract with a local newspaper for
advertising inserts (flyers) to be distributed starting the last Sunday in November.
Pioneer will start work on the content of the flyers in November. Payment of $7,000
is due following delivery of the Sunday papers containing the flyers.

8. October 20: Pioneer Advertising’s board of directors declares and pays a $5,000 cash
dividend to shareholders.

[Link] 26: Employees are paid every four weeks. The total payroll is $2,000 per day.
The pay period ended on Friday, October 26, with salaries of $40,000 being paid.

[Link] 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company
$72,000 for advertising services of $100,000 provided in October.
2.3. Trial Balance Preparation
A trial balance is a list of accounts and their balances at a given time. A company usually
prepares a trial balance at the end of an accounting period. The trial balance lists the accounts
in the order in which they appear in the ledger, with debit balances listed in the left column
and credit balances in the right column. The totals of the two columns must agree. The trial
balance proves the mathematical equality of debits and credits after posting.
Under the double-entry system, this equality occurs when the sum of the debit account
balances equals the sum of the credit account balances. A trial balance also uncovers errors in
journalizing and posting. In addition, it is useful in the preparation of financial statements.
The procedures for preparing a trial balance consist of:
1. List the account titles and their balances in the appropriate debit or credit column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Illustration below presents the trial balance prepared from the ledger of Pioneer Advertising
Agency Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial
balance also often shows account numbers to the left of the account titles.

A trial balance does not prove that a company recorded all transactions or that the
ledger is correct. Numerous errors may exist even though the trial balance columnsagree. For
example, the trial balance may balance even when a company (1) fails to journalizea
transaction, (2) omits posting a correct journal entry, (3) posts a journal entrytwice, (4) uses
incorrect accounts in journalizing or posting, or (5) makes offsetting errorsin recording the
amount of a transaction. In other words, as long as a company postsequal debits and credits,
even to the wrong account or in the wrong amount, the totaldebits will equal the total credits.

2.4. Adjusting Entries

In order for a company, to record revenues in the period in which it earns them, and to
recognize expenses in the period in which it incurs them, it makes adjusting entries at the
end of the accounting period. In short, adjustments ensure that companies follow the revenue
recognition and expense recognition principles.
The use of adjusting entries makes it possible to report on the balance sheet the appropriate
assets, liabilities, and owners’ equity at the statement date. Adjusting entries also make it
possible to report on the income statement the proper revenues and expenses for the period.
However, the trial balance the first pulling together of the transaction data may not contain
up-to-date and complete data. This occurs for the following reasons.
1. Some events are not journalized daily because it is not expedient. Examples are the
consumption of supplies and the earning of wages by employees.
2. Some costs are not journalized during the accounting period because these costs expire
with the passage of time rather than as a result of recurring daily transactions.
Examples of such costs are building and equipment deterioration and rent and
insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be
received until the next accounting period.
Adjusting entries are required every time a company prepares financial statements. At that
time, companies must analyze each account in the trial balance to determine whether it is
complete and up-to-date for financial statement purposes. The analysis requires a thorough
understanding of company operations and the interrelationship of accounts. Because of this
involved process, usually a skilled accountant prepares the adjusting entries. In gathering the
adjustment data, Companies may need to make inventory counts of supplies and repair parts.
Further, it may prepare supporting schedules of insurance policies, rental agreements, and
other contractual commitments. Companies often prepare adjustments after the balance sheet
date. However, they date the entries as of the balance sheet date.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. Each of these classes hastwo
subcategories, as Illustration below shows.

Adjusting Entries for Deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized
at a date later than the point when cash was originally exchanged. The two types of deferrals
are prepaid expenses and unearned revenues.

If a company does not make an adjustment for these deferrals, the asset and liability are
overstated, and the related expense and revenue are understated. For example, in Pioneer’s
trial balance, the balance in the asset Supplies shows only supplies purchased. This balance is
overstated; the related expense account, Supplies Expense, is understated because the cost of
supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a
balance sheet account and increase an income statement account. Illustration above shows the
effects of adjusting entries for deferrals.
Prepaid [Link] paid for and recorded before a company uses them are called
prepaid expenses. When expenses are prepaid, a company debits an asset account to show
the service or benefit it will receive in the future. Examples of common prepayments are
insurance, supplies, advertising, and rent. In addition, companies make prepayments when
they purchase buildings and equipment.
[Link] inventory count at the close of business on October 31 reveals that $10,000 of
the advertising supplies are still on hand.

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

Depreciation. Pioneer Advertising estimates depreciation on its office equipment to be

$400 per month. Accordingly, Pioneer recognizes depreciation for October by the
following adjusting entry.

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Companies make adjusting entries for
accruals to record revenues for services performed and expenses incurred in the current
accounting period. Without an accrual adjustment, the revenue account (and the related asset
account) or the expense account (and the related liability account) are understated. Thus, the
adjusting entry for accruals will increase both a balance sheetand an income statement
account.
Accrued [Link] for services performed but not yet recorded at the statement date
are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time,
as in the case of interest revenue. These are unrecorded because the earning of interest does
not involve daily transactions. Companies do not record interest revenue on a daily basis
because it is often impractical to do so. Accrued revenues also may result from services that
have been performed but not yet billed nor collected, as in the case of commissions and fees.
These may be unrecorded because only a portion of the total service has been performed and
the clients will not be billed until the servicehas been [Link] adjusting entry records
the receivable that exists at the balance sheet date and the revenue for the services performed
during the period. Prior to adjustment, both assets and revenues are understated. Accordingly,
an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a
credit (increase) to a revenue account. Illustration below shows adjusting entries for accruals.

Unearned Revenues. Analysis reveals that Pioneer earned $4,000 of the advertising
services in October. Thus, Pioneer makes the following adjusting entry.

Accrued [Link] incurred but not yet paid or recorded at the statement date are
called accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued
expenses result from the same causes as accrued revenues. In fact, an accrued expense on the
books of one company is an accrued revenue to another company. For example, the $2,000
accrual of service revenue by Pioneer is an accrued expense to the client that received the
service. Adjustments for accrued expenses record the obligations that exist at the balance
sheet date and recognize the expenses that apply to the current accounting period. Prior to
adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for
accrued expenses results in a debit (increase) to an expense account and a credit (increase) to
a liability account.
Accrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of
$50,000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of
interest.

Accrued salaries and [Link] pay for some types of expenses, such as employee
salaries and wages, after the services have been performed. For example, Pioneer Advertising
last paid salaries and wages on October 26. It will not pay salaries and wages again until
November 23. However, as shown in the calendar below, three working days remain in
October (October 29–31).

At October 31, the salaries and wages for these days represent an accrued expense and a
related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a
five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are
$6,000 ($2,000*3). The analysis and adjustment process is summarized in Illustration below.
Accrued Salaries. On November 23, Pioneer will again pay total salaries of $40,000.
Prepare the entry to record the payment of salaries on November 23.

Bad Debts. Assume Pioneer reasonably estimates a bad debt expense for the month of
$1,600. It makes the adjusting entry for bad debts as follows.

Adjusted Trial Balance

Shows the balance of all accounts, after adjusting entries, at the end of the accounting period.
 2.5. Preparation of financial statements
International accounting Standards number one (IAS 1) requires an entity to disclose
comparative information in respect of the previous period, i.e to disclose as a minimum two of
each of the statements and related notes. It introduces a requirement to include in a complete
set of financial statements a statement of financial position as at the beginning of the earliest
comparative period whenever the entity retrospectively applies an accounting policy or makes
a retrospective restatement of items in its financial statements, or when it reclassifies items in
its financial statements. The purpose is to provide information that is useful in analyzing an
entity’s financial statements.
According to ISA 1 a complete set of financial statements comprises:
(a) A statement of financial position as at the end of the period;
(b) A statement of comprehensive income for the period;
(c) A statement of changes in equity for the period;
(d) A statement of cash flows for the period;
 (e) Notes, comprising a summary of significant accounting policies and other explanatory
information; and
(f) A statement of financial position as at the beginning of the earliest comparative period
when an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements, or when it reclassifies items in its
financial statements.
In the statement of financial position
 Property, plant and equipment
 Investment property
 Intangible assets
 Financial assets
 Inventories
 Trade receivables
 Cash and cash equivalents
 Trade payables
 Provisions
 Financial liabilities
 Tax liabilities
 Equity capital and reserves
International Standards of Accounting (ISA) 1does not prescribe the order or format in which an
entity presentsitems. Paragraph 54 of the standard simply lists items that are sufficiently different
in nature orfunction to warrant separate presentation in the statement of financial position.

Illustration below shows how income statement is prepared from the adjusted trial balance and
the preparation of Retained earnings statement

The statement of financial position is also prepared from the adjusted trial balance as follows:
2.6. Closing Entries
Closing entries are taken to reduce the balance of the income statement (revenue and expense)
accounts to zero and to transfer net income or net loss to equity. Statement of financial position
(asset, liability, and equity) accounts are not closed. Dividends are closed directly to the Retained
Earnings account. The following illustration shows the closing entries from the income statement
above
Note that every transaction recorded in the journal must be posted to the ledger to see the effect
on the account and closing entries must be posted to the ledger so balances of temporary
accounts will be zero after posting the closing entries.

2.7. Post-closing trial balance preparation

Post closing trial balance is prepared after closing the temporary accounts and hence it consists
only permanent & balance sheet accounts only. The following illustration shows the post-
closing trial balance of Pioneer Advertizing Agency Inc.
2.8. Reversing Entries
After preparing the financial statements and closing the books, a company may reverse some of
the adjusting entries before recording the regular transactions of the next period. Such entries are
called reversing entries. A company makes a reversing entry at the beginning of the next
accounting period; this entry is the exact opposite of the related adjusting entry made in the
previous period. Making reversing entries is an optional step in the accounting cycle that a
company may perform at the beginning of the next accounting period. The following points
summarize guidelines for reversing entries.
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.