Chapter 3: Accounting Information System (Acfn 231 Intermediate Financial Acct I)

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
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 (owners' equity). Because the format of an
account often resembles the letter T, it is sometimes referred to as a T-account.
Real and Nominal Accounts. Real (permanent) accounts are asset, liability, and equity accounts;
they appear on the statement of financial position.
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, 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. The trial balance
taken immediately after all adjustments have been posted is called an adjusted trial balance. 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.
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) The statement of financial position
shows the financial condition of the enterprise at the end of a period. (2) The income statement
(or statement of comprehensive income) 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 (or retained
earnings statement) 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 equity account. Also known as
“closing the ledger,” “closing the books,” or merely “closing.”
Debits and Credits

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The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not mean
increase or decrease, but instead describe where a company makes entries in the recording
process. That is, when a company enters an amount on the left side of an account, it debits the
account. When it makes an entry on the right side, it credits the account. When comparing the
totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds
the credits. An account shows a credit balance if the credit amounts exceed the debits.
The equality of debits and credits provides the basis for the double-entry system of recording
transactions (sometimes referred to as double-entry bookkeeping). Under the universally used
double-entry accounting system, a company records the dual (two-sided) effect of each
transaction in appropriate accounts. This system provides a logical method for recording
transactions. It also offers a means of proving the accuracy of the recorded amounts. If a
company records every transaction with equal debits and credits, then the sum of all the debits to
the accounts must equal the sum of all the credits.
Illustration 3.1 presents 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 equity accounts, such as Share Capital
and Retained Earnings, on the credit side, but increases Dividends on the debit side.
3.2 To illustrate, consider the following eight different transactions for Perez Inc.
1. Owners invest $40,000 in exchange for ordinary shares.
2. Disburse $600 cash for administrative wages.
3. Purchase office equipment priced at $5,200, giving a 6 percent promissory note in exchange
4. Receive $4,000 cash for services performed.
5. Pay off a short-term liability of $7,000.
6. Declare a cash dividend of $5,000.
7. Convert a non-current liability of $80,000 into ordinary shares.
8. Pay cash of $16,000 for a delivery van.
Required : a) journalize each transaction on the journal
The company's ownership structure dictates the types of accounts that are part of or affect the
equity section. A corporation commonly uses Share Capital, Share Premium, Dividends, and
Retained Earnings accounts. A proprietorship or a partnership uses an Owner's Capital account
and an Owner's Drawing account. An Owner's Capital account indicates the owner's or owners'
investment in the company. An Owner's Drawing account tracks withdrawals by the owner(s).
Elements of Financial Statement
An illustration of recording process:
1. On October 1 Abebe invests birr 100,000 cash in advertising Company to be known as
Abe Advertising P.L.C.
2. On October 1 Abe Advertising purchases office equipment costing birr 50,000 by signing
a 3 month 12% notes payable.
3. On October 2 Abe advertising receive cash advance from kenaw a client for advertising
services that are expected to be completed by December 31.
4. On October 3 Abe Advertising pays office rent for October in cash birr 9,000.
5. On October 4 Abe Advertising pays birr 6000 for a one year insurance policy that will
expire next year on September 30.
6. On October 5 Abe Advertising purchases an estimated supply of advertising materials on
account from Aero supply for birr 25,000.

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 7. On October 9, Abe Advertising signs a contract with a local newspaper for advertising
inserts (flyers) to be distributed starting the last Sunday in November payments birr 7,000
is due following delivery of the Sunday papers containing the flyers.
8. On October 20 Abe Advertising’s Board of Directors and pays birr 5000 cash dividend to
shareholders.
9. On October 26, Abe Advertising pays employee salaries and wages in cash. Employees
are paid once a month every four weeks, the pay period began on Monday, October 1. As
a result the pay period ended on Friday, October 26, with salaries and wages of birr
40,000 being paid.
10. On October 31 Abe Advertising receives birr 28,000 in cash and bills Copa Company birr
72,000 for advertising Company birr 72,000 for advertising services of birr 100,000
performed in October.
Required:
a) state basic analysis of each transaction
b) state accounting equation analysis of transaction
c) state debit-credit analysis of each transaction
d) journalize each entry
e) posting to ledger

Trial Balance
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 [Link] 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.
a) From the given data Abe Advertising Company prepare Trial balance
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 columns agree. For example,
the trial balance may balance even when a company (1) fails to journalize a transaction, (2) omits
posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in
journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In
other words, as long as a company posts equal debits and credits, even to the wrong account or in
the wrong amount, the total debits will equal the total credits.

Financial Statements and Ownership Structure

The equity section of the statement of financial position reports share capital and retained
earnings. The income statement reports revenues and expenses. The retained earnings statement
reports dividends. Because a company transfers dividends, revenues, and expenses to retained
earnings at the end of the period, a change in any one of these three items affects equity.

The company's ownership structure dictates the types of accounts that are part of or affect the
equity section. A corporation commonly uses Share Capital, Share Premium, Dividends, and
Retained Earnings accounts. A proprietorship or a partnership uses an Owner's Capital account

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and an Owner's Drawing account. An Owner's Capital account indicates the owner's or owners'
investment in the company. An Owner's Drawing account tracks withdrawals by the owner(s).

The Accounting Cycle

A company normally uses these accounting procedures to record transactions and prepare
financial statements.

Identify and Prepare Adjusting Entries

In order for revenues to be recorded in the period in which services are performed and for
expenses to be recognized in the period in which they are incurred, companies make adjusting
entries.
The use of adjusting entries makes it possible to report on the statement of financial position the
appropriate assets, liabilities, and 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 salaries and 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 depreciation 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.
Underlying Concepts
Preparation of financial statements for subperiods such as quarters or months improves the
timeliness of the information but raises verifiability concerns due to estimates in preparing
adjusting entries.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. Each of these classes has two
subcategories
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or
consumed.
2. Unearned revenues: Cash received before services are performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet received
in
cash or recorded.

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2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded

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 AbeAdvertising's trial balance given the above, 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 statement of financial position account and increase
an income statement account.
Adjusting entries

Prepaid expenses
Asset
Unadjusted balance Crediting adjusting
entry (-)
Expense
Debit adjusting entry
(+)

Prepaid Expenses
Assets 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.

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Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or
through use and consumption (e.g., supplies). The expiration of these costs does not require daily
entries, an unnecessary and impractical task.
As shown above, prior to adjustment, assets are overstated and expenses are understated. Thus,
an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an
asset account.
For example, Abe Advertising purchased advertising supplies costing 25,000 on October 5. Abe
therefore debited the asset Supplies. This account shows a balance of 25,000 in the October 31
trial balance. An inventory count at the close of business on October 31 reveals that 10,000 of
supplies are still on hand. Thus, the cost of supplies used is 15,000 ( 25,000 − 10,000). The
analysis and adjustment for Supplies is summarized
Adjusting entry :
Supplies expense----------------------- birr 15,000
Supplies 15,000

.
After adjustment, the asset account Supplies now shows a balance of 10,000, which equals the
cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of
15,000, which equals the cost of supplies used in October. Without an adjusting entry, October
expenses are understated and net income overstated by 15,000. Moreover, both assets and equity
are overstated by 15,000 on the October 31 statement of financial position.
Abe Advertising paid 6,000 for a one-year fire insurance policy, beginning October 1. Abe
debited the cost of the premium to Prepaid Insurance at that time. This account still shows a
balance of 6,000 in the October 31 trial balance. An analysis of the policy reveals that 500
( 6,000 ÷ 12) of insurance expires each month.
Adjusting entry for insurance:

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The asset Prepaid Insurance shows a balance of 5,500, which represents the unexpired cost for
the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals
the insurance cost that expired in October.
Without an adjusting entry, October expenses are understated by 500 and net income overstated
by 500. Moreover, both assets and equity also are overstated by 500 on the October 31 statement
of financial position.
Depreciation
To follow the expense recognition principle, Business’s entity should report a portion of the Cost
of a long-lived asset as an expense during each period of the asset's useful life.
Depreciation is the process of allocating the cost of an asset to expense over its useful life in a
rational and systematic manner
Statement Presentation.
Accumulated Depreciation—Equipment is a contra asset account. A contra asset account offsets
an asset account on the statement of financial position. This means that the Accumulated
Depreciation—Equipment account offsets the Equipment account on the statement of financial
position. Its normal balance is a credit. Abe Advertising uses this account instead of crediting
Equipment in order to disclose both the original cost of the equipment and the total expired cost
to date.