Chapter 2: Review of the Accounting Process Chapter 1 explained that the primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related notes. The purpose of this chapter is to review the fundamental accounting process used to produce the financial statements. This review establishes a framework for the study of the concepts covered in intermediate accounting. Actual accounting systems differ significantly from company to company. This chapter focuses on the many features that tend to be common to any accounting system.
The first objective of any accounting system is to identify the economic events that can be expressed in financial terms by the system. The accounting equation underlies the process used to capture the effects of economic events. Assets equal liabilities plus owners’ equity. This general expression portrays the equality between the total economic resources of an entity (assets) and the total claims to those resources (liabilities and equity). The equation also implies that each economic event affecting this equation will have a dual effect because resources must always equal claims to those resources. The accounting equation can be expanded to include a column for each type of change in owners’ equity, as illustrated here.
Owners’ of a corporation are its shareholders, so owners’ equity for a corporation is referred to as shareholders’ equity. Shareholders’ equity for a corporation arises primarily from two sources: (1) amounts invested by shareholders in the corporation and (2) amounts earned by the corporation (on behalf of its shareholders). These are reported as (1) paid-in capital and (2) retained earnings. Retained earnings equals net income less distributions to shareholders (primarily dividends) since the inception of the corporation.
The double-entry system is used to process transactions. In the double-entry system, debit means left side of an account and credit means right side of an account. Whether a debit or a credit represents an increase or decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased by debit entries and decreased by credit entries. Accounts on the right side of the equation (liabilities and shareholders’ equity) are increased by credit entries and decreased by debit entries. This arbitrary, but effective, procedure ensures that for each transaction the net impact on the left sides of the accounts always equals the net impact on the right sides of accounts. Notice that increases and decreases in retained earnings are recorded indirectly in revenue, gain, expense, and loss accounts. For example, an expense represents a decrease in retained earnings, which requires a debit. That debit, however, is recorded in an appropriate expense account rather than in retained earnings itself. This allows the company to maintain a separate record of expenses incurred during an accounting period. The debit to retained earnings for the expense is recorded in a closing entry (reviewed later) at the end of the period, only after the expense total is reflected in the income statement. Similarly, an increase in retained earnings due to a revenue is recorded indirectly with a credit to a revenue account, which is later reflected as a credit to retained earnings. Permanent accounts (assets, liabilities, paid-in capital and retained earnings) represent the basic financial position elements of the accounting equation. Temporary accounts (revenues, gains, expenses and losses) keep track of the changes in the retained earnings component of shareholders’ equity.
This slide presents the ten steps in the accounting processing cycle. Steps 1-4 take place during the accounting period. Step one: Obtain information about external transactions from source documents. Step two: Analyze the transaction. Step three: Record the transaction in a journal. Step four: Post from the journal to the general ledger. Steps 5-8 occur at the end of the accounting period. Step five: Prepare an unadjusted trial balance. Step six: Record adjusting entries and post to the general ledger accounts. Step seven: Prepare an adjusted trial balance. Step eight: Prepare financial statements. Steps 9 and 10 are required only at the end of the year. Step nine: Close the temporary accounts to retained earnings (at year-end only). Step ten: Prepare a post-closing trial balance (at year-end only).
On July 1, two individuals each invested $30,000 in a new business, Dress Right Clothing Corporation. Each investor was issued 3,000 shares of common stock. Two accounts are affected: Cash, an asset account, increases and Common Stock, a shareholders’ equity account, increases. The journal entry to record this transaction is a debit to the Cash account and a credit to the Common Stock account for $60,000.
The General Journal on this slide summarizes several transactions for Dress Right as they would appear in a general journal. In addition to the date, account titles, debit and credit columns, the journal also has a column titled Post Ref. (Posting Reference). This usually is a number assigned to the general ledger account that is being debited or credited. for purposes of this illustration, all asset accounts have been assigned numbers in the 100s, all liabilities are 200s, permanent shareholders’ equity accounts are 300s, revenues are 400s, and expenses are 500s. Posting is the process of transferring (posting) the debit/credit information from the journal to the general ledger accounts. This slide illustrates the Cash ledger account (in T-account form) for Dress Right after all the general journal transactions for the month of July have been posted. The ledger accounts also contain a posting reference, usually the page number of the journal in which the journal entry was recorded. This allows for easy cross-referencing between the journal and the ledger. The reference GJ1 next to each of the posted amounts indicates that the source of the entry is page 1 of the general journal.
Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right. Before financial statements are prepared and before adjusting entries are recorded at the end of an accounting period, an unadjusted trial balance usually is prepared. A trial balance is simply a list of the general ledger accounts, listed in the order that they appear in the ledger, along with their balances at a particular date. Its purpose is to allow us to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances, that is, the accounting equation is in balance.
At the end of the period, even when all transactions and events are analyzed, corrected, journalized, and posted to appropriate ledger accounts, some account balances will require updating. Adjusting entries are required to implement the accrual accounting model. More specifically, these entries are required to satisfy the realization principle and the matching principle. Adjusting entries help ensure that all revenues earned in a period are recognized in that period, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless of when cash payment is made. As a result, a period’s income statement provides a more complete measure of a company’s operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company’s financial information up to date before preparing the financial statements. Adjusting entries are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received before a related expense or revenue is recognized. Accruals are transactions where cash is paid or received after a related expense or revenue is recognized. Accountants must often make estimates in order to comply with the accrual accounting model.
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.
The purpose of the income statement is to summarize the profit-generating activities of a company that occurred during a particular period of time. It is a change statement in that it reports the changes in shareholders’ equity (retained earnings) that occurred during the period as a result of revenues, expenses, gains and losses. The income statement for Dress Right indicates a profit for the month of July of $2,417. During the month the company was able to increase its net assets (equity) from activities related to selling its product. A common classification scheme is shown here operating items are separated from nonoperating items. Operating items include revenues and expenses directly related to the principal revenue-generating activities of the company. Nonoperating items include gains and losses and revenues and expenses from peripheral activities.
The purpose of the balance sheet is to present the financial position of the company on a particular date. The balance sheet is a statement that presents an organized list of assets, liabilities, and shareholders’ equity at a point in time. The asset section of Dress Right’s balance sheet is illustrated on this slide. As we do on the income statement, we group the balance sheet elements into meaningful categories. For example, most balance sheets include the classifications of current assets, as shown here. Current assets are those assets that are cash, will be converted into cash, or will be used up within one year or the operating cycle, whichever is longer. Examples of assets not classified as current include property and equipment and long-term receivables and investments. The only noncurrent asset Dress Right has is Furniture and Fixtures.
The liabilities and shareholders’ equity section of Dress Right’s balance sheet is illustrated on this slide. The liabilities are grouped into current liabilities and long-term liabilities. Current liabilities are debts that will be satisfied within one year or the operating cycle, whichever is longer. All liabilities not classified as current are classified as long-term. Dress Right has several debts classified as current and only one classified as long-term. Shareholders’ equity lists the paid-in capital portion of equity—common stock—and retained earnings. Notice that the income statement ties to the balance sheet through retained earnings. Specifically, the revenue, expense, gain, and loss transactions that make up net income in the income statement ($2,417) become the major components of retained earnings. Later in the chapter we discuss the closing process we use to transfer, or close, these temporary income statement accounts to the permanent retained earnings account. Notice that the basic accounting equation was in balance: assets equal liabilities plus shareholders’ equity.
Similar to the income statement, the statement of cash flows also is a change statement, disclosing the events that caused cash to change during the period. The statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. Operating activities are inflows and outflows of cash related to transactions entering the determination of net income. Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. Financing activities involve cash inflows and outflows from transactions with creditors and owners. During its first month of operation, Dress Right’s cash account increased $68,500, primarily with cash provided through financing activities.
The statement of shareholders’ equity is also a change statement. It discloses the sources of changes in the various permanent shareholders’ equity accounts that occurred during the period. Looking at Dress Right’s statement of shareholders’ equity, we can see the net effect, $2,417, of the profit-generating transactions that caused retained earnings to change. In addition, the company paid its shareholders a $1,000 dividend that reduced retained earnings. The statement of shareholders’ equity also includes a summary of the changes in Dress Right’s common stock account.
Recall that step 9 of the accounting processing cycle is to close temporary accounts to retained earnings. The closing process serves a dual purpose. First, the temporary accounts are reduced to zero balances, ready to measure activity in the upcoming accounting period. Second, these temporary account balances are closed (transferred) to retained earnings to reflect the changes that have occurred in that account during the period. The closing process applies only to temporary accounts. First, close revenues and expenses to income summary; then income summary is closed to retained earnings. The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (that is, the balance in income summary equals net income or loss). Next, close dividends to retained earnings.
Appendix 2A: Use of a Worksheet A worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements. It is an informal tool only and is not part of the accounting system. The worksheet is utilized in conjunction with step 5 in the processing cycle, preparation of an unadjusted trial balance. Here are the steps to follow for worksheet completion: Step 1: Enter account titles in column A and the unadjusted account balances in columns B and C. Step 2: Determine end-of-period adjusting entries and enter them in columns E and G. Step 3: Add or deduct the effects of the adjusting entries on the account balances and enter in columns H and I. Step 4: Transfer the temporary retained earnings account balances to columns J and K. Step 5: Transfer the balances in the permanent accounts to columns L and M.
Here is the completed worksheet for Dress Right Clothing Corporation. You may want to take a few minutes and review the steps provided on the previous slide and work your way through the worksheet preparation.
Appendix 2C: Subsidiary Ledgers Accounting systems employ a subsidiary ledger which contains 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. For example, 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 company’s customers purchasing goods and services on credit.
Appendix 2C: Special Journals For most external transactions, special journals are used to capture the dual effect of the transaction in debit/credit form. Examples of common special journals are cash receipts journals, cash disbursements journals, sales journals, and purchases journal. Special journals simplify the recording process in the following ways: 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.
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. Because every transaction in the cash receipts journal results in a debit to cash, a column is provided for that account. At the end of August, $11,750 debit is posted to the general ledger cash account. Similar postings occur for the accounts receivable and the sales revenue column totals. Each individual transaction that affects accounts receivable is also posted to the Accounts Receivable subsidiary ledger for each customer. The last two columns of this journal provide information needed to post individual transactions to uncommon accounts that may be affected by a cash receipt.
Page 56 : Accounting Processing Cycle Source documents Record in Journal Transaction Analysis Post to Ledger During the Accounting Period Financial Statements Unadjusted Trial Balance Adjusted Trial Balance At the End of the Accounting Period Record & Post Adjusting Entries Close Temporary Accounts Post-Closing Trial Balance At the End of the Year
Illustration 2-3 on page 58: Twelve Transactions
#1 (of 12): two individuals each invested $30,000 in a new business, Dress Right Clothing Corporation. Each investor was issued 3,000 shares of common stock.
Two accounts are affected:
Cash (an asset) increases by $60,000.
Common stock (a shareholders’ equity) increases by $60,000.
After recording all entries for the period, Dress Right’s Unadjusted Trial Balance would be as follows (page 64): Debits = Credits A Trial Balance is a list of all accounts and their balances at a particular date.
Adjusting Entries (pages 66 to 73) Prepays (page 67) Accruals (p.70-72) Estimates (p. 72-73) At the end of the period, adjusting entries are required to satisfy the realization principle and the matching principle . 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. Accountants must often make estimates in order to comply with the accrual accounting model.
Page 74: 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.
Page 76: Income statement The income statement summarizes the results of profit-generating activities of the company.
Page 77: Balance Sheet The balance sheet presents the financial position of the company on a particular date.
Page 77: Balance Sheet Notice that assets of $143,000 equals total liabilities plus shareholders’ equity of $143,000.
Page 78: Statement of Cash Flows The statement of cash flows discloses the changes in cash during a period.
Page 79: Statement of Shareholders’ Equity The statement of shareholders’ equity presents the changes in permanent shareholder accounts.
The Closing Process (page 79) Temporary Accounts Revenues Income Summary Expenses Dividends Permanent Accounts Assets Liabilities Shareholders’ Equity The closing process applies only to temporary accounts.
Conversion From Cash Basis to Accrual Basis (pages 83-85)
Read very carefully
Confirm your understanding by working through Illustration 2-14 on page 85
Appendix 2A: Use of a Worksheet A worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements.
Steps to Follow for Worksheet Completion:
Enter account titles in column A and the unadjusted account balances in columns B and C.
Determine end-of-period adjusting entries and enter them in columns E and G.
Add or deduct the effects of the adjusting entries on the account balances and enter in columns H and I.
Transfer the temporary retained earnings account balances to columns J and K.
Transfer the balances in the permanent accounts to columns L and M.
Let’s look at the completed worksheet for Dress Right.
Appendix 2C: 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. For example, 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 company’s customers purchasing goods and services on credit. After all of the postings are made from the appropriate journals, the balance in the accounts receivable control account should equal the sum of the balances in the accounts receivable subsidiary ledger accounts.
Appendix 2C: Special Journals 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:
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.
Example of a Special 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 .