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.
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.
Prepaid expenses represent assets recorded when a cash disbursement creates benefits beyond the current reporting period. Common prepaid expenses include payments for rent, insurance, and supplies. For example, a company may pay $60,000 for rent for the next 6 months. In this case, the cash payment precedes the expense recognition. The entry at the payment date is a debit to the asset, Prepaid Rent, and a credit to Cash. At the end of the period, an adjusting entry is required to record the amount of rent used during the period. The adjusting entry required in this example would be a debit to Rent Expense and a credit to Prepaid Rent for the amount of the rent used during the period.
Depreciation is the process of allocating the cost of plant and equipment over their expected useful lives. The adjusting entry for depreciation is a specific type of a prepayment adjusting entry. Straight-line depreciation is calculated as asset cost minus salvage value divided by the useful life.
Recall the Furniture and Fixtures for $12,000 that was listed on Dress Right’s unadjusted trial balance. Assume the following: the asset cost is $12,000, no salvage value, and a useful life of sixty months. Let’s calculate the depreciation expense for the month ended July 31, 2011.
The depreciation expense for one month is $200. It is calculated as $12,000 divided by 60 months. The depreciation journal entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation—Furniture and Fixtures for $200. Accumulated Depreciation is a contra asset account to the asset account Furniture and Fixtures. The normal balance in a contra asset account will be a credit, that is, “contra,” or opposite, to the normal debit balance in an asset account.
Unearned revenues are created when a company receives cash from customers in one period for goods or services that are to be provided in a future period. Unearned revenues represent liabilities for the company receiving the cash to provide either a good or service in the future. For example, if you pay $500 for season tickets to all home basketball games, the school is in debt for services to you. They must provide $500 of basketball games during the season for you to attend. The entry the school would record is a debit to Cash and a credit to Unearned Revenue for $500. At the end of the period, an adjusting entry is required to record the amount of revenue earned during the period. The adjusting entry required in this example would be a debit to Unearned Revenue and a credit to Revenue for the amount of the games provided during the period.
A third classification of adjusting entries is estimates. Accountants often must make estimates of future events to comply with the accrual accounting model. Examples of estimates include the calculation of depreciation expense and the calculation of bad debt expense.
Assume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, only $1,500 will ultimately be collected. The adjusting entry for July 31, to record this information is a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts for $500. The Allowance for Uncollectible Accounts is a contra asset account related to Accounts Receivable. In the balance sheet, Accounts Receivable is shown net of the allowance account.
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.
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.
After the closing entries are posted to the ledger accounts, a post-closing trial balance is prepared. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctly and that the accounts are now ready for next year’s transactions.
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. Other columns capture information needed for updating the accounts receivable subsidiary ledger. The total of all the transactions in the sales journal is posted to the Accounts Receivable control account and to the Sales Revenue account. Each individual transaction is also posted to the Accounts Receivable subsidiary ledger for each customer.
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.
The 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
The Accounting Processing Cycle <ul><li>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. </li></ul><ul><li>Two accounts are affected: </li></ul><ul><ul><li>Cash (an asset) increases by $60,000. </li></ul></ul><ul><ul><li>Common stock (a shareholders’ equity) increases by $60,000. </li></ul></ul>July 1 Cash 60,000 Common stock 60,000
Adjusting Entries Prepayments Accruals Estimates 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.
Prepaid Expenses Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment Today, I will pay for my first 6 months’ rent. Prepaid Expenses Items paid for in advance of receiving their benefits
Depreciation <ul><li>Depreciation is the process of allocating the cost of plant and equipment over their expected useful lives. </li></ul>Straight-Line Depreciation = Asset Cost - Salvage Value Useful Life
Depreciation Recall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance. Assume the following: Let’s calculate the depreciation expense for the month ended July 31, 2011.
Depreciation July Depreciation Expense = $12,000 - $0 60 months = $200 per month Recall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance. July 31 Depreciation expense 200 Accumulated depreciation- furniture and fixtures 200
Unearned Revenues Liability Revenue Unadjusted Balance Credit Adjustment Debit Adjustment “ Go Big Red” Buy your season tickets for all home basketball games NOW! Unearned Revenue Cash received in advance of performing services
Estimates <ul><li>Examples </li></ul><ul><ul><li>Depreciation </li></ul></ul><ul><ul><li>Uncollectible accounts </li></ul></ul>$ Accountants often must make estimates of future events to comply with the accrual accounting model.
Estimates Assume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, only $1,500 will ultimately be collected. Prepare the adjusting entry for July 31. July 31 Bad debt expense 500 Allowance for uncollectible accounts 500
The Income Statement The income statement summarizes the results of profit-generating activities of the company.
The Balance Sheet The balance sheet presents the financial position of the company on a particular date.
The Balance Sheet Notice that assets of $143,000 equals total liabilities plus shareholders’ equity of $143,000.
The Statement of Shareholders’ Equity The statement of shareholders’ equity presents the changes in permanent shareholder accounts.
The Closing Process Temporary Accounts Revenues Income Summary Expenses Dividends Permanent Accounts Assets Liabilities Shareholders’ Equity The closing process applies only to temporary accounts.
Post-Closing Trial Balance Lists permanent accounts and their balances. Total debits equal total credits.
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. Other columns capture information needed for updating the 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.