THE ACCOUNTING INFORMATION SYSTEM - wiley.com

1 CHAPTER 3 THE ACCOUNTING INFORMATION SYSTEM OVERVIEW ACCOUNTING INFORMATION must be accumulated and summarized before it can be communicated and analysed. In this chapter, we will discuss the steps involved in the ACCOUNTING cycle. We will emphasize the subject of adjusting entries. Throughout an ACCOUNTING period, cash receipts and cash disbursements are recorded. At the end of the ACCOUNTING period, adjusting entries are required so that revenues and expenses are reflected on the accrual basis of ACCOUNTING . Adjusting entries are simply entries required to bring account balances up to date.

2 The failure to record proper adjustments will cause errors on both the income statement and the balance sheet. SUMMARY OF LEARNING OBJECTIVES 1. Understand basic ACCOUNTING terminology. It is important to understand the following 11 terms: (1) Event, (2) Transaction, (3) Account, (4) Permanent and Temporary accounts, (5) Ledger, (6) Journal, (7) Posting, (8) Trial balances, (9) Adjusting entries, (10) Financial statements, and (11) Closing entries. 2. Explain double-entry rules. The left side of an account is the debit side; the right side is the credit side.

3 All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Shareholders' equity accounts, Common Shares and Retained Earnings, are increased on the credit side, whereas Dividends is increased on the debit side. 3. Identify steps in the ACCOUNTING cycle. The basic steps in the ACCOUNTING cycle are (1) identification and measurement of transactions and other events, (2) journalization, (3) posting, (4) unadjusted trial balance, (5) adjustments, (6) adjusted trial balance, (7) statement presentation, and (8) closing.

4 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. The simplest journal form is a chronological listing of transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. An unadjusted trial balance should be prepared at the end of a given period after the entries have been recorded in the journal and posted to the ledger. 5. Explain the reasons for preparing adjusting entries. Adjustments are necessary to achieve a proper matching of revenues and expenses so as to determine net income for the current period and to achieve an accurate statement of end-of-the period balances in assets, liabilities, and owners' equity accounts.

5 6. Prepare closing entries. In the closing process, all of the revenue and expense account balances (income statement items) are transferred to a clearing account called Income Summary, which is used only at the end of the fiscal year. Revenues and expenses are matched in the Income Summary account. The net result of this matching, which represents the net income or net loss for the period, is then transferred to an owners' equity account (Retained Earnings for a corporation and capital accounts for proprietorships and partnerships.)

6 3-2 Problem Solving Survival Guide for Intermediate ACCOUNTING , 6th Canadian Edition _____ 7. Explain how inventory accounts are adjusted at year-end. Under a perpetual inventory SYSTEM , the balance in the Inventory account at the end of the period should represent the ending inventory amount. When the inventory records are maintained on a periodic inventory SYSTEM , a Purchases account is used; the Inventory account is unchanged during the period. The Inventory account represents the beginning inventory amount throughout the period. At the end of the ACCOUNTING period, the Inventory account must be adjusted by closing-out the beginning inventory amount and recording the ending inventory amount.

7 8. Prepare a 10-column work sheet. The 10-column work sheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. The work sheet does not replace the financial statements. Instead, it is the accountant's informal device for accumulating and sorting INFORMATION needed for the financial statements. *9. Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses. Prepayments may also be reversed if the initial entry to record the transaction is made to an expense or revenue account.

8 *10. Differentiate the cash basis of ACCOUNTING from the accrual basis of ACCOUNTING . Accrual basis ACCOUNTING provides INFORMATION about cash inflows and outflows associated with earnings activities as soon as these cash flows can be estimated with an acceptable degree of certainty. That is, accrual basis ACCOUNTING aids in predicting future cash flows by reporting transactions and events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid. *This material is covered in an Appendix in the text. TIPS ON CHAPTER TOPICS TIP: This chapter is an extremely important one.

9 A good understanding of this chapter and an ability to think and work quickly with the concepts incorporated herein are necessary for comprehending subsequent chapters. Although adjusting entries were introduced in your principles course, you are likely to discover new dimensions to this subject in your intermediate ACCOUNTING course. Pay close attention when studying this chapter! TIP: When you encounter a transaction, always analyse it in terms of its effects on the elements of the basic ACCOUNTING equation (or balance sheet equation). For your analysis to be complete, it must maintain balance in the basic ACCOUNTING equation.

10 The basic ACCOUNTING equation is as follows: ASSETS = LIABILITIES + OWNERS' EQUITY or A = L + OE Assets are economic resources. Liabilities and owners' equity are sources of resources; liabilities are creditor sources, and owners' equity represents owner sources (owner investments and undistributed profits). The basic ACCOUNTING equation simply states that the total assets (resources) at a point in time equal the total liabilities plus total owners' equity (sources of resources) at the same point in time. The ACCOUNTING INFORMATION SYSTEM 3-3 _____ TIP: An understanding of the following terms is important.