Chapter 3 Lecture Notes
Review of the Accounting Process
I. Procedures Employed in Accounting
A. .In the first two chapters we discussed the set of concepts used by accountants for
1.identifying
2.recording
3.classifying
4.and interpreting
transactions and other events relating to enterprises.
B. In this chapter we review some basic accounting terminology
1.An event is a happening of consequence.
2.A transaction is an external event.
3.An account is a systematic arrangement that shows the effect of an event on a specific a, l, or oe. A separate account is kept for each a, l, oe, r, or e.
4.Real and Nominal Accounts
a. Real accounts are permanent accounts
(1) include the three balance sheet account types
(a)assets
(b)liabilities
(c)and owners' equity
(2)The balances of real accounts are carried forward from the end of one period to the beginning of the next.
b. Nominal accounts are temporary accounts
(1) include the four income statement account types
(a) revenues
(b) expenses
(C) gains and
(D) losses
(2) There is another nominal account, one which keeps track of the amount of equity which the firm's owners have withdrawn from the firm this period.
(a)In the case of
i)sole proprietorships
ii)and partnerships
(b)this account is called the drawing account
(c)In the case of corporations, this account is called dividends.
c.Nominal accounts are closed at the end of the period.
5.A ledger is a book of accounts
a.The general ledger contains all of the accounts
b.A subsidiary ledger provides detail about one specific general ledger account.
6.The journal is the book of original entry.
7.Posting is the process of transferring information from the journal to the ledger.
8.The trial balance is a list of all open accounts in the ledger and their balances.
a.If the trial balance is prepared immediately after the adjusting entries have been made, it is called an adjusted trial balance.
b.If the trial balance is prepared immediately after the closing entries have been posted, it is called a post-closing trial balance.
9.Adjusting entries are made at the end of an accounting period to bring all accounts up to date on an accrual basis.
10.Financial statements reflect the collection, tabulation, and final summarization of the accounting data. There are 4 financial statements
a.The balance sheet which shows the financial condition of the enterprise at the end of a period
b.The income statement which measure the results of operations for the period
c.The statement of cash flows which reports the cash provided and used by operating, investing, and financing activities during the period AND
d.The statement of retained earnings, which reconciles the balance of the retained earnings account from the beginning to the end of the period.
11.Closing is the formal process by which all nominal accounts are reduced to zero and the net income or net loss is determined and transferred to owner's equity.
II. The double-entry accounting recording process
A.The process was first formalized by Luca Paciolo in 1494.
B.Debits and credits
1.The left hand side of an account is the debit side.
2.The right hand side of an account is the credit side.
C.Put framework up on board- stress 3 RULES!
D.Every transaction or event must impact at least two accounts
E.Total debits must equal total credits both for the individual transaction or event and for the sum of all transactions and events.
F.The accounting equation A=L+OE must always be in balance.
G.Revenues and expenses are elements of owner's equity
1.Revenues increase owners equity
2.Expenses decrease owners equity
A.First a transaction (or other event) is identified and measured
1.What are we looking for? According to theory an item should be recognized in the financial statements if it is an element, measurable, and is relevant and reliable.
2.Identification usually is facilitated by a source document
a.such as a sales receipt
b.an invoice
c.or a time card
3.Measurement is usually acquisition cost, a valuation which is both
a.objective
b.and verifiable
B.The transaction is then booked in the general journal or in one of the special purpose journals. A journal entry has
1.Accounts and amounts debited
2.Accounts and amounts credited
3.A date
4.and an explanation
5.Finally the post reference is filled in when the entry is posted.
C.The information is posted from the journal to the ledgers.
1.The author uses T accounts to represent the ledger.
2.Posting to the general ledger is usually done on a monthly basis
3.Posting to the subsidiary ledgers is usually done on a daily basis.
D.A trial balance
1.is prepared to test the equality of debits and credits.
2 The trial balance also constitutes the first two columns of the ten column worksheet. See page 109.
E.Adjustments are made for accruals, deferrals and estimated items. Adjustments are usually made directly on the ten column worksheet. Only after the preparation of the financial statements are the adjusting entries journalized.
1.Accruals include both
a. accrued liabilities or expenses such as unpaid salaries
b.and accrued assets or revenues such as interest earned but not collected.
2.Deferrals include both
a.prepaid expenses such as prepaid insurance
b.and unearned revenues such as magazine subscription revenues.
3.Estimated items would include things such as
a. depreciation
b. and estimated bad debt expense.
F.An adjusted trial balance is prepared, usually on the worksheet.
1.No adjustment need be made for inventory at the end of the period if the perpetual inventory system is used.
2.If the periodic inventory system is used
a.Treat the beginning Inventory as an expense
b.and the ending inventory as a revenue
c.and handle purchases and freight in as expenses.
3.Look at the worksheet
a.Note we sum each pair of columns before we move to the next pair
b.We do not expect the income statement pair of columns to balance.
c.The period's net income must be added to the credit column of the balance sheet before that pair of columns will balance.
G.The four financial statements are prepared directly from the worksheet.
H.The nominal accounts are closed. There are four closing entries in service firms.
1. Revenues are closed into income summary
2. The expenses are closed into income summary
3. Income summary is closed into retained earnings
4. Dividends is closed into retained earnings.
I.A post closing trial balance is prepared to test the equality of debits and credits after closing.
J.And lastly reversing entries are made.
1.Reversing entries are always optional
2.The goal of reversing entries is to simplify the bookkeeping further down the line.
3.A reversing entry is the reversal of an adjusting entry, but only certain adjusting entries may be reversed.
a.Any adjusting entry which gave rise to an accrual, that is to a payable or a receivable may be reversed.
b.Only certain adjusting entries related to deferrals may be reversed.
(1)The adjusting entry for an unearned revenue can be reversed, if that item were initially recorded as a revenue and not as a liability. (liability method vs. revenue method)
(2)The adjusting entry for a prepaid expense can be reversed, if that item were initially recorded as an expense and not as an asset. (Asset method vs. expense method).
IV. Appendix 3-A: Cash Basis Accounting Versus Accrual Basis Accounting
A. GAAP requires the use of accrual basis accounting which means revenues are recognized when earned and expenses are recognized when incurred.
B. Not all firms are required to use GAAP however. Only firms whose securities trade on the open market.
C. All firms are required to keep income tax records. This system is primarily a cash based system. Therefore, firms which are not on GAAP basis for financial accounting will probably use some form of cash based accounting.
1. Over the long run the cash basis measurement of income gives the same measure as the accrual basis. But over the short run the two systems give quite different measures.
2. Since a cash based system does not recognize receivables or payables, the balance sheet of a cash based system will differ from that of an accrual based system over the short run.
D. Conversion from cash to accrual basis
1.As small firms which had been using cash basis grow, they eventually have to switch over to accrual basis either
a.To please the bankers so they can get a loan
b.or because they want to issue securities to raise capital.
2.You the accountant will then be called upon to facilitate the switch.
E. Cash flows are relevant when evaluating the liquidity of the firm, therefore we do require the presentation of a statement of cash flows. As previously mentioned accrual based statements do a better job at predicting future cash flows than do cash based statements. This is because it is too easy to manipulate the measures when the cash basis is used.