Appendix C: The Accounting Information System

Learning Objectives

  • Understand basic accounting terminology, double-entry rules, and the accounting equation.

  • Identify the steps in the accounting cycle and the recording process.

  • Explain the reasons for, and prepare, adjusting entries.

  • Explain how the type of ownership structure affects financial statements.

  • Prepare closing entries and consider matters relating to the closing process.

  • Prepare a 10-column work sheet and financial statements.

Overview of Accounting Information System

  • Definition: A system for collecting and processing transaction data to make financial information available to interested parties.

Financial Statements

  1. Statement of Financial Position (Balance Sheet under ASPE)

  2. Statement of Comprehensive Income (Income Statement under ASPE)

  3. Statement of Changes in Shareholders' Equity

  4. Statement of Cash Flows (Cash Flow Statement under ASPE)

Double-Entry Accounting

  • Key Principle: Debits = Credits

  • Every transaction recorded must maintain this equality.

  • The sum of all debits posted must equal the sum of all credits posted.

The Accounting Equation

  • Foundation of double-entry accounting.

Expanded Accounting Equation

  • Reflects changes in various elements while maintaining basic equality between the two sides.

The Accounting Cycle and Recording Process

Step 1: Identifying and Analyzing Transactions

  • Determine what to record and which accounting elements are affected.

  • Not all changes (e.g., personnel changes) are recorded; only measurable items that meet the definition of an element are included.

  • In case of uncertainty, use available information for a neutral decision.

Step 2: Journalizing

  • Record transactions as journal entries in chronological order using debits and credits.

  • Use special journals for summarizing certain types of transactions.

  • Transfer journal entries to the general ledger.

Step 3: Posting to the General Ledger

  • A ledger summarizes classified journal entries.

  • Contains separate pages for each asset, liability, and equity-related account, numbered in order.

Step 4: Preparing the Trial Balance

  • A trial balance lists account balances at a specific time (usually end of accounting period).

  • Its main purpose is to prove the equality of debits and credits.

Step 5: Adjusting Entries

  • Purpose: To ensure revenues/expenses are recorded in the correct period (Matching Principle).

  • Required every time financial statements are prepared.

  • Types of adjustments:

    • Prepayments

    • Accruals

    • Estimated items

Prepaid Expenses

  • Paid in cash and recorded as assets, expiring over time or with usage.

  • Adjusting entry involves debiting an expense account and crediting a prepaid asset account.

Unearned Revenues

  • Cash received in advance of earning revenue, recorded as liability until earned.

  • Adjusting entry records revenue as earned, affecting liability and revenue accounts.

Accrued Revenues

  • Earned but not yet received in cash; involves adjusting for assets (Receivables) and revenues at period end.

Accrued Expenses

  • Incurred but not yet paid or recorded; adjustments involve debit to expense and credit to liability (Payables).

Estimating Items: Bad Debts

  • Estimation of uncollectible revenue recorded as an expense in the period earned, following the matching principle.

Estimating Items: Unrealized Gains and Losses

  • Fair value evaluations of investments to record unrealized gains/losses in financial statements.

Step 6: Adjusted Trial Balance

  • Prepared after adjusting entries, providing a basis for financial statement preparation.

Step 7: Statement Preparation

For Proprietorship or Partnership

  • Owners’ capital and drawings netted together as Owners’ Equity.

For Corporation

  • Prepare:

    • Statement of Comprehensive Income

    • Statement of Financial Position

    • Statement of Changes in Equity

Step 8: The Closing Process

  • Close balances in revenue and expense accounts to Income Summary; transfer net income/loss to retained earnings.

  • Ensure dividends and other comprehensive income are addressed correctly.

Step 9: Post-Closing Trial Balance

  • Taken after closing entries verify equal debits and credits exist for permanent accounts only.

Step 10: Reversing Entries

  • Some companies reverse adjusting entries to simplify recording transactions in the next period, primarily for accrued revenues and expenses.

Using a Work Sheet

Structure of a Work Sheet

  • A 10-column spreadsheet for adjusting account balances and preparing financial statements:

    • Trial balance

    • Adjustments

    • Adjusted trial balance

    • Statement of Comprehensive Income

    • Statement of Financial Position

Totaling and Balancing

  • Ensure accurate entries to balance debit and credit columns, facilitating correct financial statements preparation without ledger reference.