Review of the Accounting Process

1. Review of the Accounting Process Chapter 2 © 2009 The McGraw-Hill Companies, Inc. Chapter 2: Review of the Accounting ProcessChapter 2: Review of the Accounting Process

2. Account Relationships Part I 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. Part II 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. Part III 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. Part I 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. Part II 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. Part III 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.

3. 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). 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).

4. Accounting Processing Cycle On January 1, $40,000 was borrowed from a bank and a note payable was signed. Part I On January 1, $40,000 was borrowed from a bank and a note payable was signed. Two accounts are affected: Cash, an asset account, increases and Notes Payable, a liability account, increases. Let’s prepare the journal entry. Part II The journal entry to record this transaction is a debit to the Cash account and a credit to the Notes Payable account. Part I On January 1, $40,000 was borrowed from a bank and a note payable was signed. Two accounts are affected: Cash, an asset account, increases and Notes Payable, a liability account, increases. Let’s prepare the journal entry. Part II The journal entry to record this transaction is a debit to the Cash account and a credit to the Notes Payable account.

5. At the end of the period, some transactions or events remain unrecorded. Because of this, several accounts in the ledger need adjustments before their balances appear in 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.At the end of the period, some transactions or events remain unrecorded. Because of this, several accounts in the ledger need adjustments before their balances appear in 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.

6. The income statement is a change statement that summarizes the profit-generating transactions that caused shareholders’ equity (retained earnings) to change during the period.The income statement is a change statement that summarizes the profit-generating transactions that caused shareholders’ equity (retained earnings) to change during the period.

7. The balance sheet is a position statement that presents an organized list of assets, liabilities, and equity at a particular point in time. Here is the asset section of Dress Right’s balance sheet.The balance sheet is a position statement that presents an organized list of assets, liabilities, and equity at a particular point in time. Here is the asset section of Dress Right’s balance sheet.

8. Here is the liabilities and shareholders’ equity section of Dress Right’s balance sheet. Notice that the basic accounting equation was in balance: assets equal liabilities plus equity.Here is the liabilities and shareholders’ equity section of Dress Right’s balance sheet. Notice that the basic accounting equation was in balance: assets equal liabilities plus equity.

9. The purpose of the statement of cash flows is to summarize the transactions that caused cash to change during the period. This statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. We will discuss this statement more in future chapters.The purpose of the statement of cash flows is to summarize the transactions that caused cash to change during the period. This statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. We will discuss this statement more in future chapters.

10. The statement of shareholders’ equity discloses the sources of changes in the permanent shareholders’ equity accounts. The statement of shareholders’ equity discloses the sources of changes in the permanent shareholders’ equity accounts.

11. Temporary and Permanent Accounts 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. 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.

12. Post-Closing Trial Balance 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.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.

13. End of Chapter 2 © 2008 The McGraw-Hill Companies, Inc. End of chapter 2.End of chapter 2.