TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 3 CHAPTER 3 The Accounting

TENTH CANADIAN EDITION

INTERMEDIATE ACCOUNTING

Prepared by:

Dragan Stojanovic, CARotman School of Management,

University of Toronto

CHAPTER 3The Accounting

Information System

Kieso • Weygandt • Warfield • Young • Wiecek • McConomy

CHAPTER

LEARNING OBJECTIVES:

3:

After studying this chapter, you should be able to:• Understand basic accounting terminology.• Explain double-entry rules.• Explain how transactions affect the accounting equation.• Identify the steps in the accounting cycle and the steps in the recording

process.• Explain the reasons for and prepare adjusting entries.• Explain how the type of ownership structure affects the financial statements.• Prepare closing entries and consider other matters relating to the closing

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

After studying Appendix 3A, you should be able to:• Identify adjusting entries that may be reversed.

Copyright © John Wiley & Sons Canada, Ltd.

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THE ACCOUNTING INFORMATION SYSTEM

The Accounting Information System

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Accounting Information System

• Basic terminology

• Debits and credits

• Accounting equation

Using a Worksheet

• Adjustments entered

• Work sheet columns

• Preparing financial statements from a work sheet

• Closing entries

• Monthly statements, yearly closing

Accounting Cycle and the Recording Process• Identifying

and recording transactions and other events

• Journalizing

• Posting

• Trial balance

• Adjusting entries

Appendix 3A-Using Reversing Entries

• Accruals

• Prepayments

• Summary of reversing entries


Adjusting Entries

• Adjusting entries for prepayments

• Adjusting entries for accruals

• Adjusting entries for estimated items

Financial Statements and Ownership Structure

Closing Process

• Preparing closing entries

• Reversing entries

• The accounting cycle summarized

Basic Terminology

• Event: The cause of changes of assets, liabilities, and equity

• Transaction: A transfer or exchange between two or more entities or parties

• Account: Where transactions are recorded– A separate account is used for each asset,

liability, revenue, expense, gain, loss and capital (owner’s equity)

4Copyright © John Wiley & Sons Canada, Ltd.

Basic Terminology

Permanent accounts (or “real” accounts)• Asset, liability, and equity accounts• Appear on the balance sheet• Permanent accounts are not closed at year end

Temporary accounts (or “nominal” accounts)• Revenue, expense, and dividend accounts• Revenue and expenses are on the income

statement; dividends are on the statement of changes in shareholders equity.

• Temporary accounts are closed at year end


Basic Terminology

Journalizing and Posting• A Journal is a book of original entry for all

transactions• The General Journal is a chronological listing of

transactions expressed as debits and credits to particular accounts (known as a journal entries)

• Special Journals are used to summarize transactions with common characteristics (e.g. cash receipts, sales, purchases)

• Posting: when the transaction information entered in the journal is transferred to the ledger accounts


Basic Terminology

Ledger• Book (or electronic database) containing all

accounts• Each account has a separate page• General ledger contains all asset, liability, and

all equity related accounts (capital, revenue, and expenses)

• Subsidiary ledger contains details related to a specific general ledger account (example: accounts receivable subsidiary ledger)


Basic Terminology

Trial balance• Listing of all accounts and their balances from

the general ledger at a given point in time• Objective: prove the mathematical equality of

debits and credits after posting (i.e. to ensure general ledger is in balance)

• Typically prepared after end of period adjustments (called Adjusted Trial Balance) and possibly after closing entries (called Post-closing Trial Balance)


Basic Terminology

Adjusting entries• Entries made at the end of an accounting period• Brings all accounts up to date on an accrual

accounting basis• Seven classifications of adjusting entries:

Prepayment AccrualsEstimated Items

1. Prepaid Expenses 3. Accrued Revenues 5. Bad Debts

2. Unearned Revenues 4. Accrued Expenses 6. Unrealized Holding

Gain or Loss

7. Unrealized Holding

Gain or Loss - OCI


Basic Terminology

Financial statements• Final summaries of the accounting data for a

specific time period• Four statements:

• Statement of Financial Position (or Balance Sheet under ASPE) - shows financial condition at a specific date

• Statement of Comprehensive Income (or Income Statement under ASPE) - measures the results of operations during a period of time

• Statement of Cash Flows - shows sources and uses of cash

• Statement of Changes in Shareholders’ Equity (Statement of Retained Earnings under ASPE) 10Copyright © John Wiley & Sons Canada,

Ltd.

Debits and Credits

Debit (Dr.)To record or enter anamount on the left sideof a general ledgeraccount

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Credit (Cr.)To record or enter anamount on the right sideof a general ledgeraccount

• This system of recording transactions is referred to as the double-entry accounting system; the two-sided effect of each transaction is recorded in appropriate accounts

• When a transaction is “in balance”, the debits equal the credits

• Debits and credits do not mean “increases” and “decreases” Copyright © John Wiley & Sons Canada,

Ltd.

The Accounting Equation

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Assets = Liabilities + Shareholders’ Equity*

*Shareholder’s Equity = Common Shares + Retained Earnings – Dividends + Revenues -

Expenses

Assets = Liabilities + Common Shares + Retained Earnings – Dividends + Revenues - Expenses


The Rules of Debit and Credit

• To increase the balance of any account, record the amount in the normal balance column

• To decrease the balance of any account, record the amount in the column opposite to its normal balance

• When any transaction is correctly recorded, the accounting equation will remain in balance


The Rules of Debit and Credit

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DecreaseIncreaseExpenses

IncreaseDecreaseRevenue

IncreaseDecreaseShareholders’ Equity

IncreaseDecreaseLiabilities

DecreaseIncreaseAssets

CreditDebitAccount


The Accounting Cycle: Steps

1. Analyse the transaction2. Journalize the transaction3. Post the transaction to general ledger (and sub-

ledgers) accounts4. Prepare the (unadjusted) trial balance5. Prepare necessary adjusting journal entries6. Prepare the (adjusted) trial balance7. Prepare financial statements8. Prepare closing journal entries for the year9. Prepare post-closing trial balance (optional)10. Prepare reversing entries (optional)


Recording a Transaction:Shares are issued for $3,000 cash

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Assets = Liabilities + Shareholders’ Equity

+ $3,000 + $3,000

To record this transaction as a journal entry (in General Journal):

Dr. Cash $3,000

Cr. Common Shares $3,000

These amounts are then posted to the general ledger

Cash Common Shares

3,000 3,000



Preparation of Trial Balance

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PIONEER ADVERTISING AGENCY INC. at October 31, 2014

Cash

80,000

Revenue

100,000

Dividends

5,000

Notes Payable

50,000

Account DebitCredit

Cash 80,000Accounts Receivable 72,000Advertising Supplies 25,000Prepaid Insurance 6,000Fair Value Investments 10,000Office Equipment 50,000Notes Payable 50,000Accounts Payable 35,000Unearned Service Revenue 12,000Common Shares 100,000Dividends 5,000Service Revenue 100,000Salaries Expense 40,000Rent Expense 9,000TOTALS 297,000 297,000

Preparation of Trial Balance

• From the previous example, we can see that the trial balance is “in balance”

• However, the trial balance only proves the mathematical accuracy of the ledger

• Errors may still exist such as the following:1. Transaction not journalized2. Correct journal entry not posted3. Journal entry posted twice4. Incorrect accounts used in either the journal

entry or posting5. Offsetting errors made during recording


Adjusting Journal Entries

• Adjusting entries ensure that revenue recognition and matching are followed within the period

• Reasons for adjusting entries include:– To record those events that are not journalized

daily

– To record those costs, which expire with time and are therefore not recorded

– To record item previously unrecorded

• Adjusting entries are required each time financial statements are prepared


Adjusting Entries for Prepayments

• Prepaid Expenses– Prepayments made in cash and recorded as

assets before item is used

• Unearned Revenues– Revenue received in cash and recorded as

liabilities before being earned


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• Prepaid expenses expire either with the passage of time (e.g. rent and insurance) or by being used and consumed (e.g. supplies)

• Example: Company paid $6,000 for one year insurance when coverage begins October 1 and debited Prepaid Insurance for $6,000.

• Adjust Prepaid Insurance on Dec. 31:Dr Insurance Expense 1,500

Cr Prepaid Insurance 1,500

($6,000/12 * 3)21Copyright © John Wiley & Sons Canada,

Ltd.


• When payment is received from customers for services (or goods) that will be provided in a future accounting period, a liability (unearned revenue) is recognized

• e.g. Rent, magazine subscriptions, deposits

• Example: Company received $12,000 for four months’ advertising services that begins Oct. 1. $12,000 was credited to unearned revenue

• Adjustment required on December 31:

Dr Unearned Revenue 9,000

Cr Service Revenue 9,000

($12,000/4 * 3)


Adjusting Entries for Accruals

• Accrued Revenues– Revenues earned but not yet received in

cash and not recorded

• Accrued Expenses– Expenses incurred but not yet paid in cash

and not recorded


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Adjusting Journal Entries

• Expenses must be accrued when they are incurred; also revenues must be recorded as earned

• Accruals required: interest expense, salaries expense, bad debts expense, interest earned

• Example: assume on January 5, a company pays $20,000 for salaries which includes $10,000 of salaries for December

• Adjustment required on December 31: Dr Salaries Expense 10,000

Cr Salaries Payable 10,00024Copyright © John Wiley & Sons Canada,

Ltd.

Adjusting Entries for Estimated Items

• Bad Debts– Expenses relating to impaired accounts receivable

estimated in the period and relating to revenue that has been earned

• Investments – Fair Value Adjustments– For certain categories of investments, an

unrealized gain or loss must be recorded in the statement of comprehensive income

– Adjustment made either through: • Net Income, or• Other Comprehensive Income


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Closing Entries

• Closing entries are made to close all nominal accounts (revenue and expense accounts) for the year

• The balances in these accounts are transferred to a clearing account (Income Summary)

• The balance in Income Summary represents net income or net loss for the period

• Real (or permanent) accounts are not closed• The Dividends account is closed to retained

earnings28Copyright © John Wiley & Sons Canada,

Ltd.

Closing Entries

The following closing entries are made (assume net income and other comprehensive income for the year):

1. Income Summary $$$

Expense Accounts (individually) $$$

2. Revenue Accounts (individually) $$$

Income Summary $$$

3. Income Summary $$$

Retained Earnings $$$

4. Retained Earnings $$$

Dividends $$$

5. OCI Accounts (individually) $$$

Accumulated OCI $$$


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Retained Earnings: Closing Entries

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4 3

1 2

Income Summary

Ret. Earnings

Dividends

Expense Revenue


Closing Entries: Inventory

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• In a periodic inventory system, closing entries are made to record cost of goods sold and ending inventory

• In a perpetual inventory system, such entries are not required


Periodic Inventory: Closing Entry

Collegiate Apparel Shop has the following balances at year end. The company uses a periodic inventory system.

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Beginning Inventory $ 30,000

Purchases (gross) $200,000

Transportation-In $ 6,000

Purchases Returns $ 1,000

Purchase Discounts $ 3,000

Ending Inventory $ 26,000



First Step: Determine Cost of Goods Sold

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Beginning Inventory $ 30,000

Purchases $200,000

Less: Purchase returns $1,000

Purchase discounts 3,000 4,000

Net Purchases 196,000

Plus: Transportation-In 6,000

Cost of Goods Purchased 202,000

Cost of Goods Available for Sale 232,000

Less: Ending Inventory 26,000

Cost of Goods Sold $206,000Copyright © John Wiley & Sons Canada,

Ltd.


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Cost of Goods SoldInventory (Ending) Purchases ReturnsPurchase Discounts

$ 206,000$ 26,000$ 1,000$ 3,000

Purchases (Gross) Transportation-in Inventory (Beginning)

$ 200,000$ 6,000$ 30,000

Account Dr. Cr.


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TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 3 CHAPTER 3 The Accounting