Review of the Accounting Process

THE BASIC MODEL

The accounting information system is designed to collect and organize data into information that
is useful for stakeholders.

The Accounting Equation

The basic accounting equation is what drives double-entry bookkeeping. The equation reflects
the accounts reported in the balance sheet. The basic accounting equation is as follows:

ASSETS = LIABILITIES + OWNERS' EQUITY

This is a very simple algebraic equation that reflects that the assets of an entity must be
supported by either debt or equity. As in algebra if we add or subtract something from one side
of the equation we must add or subtract the same amount on the other side of the equation. For
example, if we were to increase cash (an asset) we might have to increase note payable (a
liability account) so that the basic accounting equation remains in balance.

ASSETS = LIABILITIES + OWNERS' EQUITY

$500 = $500

In accounting language an increase in an asset account is called a debit and an increase in a

liability or equity account is called credit. Likewise, if we decrease in asset account we credit
the account and on the other side of the equation we debit a liability or equity account which
reduces its balance. The normal balance in an asset account is a debit. In contrast, to keep the
accounting equation in balance the normal balance in a liability or equity account is a credit. The
accounting equation provides the foundation for what eventually becomes the balance sheet.

T-Account Analysis
In double-entry bookkeeping, the terms debit and credit are used to identify which side of the
ledger account an entry is to be made. Debits are on the left side of the ledger and Credits are
on the right side of the ledger. It does not matter what type of account is involved.

For example if we received $500 in cash as a loan from the bank, the entry would be as follows:

CASH NOTE PAYABLE

Debit Credit Debit Credit
$500 $500

The debit to cash increases the Cash Account by $500 while the credit to Note Payable increases
this liability account by the same $500.

Above, we analyzed the accounting equation in terms of assets, liabilities and owners’ equity.
These are called real or permanent accounts. By this we mean that these accounts remain open
and active for the life of the enterprise. In contrast there are accounts that reflect activities for a
specific accounting period. These are called nominal or temporary accounts.

1
Review of the Accounting Process
Using the accounting equation format we can now expand our analysis to include both real and
nominal accounts. The nominal accounts reflect an accumulation of transactions for a specific
accounting period. Each account is closed to the Retained Earnings account at the end of the
accounting period, which is an owners’ equity (stockholders’ equity) account.

Expense Accounts
Resources that are not used up currently are assets that provide resources for future accounting
periods. Resources that are used in the current accounting period are called expenses. At the
end of each accounting period expenses are closed out to the Retained Earnings Account which
decreases Owners’ Equity. Therefore, expense accounts carry a normal debit balance.

Revenue Accounts
Revenue accounts reflect the accumulation during the current accounting period of potential
additions to retained earnings. At the end of the accounting period accumulation of revenues
during the period are closed to the Retained Earnings Account which increases Owners’
Equity. Therefore revenue accounts carry a normal credit balance (the same balance as the
Retained Earnings Account).

Dividends Declared Account

Dividends declared reflect a distribution of assets to shareholders. In a sense, Cash Dividends
are similar to an expense account except that the distribution is to the owners rather than for
expenses that are required to generate revenue. Therefore the Dividends Declared Account
carries a normal debit balance.

The following provides a graphic overview with the application of the accounting equation.
Note that the accounting equation has been expanded to include the nominal accounts. The asset
and expense accounts (the left hand side of the equation) should always equal the liability, equity
and revenue accounts (the right hand side of the equation.)

REAL ACCOUNTS

Asset Accounts = Liability Accounts + Equity Accounts

Normal Balance Normal Balance Normal Balance
Debit Credit Debit Credit Debit Credit

NOMINAL ACCOUNTS

Expense Accounts Revenue Accounts

Normal Balance Normal Balance
Debit Credit Debit Credit

Example: The following are transactions that Spencer Company entered into during the month
of June.

On June 4 Spencer invests $3,000 cash in exchange for common stock Spencer Company.
On June 6 the Company purchases equipment on account for $1,100.
On June 7 the Company pays $400 to landlord for June rent.
On June 18 the Company bills Sophie Company $500 for consulting services.

Each transaction is journalized (using general journal format) as follows:

2
Review of the Accounting Process
Date Account Debit Credit
6/4/06 Cash $3,000
Common stock $3,000
To record the sale of common stock

6/6/06 Equipment $1,100

Accounts payable $1,100
To record the purchase of equipment on account

6/7/06 Rent expense $400

Cash $400
To record the payment of rent for the month of June

6/18/06 Accounts receivable $500

Service revenue $500
To record the billing for consulting services during June

As mentioned above, the nominal accounts are closed into retained earnings (equity account) at
the end of each accounting period. Using the transactions that we journalized for the month of
June, the following demonstrates how these would be reflected in the accounting equation.

ASSETS = LIABILITIES + OWNERS' EQUITY

$3,000 = $3,000
$1,100 = $1,100
($400) = ($400)
$500 = $500
$4,200 = $1,100 + $3,100

Financial Statements and Ownership Structure

In this course we will be using the corporate form of ownership. The Equity Accounts in a
corporation include Common Stock, and Retained Earnings. Common Stock reflects the amount
of capital contributed by the owners of the business entity. Retained Earnings reflects the
retention of net income less any dividends paid since the inception of the corporation.

THE ACCOUNTING CYCLE

The accounting cycle is a continuous process of accumulating, summarizing and reporting
financial information. The steps include:

Step 1-Transactions and/or Events: Identification and measurement of external transactions

and internal events.

Step 2-Journalization: Through the use of specialized journals (such as the sales journal, the
purchases journal, the cash receipts journal, the cash disbursements journal and the payroll
journal) and the general journal the transactions and events are entered into the accounting
records. These are called the books of original entry.

3
Review of the Accounting Process
Step 3-Posting: The summarized (in specialized journals) or individual transactions (in the
general journal) are then posted from the journals to the general ledger (and subsidiary ledgers).
Nothing should ever get to the ledgers without first being entered in a journal.

Step 4-Unadjusted Trial Balance: At the end of an accounting period the working trial balance
is prepared. This involves copying each account name and account balance to a worksheet
(working trial balance). The resulting first two columns of the worksheet are called the
unadjusted trial balance.

Step 5-Identify Adjusting Journal Entries for Worksheet: Using the unadjusted trial balance,
each account is analyzed to determine the accruals and deferrals that need to be recorded. Each
adjusting journal entry is recorded in the columns provided on the working trial balance.

Step 6-Adjusted (Final) Trial Balance: Each account is adjusted for any adjusting journal
entry recorded on the worksheet and the final adjusted balance is entered in the appropriate
column entitled Final Trial Balance. These amounts reflect the corrected balances in each
account that will eventually be reported in the financial statements. Once the two columns are
footed and balance the appropriate amounts are extended to the balance sheet and income
statement columns of the worksheet. Again, the columns are footed and the difference in debits
and credits for both the income statement and balance sheet sections should be identical and
should reflect the net income or loss for the period.

Step 7-Preparation of the Financial Statements: Using the information from the worksheet,
the financial statements are prepared. The income statement is prepared first so that net income
can then be recorded in the statement of retained earnings. The statement of retained earnings is
prepared next to determine the ending balance of retained earnings. Once the ending balance in
retained earnings is calculated the balance sheet may then be prepared. The statement of cash
flows is prepared last and we will learn in a subsequent lesson the worksheet approach to
preparing this statement.

Step 8-Journalize the Period End Adjusting Entries: Once the financial statements are
prepared the proposed adjusting journal entries should be posted to the general journal.

Step 9-Post the Period End Adjusting Entries: The journalized adjusting journal entries
should then be posted to the general ledger (and subsidiary ledgers). At this point the general
ledger and the final trial balance should have the same set of numbers.

Step 10-Journalize the Closing Journal Entries: The closing journal entries consist of four
sets of journal entries. All of the nominal revenue accounts should be closed to the income
summary account. Debit revenue and credit income summary. All of the nominal expense
accounts should be closed to the income summary. Credit expense and debit income summary.
The balance in the income summary account should now reflect the net income for the
accounting period. The next journal entry should close the income summary account to the
retained earnings account. If there is a net profit this entry will be a debit to income summary
and a credit to retained earnings. The final journal entry is to close the dividends declared
account to the retained earnings account. If there were dividends declared during the accounting
period this journal entry will be a credit to dividends declared and a debit to retained earnings.

4
Review of the Accounting Process
Step 11-Post the Closing Journal Entries: Once the four closing journal entries have been
entered into the general journal, the information should be posted to the general ledger. When
this is accomplished all of the nominal accounts in the general ledger should have zero balances.

Step 12-Post Closing Trial Balance: To double check on this we prepare another trial balance
based on the new balances in the general ledger. The amounts in the post closing trial balance
should be the same as the amounts in the balance sheet that was prepared in step 7. If we have
any nominal accounts with positive balances a mistake was made along the way and will need to
be corrected before proceeding to the next accounting period.

ADJUSTING ENTRIES
There are four sources of adjusting entries. Adjusting entries can result from:
‰ Expensing an asset used during the accounting period,
‰ Performing services or delivering goods to earn revenue that the customer paid for up
front,
‰ Expensing resources that were used during the accounting period but have not been paid
for, and
‰ Recognizing revenue that has not been received in cash.

Exercise: Spencer Company has a fiscal year-end of June 30th. The following adjusting journal
entries must be prepared in order to bring the accounting records up to date for the preparation of
year-end financial statements.

Interest on notes payable of $400 is accrued.

Fees earned but unbilled total $1,400.
Salaries earned by employees of $700 have not been recorded.
Bad debt expense for year is $900.

Each adjustment is journalized (using general journal format) as follows:

Date Account Debit Credit

6/30/06 Interest expense $400
Interest payable $400
To accrue interest on note payable through June 30, 2006

6/30/06 Accounts receivable $1,400

Service revenue $1,400
To record service revenue for services unbilled at year-end

6/30/06 Salaries expense $700

Salaries payable $700
To accrue salaries through June 30, 2006.

6/30/06 Bad debt expense $900

Allowance for doubtful accounts $900
To record bad debt expense for the year-ended June 30, 2006.

THE CLOSING PROCESS

5
Review of the Accounting Process
Revenue, Expense and Dividends Declared accounts are closed at the end of each accounting
period. These accounts are closed to a VERY temporary account called Income Summary.
Income Summary exists only as a collection point at the end of the period for the closing process.
The following is an example of the closing process.

Note that the balance in the Equity Accounts is $25,000. We end the year with $100,000 balance
in the asset accounts, $25,000 balance in the liability accounts, $250,000 balance in the expense
accounts and $300,000 balance in the revenue accounts. We have omitted the Dividends
Declared account in this example.

In closing the nominal accounts at year-end, the $300,000 of Revenues (credits) is closed to the
Income Summary Account {1} and the $250,000 of Expenses (debits) is closed to the Income
Summary Account {2}. The net of these two amounts (net income) is then closed to Retained
Earnings {3}. Once the nominal accounts are closed, the year-end accounting equation
represents the balance sheet on the last day of the accounting period.

Asset Accounts = Liability Accounts + Equity Accounts

Debit Credit Debit Credit Debit Credit
$100,000 $25,000 $25,000
50,000 3
$100,000 $25,000 $75,000

Expense Accounts Revenue Accounts

Debit Credit Debit Credit
$250,000 $300,000
$250,000 2 1 $300,000
$0 $0
Income Summary
Debit Credit
2 $250,000
$300,000 1
3 $50,000
$0

The Working Trial Balance

The following comprehensive example takes you through the process of preparing a working
trial balance.

Comprehensive Example:
Spencer Company has a fiscal year end of September 30th. The general ledger has the following
account balances as of September 30, 2002:

6
Review of the Accounting Process
Spencer Company
Working Trial Balance
September 30, 2002
Unadjusted Trial Balance
Account Debit Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts $200
Inventory 27,000
Prepaid insurance 450
Equipment 50,000
Accumulated depreciation 20,000
Accounts payable 10,300
Salaries payable
Payroll taxes payable
Income taxes payable
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales 120,000
Cost of goods sold 40,000
Office expense 3,550
Administrative salaries 30,000
Payroll taxes 4,500
Bad debt expense
Insurance expense 10,950
Rent 5,000
Depreciation
Income tax expense
$209,500 $209,500

In conducting an analysis of the accounts we find the following:

(1) Based on the aged accounts receivable the controller determined that the allowance for
doubtful accounts should be 3% of the balance in accounts receivable at September 31, 2002.
(2) The company has one insurance policy, which is renewed each year on July 1st. The payment
of $6,000 on July 1, 2002 was for a one-year policy that will expire on June 30, 2003.
(3) The company calculates depreciation expense using the straight-line method. The equipment
has an estimated service life of 20 years and no salvage value.
(4) Payroll is paid on the first day of each month for the previous months services. As of
September 30, 2002 the company has accrued payroll payable of $3,000.
(5) The payroll taxes associated with payroll are calculated at 15% of gross payroll.

The adjusting journal entries for each one of the above deferrals or accruals is as follows:

7
Review of the Accounting Process
Spencer Company
Proposed Adjusting Journal Entries
September 30, 2002

Account Debit Credit

(1)
Bad debt expense $760
Allowance for doubtful accounts $760

To record the allowance for doubtful accounts at 9/30/02

(2)
Prepaid insurance $4,050
Insurance expense $4,050

To record prepaid insurance for 9 months @$500 per month

(3)
Deprecation expense $2,500
Accumulated depreciation $2,500

To record deprecation for the year ended 9/30/02

(4)
Administrative salaries $3,000
Salaries payable $3,000

To record salaries payable on 9/30/02

(5)
Payroll taxes $450
Payroll taxes payable $450

To record payroll taxes on salaries payable at 9/30/02

Now that we have analyzed the accounts and prepared the proposed adjusting journal entries we
are going to enter each one to the working trial balance. Click on the audio and follow the
process of entering each proposed adjusting journal entry.

8
Review of the Accounting Process
Spencer Company
Working Trial Balance
September 30, 2002
Unadjusted Trial
Balance Adjusting Journal Entries
Account Debit Credit # Debit # Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts $200 1 $760
Inventory 27,000
Prepaid insurance 450 2 $4,050
Equipment 50,000
Accumulated depreciation 20,000 3 2,500
Accounts payable 10,300
Salaries payable 4 3,000
Payroll taxes payable 5 450
Income taxes payable 6
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales 120,000
Cost of goods sold 40,000
Office expense 3,550
Administrative salaries 30,000 4 3,000
Payroll taxes 4,500 5 450
Bad debt expense 1 760
Insurance expense 10,950 2 4,050
Rent 5,000
Depreciation 3 2,500
Income tax expense 6
$209,500 $209,500 $10,760 $10,760

Because of space limitations the following displays the adjusting journal entries that we just
entered and the final trial balance columns. The process is one of starting with the balance in the
unadjusted trial balance column, adding or subtracting the proposed adjusting journal entry and
entering the final correct balance in the adjusted trial balance columns.

9
Review of the Accounting Process
Spencer Company
Working Trial Balance
September 30, 2002
Adjusted Trial
Adjusting Journal Entries Balance
Account # Debit # Credit Debit Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts 1 $760 $960
Inventory 27,000
Prepaid insurance 2 $4,050 4,500
Equipment 50,000
Accumulated depreciation 3 2,500 22,500
Accounts payable 10,300
Salaries payable 4 3,000 3,000
Payroll taxes payable 5 450 450
Income taxes payable 6 0
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales 120,000
Cost of goods sold 40,000
Office expense 3,550
Administrative salaries 4 3,000 33,000
Payroll taxes 5 450 4,950
Bad debt expense 1 760 760
Insurance expense 2 4,050 6,900
Rent 5,000
Depreciation 3 2,500 2,500
Income tax expense 6 0
$10,760 $10,760 $216,210 $216,210

Please note that we have not entered proposed adjusting journal entry #6. We need to determine
the pre-tax income before we can calculate the income tax. To do this we will extend the
working trial balance in the manner demonstrated in your book. There are two columns for the
income statement and two columns for the balance sheet.

10
Review of the Accounting Process
Spencer Company
Working Trial Balance
September 30, 2002

Income Statement Balance Sheet

Account Debit Credit Debit Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts $960
Inventory 27,000
Prepaid insurance 4,500
Equipment 50,000
Accumulated depreciation 22,500
Accounts payable 10,300
Salaries payable 3,000
Payroll taxes payable 450
Income taxes payable 0
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales $120,000
Cost of goods sold $40,000
Office expense 3,550
Administrative salaries 33,000
Payroll taxes 4,950
Bad debt expense 760
Insurance expense 6,900
Rent 5,000
Depreciation 2,500
Income tax expense 0
96,660 120,000 119,550 96,210
23,340 23,340
$120,000 $120,000 $119,550 $119,550

Based on the extensions it appears that we have a pretax income of $23,340. The company has
an average income tax rate of 15% of taxable income. Therefore the following proposed
adjusting journal entry needs to be prepared.

Account Debit Credit

(6)
Income tax expense $3,501
Income taxes payable $3,501

To record income tax expense on $23,340 of net income

11
Review of the Accounting Process
Now that we know the current period income tax we can return to the working trial balance and
enter this last proposed adjusting journal entry.

Spencer Company
Working Trial Balance
September 30, 2002
Adjusted Trial
Adjusting Journal Entries Balance
Account # Debit # Credit Debit Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts 1 $760 $960
Inventory 27,000
Prepaid insurance 2 $4,050 4,500
Equipment 50,000
Accumulated depreciation 3 2,500 22,500
Accounts payable 10,300
Salaries payable 4 3,000 3,000
Payroll taxes payable 5 450 450
Income taxes payable 6 3,501 3,501
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales 120,000
Cost of goods sold 40,000
Office expense 3,550
Administrative salaries 4 3,000 33,000
Payroll taxes 5 450 4,950
Bad debt expense 1 760 760
Insurance expense 2 4,050 6,900
Rent 5,000
Depreciation 3 2,500 2,500
Income tax expense 6 3,501 3,501
$14,261 $14,261 $219,711 $219,711

Now that we have all of the proposed adjusting journal entries entered on the working trial
balance we can extend the final two accounts: income tax expense and income taxes payable.

The extended columns for the income statement and balance sheet will look as follows.

12
Review of the Accounting Process
Spencer Company
Working Trial Balance
September 30, 2002

Income Statement Balance Sheet

Account Debit Credit Debit Credit
Cash $6,050
Accounts receivable 32,000
Allowance for doubtful accounts $960
Inventory 27,000
Prepaid insurance 4,500
Equipment 50,000
Accumulated depreciation 22,500
Accounts payable 10,300
Salaries payable 3,000
Payroll taxes payable 450
Income taxes payable 3,501
Note payable 30,000
Common stock 20,000
Retained Earnings 9,000
Sales $120,000
Cost of goods sold $40,000
Office expense 3,550
Administrative salaries 33,000
Payroll taxes 4,950
Bad debt expense 760
Insurance expense 6,900
Rent 5,000
Depreciation 2,500
Income tax expense 3,501
100,161 120,000 119,550 99,711
19,839 19,839
$120,000 $120,000 $119,550 $119,550

Note that after making proposed adjusting journal entry #6 we have net income of $19,839. This
is the amount that will be reported in the income statement.

The following link provides a copy complete the working trial balance in Excel.

workingtrialbalance9302002

CONVERSION OF CASH TO ACCRUAL BASIS OF ACCOUNTING

Many times accountants are called upon to take a deposit book (cash receipts) and a checkbook
(cash disbursement) and convert the cash transactions for the accounting period into accrual
accounting financial statements. It is important to remember that the deposits in the deposit book
may reflect income earned in a previous accounting period and that checks written in the
13
Review of the Accounting Process
checkbook may reflect bills incurred in a previous accounting period. Therefore the first step in
converting from cash to accrual basis accounting is to determine the amounts of receipts and
disbursements that belong in the previous accounting period. Once this is accomplished then we
need to look at transactions that might have taken place in the current accounting period that
have not been converted into cash as of the end of the period.

The following is an example of a cash basis business entity that needs to prepare accrual basis
financial statements for the bank. The check book and deposit book of Spencer Company
reflects the following for the year ended December 31, 2002.

Spencer Company
Cash Basis Income
For the Year Ended December 31, 2002

Amount
Receipts $253,000
Disbursements 87,900
Cash basis income $165,100

As a result of inspecting the accounting records we discover that the company collected $9,000
in receipts that were earned in 2001 and that the company billed $14,000 for services provided in
December 2002 but not received until January 2003. The conversion of cash receipts to accrual
basis revenue should be calculated as follows:

Spencer Company
Conversion of Cash to Accrual Basis
For the Year Ended December 31, 2002

Account Amount
Revenue for services $250,000
Interest earned 3,000
Cash basis income 253,000
Subtract receipts that reflect prior year earnings (9,000)
Add earnings not yet converted into cash 14,000
Accrual basis income $258,000

The checkbook also reflects that $6,500 in payments made in 2002 are for expenses related to
2001. Looking through the office manager’s in-box we discover that there are $8,900 in unpaid
bills as of December 31, 2002. The conversion of cash disbursements to accrual basis expenses
should be calculated as follows:

14
Review of the Accounting Process
Spencer Company
Conversion of Cash to Accrual Basis
For the Year Ended December 31, 2002

Account Amount
Salaries and wages $60,000
Payroll taxes 9,000
Rent 12,000
Utilities 2,400
Transportation 3,000
Office expense 1,500
Cash basis disbursements 87,900
Subtract expenses of prior year obligations (6,500)
Add expenses for current year not yet paid 8,900
Accural basis expenses $90,300

Now that we have completed the conversion from cash basis to accrual basis for both receipts
and disbursements we can now prepare an accrual basis income statement. The following is the
income statement that would be presented to the bank.

Spencer Company
Accrual Basis Income Statement
For the Year Ended December 31, 2002

Amount
Revenue $258,000
Expenses 90,300
Net income $167,700

15