Chapter two

Summary of the Accounting process

2.1. Identifying and journalizing transactions and other events
The accounting process or cycle is a complete sequence of accounting procedures that are
repeated in the same order during each accounting period. A typical manual system includes the
following steps:

Recording business transactions and other events in the journals.

Classifying data by posting from the journals to the ledger.
Summarizing data from the ledger in an unadjusted trial balance.
Adjusting, correcting, and updating recorded data; completion of the work sheet.
Summarizing adjusted and corrected work sheet data in the form of financial statements.
Closing the accounting records (nominal accounts) to summarize the operations of the
accounting period.
Preparation of a post - closing trial balance.
Reversing certain adjusting entries to facilitate the recording process in the subsequent
accounting period.
The recording process begins with the transaction. Business documents, such as a sales slip, a
check, a bill, or a cash register tape, provide evidence of the transaction. Transactions and other
events and circumstances are the sources or causes of changes in an entity’s assets, liabilities,
and equity. The purpose of transaction analysis is first to identify the type of account involved,
and then to determine whether to make a debit or a credit to the account. This type of analysis is
always made before preparing a journal entry.

Events are of two types:

External events: involve interaction between an entity and its environment, such as a
transaction with another entity, a change in the price of a good or service that an entity
buys or sells, a flood or earthquake, or an improvement in technology by a competitor.
Internal events: occur within an entity, such as using buildings and machinery in
operations, or transferring or consuming raw materials in production processes.
Transactions are types of external events. They are an exchange between two entities where each
receives and sacrifices value, such as purchases and sales of goods or services. In short, a
company records as many events as possible that affect its financial position

Journalizing business transactions and other events

Companies initially record transactions in chronological order (the order in which they occur).
Thus, the journal is referred to as the book of original entry. For each transaction the journal
shows the debit and credit effects on specific accounts. Companies may use various kinds of
journals, but every company has the most basic form of journal, a general journal. Entering
transaction data in the journal is known as journalizing. In its simplest form, a general journal
chronologically lists transactions and other events, expressed in terms of debits and credits to
accounts.

Each general journal entry consists of four parts:

 The accounts and amounts to be debited (Dr.),

 The accounts and amounts to be credited (Cr.),
 A date, and
 An explanation.

A company enters debits first, followed by the credits (slightly indented). The explanation begins
below the name of the last account to be credited and may take one or more lines. A company
completes the “Ref.” column at the time it posts the accounts. In some cases, a company uses
special journals in addition to the general journal. Special journals summarize transactions
possessing a common characteristic (e.g., cash receipts, sales, purchases, cash payments). As a
result, using them reduces bookkeeping time.

Posting transactions and other events

The entire group of accounts maintained by a company is the ledger. The ledger keeps in one
place all the information about changes in specific account balances. Companies may use various
kinds of ledgers, but every company has a general ledger. Transferring journal entries to the
ledger accounts is called posting. This phase of the recording process accumulates the effects of
journalized transactions into the individual accounts. Companies arrange the ledger in the
sequence in which they present the accounts in the financial statements, beginning with the
balance sheet accounts. Each account is numbered for easier identification. The ledger provides
the balance in each of the accounts.

Posting involves the following steps:

 In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal
page, and debit amount shown in the journal.
 In the reference column of the journal, write the account number to which the debit
amount was posted.
 In the ledger, in the appropriate columns of the account(s) credited, enter the date, journal
page, and credit amount shown in the journal.
 In the reference column of the journal, write the account number to which the credit
amount was posted.

For simplicity, we use the T-account form to show the posting instead of the standard account
form. The standard account form is called the three-column form of account. It has three money
columns—debit, credit, and balance. The balance in the account is determined after each
transaction. Companies use the explanation space and reference columns to provide special
information about the transaction.

Posting should be performed in chronological order. That is, the company should post all the
debits and credits of one journal entry before proceeding to the next journal entry. Postings
should be made on a timely basis to ensure that the ledger is up to date. The reference column of
a ledger account indicates the journal page from which the transaction was posted. The
explanation space of the ledger account is used infrequently because an explanation already
appears in the journal.

Trial Balance Preparation

A trial balance is a list of accounts and their balances at a given time. A company usually
prepares a trial balance at the end of an accounting period. The trial balance lists the accounts in
the order in which they appear in the ledger, with debit balances listed in the left column and
credit balances in the right column. The totals of the two columns must agree. The trial balance
proves the mathematical equality of debits and credits after posting. Under the double-entry
system, this equality occurs when the sum of the debit account balances equals the sum of the
credit account balances. A trial balance also uncovers errors in journalizing and posting. In
addition, it is useful in the preparation of financial statements. The procedures for preparing a
trial balance consist of:

 List the account titles and their balances in the appropriate debit or credit column.
 Total the debit and credit columns.
 Prove the equality of the two columns.

A trial balance does not prove that a company recorded all transactions or that the ledger is
correct. Numerous errors may exist even though the trial balance columns agree. For example,
the trial balance may balance even when a company:

 Fails to journalize a transaction,

 Omits posting a correct journal entry,
 Posts a journal entry twice,
 Uses incorrect accounts in journalizing or posting, or
 Makes offsetting errors in recording the amount of a transaction. In other words, as long
as a company posts equal debits and credits, even to the wrong account or in the wrong
amount, the total debits will equal the total credits.

Adjusting Entries
In order for revenues to be recorded in the period in which services are performed and for
expenses to be recognized in the period in which they are incurred, companies make adjusting
entries. In short, adjustments ensure that a company follows the revenue recognition and expense
recognition principles.

The use of adjusting entries makes it possible to report on the balance sheet the appropriate
assets, liabilities, and owners’ equity at the statement date. Adjusting entries also make it
possible to report on the income statement the proper revenues and expenses for the period.
However, the trial balance—the first pulling together of the transaction data—may not contain
up-to-date and complete data. This occurs for the following reasons.
  Some events are not recorded daily because it is not efficient to do so. Examples are the
use of supplies and the earning of wages by employees.
 Some costs are not recorded during the accounting period because these costs expire with
the passage of time rather than as a result of recurring daily transactions. Examples of
such costs are building and equipment depreciation and rent and insurance.
 Some items may be unrecorded. An example is a utility service bill that will not be
received until the next accounting period. Adjusting entries are required every time a
company prepares financial statements. At that time a company must analyze each
account in the trial balance to determine whether it is complete and up-to-date for
financial statement purposes.

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals. Each of these classes has two
subcategories.

Deferrals:

Prepaid expenses: expenses paid in cash before they are used or consumed.
Unearned revenues: cash received before services are performed.

Accruals:

Accrued revenues: revenues for services performed but not yet received in cash or
recorded.
Accrued expenses: expenses incurred but not yet paid in cash or recorded.

Adjusting Entries for Deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a
date later than the point when cash was originally exchanged. If a company does not make an
adjustment for these deferrals, the asset and liability are overstated, and the related expense and
revenue are understated. Thus, the adjusting entry for deferrals will decrease a balance sheet
account and increase an income statement account.
Prepaid Expenses: assets paid for and recorded before a company uses them are called prepaid
expenses. When expenses are prepaid, a company debits an asset account to show the service or
benefit it will receive in the future. Examples of common prepayments are insurance, supplies,
advertising, and rent. In addition, companies make prepayments when they purchase buildings
and equipment. Prepaid expenses are costs that expire either with the passage of time (e.g., rent
and insurance) or through use and consumption (e.g., supplies). The expiration of these costs
does not require daily entries, an unnecessary and impractical task. Accordingly, a company
usually postpones the recognition of such cost expirations until it prepares financial statements.
At each statement date, a company makes adjusting entries to record the expenses that apply to
the current accounting period and to show the remaining amounts in the asset accounts

Unearned Revenues: when companies receive cash before services are performed, they record a
liability by increasing (crediting) a liability account called unearned revenues. In other words, a
company now has a performance obligation (liability) to provide service to one its customers.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books
of one company is likely to be a prepayment on the books of the company that made the advance
payment.

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Companies make adjusting entries for
accruals to record revenues for services performed and expenses incurred in the current
accounting period. Without an accrual adjustment, the revenue account (and the related asset
account) or the expense account (and the related liability account) are understated. Thus, the
adjusting entry for accruals will increase both a balance sheet and an income statement account.

Accrued Revenues: revenues for services performed but not yet recorded at the statement date are
accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the
case of interest revenue. These are unrecorded because the earning of interest does not involve
daily transactions. Accrued revenues also may result from services that have been performed but
not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded
because only a portion of the total service has been performed and the clients will not be billed
until the service has been completed. An adjusting entry records the receivable that exists at the
balance sheet date and the revenue for the services performed during the period. Prior to
adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for
accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a
revenue account.

Accrued Expenses: expenses incurred but not yet paid or recorded at the statement date are called
accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued expenses
result from the same causes as accrued revenues. In fact, an accrued expense on the books of one
company is accrued revenue to another company. Adjustments for accrued expenses record the
obligations that exist at the balance sheet date and recognize the expenses that apply to the
current accounting period. Prior to adjustment, both liabilities and expenses are understated.
Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense
account and a credit (increase) to a liability account.

Adjusted Trial Balance

After journalizing and posting all adjusting entries, Pioneer Advertising prepares another trial
balance from its ledger accounts. This trial balance is called an adjusted trial balance. The
purpose of an adjusted trial balance is to prove the equality of the total debit balances and the
total credit balances in the ledger after all adjustments. Because the accounts contain all data
needed for financial statements, the adjusted trial balance is the primary basis for the preparation
of financial statements.

Preparation of financial statements

After adjusted trial balance is prepared, financial statements could be prepared easily. Four basic
financial statements are usually prepared by most organizations.

Closing Entries
Closing entries are journal entries that a company makes at the end of the accounting period to
reduce the balance in each temporary account to zero, and to update the retained earnings
account.

Reversing Entries
After the completion of adjusting and closing of accounting records for the current period, it
begins a new accounting cycle for the next accounting period. Before journalizing the daily
transactions of the new accounting period in the general journal, most companies prepare
reversing entries.
A reversing entry is the exact reverse (accounts and amounts) of an adjusting entry. It is optional
and has one purpose, to simplify the recording of a later transaction related to the adjusting entry.