Chapter 4

Accounting – A Financial Information System

The Accounting Process

• Accounting process: a financial information system designed to record, classify, report, and interpret financial data of interest to organizations of all varieties

The Accrual Concept• Three aspects of the accrual concept

1. Revenue earned is measured by the asset received in exchange. It does not necessarily correspond to cash.

2. Expenses are costs incurred by the firm in earning revenue and are measured by the cost of the asset consumed or services used. They are not necessarily related to the expenditure of cash.

3. Accounting income is determined by matching the expenses incurred in a period with the revenues earned in that period. The difference between revenues and expenses constitutes income for the period.

Double-Entry Accounting

• Double-entry accounting: bookkeeping system that provides a set of techniques to keep track of accounting data while minimizing the probability of an arithmetic error

Double-Entry Accounting

• Five fundamental categories of data– Balance sheet accounts

1. Assets2. Liabilities3. Equities

– Income statement accounts1. Revenue2. Expenses

Double-Entry Accounting

• Recall from Chapter 3:

• The balance sheet must always balance!• Lack of balance automatically exposes

arithmetic error

ASSETS LIABILITIES EQUITIES

Total business resources = Creditor’s claims + Owner’s claims

Double-Entry Accounting

• To account for changes in equity brought about by the earning of revenue or incurring expenses:

• This equation is the basis of double-entry accounting.

• The left-hand side must always be equal to the right-hand side.

Assets = Liabilities + Equities + Revenues - Expenses

Assets + Expenses = Liabilities + Equities + Revenues

Double-Entry Accounting

• Posting the account: making entries, or notations, in various accounts

• Whenever accounting records are posted, at least two entries must be made- one or more on the left-hand side and one or more on the right-hand side.

The System of Debits and Credits

• Debit: entry on left-hand side of an account• Credit: entry on right-hand side of an account

The System of Debits and Credits

• Whether a debit or credit increases or decreases the amount of a particular account depends on the type of account.

• Examples:– An asset account (i.e. cash) is a left-hand side

account and would be increased by a debit entry and decreased by a credit entry.

– Revenue is a right-side account and would be decreased by a debit entry and increased by a credit entry.

The System of Debits and Credits

• Debit side (Dr.)– Assets + Expenses– Debit (Dr.) to increase– Credit (Cr.) to decrease– Normal balance = Debit

• Credit side (Cr.)– Liabilities + Equities +

Revenues– Credit (Cr.) to increase– Debit (Dr.) to decrease– Normal balance = Credit

*For the accounting equation to be in balance, the sum of debit entries must always be equal to the sum of the credit entries.

The Accounting Cycle

• Accounting cycle: a logical series of steps that accountants follow to keep necessary accounting records and prepare financial statements.

The Accounting Cycle

• 6-Step Accounting Cycle1. Sort business transactions into an appropriate

number of debits and credits to be entered on accounting records

2. Record these transactions (as debit and credit entries) in a journal for later posting to general ledger

3. At the end of each month, post journal entries to general ledger

The Accounting Cycle

• 6-Step Accounting Cycle (continued)4. Make adjusting entries to general ledger• Adjusting entries result from the need to match

expenses with revenues in accordance with the accrual concept

5. “Closing the books” at the end of the year - all “temporary” accounts are closed out• Temporary accounts: accounts that begin the new

year with a zero balance (generally, income statement accounts)

6. After the closing process, financial statements for period are prepared

The Closing Process

1. Close out revenue and expense accounts2. Transfer these balances to income summary account3. Close income summary account to capital account4. All permanent accounts must be balanced5. All permanent accounts must be double ruled, with

balances brought forward to the beginning of the next accounting period

6. Financial statements are developed for end of the period

The Closing Process

• After the closing process, an income statement and balance sheet can be constructed directly from the accounts.

• The resulting income statement is essentially a written statement of the closing process.