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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. Assets
2. Liabilities
3. Equities
– Income statement accounts
1. Revenue
2. Expenses
Double-Entry Accounting
• Recall from Chapter 3:
ASSETS
LIABILITIES
EQUITIES
Total business resources = Creditor’s claims + Owner’s claims
• The balance sheet must always balance!
• Lack of balance automatically exposes
arithmetic error
Double-Entry Accounting
• To account for changes in equity brought about
by the earning of revenue or incurring expenses:
Assets = Liabilities + Equities + Revenues - Expenses
Assets + Expenses = Liabilities + Equities + Revenues
• This equation is the basis of double-entry
accounting.
• The left-hand side must always be equal to the
right-hand side.
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 Cycle
1. 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.
2.
3.
4.
5.
Close out revenue and expense accounts
Transfer these balances to income summary account
Close income summary account to capital account
All permanent accounts must be balanced
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.