CHAPTER 3

The Accounting Information System

LEARNING OBJECTIVES
1. Understand basic accounting terminology.
2. Explain double-entry rules.
3. Identify steps in the accounting cycle.
4. Record transactions in journals, post to ledger accounts, and prepare a trial balance.
5. Explain the reasons for preparing adjusting entries.
6. Prepare financial statements from the adjusted trial balance.
7. Prepare closing entries.
8. Prepare financial statements for a merchandising company.
*9. Differentiate the cash basis of accounting from the accrual basis of accounting.
*10. Identify adjusting entries that may be reversed.
*11. Prepare a 10-column worksheet.

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 3-1
CHAPTER REVIEW

*Note: All asterisked (*) items relate to material contained in the Appendices to the chapter.

1. Chapter 3 presents a concise yet thorough review of the accounting process. The basic
elements of the accounting process are identified and explained, and the way in which
these elements are combined in completing the accounting cycle is described.

Accounting Information System

2. (L.O. 1) The accounting information system collects and processes transaction data
and disseminates the financial information to interested parties. Factors that shape these
systems include: the nature of the business, the transactions in which it engages, the size
of the firm, the volume of data to be handled, and the informational demands of
management and other users. Financial accounting rests on a set of concepts used in
identifying, recording, classifying, and interpreting information related to the transactions
and other events of a business enterprise. To understand the accounting process, one
must be aware of the basic terminology employed in collecting accounting data. The
basic terminology includes: event, transaction, account, real accounts, nominal
accounts, ledger, journal, posting, trial balance, adjusting entries, financial
statements, and closing entries. These terms refer to the various activities that make
up the accounting cycle. As we review the steps in the accounting cycle, the individual
terms will be defined.

3. (L.O. 2) Double-entry accounting refers to the process used in recording transactions.

The terms debit and credit are used in the accounting process to indicate the effect
a transaction has on account balances. The debit side of any account is the left side; the
right side is the credit side. Assets and expenses are increased by debits and decreased
by credits. Liabilities, equity, and revenues are decreased by debits and increased by
credits.

4. In a double-entry system, for every debit there must be a credit and vice-versa. This leads
us to the accounting equation: Assets = Liabilities + Equity.

5. The equity section of the statement of financial position reports the owners’ interest in the
assets of the company. A corporation uses Share Capital, Share Premium, Dividends,
and Retained Earnings. A sole proprietorship or a partnership uses a Capital account and
a Drawing account.

6. In a corporation, dividends, revenues, and expenses are transferred to retained earnings

at the end of a period, so a change in any one of these three accounts affects equity.

The Accounting Cycle

7. (L.O. 3) The first step in the accounting cycle is analysis of transactions and selected
other events. The purpose of this analysis is to determine which events represent
transactions that should be recorded.

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 8. Events can be classified as external or internal. External events are those between an
entity and its environment, whereas internal events relate to transactions totally within an
entity.

9. (L.O. 4) Transactions are initially recorded in a journal, sometimes referred to as the

book of original entry. A general journal is merely a chronological listing of transactions
expressed in terms of debits and credits to particular accounts. No distinction is made in
a general journal concerning the type of transaction involved. In addition to a general
journal, specialized journals are used to accumulate transactions possessing common
characteristics.

10. The next step in the accounting cycle involves transferring amounts entered in the journal
to the general ledger. The ledger is a book that usually contains a separate page for
each account. Transferring amounts from a journal to the ledger is called posting.
Transactions recorded in a general journal must be posted individually, whereas entries
made in specialized journals are generally posted by columnar total.

11. The next step in the accounting cycle is the preparation of a trial balance. A trial balance is
a list of all open accounts in the general ledger and their balances. An entity may prepare
a trial balance at any time in the accounting cycle. A trial balance prepared after posting
has been completed serves to check the mathematical equality of debits and credits in
the posting process and provides a listing of accounts to be used in preparing financial
statements. A trial balance does not prove that a company recorded all transactions or
that the ledger is correct, because numerous errors may exist even though the trial
balance columns agree.

12. (L.O. 5) Preparation of adjusting journal entries is the next step in the accounting cycle.
Adjusting entries are entries made at the end of accounting period to bring all accounts
up to date on an accrual accounting basis so that correct financial statements can be
prepared. Adjusting entries are necessary to achieve a proper matching of revenues and
expenses in the determination of net income for the current period and to achieve an
accurate statement of the assets and equities existing at the end of the period. One
common characteristic of adjusting entries is that they affect at least one real account
(asset, liability, or equity account) and one nominal account (revenue or expense
account). Adjusting entries can be classified as prepaid expenses, unearned revenues,
accrued revenues, and accrued expenses.

13. Prepaid expenses and unearned revenues refer to situations where cash has been paid
or received but the corresponding expense or revenue will not be recognized until a future
period. Accrued revenues and accrued expenses are revenues and expenses recognized
in the current period for which the corresponding payment or receipt of cash is to occur in
a future period. Estimated items are expenses such as bad debts and depreciation whose
amounts are a function of unknown future events or developments.

14. After adjusting entries are recorded and posted, an adjusted trial balance is prepared.

15. (L.O. 6) From the adjusted trial balance, a company can directly prepare its financial
statements.

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 3-3
16. (L.O. 7) After financial statements have been prepared, nominal (revenues and expenses)
accounts should be reduced to zero in preparation for recording the transactions of the
next period. This closing process requires recording and posting of closing entries. All
revenue and expense accounts are reduced to zero by closing them through the Income
Summary account. The net balance in the Income Summary account is equal to net
income or net loss for the period. The net income or net loss for the period is transferred to
an equity account. For a corporation, the equity account is Retained Earnings, for proprie -
torships and partnerships, it is a capital account. In a corporation, dividends are closed
directly to Retained Earnings.

17. A third trial balance may be prepared after the closing entries are recorded and posted.
This post-closing trial balance shows that the company has properly journalized and
posted the closing entries.

18. A final step, preparing reversing entries, is optional. This step is discussed in learning
objective 10, see paragraph 25 below.

19. In summary, the steps in the accounting cycle performed every fiscal period are as follows:

a. Enter the transactions of the period in appropriate journals.

b. Post from the journals to the ledger (or ledgers).

c. Prepare an unadjusted trial balance (trial balance).

d. Prepare adjusting journal entries and post to the ledger(s).

e. Prepare a trial balance after adjusting (adjusted trial balance).

f. Prepare the financial statements from the adjusted trial balance.

g. Prepare closing journal entries and post to the ledger(s).

h. Prepare a trial balance after closing (post-closing trial balance).

i. Prepare reversing entries (optional) and post to the ledger(s).

Financial Statements for a Merchandising Company

20. (L.O. 8) The income statement for a merchandising company differs from that of a service
company because a product is being sold rather than a service. This difference requires
classifying amounts into categories such a gross profit on sales, income from operations,
income before taxes, and net income. Earnings per share is still shown on the face of the
income statement.

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21. The retained earnings statement is still formatted the same way: net income is added to
the beginning retained earnings balance, and then dividends are deducted to arrive at
ending retained earnings.

22. The only change made to the statement of financial position is the inclusion of a new
current asset inventory.

23.The closing entries for a merchandising company include a new revenue account, sales
revenue, and a new expense account, cost of goods sold.

Cash-Basis Accounting Versus Accrual-Basis Accounting

*24. (L.O. 9) Cash-Basis Accounting Versus Accrual-Basis Accounting, is presented in

Appendix A of Chapter 3 for the purpose of demonstrating the difference between cash
basis and accrual-basis accounting. Under the strict cash basis of accounting, revenue
is recognized only when cash is received, and expenses are recorded only when cash is
paid or dispersed. The accrual basis of accounting recognizes revenue when it is earned
and expenses when incurred, without regard to the time of receipt or payment of cash.

Using Reversing Entries

*25. (L.O. 10) Appendix B covers preparation and posting of reversing entries, the final
optional step in the accounting cycle. A reversing entry is made at the beginning of the
next accounting period and is the exact opposite of the adjusting entry made in the
previous period. The recording of reversing entries as an optional step in the accounting
cycle may be performed at the beginning of the next accounting period. The entries
subject to reversal are the adjusting entries for accrued revenues and accrued expenses
recorded at the close of the previous accounting period.

Using a Worksheet: The Accounting Cycle Revisited

*26. (L.O. 11) Appendix C covers the use of a ten-columnworksheet, which serves as an aid to
the accountant in adjusting the account balances and preparing the financial statements.
The worksheet provides an orderly format for the accumulation of information necessary for
preparation of financial statements. Use of a worksheet does not replace any financial
statements, nor does it alter any of the steps in the accounting cycle. Instead, the
worksheet is an informal tool that helps to accumulate and sort information needed for the
financial statements.

Copyright © 2018 John Wiley & Sons, Inc.   Kieso Intermediate: IFRS 3e, Instructor’s Manual 3-5
LECTURE OUTLINE

Chapter 3 provides a review of accounting procedures throughout the accounting cycle.

Depending on time constraints and students’ accounting course background, Chapter 3 can be
approached in several different ways: (1) Spend 2-3 class sessions reviewing the chapter and
Appendices 3-A through 3-C. (2) Spend 1-2 class sessions reviewing selected portions of the
chapter and Appendix 3-A. (3) Omit the chapter entirely.

It is assumed that all students have completed at least one course in financial accounting.
Therefore, students should already be familiar with the mechanics of journalizing, posting, and
preparing adjusting entries and financial statements, etc. An important objective of a review of
these procedural details is to prepare students: (1) to progress from mere memorization of
required journal entries to an understanding of the entries’ impact on the financial statements,
and (2) to visualize the effect of errors (both the failure to record transactions and the improper
recording of transactions) on the financial statements.

The following lecture outline can be expanded upon or reduced to suit the needs of your class.
A. (L.O. 1) Basic Terminology. Review the 11 terms defined on text page 3-4.

B. (L.O. 2) Double-Entry Accounting. Review the mechanics of debits and credits and the
accounting equation.

C. (L.O. 3) The Accounting Cycle.

1. Identifying and Recording Transactions and Other Events

2. (L.O. 4) Journalization.

a. General Journal.
b. Special Journals.

3. Posting to the Ledger.

4. Trial Balance.
5. (L.O. 5) Adjusting Entries. The ability to classify adjusting entries into one of these four
categories is necessary to an understanding of reversing entries.

a. Prepaid expenses.

b. Unearned revenues.

c. Accrued liabilities (expenses).

d. Accrued assets (revenues).

6. Prepare an adjusted trial balance.

7. (L.O. 6) Prepare financial statements from adjusted trial balance.

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 8. (L.O. 7) Prepare closing entries.
a. Temporary accounts vs. permanent accounts.

b. Post-closing trial balance.

c. Reversing entries.

D. (L.O. 8) Financial statements for a merchandising company.

1. Income statement

a. Net sales

b. Cost of goods sold

c. Gross profit on sales

d. Selling and administrative expenses

e. Income from operations

f. Other revenues and gains

g. Other expenses and losses

h. Income before income taxes

i. Income taxes

j. Net income

2. Retained earnings statement

a. Beginning Retained Earnings plus Net income

b. Less Dividends is equal to Ending Retained Earnings

3. Statement of financial position

a. Non-current assets

b. Current assets–Inventory

c. Cash

d. Equity

e. Non-current liabilities

f. Current liabilities

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 4. Closing entries

a. Sales revenue closed to Income Summary

b. Cost of goods sold and other expenses closed to Income Summary

c. Income Summary closed to Retained Earnings

c. Dividends closed to Retained Earnings

E. (L.O. 9) APPENDIX 3-A. Cash basis versus accrual-basis accounting.

1. Strict cash basis. Recognize revenue when cash is received and expenses when cash
is paid.

a. Used by small businesses and individual taxpayers.

b. Not in conformity with IFRS.

2. Modified cash basis. Recognize revenue when cash is received. Depreciable assets
are capitalized and depreciated; prepaid assets are capitalized and expensed as used;
and all other expenses are recognized as paid. Used by service organizations
(accountants, lawyers, doctors, and architects).

3. Accrual basis. Revenues are recognized when earned and expenses when incurred.

4. Conversion from cash to accrual basis.

F (L.O. 10) APPENDIX 3-B. Using reversing entries.

1. Use of reversing entries is optional.

2. In an accounting system which uses reversing entries, the following types of
adjusting entries should be reversed:
a. adjusting entries for unearned and prepaid items where the original amount
was entered in a revenue or expense account.
b. adjusting entries for all accrued items.

G. (L.O. 11) APPENDIX 3-C. Using a worksheet: The accounting cycle revisited.

1. The worksheet does not replace the financial statements.

2. Worksheet columns.

3. Preparing the worksheet.

4. Preparing the financial statements from a worksheet.

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