The Accounting Information System - Wiley

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The Accounting Information System

3 C H A P T E R

Needed: A Reliable Information System

Maintaining a set of accounting records is not optional. The Internal Revenue Service requires that businesses prepare and retain a set of records and documents that can be audited. The Foreign Corrupt Practices Act (federal legislation) requires public companies to ". . . make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets. . . ." But beyond these two reasons, a company that does not keep an accurate record of its business transactions may lose revenue and is more likely to operate inefficiently.

Some companies are inefficient partly because of poor accounting systems. Consider, for example, the Long Island Railroad, once one of the nation's busiest commuter lines. The LIRR lost money because its cash position was unknown: Large amounts of money owed the railroad had not been billed; some payables were erroneously paid twice; and redemptions of bonds were not recorded. Also, consider FFP Marketing, which operates convenience stores in eleven states. It was forced to restate earnings in 1999 and 2000 when faulty bookkeeping was discovered for its credit card accounts and fuel payables.

Poor accounting and record keeping were also costly for the City of Cleveland, Ohio. A recent audit discovered over 313 examples of dysfunctional accounting, costing taxpayers over $1.3 million in 2001. Due to its poor accounting system, the Cleveland treasurer did not have a good record of the cash available for investment and missed out on returns that could have been earned if these funds were invested. And delayed recording of pension payments in the city ledgers created the false impression of $13 million in the city coffers, funds that actually were committed to the pensions.

Even the use of computers is no assurance of accuracy and efficiency. "The conversion to a new system called MasterNet fouled up data processing records to the extent that Bank of America was frequently unable to produce or deliver customer statements on a timely basis," said an executive at one of the country's largest banks.

Although these situations are not common in large organizations, they illustrate the point: Accounts and detailed records must be properly maintained; the cost of not doing so can be severe. At FFP Marketing, trading in its stock was suspended until it could sort out the errors and issue correct financial statements for 2001, and the City of Cleveland`s municipal bond rating took a hit because of its poor accounting practices.

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Understand basic

accounting terminology.

Explain double-entry

rules.

Identify steps in the

accounting cycle.

Record transactions in

journals, post to ledger accounts, and prepare a trial balance.

Explain the reasons for

preparing adjusting entries.

Prepare closing entries. Explain how inventory

accounts are adjusted at year-end.

Prepare a 10-column work

sheet.

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PREVIEW OF CHAPTER 3

As the opening story indicates, a reliable information system is a necessity for all companies. The purpose of this chapter is to explain and illustrate the features of an accounting information system. The content and organization of this chapter are as follows.

THE ACCOUNTING INFORMATION SYSTEM

Accounting Information

System

? Basic terminology ? Debits and credits ? Basic equation ? Financial

statements and ownership structure

The Accounting Cycle

? Indentification and recording

? Journalizing ? Posting ? Trial balance ? Adjusting entries ? Adjusted trial

balance ? Closing ? Post-closing trial

balance ? Reversing entries

Using a Work Sheet

? Adjustments entered

? Work sheet columns

? Preparing financial statements from a work sheet

? Closing enteries

ACCOUNTING INFORMATION SYSTEM

The system of collecting and processing transaction data and disseminating financial information to interested parties is known as the accounting information system. Accounting information systems vary widely from one business to another. Factors that shape these systems are the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others place on the system. A good accounting information system helps management answer such questions as:

How much and what kind of debt is outstanding? Were our sales higher this period than last? What assets do we have? What were our cash inflows and outflows? Did we make a profit last period? Are any of our product lines or divisions operating at a loss? Can we safely increase our dividends to stockholders? Is our rate of return on net assets increasing?

Many other questions can be answered when there is an efficient accounting system to provide the data. A well-devised accounting information system is beneficial for every business enterprise.

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Accounting Information System ? 63

Basic Terminology

Financial accounting rests on a set of concepts (discussed in Chapters 1 and 2) for identifying, recording, classifying, and interpreting transactions and other events relating to enterprises. It is important to understand the basic terminology employed in collecting accounting data.

BASIC TERMINOLOGY

EVENT. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal.

TRANSACTION. An external event involving a transfer or exchange between two or more entities.

ACCOUNT. A systematic arrangement that shows the effect of transactions and other events on a specific asset or equity. A separate account is kept for each asset, liability, revenue, expense, and for capital (owners' equity).

REAL AND NOMINAL ACCOUNTS. Real (permanent) accounts are asset, liability, and equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue, expense, and dividend accounts; except for dividends, they appear on the income statement. Nominal accounts are periodically closed; real accounts are not.

LEDGER. The book (or computer printouts) containing the accounts. Each account usually has a separate page. A general ledger is a collection of all the asset, liability, owners' equity, revenue, and expense accounts. A subsidiary ledger contains the details related to a given general ledger account.

JOURNAL. The book of original entry where transactions and selected other events are initially recorded. Various amounts are transferred to the ledger from the book of original entry, the journal.

POSTING. The process of transferring the essential facts and figures from the book of original entry to the ledger accounts.

TRIAL BALANCE. A list of all open accounts in the ledger and their balances. A trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is designated as a post-closing or after-closing trial balance. A trial balance may be prepared at any time.

ADJUSTING ENTRIES. Entries made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared.

FINANCIAL STATEMENTS. Statements that reflect the collection, tabulation, and final summarization of the accounting data. Four statements are involved: (1) The balance sheet shows the financial condition of the enterprise at the end of a period. (2) The income statement measures the results of operations during the period. (3) The statement of cash flows reports the cash provided and used by operating, investing, and financing activities during the period. (4) The statement of retained earnings reconciles the balance of the retained earnings account from the beginning to the end of the period.

CLOSING ENTRIES. The formal process by which all nominal accounts are reduced to zero and the net income or net loss is determined and transferred to an owners' equity account; also known as "closing the ledger," "closing the books," or merely "closing."

OBJECTIVE

Understand basic accounting terminology.

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64 ? Chapter 3 The Accounting Information System

OBJECTIVE

Explain double-entry

rules.

Debits and Credits

The terms debit and credit mean left and right, respectively. They are commonly abbreviated as Dr. for debit and Cr. for credit. These terms do not mean increase or decrease. The terms debit and credit are used repeatedly in the recording process to describe where entries are made. For example, the act of entering an amount on the left side of an account is called debiting the account, and making an entry on the right side is crediting the account. When the totals of the two sides are compared, an account will have a debit balance if the total of the debit amounts exceeds the credits. An account will have a credit balance if the credit amounts exceed the debits.

The procedure of having debits on the left and credits on the right is an accounting custom or rule. We could function just as well if debits and credits were reversed. However, the custom of having debits on the left side of an account and credits on the right side (like the custom of driving on the right-hand side of the road) has been adopted in the United States. This rule applies to all accounts.

The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

All asset and expense accounts are increased on the left (or debit side) and decreased on the right (or credit side). Conversely, all liability and revenue accounts are increased on the right (or credit side) and decreased on the left (or debit side). Stockholders' equity accounts, such as Common Stock and Retained Earnings, are increased on the credit side, whereas Dividends is increased on the debit side. The basic guidelines for an accounting system are presented in Illustration 3-1.

ILLUSTRATION 3-1 Double-entry (Debit and Credit) Accounting System

Normal Balance--Debit Asset Accounts

Debit

Credit

+ (increase) ? (decrease)

Normal Balance--Credit Liability Accounts

Debit

Credit

? (decrease) + (increase)

Expense Accounts

Debit

Credit

+ (increase) ? (decrease)

Stockholders' Equity Accounts

Debit

Credit

? (decrease) + (increase)

Revenue Accounts

Debit

Credit

? (decrease) + (increase)

Basic Equation

In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (Illustration 3-2).

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Assets

Accounting Information System ? 65

ILLUSTRATION 3-2

The Basic Accounting

=

Liabilities

+

Stockholders' Equity

Equation

Illustration 3-3 expands this equation to show the accounts that comprise stockholders' equity. In addition, the debit /credit rules and effects on each type of account are illustrated. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. Like the basic equation, the expanded basic equation must be in balance (total debits equal total credits).

ILLUSTRATION 3-3 Expanded Basic Equation and Debit /Credit Rules and Effects

Basic Equation

Assets = Liabilities +

Stockholders' Equity

Expanded Basic Equation

Debit/Credit Rules

Assets

Dr. Cr. +?

Common

Retained

= Liabilities + Stock + Earnings ? Dividends + Revenues ? Expenses

Dr. Cr. ?+

Dr. Cr. ?+

Dr. Cr. ?+

Dr. Cr. +?

Dr. Cr. ?+

Dr. Cr. +?

Every time a transaction occurs, the elements of the equation change, but the basic equality remains. To illustrate, here are eight different transactions for Perez Inc.

Owners invest $40,000 in exchange for common stock.

Assets + 40,000

=

Liabilities

+

Stockholders' Equity

+ 40,000

Disburse $600 cash for secretarial wages.

Assets ? 600

=

Liabilities

+

Stockholders' Equity

? 600 (expense)

Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange.

Assets + 5,200

=

Liabilities

+5,200

+

Stockholders' Equity

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