ACCT 301 Chapter 2
Economic events: cause changes in the financial position of the company
External events: involve an exchange between the company and another
entity
Internal events: do not involve an exchange transaction but do affect the
company’s financial position
Accounting equation:
oAssets = Liabilities + Owner’s Equity
Each event, or transaction has a dual effect on the accounting equation
Owner’s equity for a corporation called shareholders’ equity is classified
by source as either paid-in capital or retained earnings
Equity is made up of paid in capital AND retained Earnings
oRetained Earnings are:
+Revenues
+Gains
-Expenses
-Losses
-Dividends
Permanent accounts represent the basic financial position elements of
the accounting equation
Temporary accounts keep track of the changes in the retained earnings
component of shareholder’s equity
Steps of the Accounting Processing Cycle
oDuring the Accounting period
Step 1: Obtain information about external transactions
from source documents
Step 2: Analyze the transaction
Transactional analysis: the process of reviewing the
source documents to determine the dual effect on
the accounting equation and the specific elements
involved
Step 3: Record the transaction in a journal
Step 4: Post from the journal to the general ledger
accounts
oAt the end of the accounting period
Step 5: Prepare an unadjusted trial balance
trial balance: list of the general ledger accounts
along with their balances at a particular date, listed
in the order that they appear in the ledger
purpose is to allow us to check for completeness and
to verify that the sum of the accounts with debit
balances equals the sum of the accounts with credit
balances
We record increases and decreases in retained
earnings from revenue, expense, gain and loss
transactions indirectly in temporary accounts
Step 6: Record adjusting entries and post to the general
ledger accounts
adjusting entries are required to implement the
accrual accounting model
adjusting entries necessary for three situations:
o1: Prepayments
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transactions in which the cash flow
precedes expense or revenue recognition
Prepaid expenses represent assets
recorded when a cash disbursement
creates benefits beyond the current
reporting period
adjusting entry for a prepaid
expense is a debit to an expense
and a credit to an asset
Deferred revenues represent liabilities
recorded when cash is received from
customers in advance of providing a
good or service.
adjusting entry for a deferred
revenue is a debit to a liability and
a credit to revenue
o2: Accruals
transactions where the cash outflow or
inflow takes place in a period subsequent
to expense or revenue recognition
Accrued liabilities represent liabilities
recorded when an expense has been
incurred prior to a cash payment
adjusting entry for an accrued
liability is a debit to an expense
and a credit to a liability
Accrued receivables involve situations
when the revenue is recognized in a
period prior to a cash receipt
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adjusting entry for an accrued
revenue is a debit to an asset, a
receivable, and a credit to revenue
o3: Estimates
accountants often must make estimates
in order to comply with the accrual
accounting model
Step 7: Prepare an adjusted trial balance
Step 8: Prepare financial statements
income statement: is a change statement that
summarizes the profit-generating transactions that
caused shareholders’ equity (RE) to change during
the period
balance sheet: represents an organized list of assets,
liabilities and equity at a particular point in time
statement of cash flows: purpose to report the
events that caused cash to change during the period
ostatement classifies into:
ooperating activities
oinvesting activities:
ofinancing activities:
statement of shareholder’s equity discloses the
sources of changes in the permanent shareholders’
equity accounts
oAt the end of the year
Step 9: Close the temporary accounts to retained earnings
closing process serves a dual purpose: the temporary
accounts (revenues, expenses, gains and losses) are
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reduced to zero balances, ready to measure activity
in the upcoming accounting period, AND these
temporary account balances are closed (transferred)
to retained earnings to reflect the changes that have
occurred in that account during that period.
intermediate step is often the income summary
Step 10: Prepare a post-closing trial balance
purpose is to verify that the closing entries were
prepared and posted correctly and that the accounts
are now ready for next year’s transactions
Appendix:
osubsidiary ledger: contains a group of subsidiary accounts
associated with particular general ledger control accounts
ospecial journals: used to capture the dual effect of the
transaction in debit/credit form
examples:
cash receipts journal: record cash receipts
cash disbursements journal
sales journal: record credit sales
purchases journal
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