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Lecture

CHAPTER 3 TEXTBOOK REVIEW A 6 page summary of the entire third chapter of the RSM220 textbook (Intermediate Accounting)


Department
Rotman Commerce
Course Code
RSM220H1
Professor
Dragan Stojanovic

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THE ACCOUNTING INFORMATION SYSTEM
Definition: The system of collecting and processing transaction data and making financial information available to
interested parties
Basic terminology – used in collecting accounting data:
oEvent: A happening of consequence. An event generally is the source or cause of changes in assets,
liabilities, and equity. Events can be external or internal.
oTransaction: A transaction is an external event involving a transfer or exchange between two or more
entities or parties
oAccount: A systematic arrangement that accumulates transactions and other events. A separate account is
kept for each asset, liability, revenue and expense, and for gains, losses and capital (owners’ equity)
oPermanent and temporary accounts: Permanent (real) accounts are asset, liability and equity accounts;
they appear on the balance sheet. Temporary (nominal) accounts are revenue, expense, and dividend
accounts; except for dividends, they appear on the income statement. Temporary accounts are periodically
closed; permanent accounts are left open.
oLedger: The book (or electronic database) containing the accounts. Each account usually has a separate
page. A general ledger is a collection of all the asset, liability, owner’s equity, revenue, and expense
accounts. A subsidiary ledger contains the details of a specific general ledger account
oJournal: The book of original entry where transactions and other selected events are first recorded.
Various amounts are transferred to the ledger from the book of the original entry, the journal.
oPosting: The process of transferring the essential facts and figures from the book of original entry, the
ledger accounts.
oTrial balance: A list of all open accounts in the ledger and their balances. A trial balance that is 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 known as a post-closing or after-closing trial
balance. A trial balance can be prepared at any time.
oAdjusting entries: Entries that are 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
oFinancial statements: Statements that reflect the collecting, tabulating, and final summarizing of the
accounting data. Four financial statements are involved:
(1) The balance sheet, which shows the enterprise’s financial condition at the end of a period
(2) The income statement, which measures the results of operations during the period
(3) The statement of cash flows, which reports the cash provided and used by operating,
investing, and financial activities during the period
(4) The statement of retained earnings or statement of changes in shareholders’ equity, which
reconciles the balance of the retained earnings and other equity accounts from the beginning to
the end of the period. Comprehensive income is generally shown in a separate statement – the
statement of comprehensive income (starting with net income) – or as part of the income
statement
oClosing entries: The formal process for reducing temporary accounts to zero and then determining net
income or net loss and transferring it to an owners’ equity account. Using closing entries is also known as
“closing the ledger,” “closing the books,” or merely “closing”
DEBITS AND CREDITS:
Debit/credit – refer to the left and right sides of a general ledger account, respectively
oDr. – Debit; Cr. – Credit
Act of entering an amount on the left side of an account is called debiting the account
Making an entry on the right side is crediting the account
When the total of the two sides are compared, the account will have a debit balance if the total of the debit amounts
is more than the credit; an account will have a credit balance if the credit amounts exceed the debits
Equality of debits and credits is the basis for the double-entry system of recording transactions (“double-entry
bookkeeping”)
Under the double-entry accounting system, which is used everywhere, the two-sided (dual) effect of each
transaction is recorded in appropriate accounts
If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must

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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)
All liability and revenue accounts are increased on the right (or credit side) and decreased on the left (or debit
side)
Shareholders equity accounts, such as Common Shares, and Retained Earnings, are increased on the credit side,
whereas Dividends is increased on the debit side
Accounting Equation:
Double-entry system for every debit there must be a credit and vice versa
oAssets = Liabilities + Shareholders’ Equity
oTotal debits must always equal total credits
Assets = Liabilities + SE
oAssets = Increases (Dr), Decreases (Cr)
oLiabilities = Increases (Cr), Decreases (Dr)
oShareholder’s Equity = Common Shares + Retained Earnings – Dividends + Revenues - Expenses
Common Shares = Increases (Cr), Decreases (Dr)
Retained Earnings = Increases (Cr), Decreases (Dr)
Dividends = Increases (Dr), Decreases (Cr)
Revenues = Increases (Cr), Decreases (Dr)
Expenses = Increases (Dr), Decreases (Cr)
Financial Statements and Ownership Structure
Common shares, retained earnings and accumulated other comprehensive income are reported in the shareholders’
equity section of the balance sheet
Dividends are reported on the statement of retained earnings
Revenues and expenses are reported on the income statement – eventually transferred to retained earnings at the
end of the period while other comprehensive income is transferred to accumulated other comprehensive income
A change in one of these items – affects shareholders equity
Corporation:
oCommon Shares, Contributed Surplus, Dividends and Retained Earnings, Accumulated Other
Comprehensive Income
Proprietorship/Partnership:
oA capital account is used to indicate the investment in the company by the owner(s)
oA drawings/withdrawal account may be used to indicate withdrawals by the owner(s)
Grouped together under Owners’ Equity
The Accounting Cycle:
o[1] Identification and measurement of transactions/other events
o[2] Journalization: General journal, cash receipts journal, cash disbursements journal, purchases journal,
sales journal, other special journals
o[3] Posting: General ledger (usually monthly); subsidiary ledgers (usually daily)
o[4] Trial Balance Preparation
o[5] Adjustments: Accruals, Prepayments, Estimated items
o[6] Adjusted trial balance
o[7] Statement Preparation: Income statement, Retained earnings, Balance sheet, Cash flows
o[8] Closing: temporary accounts
o[9] Post-closing trial balance
o[10] Reversing entries: (optional)
Identifying and Recording Transactions and Other Events
First step – to analyze transactions and other selected events – problem = determining what to record
oNo particular rule for whether an event should be recorded
oGenerally agreed that changes in personnel, changes in managerial policies and the value of human
resources should not be recorded
oWhen company makes a cash sale or purchase it should be recorded
oAn item should be recognized in the financial statements if it meets the definition of an element (e.g.
liability, asset), and is measurable
oWhere there is uncertainty about the future event occurring or not (e.g. potential loss from a lawsuit), the
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entity must use all available information to make a neutral decision as to whether the liability/asset exists
or not
Events of two types:
o(1) External events involve interaction between an entity and its environment, such as a transaction with
another entity, a change in the price of a product or service that an entity buys or sells, a flood or
earthquake, or a competitor’s improvement in its technology
o(2) Internal events occur within an entity, such as using buildings and machinery in its operations, or
transferring or consuming raw materials in production processes
Many events have both external and internal elements
As a particular kind of external event, a transaction can be an exchange in which each entity both receives and
gives up value, such as a purchase or sale of goods/services
A transaction can be a transfer in one direction (non-reciprocal) in which an entity incurs a liability or transfers an
asset to another entity without directly receiving value in exchange
oE.g. distributions to owners, the payment of taxes, gifts, charitable contributions, uninsured losses and
thefts
Journalizing:
oThe varied effects of transactions on the basic business elements (assets, liabilities and equities) are
categorized and collected in accounts
oGeneral ledger: a collection of all the asset, liability, shareholders’ equity, revenue and expense accounts
oA T account is a convenient method for showing the effect of transactions on particular asset, liability,
equity, revenue and expense items
Simplest journal chronological listing of transactions and other events that expresses the transactions and events
as debits and credits to particular accounts – general journal
Sometimes, businesses use special journals in addition to the general journal – they summarize transactions that
have a common characteristics (e.g. cash receipts, sales, purchases, cash payments), which saves time in doing the
various bookkeeping tasks
Posting:
The items entered in a general journal must be transferred to the general ledger called ‘posting’ and is part of
the summarizing and classifying process
The general journal posting is completed when all the posting reference numbers have been recorded opposite the
account titles in the journal
oThe number in the posting reference column serves two purposes:
(1) It indicates the ledger account number of the account involved
(2) It indicates that the posting has been completed for that item
Trial Balance:
A list of accounts and their balances at a specific time – typically prepared at the end of an accounting period
Accounts are listed in the order in which they appear in the ledger, with debit balances listed in the left column and
credit balances in the right column; two columns must agree
Main purpose of trial balance: prove the mathematical equality of the debits and credits after posting
Under the double-entry system, this equality will occur when the sum of the debit account balances equals the sum
of the credit account balances
A trial balance also uncovers errors in journalizing and posting – it is useful also when preparing financial
statements
To prepare a trial balance:
o(1) List the account titles and their balance
o(2) Total the debit and credit columns
o(3) Prove the equality of the two columns
A trial balance does not prove that all transactions have been recorded or that the ledger is correct
Adjusting entries:
In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognized in
the period for which they are incurred, adjusting entries are made at the end of the accounting period
Adjustments are needed to ensure that the revenue recognition principle is followed and that proper matching
occurs
Types of Adjusting Entries:
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