ACCO 20043 FINANCIAL ACCOUNTING AND REPORTING 2

MODULE 1: REVIEW OF THE ACCOUNTING PROCESS

LECTURE

DEFINITION OF TERMS:

Accounting

There are many definitions of accounting that have been issued by different organizations and
publications. The following are some of those definitions:

“Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of
money, transactions and events which are, in part at least, of financial character, and interpreting the
results thereof.” – American Institute of Certified Public Accountants (AICPA)

“Accounting is the process of identifying, measuring and communicating economic information to permit
informed judgment and decision by users of the information.” – American Accounting Association (AAA)

“Accounting is a service activity. Its function is to provide quantitative information, primarily financial
in nature, about economic entities, that is intended to be useful in making economic decision.” –
Accounting Standards Council (ASC), succeeded by Financial Reporting Standards Council (FRSC).

For additional reading and in-debt discussion, please refer to the following link:
https://businesstips.ph/what-is-accounting/
Victorino Abrugar
May 29, 2011

Stakeholders

Generally, all parties (profit or non-profit) who have interest (direct or indirect) in an entity or
organization. They are also called the users of the financial information gathered in the accounting
process.

Users are grouped into two classification:

1. External Users – they are groups or individuals who are not directly concerned with the day-to-
day operations of the entity but are indirectly related to the said entity. They make decisions that
affect their relationship to the entity.
2. Internal Users – they are the management personnel in all levels within an entity who are
responsible for the planning and control of the operations and therefore for the planning and
control of the operations and therefore, they have access to the day-to-day operations of the
entity.

Accounting Process
Accounting process refers to the procedures or series of steps, undertaken to come up with the
information reported in the financial statements. The accounting process is also referred to as the
accounting cycle.

The accounting cycle is divided into two phases:

A. Recording Phase – the recording phase includes collecting information about economic events in
the appropriate accounting records.

Economic events are transactions that changes the balance of an asset, a liability, or an
equity account.

Accounting records include business documents, journals, and ledgers.

The recording phase is composed of the following steps:

1. Documentation – this is the process of preparing or receiving appropriate business
documents. Business documents are original source materials which serve as evidence of
transactions. It includes official receipts, sales invoices, purchase invoices, credit
memoranda, debit memoranda.

2. Journalizing – this is the process of recording transactions for the first time in the
accounting books called journals. Journals are called books of original entry.
Transactions are recorded based on the documents prepared or received during the
documentation stage.

3. Posting – this is the process of transferring the recorded transactions in the journal to the
accounts in the ledger. A ledger is a group of related accounts and is called the book of
final entry. The objective of posting is to classify the effects of transactions on specific
asset, liability, income and expense accounts.

General Ledger – is the principal ledger which contains all the accounts that are reported
in the financial statements, namely: assets, liabilities, equity, income, and expenses.

Subsidiary Ledger – contains details of some general ledger account balances. The
composition of general ledger accounts is found in the subsidiary ledgers.

Control account – a general ledger account that has a supporting subsidiary ledger.

Contra accounts – accounts established to record deductions from related accounts with
positive balances.

Adjunct accounts – accounts set up to record additions to related accounts.

B. Summarizing phase – includes the steps necessary for the preparation of periodic summary
reports.

This phase includes the following steps:

4. Preparing a trial balance – this is the process of preparing a summary of the balances of
the accounts in the general ledger. The trial balance is, as the name suggests, is a table
where we lay out all our debit accounts and all our credit accounts to see if they balance
or not. A trial balance is important because it acts as a summary of all of our accounts. By
looking at our trial balance, we can immediately see our bank balance, our loan balance,
our owner’s equity balance. In fact, we can immediately see the balance of every single
account in our business.

A trial balance is the accounting equation of our business laid out in detail. It has our
assets, expenses and drawings on the left (the debit side) and our liabilities, revenue and
owner’s equity on the right (the credit side). We can see everything clearly and make sure
it all balances.
A trial balance that balances tells us that we’ve done all our journals and ledgers
correctly. it’s saying, “All your transactions for the year have been entered, and,
everything looks right!”
https://www.guru99.com/the-trial-balance.html
How to Prepare Trial Balance with Example
Guru99

5. Compiling adjusting data – this is the process of gathering and putting together various
data necessary to update the balances of certain accounts in the books of the company.
These adjustments are necessary so that income and expenses will be reported in the
period that are earned and incurred, respectively; hence profit will not be misstated.

The following are the most common types of adjusting data:

a. Accrued expense is an expense incurred but not yet paid as of the statement of
financial position date.

Expense xxx
Payable xxx

b. Accrued revenue is revenue that has been recognized by the business, but the
customer has not yet been billed. Accrued revenue is particularly common in service
related businesses, since services can be performed up to several months prior to a
customer being invoiced.

Revenue must be accrued, otherwise revenue totals would be significantly

understated, particularly in comparison to expenses for the period.

Revenue/Income xxx
Income Summary xxx

c. Deferred revenue is used when your company receives a payment in advance of

work that has not been completed. In many cases, a client may pay in advance for
work that is to be done over a specific period of time. When the revenue is later
earned, the journal entry is reversed.
 a. To record the initial receipt of cash:
Under Liability Method:
Cash xxx
Unearned Income xxx

Under Income Method:

Cash xxx
Income xxx

b. To record the adjustment at the end of the accounting period:

Under Liability Method:
Unearned Income xxx
Income xxx
(Amount recorded is the earned portion of the prepayment)

Under Income Method:

Income xxx
Unearned Income xxx
(Amount recorded is the unearned portion of the prepayment)

d. Prepaid expenses also need to be recorded as an adjusting entry. For instance, if you
decide to prepay your rent in January for the entire year, you will need to record the
expense each month for the next 12 months in order to account for the rental payment
properly.

If you don’t, your financial statements will reflect an abnormally high rental expense
in January, followed by no rental expenses at all for the following months.

a. To record the initial receipt of cash:

Asset Method
Prepaid Expense xxx
Cash xxx

Expense Method
Expense xxx
Cash xxx

b. To record the adjustment at the end of the accounting period:

Asset Method
Expense xxx
Prepaid Expense xxx
(Amount recorded is the expired or used portion of the pre-payment)

Expense Method
Prepaid Expense xxx
Expense xxx
(Amount recorded is the unexpired or unused portion of the pre-payment)
 e. Depreciation expense and accumulated depreciation will need to be posted in
order to properly expense the useful life of any fixed asset.

Depreciation is always a fixed cost, and does not negatively affect your cash flow
statement, but your balance sheet would show accumulated depreciation as a contra
account under fixed assets.

Depreciation Expense xxx

Accumulated Depreciation xxx

For additional reading and in-debt discussion, please refer to the following link:
https://www.fool.com/the-blueprint/adjusting-entries/
Mary Girsch-Bock
Adjusting Entries: What They Are and Why You Need Them
Updated May 24, 2020

6. Preparing a worksheet/end-of-period spreadsheet – a worksheet is a working paper

which contains data in the trial balance, the adjustments compiled in step 5, and the
developed income statement and statement of financial position data. This step is optional
but it facilitates the preparation of the financial statements.

7. Preparing the financial statements – after the worksheet is completed, the financial
statements are prepared.

PAS 1 provides that a complete set of financial statements shall consist of the following:
A. Statement of financial position
B. Statement of comprehensive income
C. Statement of cash flows
D. Statement of changes in owners’ equity
E. Notes

For additional reading and in-debt discussion, please refer to the following link:
https://www.youtube.com/watch?v=-dPLqWYuT_k
Trial Balance to Income Statement and Statement of Financial Position
Deirdre Macnamara
October 4, 2019

8. Adjusting and closing the books – the adjustments that were recorded in the worksheet
are now formally recorded in the general journal and posted to the accounts in the general
ledger. The balances of the nominal accounts, which consist of income, expense, and
drawing accounts, are then closed to Income Summary account. The balance of the
Income Summary account is then transferred to the owner’s equity (capital) account. A
debit balance in the Income Summary account represents a loss while credit balance
represents a profit. Lastly, the balance of the owner’s drawing account is closed to
 owner’s equity (capital) account. When the closing process is completed, all nominal
accounts will have zero balances.

Following are the pro-forma closing entries prepared at the end of the accounting period:
A. To close the balances of income accounts:
Revenue/Income xxx
Income Summary xxx

B. To close the balances of expense accounts:

Income Summary xxx

Expenses xxx

C. To close the balances of Income Summary accounts (credit balance):

Income Summary xxx

Capital xxx

To close the balances of Income Summary accounts (debit balance):

Capital xxx
Income Summary xxx

D. To close the balance of the drawing account:

Capital xxx
Drawing xxx

9. Preparing a post-closing trial balance – this step is done after all the balances of nominal
accounts have been closed. The post-closing trial balance is prepared to check the
equality of debit and credits of real accounts after journalizing and posting the closing
entries.

10. Reversing the accounts - Reversing entries are made on the first day of an accounting
period to remove accrual adjusting entries that were made at the end of the previous
accounting period.

Two benefits of using reversing entries are:

 It greatly reduces the chance of double-counting revenues and/or expenses, and
 It allows for more efficient processing of the actual invoices that will be
processed in the new accounting period

A. Accrued Expense
Payable xxx
Expense xxx

B. Accrued Income
 Income xxx
Receivable xxx

C. Prepaid Expense – expense method

Expense xxx
Prepaid Expense xxx

D. Deferred Revenue – revenue method

Unearned Income xxx
Income xxx

For additional reading and in-debt discussion, please refer to the following link:
https://www.accountingcoach.com/blog/reversing-entries
What are reversing entries and why are they used?
Harold Averkamp

https://www.accountingtools.com/articles/what-is-a-reversing-entry.html
Reversing entries
May 18, 2019

References:

Abrugar, V. (2011, May 29). What is Accounting?. Retrieved from https://businesstips.ph/what-is-

accounting/ on May 24, 2020

Averkamp, H. (2020). What are reversing entries and why are they used?. Retrieved from
https://www.accountingcoach.com/blog/reversing-entries

Baysa, G. & Lupisan, M.C. (2014). Accounting for Partnership and Corporation. Manila, Philippines:
Millenium Books, Inc.

Bock, M. (2020, May 24). Adjusting Entries: What They Are and Why You Need Them. Retrieved from
https://www.fool.com/the-blueprint/adjusting-entries/ on May 25, 2020

Macnamara, D. (2019, October 4). Trial Balance to Income Statement and Statement of Financial
Position. Retrieved from https://www.youtube.com/watch?v=-dPLqWYuT_k

Reversing entries. (2019). Retrieved from https://www.accountingtools.com/articles/what-is-a-reversing-

entry.html