Intermediate Accounting 1

1
The Accounting Process

Module 002: The Accounting Process

Course Learning Outcomes:

1. State the sequence of the procedures followed in the accounting process.
2. Understand the recording process and know the different types of
accounting records and their uses.
3. Enumerate the components of a complete set of financial statements.
4. Know the methods of initial recording of income and expenses.

The Accounting Process

The accounting process comprises the activities of identifying, measuring, and
communicating economic information that is useful for decision making purposes.
The accounting process is effected through an entity’s accounting information system and
culminates to the preparation of the financial statements.

Accounting Information System

Accounting information system (accounting system) is the system of collecting and
processing transaction data and disseminating financial information to interested
parties. It is a subsystem of Management Information System (MIS).
Management Information System is a set of data gathering, analyzing, and reporting
functions designed to provide management with the information it needs to carry out
its functions. The major components of an MIS are as follows:
I. Financial Information System or Accounting Information System
II. Personnel Information System
III. Logistics Information System
Components of Accounting Information System
1. Personnel directly involved in accounting work.

2. Accounting policies and standards.

Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements.
Not all of the PFRSs are applicable to an entity. An entity adopts and applies
only those PFRSs that are relevant and applicable to its operations . The PFRSs
adopted and applied become the entity’s accounting policies. Such accounting
policies are disclosed in the entity’s notes to financial statements.

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 3. Procedures or set of interrelated activities involving the originating, processing
and reporting of financial and related data.

4. Equipment and devices used in the system to expedite work, to provide controls,
and prevent fraud and errors.

5. Records and reports necessary to gather, process, store and transmit financial
and other information.

The Accounting Cycle

Accounting Cycle represents the steps or accounting procedures normally used by entities
to record transactions and prepare financial statements. The accounting cycle implements
the accounting process.

Steps in the Accounting Cycle

1. Identifying and analyzing business documents or transactions. The accountant
gathers information from source documents and determines the impact of the
transactions on the financial position as represented by the basic equation “Assets
= Liabilities + Equity.”

2. Journalizing – the accountable events identified are recorded in the journals.

3. Posting – information from the journal are transferred to the ledger. The ledger
is a device that stores the accounts.

4. Preparing the unadjusted trial balance (this is the start of the worksheet
preparation) – balances of the general ledger accounts are proved as to the
equality of debits and credits and serve as basis for adjusting entries.

5. Preparing the adjusting entries – Adjusting entries are needed to update

accounts on an accrual basis of accounting by recording accruals of income and
expenses, expiration of deferrals, estimations, and other events often not signaled
by new source documents.

6. Preparing the adjusted trial balance – After posting the adjusting entries, the
monetary totals of debits and credits are again checked for equality. The adjusted
trial balance facilitates the preparation of the financial statements.

7. Preparing the financial statements – The financial statements are the means by
which the information processed is communicated to the users.

8. Closing the books – involves journalizing and posting closing entries and ruling
the ledger. Temporary accounts or nominal accounts are closed and the resulting
profit or loss is transferred to the retained earnings account.

9. Preparing the post-closing trial balance – After posting the closing entries, the
monetary totals of debits and credits are again checked for equality. The post-
closing trial balance provides the balances that will be extended to the next
accounting period.
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The Accounting Process

10. Preparing the reversing entries – Reversing entries are usually made at the
beginning of the next accounting period. Reversing entries facilitate the recording
of certain transactions in the next accounting period.
The preparation of trial balances and reversing entries represented by steps 4, 6, 9 and
10 are optional. They are not required in the preparation of financial statements.
However, for best internal control purposes, trial balances should be prepared.

Identifying and Analyzing Transactions and Events

Identifying and analyzing transactions and events is the process of selecting a
transaction or event and analyzing its impact on the financial position.
Accounting Records of a Business Entity
1. Business or source documents – these are the original source materials
evidencing a transaction. Examples are purchase invoice, official receipts,
vouchers, debit or credit memoranda, and miscellaneous bills for expenses.

2. Books of Original Entry – these refer to the journals such as the General
Journal and the Special Journals.

3. Books of Final Entry – these refer to the ledgers such as the General Ledger
and the Subsidiary Ledgers.
Systems of Recording Transactions
1. Double-entry system – Under this system, each transaction is recorded in two
parts – debit and credit. The double-entry system makes use of the following
concepts:

a. Duality – this concept views each transaction as having two-fold effect

on values – a value received and a value parted with, and each
transaction is recorded using at least two accounts.
b. Equilibrium – this concept requires each transaction to be recorded in
terms of equal debits and credits.

This type of recording is in line with the PFRSs because profit or loss is
determined through the transaction approach. Under the transaction approach,
profit or loss is determined as the difference between income and expenses.

Accounts recognized under the double entry-system include assets, liabilities,

equity, income and expenses.

Books used under the double-entry system include journal, special journal,
general ledger, subsidiary ledger and other important books.

2. Single-entry system – Under this system, each transaction is recorded through

narrative. Transactions are not analyzed in terms of debits and credits. Profit
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 or loss for the period is determined through the capital maintenance approach
or by comparing the beginning and ending balances of equity.

This type of recording is not in line with the PFRSs because profit or loss is not
determined using the transaction approach. Moreover, internal control is not
enhanced under this type of recording because records are usually inadequate.

Accounts recognized under the single-entry system include cash, accounts

receivable, accounts payable, equity, etc.

Books used under the single-entry system include cash books and subsidiary
ledgers (personal accounts).

Journals are used only under the double-entry system because only this system utilizes
debits and credits. However, ledgers are used under both the double-entry and single-
entry systems.
Accrual basis and cash basis of accounting can be applied under both the double-entry
and single-entry systems.
Under accrual basis, income and expenses are recognized when earned and incurred,
regardless of when cash is received or paid. Under cash basis, income and expenses
are recognized when cash is received or paid, regardless of when earned or incurred.

Journalizing
Journalizing is the process of recording transactions in the journal by means of journal
entries.
Journal (also called the book of original entry) is a formal record where transactions
are initially recorded chronologically through journal entries.
Types of Journals
1. General Journal – a book of original entry used to record transactions other
than those which are recorded in the special journals. If special journals are not
utilized, all transactions are recorded in the general journal.

2. Special Journal – a book of original entry used to record transactions of a similar

nature.
Examples of Special Journals
1. Sales Journal – a journal used to record sales on account
2. Purchases Journal – a journal used to record purchases of inventory on account.
3. Cash receipts journal – a journal used to record all transactions involving
receipts of cash.
4. Cash disbursement journal – a journal used to record all transactions involving
payments of cash.
Transactions not recorded in special journals are recorded in the general journal.
Examples of such transactions include purchases of inventory for note payable,
adjusting entries, reversing entries, etc.
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Types of Journal Entries

1. Simple journal entry – one which contains a single debit and a single credit
element.

2. Compound journal entry – one which contains two or more debits or credits.

3. Adjusting entries – entries made prior to the preparation of the financial

statements to update certain accounts so that they reflect correct balances as
at the designated time.

4. Closing entries – entries made at the end of the accounting period after all
adjustments have been made to zero-out the balances of nominal accounts and
to update the retained earnings account.

5. Reversing entries – entries usually made in the next accounting period to

reverse certain adjusting entries in the previous accounting period in order to
facilitate recording of cash receipts and disbursements in the next accounting
period.

6. Correcting entries – entries made to correct accounting errors committed.

7. Reclassification entries – entries made to transfer an item from one account to

another account that better describes the nature of the item transferred.

Posting
Posting is the process of transferring data from the journal to the appropriate accounts in
the ledger. It serves to classify the effects of transactions on specific asset, liability, equity,
income and expense accounts.

Ledger is a systematic compilation of a group of accounts.

Kinds of Ledgers
1. General Ledger – one which contains all accounts appearing in the financial
statements.

2. Subsidiary Ledger – a supporting ledger consisting of a group of accounts with

similar nature, the total of which is in agreement with the balance of the related
controlling account in the general ledger.

For example, the “Accounts receivable” account is a controlling account

appearing in the general ledger. This account is supported by various
subsidiary accounts in the subsidiary ledger such as “Accounts receivable –
Customer A”, “Accounts receivable – Customer B”, etc. The sum of various
subsidiary accounts in the subsidiary ledger should equal the amount of the
“Accounts receivable” account in the general ledger.
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Account is the basic storage of information in accounting, e.g., cash, accounts
receivable, land, accounts payable, etc.
Accounts in the general ledger follow the format of a T-account, wherein the left side
is called the debit side and the right side is called the credit side. The term debit simply
means to the left side of an account while credit means the right side.
Although not treated as a formal record, the T-account is useful in making accounting
analyses.
Chart of Accounts is a list of all the accounts used by the entity. To promote
comparability, account titles should conform with PFRSs and industry practices.
Furthermore, regulated entities should have charts of accounts that conform with
relevant regulations (e.g., a bank’s chart of accounts should conform with the chart of
accounts endorsed by the Bangko Sentral ng Pilipinas).
Types of Accounts
1. Real accounts – accounts which are not closed at the end of the accounting
period. These accounts are shown in the statement of financial position.

2. Nominal accounts – accounts which are closed at the end of the accounting
period. These accounts include all income statement accounts, dividends and
drawings account, clearing accounts (e.g. ‘Income Summary’ account) and
suspense accounts (e.g., ‘Cash shortage or overage account’), and the like.

The “Drawings” account is used by sole proprietorships and partnerships. The

“Dividends” account is used by corporations when dividends are declared prior
to year-end.

3. Mixed accounts – accounts having both statement of financial position and

income statement components. These accounts are subject to adjustment.

Mixed accounts include unadjusted prepayments and deferrals having both

expired and unexpired components. The expired portion is the income
statement component while the unexpired portion is the statement of financial
position component.

4. Contra accounts – offset accounts or accounts which are deducted from a

related account, e.g., allowance for doubtful accounts and accumulated
depreciation.

5. Adjunct accounts – accounts which are added to a related account, e.g.,

premium on bonds payable and freight-in.
Conceptually, valuation accounts such as contra accounts and adjunct accounts are
neither assets nor liabilities.
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Preparation of Trial Balance

Trial Balance is a list of accounts and their balances, prepared for the purpose of proving
the mathematical accuracy of the monetary totals of debits and credits in the ledger. The
preparation of the trial balance creates a starting point for the preparation of the financial
statements.

The concept in the preparation of the unadjusted trial balance as it relates to internal control
is that adjusting entries and consequently financial statements cannot be prepared unless
the total debits and credits in the unadjusted trial balance are equal.
Types of Trial Balance
1. Unadjusted trial balance – this is prepared before adjusting entries. It contains
real, nominal and mixed accounts.

2. Adjusted trial balance – this is prepared after adjusting entries. It contains real
and nominal accounts.

3. Post-closing trial balance – this is prepared after the closing process. It contains
real accounts only.
Errors revealed by a trial balance
Errors revealed by a trial balance are those errors which caused the total debits and
total credits to be unequal, Examples are:
1. Journalizing or posting one-half of an entry, i.e., a debit without a credit or vice
versa
2. Recording one part of an entry for a different amount than the other part
3. Errors of transplacement (slide error) on one side of an entry
4. Error of transposition on one side of an entry
Transplacement error is committed when the number of digits in an amount is
incorrectly increased or decreased, e.g., a P1,000 amount is recorded as P100 or
P10,000.
Transposition error is committed when digits in an amount are interchanged, e.g., a
P1,725 amount is recorded as P1,275.
Errors not revealed by a trial balance
Errors that do not make the total debits and total credits unequal are not revealed by
a trial balance. Examples are:
1. Omitting entirely the entry for a transaction
2. Journalizing or posting an entry twice
3. Using a wrong account with the same normal balance as the correct account
4. Wrong computation with same erroneous amounts posted to debit and credit
sides

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Preparation of Adjusting Entries
Adjusting entries are made prior to the preparation of financial statements to update
certain asset, liability, income or expense accounts in order to bring them to their adjusted
balances.

All adjusting entries involve at least one statement of financial position account and one
statement of profit or loss and other comprehensive income account. Moreover, all adjusting
entries affect the comprehensive income for the period.
Purposes of Adjusting Entries
1. To take up unrecorded income and expense of the period (e.g., accruals for
income and expenses).
2. To split mixed accounts into their real and nominal elements (e.g., adjustments
to prepayments and unearned income).

Preparing a Worksheet
A worksheet is an analytical device used in accounting to facilitate the gathering of data for
adjustments, the preparation of financial statements, and closing entries. Although optional,
worksheets are commonly prepared in practice, using spreadsheet application.
Heading the Worksheet
The heading of the worksheet should show the following:
1. Name of the entity
2. Title of the working paper (e.g., Worksheet)
3. Time period covered

Preparing the Financial Statements

Financial statements are the means by which the information accumulated and processed
in financial accounting is periodically communicated to the users. Financial statements are
the end products of the accounting process.

Under PAS 1 Presentation of Financial Statements, a complete set of financial statements

comprises:

1. A statement of financial position as at the end of the period;

2. A statement of profit or loss and other comprehensive income for the period;

3. A statement of changes in equity for the period;

4. A statement of cash flows for the period;

5. Notes, comprising a summary of accounting policies and other explanatory notes; and
6. A statement of financial position as at the beginning of the earliest comparative
period when an entity applies an accounting policy retrospectively or makes a
retrospective restatement of items in its financial statements, or when it reclassifies
items in its financial statements.
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Heading the Financial Statements

The heading of the financial statements should show the following:
1. Name of the reporting entity
2. Title of the financial statement
3. Reporting period
The statement of financial position is dated as at the end of the reporting period. The
statements of profit or loss and comprehensive income, changes in equity, and cash
flows are dated covering the reporting period. In practice, notes to financial
statements are simply dated by the end of the reporting period. Some entities don not
date notes at all.
Illustration:

Type of Financial Statement Date

1. Statement of financial position As of (or As at) December 31, 20XX

2. Statement of profit or loss and other For the year ended December 31,
comprehensive income 20XX

3. Statement of Changes in Equity For the year ended December 31,

20XX

4. Statement of Cash Flows For the year ended December 31,

20XX

5. Notes December 31, 20XX

Methods of Initial Recording of Income and Expenses

Income may initially be recorded using either the (1) liability method or the (2) income
method.

1. Liability method – under this method, cash receipts from items of income are initially
credited to a liability account, e.g., unearned rent. At the end of the period, the
adjusting entry would be for the earned portion (income portion) of the cash receipt.
2. Income method – under this method, cash receipts from items of income are initially
credited to an income account, e.g., rent income. At the end of the period, the adjusting
entry would be for the unearned portion (liability portion) of the cash receipt.

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Illustration 1: Liability Method vs. Income Method

An entity receives P60,000 advance rent covering 3 years starting January 1, 2018.

The receipt is initially recorded under each of the methods as follows:

Liability Method Income Method

Jan. 1, 2018 Jan. 1, 2018
Cash on hand 60,000 Cash on hand 60,000
Unearned rent 60,000 Rent income 60,000

The year-end adjusting journal entries (AJE) under each of the methods are as follows:

Liability Method Income Method

Dec. 31, 2018 Dec. 31, 2018
Unearned rent 20,000 Rent income 40,000
Rent income (60K x 1/3) 20,000 Unearned rent (60K x 2/3) 40,000

Regardless of the method used, the amounts of unearned rent and rent income recognized
in the financial statements would be the same. Analyze the T-accounts below.

Liability method Income method

Unearned rent Unearned rent
60,000 1/1/18 - 1/1/18
AJE 20,000 40,000 AJE
12/31/18 40,000 12/31/18 40,000

Rent income Rent income

- 1/1/18 60,000 1/1/18
20,000 AJE AJE 40,000
12/31/18 20,000 12/31/18 20,000

Expenses

Expenses may initially be recorded using either the (1) asset method or (2) expense method.

1. Asset method – under this method, cash disbursements for items of expenses are
initially debited to an asset account, e.g., prepaid insurance. At the end of the period,
the adjusting entry would be for the expired portion (expense portion) of the cash
disbursement.
2. Expense method – under this method, cash disbursements for items of expenses are
initially debited to an expense account, e.g., insurance expense. At the end of the
period, the adjusting entry would be for the unexpired portion (asset portion) of the
cash disbursement.
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Illustration 2: Asset Method vs. Expense Method

An entity prepays a P20,000 one-year insurance on October 1, 2018.

The disbursement is initially recorded under each of the methods as follows:

Asset Method Expense Method

Oct. 1, 2018 Oct. 1, 2018
Prepaid insurance 20,000 Insurance expense 20,000
Cash in bank 20,000 Cash in bank 20,000

The year-end adjusting journal entries under each of the methods are as follows:

Asset Method Expense Method

Dec. 31, 2018 Dec. 31, 2018
Insurance expense 5,000 Prepaid insurance 5,000
Prepaid insurance 5,000 Insurance expense 5,000

20,000 x 3/12 = 5,000

20,000 x 9/12 = 15,000

Regardless of the method used, the amounts of prepayment and expense recognized in the
financial statement would be the same.

Closing the Books

Closing the books is the process of preparing closing entries for nominal accounts and
ruling and balancing real accounts.

Closing entries are entries prepared at the end of the accounting period to “zero out” all
temporary or nominal accounts in the ledger. This is done so that the transactions in a period
will not commingle with the next period’s transactions. Closing the books is an application
of the periodicity concept.

Illustration: Closing Entries

The inexperienced accountant of JKL Co. prepared the following closing entry on December
31, 2018:

Dec. 31, 2018 Prepaid insurance 10,000

Accrued interest expense 2,000
Cost of goods sold 170,000
Interest income 20,000
Dividend income 30,000
Unrealized gain – OCI 5,000
Income Summary 447,000

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 Dividends 12,000
Sales 450,000
Operating expenses 200,000
Finance cost 2,000
Accrued interest income 20,000

Dec. 31, 2018 Retained earnings 447,000

Income summary 447,000

Requirement: How much is the correct amount of “Income Summary" to be closed to retained
earnings?

Solution:

Dec. 31, 2018 Interest income 10,000

Dividend income 2,000
Sales 170,000
Operating expenses 200,000
Finance cost 2,000
Cost of goods sold 170,000
Income summary 128,000
Dec. 31, 2018 Retained earnings 140,000
Income summary 128,000
Dividends 12,000

Notes:

 Only income statement accounts, i.e., those that enter into the determination of profit
or loss, are closed to the “Income Summary”
 Income accounts are closed by debiting them. Expense accounts are closed by
crediting them.
 The dividends account is directly closed to retained earnings because dividends
declared do not enter into the determination of profit or loss. The dividends account
is similar to the “drawings” account used in sole proprietorships and partnerships.
The dividends account may be used when dividends are declared prior to year-end.
 Accrued interest expense is a liability account similar to “interest payable.” Accrued
interest income is a receivable account similar to “interest receivable.” These are real
accounts.
 The “Unrealized gain – Other Comprehensive Income” account is a real account that
is accumulated in equity.

Preparing the Post-Closing Trial Balance

The post-closing trial balance is prepared in order to prove the equality of debits and credits
in the ledger after the closing process. It contains statement of financial position accounts
only because all income statement accounts are closed. The post-closing trial balance
provides the balances that will be extended to the next accounting period.
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Reversing Entries
Reversing entries are usually made on the first day of the next accounting period to reverse
certain adjusting entries in the immediately preceding period.
Purposes of Reversing Entries:
1. To facilitate the recording of cash receipts and disbursements in the
next accounting period;
2. To provide convenience in recording the next accounting period’s year-
end adjustments for accruals; and
3. To promote consistency in the application of accounting procedures.

Adjusting entries that may be reversed

1. All accruals, whether for income or expense
2. Prepayments initially recorded using the expense method
3. Unearned income initially recorded using the income method

Illustration: Reversing Entries

On September 30, 2018, JKL Co. issued a P1,000,000, 12%, 4-year note payable to MNO, Inc.
Interest and principal, in 4 equal annual installments, are payable every September 30. JKL
Co. records disbursements for expenses using nominal accounts. At December 31, 2018, the
following adjusting entry was made to take up the accrued interest.

Dec. 31, 2018 Interest Expense (1M x 12% x 3/12) 30,000

Interest payable 30,000

Requirements:
a. If no reversing entries are made, what is the adjusting entry on December 31, 2019 to
take up accrued interest?
b. If reversing entries are made, what is the adjusting entry on December 31, 2019 to
take up accrued interest?

Solutions:

The transactions in 2019 are recorded as follows:

Sept. 30, Note payable (1M ÷ 4 equal annual installments) 250,000

2019 Cash in bank 250,000
to record the first installment payment of principal
on the note
Sept. 30, Interest expense (1M x 12%) 120,000
2019 Cash in bank 120,000

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 to record the cash payment for interest from Sept.
30, 2018 to Sept. 30, 2019 using nominal account
(i.e., expense method)

To determine the year-end adjustments, the adjusted balances of interest expense and
interest payable are computed first. Next, the unadjusted balances are determined. The
differences between the adjusted and unadjusted balances represent the adjustments.

The adjusted balance of interest expense for 2019 is computed as follows:

Interest expense from Jan. 1 to Sept. 30, 2019

(1M x 12% x 9/12) 90,000
Interest expense from Oct. 1 to December 31, 2019
[(1M - 250K) x 12% x 3/12] 22,500
Adjusted balance of interest expense in 2019 112,500

The adjusted balance of interest payable for 2019 is computed as follows:

Interest expense incurred from Oct. 1 to Dec. 31, 2019 but not
yet paid [(1M- 250K) x 12% x 3/12] 22,500

Requirement (a): No reversing entries made

The beginning balance from the adjusting entry made on December 31, 2018, the
transactions in 2019, and the computed adjusted balances are placed on the T-accounts
below, then the adjustments are squeezed.

Interest payable
beg. Bal. 30,000
September 30, 2019 -
Adjustment (squeeze) 7,500
Adjusted end. Bal. 22,500

Interest expense
beg. Bal. -
September 30, 2019 120,000
Adjustment (squeeze) 7,500
Adjusted end. Bal. 112,500

From the T-accounts above, the year-end adjusting entry if no reversing entries are made is
as follows:
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Dec. 31, 2019 Interest payable 7,500

Interest expense 7,500

Requirement (b): Reversing entries are made

In addition to the transactions during the year, the following reversing entry, which is the
exact opposite of the December 31, 2018 adjusting entry, should also be placed in the T-
accounts.

Jan. 1, 2019 Interest payable 30,000

Interest expense 30,000
to record the reversing entry

Interest payable
beg. Bal. 30,000
Reversing entry 30,000
Sept. 30, 2019
Adjustment (squeeze) 22,500
Adjusted end. Bal. 22,500

Interest expense
beg. Bal. -
Reversing entry 30,000
September 30, 2019 120,000
Adjustment (squeeze) 22,500
Adjusted end. Bal. 112,500

From the T-accounts above, the year-end adjusting entry if reversing entries are made is as
follows:

Dec. 31, 2019 Interest expense 22,500

Interest payable 22,500

Notice that the adjusting entry if reversing entries are made is only for the expense incurred
but not yet paid. Thus, reversing entries simplify the recording of transactions and adjusting
entries.

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References and Supplementary Materials
Books and Journals
1. Valix, C.T., Peralta, J.F, & Valix, C.M. (2019), Intermediate Financial Accounting (2019
edition, Volume 1). Manila, Philippines: GIC Enterprises & Co., Inc.
2. Robles, N.S., & Empleo, P.M., The Intermediate Accounting Series Volume 1 (2016
edition). Manila, Philippines: GIC Enterprises & Co., Inc.
3. Milan, Z.V.B., Intermediate Financial Accounting 1A (2016 edition). Baguio City,
Philippines: Bandolin Enterprise

Online Supplementary Reading Materials

1. https://thebookkeeper.ae/accounting-process-accounting-basics/; August 16,2019
2. https://www.accountingformanagement.org/accounting-cycle-steps/; August 16,
2019