FEU MAKATI

Theory of Accounts TOA Lecture 1

Prof. Francis H. Villamin
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REVIEW OF THE FINANCIAL ACCOUNTING PROCESS

I. THE ACCOUNTING PROCESS/ACCOUNTING SYSTEM

An 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 system and culminates to the preparation of the financial statements.

An accounting system is the means by which a reporting entity records and stores the financial and
managerial information from its transactions or economic events so that it can retrieve and report the
information in an accounting statement.

Components of an accounting system

1. Personnel directly involved in accounting work.
2. Accounting policies and standards. These are specific principles, bases and conventions, rules
and practices applied by an entity in preparing and presenting financial statements.
3. Procedures or a 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 the work, provide controls and minimize if
not totally prevent fraud and errors.
5. Records and reports necessary to gather, process, store and transmit financial and other
information.

II. BOOKKEEPING SYSTEM

Bookkeeping is the systematic and chronological recording of transactions and events in books of
account. It is also known as the recording phase of accounting.

Systems of Bookkeeping
1. Double Entry Bookkeeping – A system of bookkeeping which views a transaction as having two-
fold effect on accounting values (a value received and a value parted with and which reflects
these two-fold effects in the accounting record).

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

The accounts recognized under this system include assets, liabilities, equity, income and
expenses and the books used include journal, special journal, ledger, subsidiary ledger and other
important books.

2. Single Entry Bookkeeping – A system of bookkeeping whereby, as a general rule, only cash and
personal accounts are recognized.

This type of recording is not in line with GAAP because profit or loss is not determined using the
transaction approach.

The accounts recognized under this system include Cash, Accounts Receivable, Accounts
Payable and Equity and the books include only ledgers but not journals which are used only at
double entry system.

III. BROAD STEPS OF OPERATION IN THE FINANCIAL ACCOUNTING PROCESS

These are the series of steps undertaken in one accounting period to identify, record, store and report
accounting information contained in accountable events.
1. Selecting the event (or identification of accountable events) – An event or transaction is selected for
recording if it complies with the criteria for accountable events or under double-entry principles.
2. Analyzing the events – events are analyzed to determine their effects on the financial position of the
enterprise.
3. Measuring the effects – effects of the events on the financial position of the enterprise are measured
and represented by money amounts.
4. Classifying the measured effects – the effects are classified according to the individual assets and
liabilities, owners’ equity items, revenue and expenses affected.
5. Recording the measured effects - the effects are recorded according to the asset, liability, equity,
revenue and expense items affected (Journalizing and posting)
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6. Summarizing the recorded effects – the amount of changes for each asset, liability, equity item,
revenue and expenses are summarized and related data are grouped. (Trial balance preparation)
7. Adjusting the records – re-measurements, new data, corrections or other adjustments are often
required after the events have been initially recorded, classified and summarized of financial
statements. (Preparation of adjusting entries including worksheet preparation).
8. Communicating the processed information – the information is communicated to users in the form.
(Preparation of Financial Statements)

IV. ACCOUNTING CYCLE

- A series of well-defined steps leading to the communication of the effects of a business transaction.
The accounting cycle implements the accounting process from period to period.

A. Parts of the Financial Accounting Process:

1) Recording Phase – includes identifying and analyzing transactions, journalizing and posting.
2) Summarizing Phase - includes the preparation of unadjusted trial balance, adjusting entries, financial
statements, closing entries, post-closing trial balance and revenue entries.

B. Steps in the Accounting Cycle

1) Identifying and Analyzing transactions and events to be recorded – Gathering of information from
source documents and determine the impact of the transaction or event on the financial position using
the equation “Assets equals Liabilities + Owners’ Equity”
2) Journalizing the transactions and events – Act of recording transactions in the business forms to
appropriate journals.
3) Posting – act of transferring peso amounts and other information from the journal to the ledger.
4) Preparing the unadjusted trial balance – balance of the general ledger accounts are proved as to
the equality of debits and credits and to serve as a basis for adjusting entries.
5) Journalizing and posting the adjusting entries – to take up accruals, expiration of deferrals,
estimations and other events often not signaled by new source documents.
6) Preparing the adjusted trial balance (or preparing the worksheet) – Checking the equality of debits
and credits after adjustments and to facilitate the preparation of financial statements.
7) Preparing the financial statements – the means by which the processed information is
communicated to external decision-makers.
8) Closing the books – involves journalizing and post-closing entries, and ruling and balancing real
accounts in the ledger. Temporary capital accounts (or nominal accounts) are closed and the
resulting net income or loss is transferred to the capital account or retained earnings account.
9) Taking a post-closing trial balance – this is done to prove equality of debits and credits in the ledger
after the closing process.
10) Preparing, entering and posting of reversing entries – this is done to facilitate the recording of
certain transactions in the succeeding accounting period.

C. 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, miscellaneous
bills for expenses.
2. Books of original entry – these refer to the journals such as the General Journal and the special
journals (sales journal, purchase journal, cash receipts journal, cash disbursement journal, or voucher
register and check register).
3. Books of final entry – these refer to the Ledgers: General Ledger and Subsidiary ledgers

V. IDENTIFYING AND ANALYZING TRANSACTIONS AND EVENTS

- The process of selecting a transaction or event and analyzing its impact on the financial position.
1. The “dual effects principle” of the double entry system of bookkeeping is used. Each recorded
event affects at least two items in the financial accounting records.
2. The account is used as the storage unit of information in double-entry system. It is composed of
three parts, the name of the account, (or account title), the left side (or debit), the right side (or credit)
3. Rules of debit and credit:
DEBIT CREDIT
a. Increases in assets. a. Decrease in assets.
b. Decrease in liabilities. b. Increase in Proprietorship
c. Decrease in proprietorship due to: c. Increase in proprietorship due to:
Decrease in investment due to personal Original investment,
withdrawals Additional investment
Decrease in income or retained earnings Increase in income
Increase in expense Decrease in expense

VI. JOURNALIZING
- The process of recording transactions by means of a journal entry in the journal.
A. Types of journal entries as to the time prepared:
a. Opening entry – entry beginning a new system of accounting for enterprises.
b. Current entries – entries to record transactions completed by the business during a given
period.
c. Adjusting entries – entries made at the end of the accounting period to update certain
amounts so that they reflect correct balances at a designed time.
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d. Closing entries – entries made at the end of the accounting period after adjustments, by
means of closing nominal accounts to a summary account transferring the balances to
Capital.
e. Reversing entries – entries made at the start of the subsequent accounting period to reverse
certain adjusting entries made in the immediately preceding accounting period.
f. Correcting entries – entries made to correct entries made in error.
g. Reclassification entries – entries that transfer an item from one account to another that may
clearly describe the nature of the item transferred.

B. Types of journal entries as to form:

a. Simple journal entry – contains a single debit and single credit element.
b. Compound journal entry – has two or more elements and often representing two or more
transactions.

C. JOURNAL
- A formal record or book of original entry where transactions are recorded for the first time.

D. Types of Journals:
a. Simple journal – a book of original entry used to record all transactions
1. general journal – simple journal with two money columns
2. combination journal – simple journal with several money columns
b. Special journal – multi-column book to record transactions of a similar nature.

Types of Special Journals:

a. Sales journal – a journal used to record sales on account.

b. Purchases journal – a journal used to record purchases of inventory on account.
c. Cash receipts journal – a journal used to record all transactions involving receipts of cash.
d. Cash disbursements journal – a journal used to record all transactions involving payment
of cash.

E. Voucher System – a special method of accounting for business transactions which involves the
payment of cash immediately or in the future. It is one of the means of establishing internal
control over the expenditure of the business.

F. Books of Accounts Used:

1. Voucher register – records vouchers issued
2. Check register – records all sales involving payment by checks
3. Sales register – records all sales of merchandise
4. Cash receipts journal – records all receipts of cash
5. General journal – records transactions not accommodated in special journal

G. Procedures for the Voucher System:

1. Preparing the voucher
2. Approval of voucher (control measure)
3. Recording the voucher
4. Filing the unpaid voucher
5. Filing the paid voucher

H. Advantages of the Voucher System:

1. Better control over disbursements
2. Facility in taking cash discount
3. Elimination of account payable subsidiary ledger

I. Disadvantages of Voucher System

1. Lacks flexibility
2. May result in duplication of work and increased bookkeeping expenses

VII. POSTING
- It is the process of transferring data from the journal to the appropriate accounts in the ledger.

A. Purpose:
It serves to classify the effects of transactions on specific asset, liability, proprietorship, revenue
and expense accounts.

B. Ledger
Systematic compilation of a group of accounts
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C. Kinds of Ledger
a. General Ledger – contains all accounts appearing in the financial statements.
b. Private Ledger – contains confidential information of accounts.
c. Subsidiary Ledger – a supporting ledger consisting of a group of accounts of similar nature,
the total of which is in agreement with a controlling account in the general ledger.

D. Kinds of Subsidiary Ledger:

a. Accounts Receivable Ledger
b. Accounts Payable Ledger
c. Work in Process Ledger
d. Finished Goods Ledger
e. Factory Ledger
f. Plant Ledger
g. Expense Ledger

E. Advantages of a subsidiary ledger:

1. The general ledger is relieved of too much detail.
2. The trial balance is shorter.
3. The preparation of financial statements is facilitated.
4. Work could be divided between several persons.

F. Accounts – are accounting devices used to summarize changes in asset, liability or

proprietorship.

G. Kinds of Accounts
1. Real accounts – accounts which are not closed at the end of the accounting period. These
accounts are included 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 and other
suspense accounts such as “Income Summary” account, “Cash short or over” account. 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 statements of financial position and income statement
components. These accounts are subject to adjustments.
4. Contra accounts – are offset accounts or accounts which are deducted from the related
account. Examples include “Allowance for Uncollectible Accounts”, “Accumulated
Depreciation”
5. Adjunct accounts – are accounts which are added to the related account. Examples include
“Premium on Bonds Payable”, “Freight In”

VIII. PREPARING THE TRIAL BALANCE

This is the third step of the bookkeeping cycle which is the listing down of accounts with open balances in
order to prove the mathematical accuracy of the debits and credits in the ledger.

A. TYPES OF TRIAL BALANCE:

a. As to Form:
1. Trial Balance of Balances – contains accounts with open balances only.
2. Trial Balance of Totals – contains all accounts in the ledger, both open and closed.

b. As to Time of Preparation:
1. Periodic or Unadjusted Trial Balance – this is prepared before the preparation of adjusting
entries.
Contents: Real, Nominal and Mixed Accounts
2. Adjusted Trial Balance – one prepared after adjusting entries.
Contents: Real and Nominal Accounts
3. Post-closing Trial Balance – one prepared after the closing process.
Contents: Real Accounts only

B. ERRORS REVEALED BY A TRIAL BALANCE

1. Error of Transplacement
2 Error of Transposition
3. Error in posting one side of an entry
4. Omission in posting one side of an entry

C. ERRORS NOT REVEALED BY A TRIAL BALANCE

1. Wrong computation
2. Wrong classification of account (wrong account used)
3. Double-posting both sides of an entry
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4. Omission in posting both sides of an entry

5. Omission in journalizing a transaction

IX. PREPARATION OF ADJUSTING ENTRIES

These are entries made at the accounting period to update or bring to their correct balances
certain asset, liability, revenue or expense accounts.
A. CONCEPTS INVOLVED:
1. ACCRUAL
Revenue must be recognized when earned, even if cash is not yet received. Expenses must
be recorded when benefits are received, even if cash is not yet paid.

2. MATCHING OF COSTS AGAINST REVENUE

To have a fair measurement of revenue in a given period of time, all costs and expenses
incurred in generating that revenue must be deducted therefrom.

3. ACCOUNTING PERIOD
A transaction is recorded on the basis of business papers. Certain transactions, however,
remain “unfinished” at the time of reporting financial information. Estimates and updating
entries therefore become necessary in order to reflect more fairly the status of certain
accounts.

B. PURPOSE OF ADJUSTING ENTRIES:

1. To take up unrecorded income and expenses of the period
a. Accrued Expense
b. Accrued Income

2. To split mixed accounts into their real and nominal elements:

a. Prepaid expenses
b. Unearned or pre-collected income
c. Bad debts
d. Inventory
e. Depreciation

X. PREPARING ADJUSTED TRIAL BALANCE OR A WORKSHEET

A. Definition
A worksheet is an analytical device used in accounting to facilitate the gathering of data
adjustment, the preparation of financial statements, and closing entries.

B. Factors affecting the money columns of the worksheet

1. Concept followed in Accounting for Revenue and Expenses:
(Cash, Modified Cash, Accrual Basis)
2. Nature of the Business
3. Ownership of the Business
4. Volume of Activities

XI. PREPARING FINANCIAL STATEMENTS

A. Definition:
Financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users.

B. Components of the Basic Financial Statements:

1. Statement of Financial Position – conventionally called “Balance Sheet”, a formal statement
showing assets, liabilities, capital or the financial position of an enterprise as of a given date.
2. Statement of Comprehensive Income – presents the revenue, expenses, gains, losses,
both realized and unrealized, that are the results of the enterprise’s profit-directed activities
during a given period of time.
3. Statement of Changes in Equity – shows the movements in the elements of stockholders’
equity which includes the net income and items such as dividends, appropriations and
adjustments of net income of prior periods.
4. Statement of Cash Flows – is a statement that summarizes the cash inflows and outflows
arising from operating, financing, and investing activities of the enterprise for a given period of
time.
5. Notes – contain explanatory material, and disaggregations of certain items in the face of the
financial statements, as well as other significant quantifiable and non-quantifiable information
that are necessary in making economic decisions.

XII CLOSING THE BOOKS

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A. Definition:
Closing the books is the process of preparing closing entries and ruling and balancing real
accounts.
Closing entries are entries prepared at the end of the accounting period to “empty” or bring to
zero all nominal accounts in the ledger.
B. Steps in preparing closing entries:
1. Close all nominal accounts to income and expense summary account.
2. Close Income and Expense Summary account to Drawing (in case of a single proprietorship
or partnership), or to Retained Earnings (if corporation).
3. Close Drawing to Capital.

XIII PREPARING THE POST-CLOSING TRIAL BALANCE

A. Definition:
A post-closing trial balance is a trial balance prepared after closing the books.
B. Purpose:
To prove the equality of the debits and credits in the ledger after the closing process.
C. Contents:
Real accounts only

XIV REVERSING ENTRIES

A. Definition:
Reversing entries are entries made on the first day of the succeeding accounting period to
reverse certain adjusting entries done in an immediately preceding period.
B. Purpose:
1. For convenience in recording accruals
2. For consistency
C. Adjustments requiring reversal:
1. Accrued expense
2. Prepaid expense, expense method
3. Unearned income, income method

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