Philippine826School

R. Papa St.of Business

Sampaloc, Manila
Administration
CPA REVIEW
THEORY OF ACCOUNTS
HAND OUT NO. 05-33 MAY 2006

REVIEW OF ACCOUNTING PROCESS

The accounting process can be described as a set of procedures used in identifying,

recording, classifying, and interpreting information related to the transactions and other
events of a business enterprise. To understand the accounting process, the following basic
terminology, make up the accounting cycle:

Transactions - Transactions are events that transfer or exchange goods or services between
two or more entities.

Real accounts – are balance sheet accounts (asset, liability, or equity account)

Nominal accounts- are income statements accounts (revenue or expense account).

Journal - sometimes referred to as the book of original entry. A general journal is merely a
chronological listing of transactions expressed in terms of debits and credits to particular
accounts.

Ledger – refer to the book of final entry. Summarized the total credits and total credits posted
per account.

Posting – Transferring amounts from a journal to the ledger. Transactions recorded in a

general journal must be posted individually, whereas entries made in specialized journals are
generally posted by columnar total.

Trial balance - A trial balance is a list of all open accounts in the general ledger and their
balances. Proves the equality of total debits and total credits.

Work sheet - serves as an aid to the accountant in adjusting the account balances and
preparing the financial statements. The work sheet provides an orderly format for the
accumulation of information necessary for preparation of financial statements. Use of a work
sheet does not replace any financial statements, nor does it alter any of the steps in the
accounting cycle.

Adjusting entries - Adjusting entries are entries made at the end of accounting periods to
bring all accounts up to date on an accrual accounting basis so that correct financial
statements can be prepared.

Closing entries - All nominal accounts are reduced to zero by closing them through the
Income Summary account.

Reversing entries - A reversing entry is made at the beginning of the next accounting period
and is the exact opposite of the adjusting entry made in the previous period. The recording of
reversing entries is an optional step in the accounting cycle that may be performed at the
beginning of the next accounting period. The entries subject to reversal are the adjusting
entries for accrued revenues and accrued expenses initially entered in expense or income
accounts.

OVERVIEW OF THE ACCOUNTING PROCESS

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 Recording Phase

A. Analyze business documents—ascertain what transactions and events should be

recorded.
B. Record transactions—originally record debits and credits in chronological order in a
journal.
C. Post transactions—transfer debits and credits to ledger accounts which summarize
changes in financial statement elements (assets, liabilities and owners’ equity, revenues,
and expenses).

REPORTING PHASE

A. Prepare a trial balance—a list of balances in general ledger accounts; first two columns of
a worksheet.
B. Prepare adjusting entries—all relevant information that has not been recorded must be
determined, recorded, and posted so that accounts are current prior to preparing financial
statements.
C. Prepare financial statements. Financial statements may be prepared from the adjusted
account balances in the ledger or a work sheet. Preparation should include footnote
disclosures.
D. Close the nominal accounts. All nominal (temporary) account balances are brought to zero
at the end of the fiscal year. These accounts are being closed to income summary
account. Any balance is transferred to retained earnings for corporation, and to capital
account for sole proprietorship and partnership. Real accounts are not closed.
E. Prepare a post-closing trial balance.
1. Debits and credits should be equal after closing
2. The post-closing trial balance should show that all nominal accounts carry zero
balances into the new year.

Double entry accounting

1. Basic accounting equation: Assets = Liabilities + Owners’ Equity

2. Debits are entries on left side of accounts and credits are entries to right side of
accounts.
3. Journal entries provide a systematic method for summarizing a business event’s
effect on the basic accounting equation.
4. Summary
a. Assets are increased by debits and decreased by credits.
b. Liability and owners’ equity accounts are increased by credits and decreased
by debits.
c. Owners’ equity for a corporation includes capital stock and retained earnings
accounts.
d. Revenues, expenses, and dividends relate to owners’ equity through the
retained earnings account.
e. Expense and dividends are increased by debit and decreased by credits.
f. Revenues are increased by credits and decreased by debits.
g. Revenues – expenses = net income for the period, which increases owners’
equity through retained earnings.

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 Preparing adjusting entries

1. Asset depreciation—a systematic allocation of an asset’s cost to expense and a

reduction, using a contra (or offset) account, in carrying value for a period during
which the asset is used in operations.
2. Bad Debts—estimated amount of uncollectible accounts receivable charged to current
period’s income as bad debt expense.
3. Accrued expenses—expenses incurred, but not to be paid until a following period.
4. Accrued revenues—revenues earned, but not to be received in cash until a following
period.
5. Prepaid expenses—recorded cash payments for benefits not yet received or only
partially so.
a. Was recorded by an original debit to an asset account—now, debit expense and
credit asset.
b. Was recorded by an original debit to expense—now, debit asset and credit
expense.
6. Deferred revenues—recorded cash receipts for services to be rendered in the future
or only partially rendered at the balance sheet date.
a. Was recorded by an original credit to a revenue account—now, debit revenue and
credit liability.
b. Was recorded by an original credit to a liability account—now, debit liability and
credit revenue.
7. Adjusting the inventory account.
a. Periodic system. Under the “adjusting method,” debit/credit Inventory for the
increase/decrease from the beginning of the period, then make appropriate
entries to transfer the balances in Purchases and related accounts to Cost of
Goods Sold.
b. Perpetual system. No adjustment is needed, except for unrecorded spoilage, theft
losses, or other “shrinkage” (as evidenced by a difference in the balance of the
inventory account with the appropriate balance as determined according to a
“physical” inventory).
TRUE/FALSE

1. The records used for the initial classifying and recording of business transactions are ledgers.

2. A business transaction is an event that involves the transfer or exchange of goods or services
between two or more entities.

3. Information recorded in the journals is transferred to appropriate accounts in the ledger by a

process referred to as summarizing.

4. The accounting process consists of the recording phase and the summarizing phase.

5. The original source materials evidencing business transactions are called source documents.

6. Double-entry bookkeeping records each transaction in a way that maintains the equality of the
accounting equation.

7. The International Accounting Standards Board explicitly supports the use of the cash basis for small
companies in the service industry..

8. Liabilities, owners' equity, and revenues are decreased by debits and increased by credits.

9. Assets, expenses, and dividends are decreased by debits and increased by credits.

10. Preparation of an adjusted trial balance ensures that all adjusting entries have been made for the
correct amounts.

Terminology.

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 In the space provided at the right, write the word or phrase that is defined or indicated.

1. Revenue and expense accounts. 1. _____________________________________

2. An optional step in the accounting 2. _________________________________________

cycle.

3. A revenue collected, but not earned.3. _____________________________________

4. A revenue earned, but not collected.4. _____________________________________

5. Asset, liability, and equity accounts. 5. _____________________________________

6. An expense paid, but not incurred. 6. _____________________________________

7. An expense incurred, but not paid. 7. _____________________________________

EXERCISE I - RECORDING

INSTRUCTIONS: For Power Enviro Systems Consultants, Inc. indicate the accounts to be
debited and credited in recording the transactions described below by inserting the letter
designation for the accounts in the appropriate columns.

A. Accounts Payable E.Equipment I.Capital Stock M.Prepaid Insurance

B. Accounts Receivable F.Land J.Dividends N. Professional Fees
C. Building G.Notes Payable K.Office Supplies O.Rent Expense
D. Cash H.Notes Rec. L.Office Supplies Expense P.Wages Expense

For For
TRANSACTIONS Debit Scoring Credit Scoring
0. Provided professional services on account ......................... B 0. ____ N 0. ____
1-2. Provided professional services for cash .............................. 1. ____ 2. ____
3-4. Paid dividends to stockholders .......................................... 3. ____ 4. ____
5-6. Purchased office supplies on account ................................. 5. ____ 6. ____
7-8. Discovered an error in computing and paying the wages of
an employee. 7. ____ 8. ____
Paid cash to the employee for the amount of the
underpayment .....................................................................
9-10. Paid insurance premium covering a two-year period .......... 9. ____ 10. ____
11-12. Purchased building and equipment, paying one-fourth in
cash and 11. 12. ____
giving a note for the balance ............................................... ____
13-14. Sold office supplies to employees at cost, receiving cash ... 13. 14. ____
____
15-16. Returned for credit equipment purchased on account ......... 15. 16. ____
____
17-18. Received cash from customers on account ........................ 17. 18. ____
____

EXERCISE 2—CLASSIFICATION OF ACCOUNTS

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 INSTRUCTIONS: The customary classifications for accounts listed in the chart of accounts are
listed below. Classify each account by inserting the appropriate letter in the classification column
and indicate the normal balance by inserting a check mark in the debit column or the credit column.

CLASSES
A. Assets B. Liabilities C. Owner’s Equity D. Revenue E. Expenses

Normal For
Balance
ACCOUNTS Classification Debit Credit Scoring
0. Land .....................................................................
A v 0. ____
1. Equipment ............................................................ 1. ____
2. Accounts Receivable ............................................ 2. ____
3. Notes Payable ...................................................... 3. ____
4. Supplies ............................................................... 4. ____
5. Dividends ............................................................. 5. ____
6. Fees Earned ......................................................... 6. ____
7. Prepaid Insurance ................................................ 7. ____
8. Wages Expense ................................................... 8. ____
9. Cash ..................................................................... 9. ____
10. Unearned Revenue .............................................. 10. ____

EXERCISE 3—ADJUSTING ENTRIES
INSTRUCTIONS: Indicate the accounts to be debited and credited to record the selected
adjusting entries described below by inserting the letter designations in the appropriate columns.

A. Accounts Receivable F. Prepaid Insurance J.Rent Expense N.Taxes Expense

B. Accumulated DepreciationG. Prepaid Rent K.Rent Revenue O.Unearned Rent
C. Depreciation Expense H. Prepaid Taxes L.Supplies P.Wages Expense
D. Equipment I. Professional Fees M.Supplies Expense
E. Insurance Expense Q. WagesPayable

For For
DESCRIPTIONS Debit Scoring Credit Scoring
0. Adjust for unearned rent earned during the period ....................... O 0. ____ K 0. ____
1-2. Adjust for wages accrued at the end of the period ........................ 1. ____ 2. ____
3-4. Adjust for depreciation of equipment for the period ...................... 3. ____ 4. ____
5-6. Adjust for prepaid insurance expired during the period ................ 5. ____ 6. ____
7-8. Adjust for supplies used during the period .................................... 7. ____ 8. ____
9-10. Adjust for rent accrued at the end of the period on property rented 9. ____ 10.
to others ....................................................................................... ____
11-12. Adjust for professional fees accrued at the end of the period ....... 11. 12.
____ ____

EXERCISE 4—CLOSING ENTRIES

INSTRUCTIONS: Indicate the accounts to be debited and credited to record the selected closing entries
described below by inserting the letter designations in the appropriate columns.

A. Accumulated Depreciation D. Depreciation Expense

B. Retained Earnings E. Fees Earned G. Salaries Expense .
C. Dividends F. Income Summary H. Salaries Payable

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 For For
DESCRIPTIONS Debit Scoring Credit Scoring
0. Close the salaries expense account ............................................. F 0. ____ G 0. ____
1-2. Close the appropriate depreciation account ................................. 1. ____ 2. ____
3-4. Close the dividends account ......................................................... 3. ____ 4. ____
5-6. Close the income summary account (net loss) ............................. 5. ____ 6. ____

EXERCISE 5—PRINCIPLES AND TERMINOLOGY—MERCHANDISING
INSTRUCTIONS: Answer the following questions by writing the appropriate words or amounts
in the Answers column.

For
Answers Scorin
g
Sales Returns
0. The account in which returns of merchandise sold are and Allowances 0.
recorded ............................................................................ ____
1. The principal ledger that contains all of the balance sheet
and income statement accounts is called the .................... 1.
____
2. Each subsidiary ledger is represented by a summarizing
account in the general ledger called a(n) ........................... 2.
____
3. The accounts in the accounts payable ledger have a
normal balance of (debit or credit) ..................................... 3.
____
4. The bill that the seller sends to the buyer listing the terms of
the sale is called a(n) ......................................................... 4.
____
5. A return of P1,000 has been recorded on a sales invoice for
P8,000, terms 1/10, n/30, which is paid within the discount
period. The amount of the discount is ............................... P 5.
____
6. The title of the account in which the transportation costs are
recorded by the purchaser is ............................................. 6.
____
7. If the seller is to pay the cost of delivery of the goods, the
terms of sale are stated as FOB ........................................ 7.
____
8. The difference between sales and cost of merchandise sold 8.
is called ............................................................................. ____
9. If ownership (title) to merchandise passes to the buyer
when merchandise is shipped to the buyer, the shipping 9.
terms are ........................................................................... ____
10. The inventory system where both sales and cost of
merchandise sold are recorded for each item sold is called 10.
the ..................................................................................... ____

11.The merchandise accounting system in which the cost of the

merchandise sold is determined at the end of the accounting 11.
period is called the ......................................................................... ____

12.If the buyer incurs the cost of delivery of the goods, the terms of 12. __
sale are stated as FOB ......................................................
13. If the amount of cash overages for a period exceeds the
amount of cash shortages, the balance in the account Cash
Short or Over will be a (answer debit or credit) .................... 13.
____

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 14. If the account Cash Short or Over has a debit balance at the
end of the period, the balance would be reported on the
income statement as (answer expense or income) .............. 14.
____
15. Procedures designed to identify theft or misuse of cash are
called ................................................................................... 15.___
_
16. Vouchers are ordinarily filed in the unpaid voucher file in
order of .............................................................................. 16.___
_

MULTIPLE CHOICE

1. A trial balance may prove that debits and credits are equal, but
a. an amount could be entered in the wrong account.
b. a transaction could have been entered twice.
c. a transaction could have been omitted.
d. all of these.

2. Adjusting entries are necessary to

1.obtain a proper matching of revenue and expense.
2.achieve an accurate statement of assets and equities.
3.adjust assets and liabilities to their fair market value.
a. 1
b. 2
c. 3
d. 1 and 2

3. Why are certain costs of doing business capitalized when incurred and then depreciated or
amortized over subsequent accounting cycles?
a. To reduce the federal income tax liability
b. To aid management in cash-flow analysis
c. To match the costs of production with revenues as earned
d. To adhere to the accounting constraint of conservatism

4. When an item of expense is paid and recorded in advance, it is normally called a(n)
a. prepaid expense.
b. accrued expense.
c. estimated expense.
d. cash expense.

5. When an item of revenue or expense has been earned or incurred but not yet collected or
paid, it is normally called a(n) ____________ revenue or expense.
a. prepaid
b. adjusted
c. estimated
d. accrued

6. When an item of revenue is collected and recorded in advance, it is normally called a(n)
___________ revenue.
a. accrued
b. prepaid
c. unearned
d. cash

7. An accrued expense can best be described as an amount

a. paid and currently matched with earnings.
b. paid and not currently matched with earnings.
c. not paid and not currently matched with earnings.
d. not paid and currently matched with earnings.
8. If, during an accounting period, an expense item has been incurred and consumed but not
yet paid for or recorded, then the end-of-period adjusting entry would involve

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 a. a liability account and an asset account.
b. an asset or contra asset account and an expense account.
c. a liability account and an expense account.
d. a receivable account and a revenue account.

9. Which of the following must be considered in estimating depreciation on an asset for an

accounting period?
a. The original cost of the asset
b. Its useful life
c. The decline of its fair market value
d. Both the original cost of the asset and its useful life.

10. Which of the following would not be a correct form for an adjusting entry?
a. A debit to a revenue and a credit to a liability
b. A debit to an expense and a credit to a liability
c. A debit to a liability and a credit to a revenue
d. A debit to an asset and a credit to a liability

11. An accounting record into which the essential facts and figures in connection with all
transactions are initially recorded is called the
a. ledger.
b. account.
c. trial balance.
d. none of these.

12. The debit and credit analysis of a transaction normally takes place
a. before an entry is recorded in a journal.
b. when the entry is posted to the ledger.
c. when the trial balance is prepared.
d. at some other point in the accounting cycle.

13. Under the cash basis of accounting, revenues are recorded

a. when they are earned and realized.
b. when they are earned and realizable.
c. when they are earned.
d. when they are realized.

14. When converting from cash basis to accrual basis accounting, which of the following
adjustments should be made to cash receipts from customers to determine accrual basis
service revenue?
a. Subtract ending accounts receivable.
b. Subtract beginning unearned service revenue.
c. Add ending accounts receivable.
d. Add cash sales.

15. Factors that shape an accounting information system include the

a. nature of the business.
b. size of the firm.
c. volume of data to be handled.
d. all of these.

16. Which of the following criteria must be met before an event or item should be recorded for
accounting purposes?
a. The event or item can be measured objectively in financial terms.
b. The event or item is relevant and reliable.
c. The event or item is an element.
d. All of these must be met.

17. Which of the following is a recordable event or item?

a. Changes in managerial policy
b. The value of human resources
c. Changes in personnel

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 d. Exchange of investment

18. Which of the following is not an internal event?

a. Depreciation
b. Using raw materials in the production process
c. Dividend declaration and subsequent payment
d. All of these are internal transactions.

19. In an accrual accounting system

a. all accounts have normal debit balances.
b. a debit entry is recorded on the left-hand side of an account.
c. liabilities, owner's capital, and dividends all have normal credit balances.
d. revenues are recorded only when cash is received.

20. A common business transaction that would not affect the amount of owners' equity is
a. signing a note payable to purchase equipment.
b. payment of property taxes.
c. billing of customers for services rendered.
d. payment of dividends.

21. The basic financial statements are listed below:

(1) Balance sheet

(2) Statement of retained earnings
(3) Income statement
(4) Statement of cash flows

In which of the following sequences does the accountant ordinarily prepare

the statements?
a. 1, 4, 3, 2.
b. 2, 1, 3, 4.
c. 3, 2, 1, 4.
d. 3, 2, 4, 1.

22. Which of the following regarding accrual versus cash-basis accounting is true?
a. The ASC believes that the cash basis is appropriate for some smaller companies,
especially those in the service industry.
b. The cash basis is less useful in predicting the timing and amounts of future cash
flows of an enterprise.
c. Application of the cash basis results in an income statement reporting revenues
and expenses.
d. The cash basis requires a complete set of double-entry records.

23. Under the cash basis of accounting

a. revenues are recorded when they are earned.
b. accounts receivable would appear on the balance sheet.
c. depreciation of assets having an economic life of more than one year
is recognized.
d. the matching principle is ignored.

24. Total net income over the life of an enterprise is

a. higher under the cash basis than under the accrual basis.
b. lower under the cash basis than under the accrual basis.
c. the same under the cash basis as under the accrual basis.
d. not susceptible to measurement.

25. If the inventory account at the end of the year is understated, the effect will be to
a. overstate the gross profit on sales.
b. understate the net purchases.
c. overstate the cost of goods sold.
d. overstate the goods available for sale.

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 26. Reversing entries are
1. normally prepared for prepaid, accrued, and estimated items.
2. necessary to achieve a proper matching of revenue and expense.
3. desirable to exercise consistency and establish standardized procedures.
a. 1
b. 2
c. 3
d. 1 and 2

27. Adjusting entries that should be reversed include those for prepaid or unearned items that
a. create an asset or a liability account.
b. were originally entered in a revenue or expense account.
c. were originally entered in an asset or liability account.
d. create an asset or a liability account and were originally entered in a revenue or expense
account.

28. Adjusting entries that should be reversed include

a. all accrued revenues.
b. all accrued expenses.
c. those that debit an asset or credit a liability.
d. all of these.

29. Failure to record the expired amount of prepaid rent expense would not
a. understate expense.
b. overstate net income.
c. overstate owners' equity.
d. understate liabilities.

30. On June 30, a company paid P3,600 for insurance premiums for the current year and debited the
amount to Prepaid Insurance. At December 31, the bookkeeper forgot to record the amount
expired. The omission has the following effect on the financial statements prepared December 31:

a. overstates owners' equity.

b. overstates assets.
c. understates net income.
d. both (a) and (b).

31. Year-end net assets would be overstated and current expenses would be understated as a
result of failure to record which of the following adjusting entries?
a. Expiration of prepaid insurance
b. Depreciation of fixed assets
c. Accrued wages payable
d. All of these

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32.A prepaid expense can best be described as an amount
a. paid and currently matched with revenues.
b. paid and not currently matched with revenues.
c. not paid and currently matched with revenues.
d. not paid and not currently matched with revenues.

33. An accrued revenue can best be described as an amount

a. collected and currently matched with expenses.
b. collected and not currently matched with expenses.
c. not collected and currently matched with expenses.
d. not collected and not currently matched with expenses.

34. An unearned revenue can best be described as an amount

a. collected and currently matched with expenses.
b. collected and not currently matched with expenses.
c. not collected and currently matched with expenses.
d. not collected and not currently matched with expenses.

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ANSWER:

Terminology
1. Nominal (temporary) accounts. 5. Real (permanent) accounts.
2. Reversing entries. 6. Prepaid expense.
3. Unearned revenue. 7. Accrued expense.
4. Accrued revenue.

EXERCISE 1- RECORDING

Analysis of Transactions

Debit Credit
1. D 2. N
3. J 4. D
5. K 6. A
7. P 8. D
9. M 10. D
11. C, E 12. D, G
13. D 14. K
15. A 16. E
17. D 18. B

EXERCISE 2

Classification of Accounts

Classi- Normal Balance

fication Debit Credit
1. A v
2. A v
3. B v
4. A v
5. C v
6. D v
7. A v
8. E v
9. A v
10. B v

EXERCISE 3
ADJUSTING ENTRIES

Debit Credit
1. P 2. Q
3. C 4. B
5. E 6. F
7. M 8. L
9. A 10. K
11. A 12. I

EXERCISE 4
Closing Entries

Debit Credit
1. F 2. D
3. B 4. C
5. B 6. F

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EXERCISE 5

Principles and Terminology

1. general ledger
2. controlling account
3. credit
4. invoice
5. P70
6. Merchandise Inventory
7. destination
8. gross profit
9. FOB shipping point
10. perpetual inventory system
11. periodic inventory system
12. shipping point
13. credit
14. expense
15. detective controls
16. due date

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