Intermediate Accounting: IFRS Edition, 3rd Edition Class Notes

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CHAPTER 1Financial Reporting and AccountingStandardsLEARNING OBJECTIVES1.Describe the growing importance of global financial markets and its relation tofinancial reporting.2.Identify the major financial statements and other means of financial reporting.3.Explain how accounting assists in the efficient use of scarce resources.4.Explain the need for high-quality standards.5.Identify the objective of financial reporting.6.Identify the major policy-setting bodies and their role in the standard-settingprocess.7.Explain the meaning of IFRS.8.Describe the challenges facing financial reporting.

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CHAPTER REVIEW1.Chapter 1 describes the environment that has influenced both the development and useof the financial accounting process. The chapter traces the development of financialaccountingstandards,focusingonthe groups that have hadorcurrently havetheresponsibility for developing such standards. Certain groups other than those with directresponsibility for developing financial accounting standards have significantly influenced thestandard-setting process. These various pressure groups are also discussed in Chapter 1.Global Markets2.(L.O. 1)World markets are becoming increasingly intertwined. And, due to technologicaladvances and less onerous regulatory requirements, investors are able to engage infinancial transactions across national borders, and to make investment, capital allocation,and financing decisions involving many foreign companies. As a result, an increasingnumberof investors are holding securities of foreign companies, and a significant numberof foreign companies are found on national exchanges. The move toward adoption ofinternational financial reporting standards has and will continue to facilitate this movement.3.(L.O.2)Financial accountingis the process that culminates in the preparation offinancial reports on the enterprise for use by both internal and external parties.4.Financial statementsare the principal means through which a company communicatesits financial information to those outside it. The financial statements most frequentlyprovided are (1) the statement of financial position, (2) the income statementorstatementof comprehensive income, (3) the statement of cash flows, and (4) the statement ofchanges in equity. Note disclosures are an integral part of each financial statement. Othermeans of financial reporting include the president’s letter or supplementary schedules inthe corporate annual report, prospectuses, and reports filed with government agencies.5.(L.O.3)Accounting is important for markets, free enterprise, and competition because itassists in providing information that leads to capital allocation.Reliable information leadsto a better, more effective process of capital allocation,which in turn is critical to ahealthier economy.6.(L.O.4)To facilitate efficient capital allocation, investors need relevant information and afaithful representation of that information to enable them to make comparisons acrossborders. A single,widely accepted set of high-quality accounting standards is a necessityto ensure adequate comparability. In order to achieve this goal the followingelementmust bepresent:a.A single set of high-quality accounting standards established by a single standard-setting body.b.Consistency in application and interpretation.c.Common disclosures.

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d.Common high-quality auditing standards and practices.e.A common approach to regulatory review and enforcement.f.Education and training of market participants.g.Common delivery systems (e.g., eXtensible Business Reporting Language—XBRL).h.A common approach to corporate governance and legal frameworks around the world.7.Themajorstandard-settersoftheworld,coupledwithregulatoryauthorities,nowrecognize that capital formation and investor understanding is enhanced if a single set ofhigh-quality accounting standards is developed.Objective of Financial Reporting8.(L.O.5)Theobjectiveofgeneral-purposefinancialreportingistoprovidefinancialinformationaboutthereportingentitythat is useful topresentandpotential equityinvestors, lenders, and other creditors in making decisionsaboutproviding resources totheentity.a.General-purpose financialstatements provide at the least cost the most usefulinformation possible to a wide variety of users.b.Equity investors and creditorsare the primary user groupsand have the mostcritical and immediate needsfor information in the financial statements. Investorsandcreditorsneed this information to assess a company’s ability to generate net cashinflows and to understand management’s ability to protect and enhance the assets ofa company.c.Theentity perspectivemeans that the company is viewed as being separate anddistinct from itsinvestors(bothshareholdersand creditors). Therefore, the assets ofthecompany belong to the company, not a specific creditor or shareholder. Financialreportingfocusedonlyontheneedsoftheshareholder—theproprietaryperspective—is not considered appropriate.d.Decision-usefulnessmeans that information contained in the financial statementsshould help investors assess the amounts, timing, and uncertainty of prospective cashinflows from dividends or interest, and the proceeds from the sale, redemption, ormaturity of securities or loans. In order for investors to make these assessments, thefinancial statements and related explanations must provide information about thecompany’s economic resources, the claims to those resources, and the changes inthem.9.Information generated using theaccrual basisof accounting provides a better indicationof a company’s present and continuing ability to generate favorable cashflows than thecash basis.

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Standard-Setting Organizations10.(L.O.6)ThemaininternationalstandardsettingorganizationistheInternationalAccounting Standards Board (IASB),based in London, United Kingdom.The IASBissuesInternational Financial Reporting Standards (IFRS)which are used bymostforeign exchanges.11.Thetwoorganizationsthathavearoleininternationalstandard-settingaretheInternational Organization of Securities Commissions (IOSCO)and the IASB.(Adetailed discussion of the U.S system is provided at the book’s companion website)a.The IOSCO does not set accounting standards;it is dedicated to ensuring that theglobal markets can operate in an efficient and effective basis.b.The member agencies have agreed to:(1)Cooperate together to promote high standards of regulation in order to maintainjust, efficient, and sound markets.(2)Exchange information on their respective experiences in order to promote thedevelopment of domestic markets.(3)Unitetheireffortstoestablishstandardsandaneffectivesurveillanceofinternational securities transactions.(4)Provide mutual assistance to promote the integrity of the markets by a rigorousapplication of the standards and by effective enforcement against offenses.12.IOSCO recommends thatitsmembers allow multinational issuers to use IFRS in cross-folderofferingsandlistings,assupplementedbyreconciliation,disclosure,andinterpretation where necessary, to address outstanding substantive issues at a national orregional level.13.Theinternationalstandard-settingstructureiscomposedofthefollowingfourorganizations:a.TheIFRS foundation(22 trustees) provides oversight to the IASB, IFRS AdvisoryCouncil,andIFRSInterpretationsCommittee.Itappointsmembers,reviewseffectiveness, and helps in fundraisingefforts for these organizations.b.TheInternational Accounting Standards Board(IASB) consisting of 13members,develops in the public interest, a single set of high-quality, enforceable, and globalinternational financial reporting standards for general-purpose financial statements.c.TheIFRSAdvisory Council(40 or more members) provides advice and council tothe IASB on major policies and technical issues.d.TheIFRS Interpretations Committee(14members)assists the IASB through thetimely identification, discussion, and resolution of financial reporting issues within theframework of IFRS.14.In addition, as part of the governance structure, aMonitoring Boardwas created. Itestablishes a link between accounting standard-setters and those publicauthoritiesthatgenerally oversee them (e.g. IOSCO). It also provides political legitimacy to the overallorganization.

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15.The IASB has a thorough, open and transparentdue processin establishing financialaccounting standards. It consists of the following elements:a.An independent standard-setting board overseen by geographically and professionallydiverse body of trustees.b.A thorough and systematic process for developing standards.c.Engagement with investors, regulators, business leaders, and the global accountancyprofession at every stage of the process.d.Collaborative efforts with the worldwide standard-setting community.16.To implement its due process, the IASB follows specific steps to develop a typical IFRS.a.Topics are identified and placed on the Board’s agenda.b.Research and analysisisconducted and preliminary views of pros and consareissued.c.Public hearings are held on the proposed standard.d.TheBoard evaluates research and public responsesand issues anexposure draft.e.TheBoard evaluatestheresponses and changestheexposure draft, if necessary.Thenthefinal standard is issued.17.The following characteristicsof theIASBare meant toreinforce the importance of anopen, transparent, and independent due process.a.Membership:The Board consists of 13well-paidmembers, from different countries,serving 5-year renewable terms.b.Autonomy:The IASB is notpart of any professional organization. It is appointed byand answerable only to the IFRS Foundation.c.Independence:Full-timeIASBmembersmustseveralltieswiththeirformeremployer. Members are selected for their expertisein standard-settingrather than torepresent a given country.d.Voting:Nine of16votes are needed to issue a new IFRS.18.The IASB issues three major types of pronouncements.a.International Financial Reporting Standards:To date the IASB has issued17standards.Inaddition,thepreviousinternationalstandard-settingbody,theInternational Accounting Standards Committee (IASC)issued 41InternationalAccounting Standards (IAS). Those that have not been amended or superseded areconsidered under the umbrella of IFRS.b.ConceptualFramework for Financial Reporting:The IASBissued theFrameworkfor the Preparation and Presentation of Financial Statements(referred to as theFramework) with the intent to create a conceptual framework that would serve as atool for solving existing and emerging problems in a consistent manner. However, the

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FrameworkisnotanIFRSanddoesnotdefinestandardsforanyparticularmeasurementordisclosure issue. Nothing in the Framework overridesanyspecificIFRS.c.International Financial Reporting Interpretations:Interpretationsare issued by theIFRSInterpretationsCommitteeandareconsideredauthoritativeandmustbefollowed.Over twentyhave been issued to date. These interpretations cover (1) newlyidentified financial reporting issues not specifically dealt with in IFRS, and (2) issueswhere unsatisfactory or conflicting interpretations have developed, or seem likely todevelop, in the absence of authoritative guidance.19.(L.O. 7)The IASB has no regulatory mandate and no enforcement mechanism. It relieson other regulators to enforce the use of its standards. For example, the European Unionrequires publicly traded member country companies to use IFRS. Any company indicatingthat it prepares its financial statements in conformity with IFRS must use all of thestandards andinterpretations. The hierarchy of authoritative pronouncements is: IFRS, IAS,Interpretations issued by either the IFRSInterpretationCommitteeor its predecessor theIAS Interpretations Committee, theConceptualFrameworkfor Financial Reporting, andpronouncements of other standard-setting bodies that use a similar conceptual frameworkto develop accounting standards(e.g., U.S.GAAP).Financial Reporting Challenges20.(L.O.8)AlthoughIFRS aredevelopedby usingsoundresearchandaconceptualframework that has its foundation in economic reality, a certain amount of pressure andinfluence is brought to bear by groups interested inoraffected by IFRS. The IASB doesnot exist in a vacuum, and politics and special-interest pressure remain a part of thestandard-setting process.21Theexpectations gapis thedifference betweenwhat the public thinks accountantsshould do and what accountants think they can do. Ithas been highlighted by the manyaccounting scandals that have occurred.In order to meet the needs of society with highlytransparent, clean, and reliable systems, considerable costs will be incurred.22.The significant financial reporting challenges facing the accounting profession are:a.Non-financial measurementssuch as customer satisfaction indexes, backlog infor-mation, and reject rates on goods purchased.b.Forward-looking information.c.Soft assets(intangibles).d.Timeliness.

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23.In accounting,ethical dilemmasare encountered frequently. The whole process of ethicalsensitivity and selection among alternatives can be complicated by pressures that maytake the form of time pressure, job pressures, client pressures, personal pressures, andpeer pressures. And, there is no comprehensive ethical system to provide guidelines.24.Convergence to a single set of high-quality global financial reporting standards is a realpossibility. For example, the IASB andtheFASB(of theUnitedStates)have spentthelast 16years workingtoconverge their standards.25.In addition, U.S. and European regulators have agreed to recognize each other’s standardsfor listing on the various world securities exchanges. As a result, costly reconciliationre-quirementshave beeneliminated and hopefullywilllead to greater comparability andtransparency.

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LECTURE OUTLINEThe material in this chapter usually can be covered in one on two class sessions, dependingon whether the chapter appendix is discussed.A.(L.O. 1)Global Markets and IFRS.1.World markets are becoming more intertwined.2.An increasing number of investors are holding securities in foreign companies.3.An increasing number of foreign companies are found on national exchanges.4.Companies have expanded choices of where to raise capital through debt or equity.5.The move toward adoption of international financial reporting standards has and willcontinue to facilitate this movement.B.(L.O.2)What are the major financial statements and other means of financial reporting?Identification, measurement,andcommunicationof financial information (discussdifference between financial statements and financial reporting).a.Financial statements:(1)Income statement orstatement of comprehensive income.(2)Statement of financial position.(3)Statement of cash flows.(4)Statement of changes in equity.(5)Note disclosures.b.Financial reporting:(1)President’s letter or supplementary schedules in the annual report.(2)Prospectuses.(3)Reports filed with government agencies.(4)News releases and management forecasts.(5)Social or environmental impact statements.

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C.(L.O.3)How does accounting assist in the allocation of scarce resource?1.A world of scarce resources. Accounting helps to identify efficient and inefficient usersof resources.2.Capital allocation. Accounting assists in the effective capital allocation process byproviding financial reports to interested users.3.Changing user needs. Accounting will continue to be faced with challenges to providinginformation needed for an efficient capital allocation process.D.(L.O.4)Why the need for high-quality standards?1.To facilitate efficient capital allocation.2.In order to ensure adequate comparability across borders, a single, widely acceptedset of high-quality accounting standards is a necessity.3.Identify the elements involved:a.A single set of high-quality accounting standards established by a single standard-setting body.b.Consistency in application and interpretation.c.Common disclosures.d.Common high-quality auditing standards and practices.e.Common approach to regulatory review and enforcement.f.Education and training of market participants.g.Common delivery systems.h.Common approach to corporate governance and legal frameworks around the world.4.Major standard-setters and regulatory authorities around the world recognize thatcapital formation and investor understanding will be enhanced by a single set of high-quality accounting standards.E.(L.O.5)Define the objective of financial reporting.1.To provide financial information about the reporting entity that is useful to present andpotential equity investors, lenders, and other creditors in making decisionsaboutproviding resources to the entity.

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2.Describe the elements of the objective:a.General-Purpose Financial Statements:provide the mostusefulinformationpossibleto a wide variety of users for the least cost.b.Equity Investors and Creditors:are the primary user group and have the mostcritical and immediate need for information in financial reports, in order to:(1)Assess an entity’s ability to generate net cash inflows, and(2)Understand management’s ability to protect and enhance the assets of theentity.c.Entity Perspective:companies are viewed as separate and distinct fromboththeirshareholders and creditors.(1)The assets of the entity are viewed as belonging to the entity, not any specificcreditor or shareholder.(2)Theproprietary perspective, which focuses solely on the needs of theshareholders is not appropriate.e.Decision-Usefulness:information contained in the financial statements shouldbe useful to investors in order to:(1)Assess the amounts, timing, and uncertainty of prospective cash inflows fromdividends or interest, and(2)The proceeds from the sale, redemption, or maturity of securities or loans.(3)The accrual basis of accounting provides more useful information than thecash basis.F.(L.O.6)Identify the major standard-setting bodies and their rolesin the standard-settingprocess.1.International Organization of Securities Commissions (IOSCO):(a)Does not set accounting standards.(b)Dedicated to ensuring that global markets operate in an efficient and effectivebasis.(c)Regulates the world’s securities and futures markets.(d)Supports development and use of IFRS as a set of high-quality internationalstandards in cross-border offeringsandlistings.

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2.International standard-setting structure.a.InternationalFinancial Reporting Standards Foundation(IFRS Foundation):(1)Selects members of the IASB,theIFRSAdvisory Council, and the IFRSInterpretations committee.(2)Funds their activities.(3)Overseestheiractivities.(4)22 Trusteesb.International Accounting Standards Board (IASB):Develops a single set ofhighqualityenforceable,andglobalIFRSforgeneral-purposefinancialstatements.d.IFRSAdvisory Council:Consults with the IASB on major policiesand technicalissues.e.IFRSInterpretations Committee:(1)Assists the IASBinthe timelyidentification, discussion and resolution offinancial reporting issues within the framework of IFRS.(2)14members.G.Discuss the elements comprising due process:1.An independent standard-setting board overseen by a geographically and profession-ally diverse body of trustees.2.A thorough and systematic process for developing standards.3.Engagement with investors, regulators, business leaders, and the global accountancyprofession at every stage of the process.4.Collaborative efforts with the worldwide standard-setting community.F.Describe the specific steps the IASB takes to implement due process:1.Topics identified and placed on the Board’s agenda.2.Research and analysis conducted and preliminary views of pros and cons issued(Discussion Papers).3.Public hearings on proposed standard.4.Board evaluates research and public response and issues exposure draft.5.Board evaluates responses and changes exposure draft, if necessary. Final standardissued. Requiresnineof16memberstovotein favor ofthenew standardbeforeissuance.

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G.Discuss the characteristics of the IASB.1.Membership2.Autonomy3.Independence4.VotingH.The IFRS issues 3 major types of pronouncements.1.International Financial Reporting Standards (IFRS)(includes remainingInterna-tional Accounting Standards (IAS))2.ConceptualFramework for Financial Reporting3.International Financial ReportingStandardsInterpretationsI.(L.O.7)IFRS hierarchy.1.Hierarchy of pronouncementsin the following order:a.IFRS, International Accounting Standards (IAs) that have not been amended asuperseded by the IASB, IFRS Interpretations, and IAS Interpretations.b.Conceptual Framework for Financial Reporting.c.Pronouncements of other standard-setting bodies that use a similar conceptualframework(e.g. U.S. GAAP).J.(L.O.8)Describe the challenges facing financial reporting.1.IFRS in a Political Environment.a.Describe pressure groups, their composition, and their interests.b.Discuss the impact of accounting on the interests of each group.2.Theexpectations gap:What people think accountants should be doing versuswhataccountants think they can do.3.Describe significant financial reporting issues:a.Non-financial measurementsb.Forward-looking informationc.Soft assetsd.Timeliness

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4.Discuss the steps to take in solving an ethical dilemma.a.Recognize an ethical dilemma exists.b.Identify and analyze the elements of the dilemma.c.Identify and analyze the alternatives available.d.Select the best or most ethical alternative.5.Discusssomeofthestepstakentodatethatdemonstratehowinternationalconvergence is occurring.K.Global Accounting Insights1.Why a single set of international accounting standards is needed.a.Multinational corporationsb.Mergers and acquisitionsc.Information technologyd.Financial markets2.U. S. GAAPversusIFRSa.Similaritiesb.Differences

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CHAPTER 2Conceptual Framework for FinancialReportingLEARNING OBJECTIVES1.Describe the usefulness of a conceptual framework.2.Describe efforts to construct a conceptual framework.3.Understand the objective of financial reporting.4.Identify the qualitative characteristics of accounting information.5.Define the basic elements of financial statements.6.Describe the basic assumptions of accounting.7.Explain the application of the basic principles of accounting.8.Describe the impact thatthe costconstrainthason reporting accountinginformation.

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CHAPTER REVIEW1.Chapter 2 outlines the development of a conceptual framework for financial accounting andreporting by the IASB. The entire conceptual framework is affected by the environmentalaspects discussed in Chapter 1. It is composed of the basic objective, fundamental concepts,and operational guidelines. These notions are discussed in Chapter 2 and should enhanceyour understanding of the topics covered in intermediate accounting.Conceptual Framework2.(L.O. 1)Aconceptual frameworkis importantas a coherent system of concepts thatflow from an objectiveand the objective identifies the purpose of financial reporting.Bybuildinguponanestablishedbodyofconcepts,asoundlydevelopedconceptualframeworkleadstomore useful andconsistentpronouncements over time and allows theaccounting profession to solvenew andemergingpractical problems more quickly.3.(L.O. 2)Although the IASB issued the Conceptual Framework for Financial Reporting in2010, it remains a work in process.The framework consists of three levels. The first levelidentifies the objective of financial reporting. The second level provides the qualitativecharacteristics that make accounting informationuseful and the elements of financialstatements. The third level identifies the assumptions,principlesandconstraints thatdescribe the reporting environment.Working together the IASB and the FASB developedtheconverged concept statements on theobjective of financial reporting and qualitativecharacteristics of accounting information.Both Boards are now working on their ownindividual schedules to address the remaining elements of the framework.First Level: Basic Objective4.(L.O.3)TheobjectiveoffinancialreportingisthefoundationoftheConceptualFramework. The objective of general-purpose financial reporting is to provide financialinformationaboutthereportingentitythat is useful topresentandpotential equityinvestors, lenders, and other creditors in making decisionsabout providing resources tothe entity.5.An implicit assumption is that users need reasonable knowledge of business and financialaccounting matters to understand the information contained in financial statements. Thismeans that financial statement preparers assume a level of competence on the part ofusers, which impacts the way and the extent to which companiesreportinformation.Second Level: Fundamental Concepts6.(L.O. 4)The second level bridges the “why” or objective of accounting with the “how ofaccounting that addresses recognition, measurement and financial presentation.Thefundamental qualities that make accounting information useful for decision making arerelevance and faithful representation.a.Relevance:Accounting information is relevant if it is capable of making a differencein a decision. Financial information is capable of making a difference when it has

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predictive value, confirmatory value, or both.If the monetary size of an item couldinfluence a user’s discussion, then the item is material and must be disclosed.(1)PredictiveValue:Financialinformationhasvalueasaninputtopredictiveprocessesusedbypotentialinvestorsinformingtheirexpectationsofacompany’s future.(2)Confirmatory Value: Financial information that helps users confirm or correctpriorexpectations.(3)Materiality:Materiality is a company-specific aspect of relevance. Information ismaterial if omitting ormisstatingwould make a difference inusers’decisions. Itrequires evaluating both the relativesizeand importance of an item.Whilecompanies and auditors adopta general rule of thumb is that anything under 5percent of net income is considered immaterial, this depends upon specific rules;companiesmustconsiderbothquantitativeandqualitativefactorswhendetermining materialitythresholds.b.Faithful Representation:Means that the numbers and descriptions contained in thefinancialstatementsmatchwhatreallyexistedorhappened.Tobeafaithfulrepresentation, information must be complete, neutral, and freefromerror.(1)Completeness:Thefinancialstatementsincludealltheinformationthatisnecessary for faithful representation of the economic phenomena that it purportsto represent.(2)Neutrality:Information is neutral if it is unbiased, i.e., it is not presented in amanner that favors one set of interested parties over another.(3)Free from error:Does not mean total freedom from error. It means that theinformation presented is as accurate as possible, giventhatany estimates arebased on the best information available at the time.7.The enhancing qualities are complementary to the fundamental qualitative characteristics.They include comparability, verifiability, timeliness, and understandability.a.Comparability:Information that is measured and reported in a similar manner fordifferent companies is considered comparable. It enables users to identify the realsimilarities and differences in economic events between companies.Another type ofcomparability isconsistency,whichis present when a company applies the sameaccounting treatment to similar events, from period to period.b.Verifiability:Occurs when independent measurers, using the same methods, obtainsimilar results.c.Timeliness:Means having information available to decision-makers before it loses itscapacity to influence decisions.d.Understandability:Is the quality of information that lets reasonably informed userssee the connection between their decisions and the information contained in the

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financial statements. Understandability is enhanced when information is classified,characterized, and presented clearly and concisely.8.(L.O. 5)The IASB classifies the elements of the financial statements into two groups.The first group describes amounts of resources and claims to resources at a moment intime. The second group describes transactions, events and circumstances that affect acompany during a period time.a.Resources and claims to resources at a moment in time.(1)Asset:A resource controlled by the entity as a result of past events and fromwhich future economic benefits are expected to flow to the entity.(2)Liability:A present obligation of the entity arising from past events, the settlementof which is expected to result in an outflow from the entity of resources embodyingeconomic benefits.(3)Equity:The residual interest in the assets of the entity after deducting all itsliabilities.b.Transactions, events, and circumstances that affect a company during a period of time.(1)Income:Increases in economic benefits during the accounting period in the formof inflows or enhancements of assets or decreases of liabilities that result inincreasesinequity,otherthanthoserelatingtocontributionsfromequityparticipants.(2)Expenses:Decreases in economic benefits during the accounting period in theform of outflows or depletions of assets or incurrences of liabilities that result indecreases in equity, other than those relating to distributions to equity participants.Third Level: Recognition, Measurement, and Disclosure Concepts9.(L.O. 6)In the practice of financial accounting, certain basic assumptions are important toan understanding of the manner in which information is presented. The following fivebasic assumptions underlie the financial accounting structure.a.Economic Entity Assumption:Means that economic activity can be identified with aparticular unit of accountability. In other words, a company keeps its activity separateand distinct from its owners and any other business unit.b.GoingConcernAssumption:Intheabsenceofinformationtothecontrary,acompany is assumed to have a long life. The legitimacy of the cost principle isdependentuponthegoingconcernassumption,wherebydepreciationandamortization policies are justified and appropriate only if there is some permanence tothe company’s continuance.c.MonetaryUnitAssumption:Moneyisthecommondenominatorofeconomicactivity and provides an appropriate basis for accounting measurement and analysis.The monetary unit is assumed to remain relatively stable over the years in terms of

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purchasing power. Therefore, this assumption disregards any inflation or deflation inthe economy in which the company operates.d.Periodicity Assumption:The life of a company can be divided into artificial timeperiods for the purpose of providing periodic reports on the economic activities of thecompany.e.Accrual Basis of Accounting:Transactions that change a company’s financialstatements are recorded in the periods in which the events occur. The cash basis ofaccounting is prohibited under IFRS because it violates both the revenue recognitionprinciple and the expense recognition principle.10.(L.O. 7)The basic principles of accounting are used to record and reporttransaction. Thefour basic principles of accounting are:a.MeasurementPrinciples:Wecurrentlyhavetwoacceptablemeasurementprinciples:historicalcost and fair value. Choosing which principle to follow generallyreflects the trade off between relevance and faithful representation.(1)Historical Cost:IFRS requires many assets and liabilities be reported at theiracquisition price, or cost, sometimes referred to as historical cost.Using cost hasan important advantage:It is thought to be a faithful representation of the amountpaid for a given item. Many users favorhistorical costbecause itprovides averifiablebenchmark for measuring historical trends.(2)Fair Value:Is a market-based measure. At acquisition,historical cost and fairvalue are identical. In subsequent periods, as market and economic conditionschange, the twovalues maydiverge. It is felt that where fair value information isavailable, it provides more relevant information about the expected future cashflows related to an asset or liability. The IASB allows companies the option to usefair value,known asthefair value option, forthemeasurementbasisof financialassets and financial liabilities.b.Revenue Recognition Principle:When a company agrees to perform a service orsell a product it has aperformance obligation. Therefore, revenue is recognized inthe period in which the performance obligation is satisfied.c.ExpenseRecognitionPrinciple:Recognitionofexpensesisrelatedtotheconsumption ofassetsor incurring of liabilities. The expense recognition principle isimplementedinaccordancewiththedefinitionofexpensebymatchingefforts(expenses) with accomplishments(revenues). Some costs are difficult to associatewith revenues and must be allocated to expense based on a “rational and systematic”allocationpolicy.Product costs,like materials, labor, and overhead,are expensedwhen the units they are attached to are sold.Period costs,like officers’ salaries orother administrative expenses,are expensedas incurred.d.Full Disclosure Principle:Financial statements should include sufficient informationto permit a knowledgeable user to make an informed decision about the financialcondition of the company in question. Users can findfinancialinformation (1) within

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the main body of the financial statements, (2) in the notes to those statements, or (3)as supplementary information.11.(L.O. 8)In providing informationwith the qualitative characteristics that make it useful,companies, must consideranoverriding factor that limitsthe reporting.This is referred toas thecost constraint.a.Cost-Benefit Relationship:Rule-making bodies and governmental agencies usecost-benefit analysisbefore making final their informational requirements.Thedifficulty in cost-benefit analysis is that the costs and especially the benefits are notalways evident or measurable.(1)Costs:The costs are of several kinds: costs of collecting and processing, ofdisseminating, of auditing, of potential litigation, of disclosureto competitors, andof analysis and interpretation.(2)Benefits: Benefits to preparers may include greater management control andaccess to capital at a lower cost. User benefits may include receiving betterinformation for allocation of resources, tax assessment, and rate regulation.b.The IASBseeksinput on costs and benefitsof new standards duringthe due processprocedureandattempts to determine thatthe costs imposed by eachproposedpronouncementis justified by the overall benefits of the financialinformationgained.LECTURE OUTLINEThe material in this chapter can usually be covered in two class sessions. The first classsession can be used for lecture and discussion of the concepts presented in the chapter. Thesecond class session can be used to develop student’s understanding of these concepts byapplying them to specific accounting situations. Students frequently believe that they understandtheconceptsbuthavedifficultycorrectlyidentifyingimproperaccountingproceduresinpractical situations. Apparently, students are not alone in this difficulty.A.(L.O. 1)Need for a Conceptual Framework.1.Build on and relateto an established body of concepts.2.Issue more useful and consistent pronouncements over time.3.Increase financial statement users’ understanding of and confidence in financial reporting.4.Enhance comparability among companies’ financial statements.5.Provide a framework forquicklysolving new and emerging practical problems.B.(L.O. 2)Development of a Conceptual Frameworkwith three levels.C.(L.O. 3)First Level: Basic Objective. (Recall that this was discussed in Chapter 1).

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1.Financial information that isusefulto present and potential equityinvestors, lendersand othercreditorsin making decisionsabout providing resources to the entity.2.Financial informationthat ishelpful to capital providers may also be useful to otherusersof financial reportingwho are not capital providers.D.(L.O. 4)Second Level: FundamentalConcepts.1.Qualitative characteristics. The overriding criterion for evaluating accounting informationis that it must beuseful for decision making.a.Fundamental qualities of useful accounting information.(1)Relevance.Accounting information is relevant if it is capable of makinga difference in a decision. Relevant informationincludes:(a)Predictive value.(b)Confirmatoryvalue.(c)Materiality(2)FaithfulRepresentation.Foraccountinginformationtobeuseful,thenumbers and descriptions contained in the financial statements must faithfullyrepresent what really existed or happened. To be a faithful representation,information must be:(a)Complete(b)Neutral(c)Freefromerrorb.Enhancing qualities of useful informationdistinguish more useful information fromless useful information.(1)Comparability.Informationthatismeasuredandreportedinasimilarmanner for different companies is considered comparable.Consistency,anothertypeofcomparability,iswhenacompanyappliesthesameaccounting treatment to similar events,fromperiod to period.(2)Verifiability. When independent measurers, using the same methods, obtainsimilar results.(3)Timeliness. Having information available to decision-makers before it losesits capacity to influence decisions.(4)Understandability. When information lets reasonably informed users see theconnection between their decisions and the information contained in thefinancial statements.

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2.(L.O. 5)Elements.(See text page37for definitions.) Items a-c are elements ata moment in time. Items d and e are elements during a period of time.a.Asset.b.Liability.c.Equity.d.Income.e.Expenses.E.(L.O. 6)Third Level: Recognition, Measurement, and Disclosure Concepts.1.BasicAssumptions.a.Economic entity assumption—economic activity can be identified with a particularunit of accountability.b.Going concern assumption—companies will have a long enough life to justifydepreciation and amortization.c.Monetaryunitassumption—themonetaryunit(i.e.,theeuro)isthemosteffectivemeansofexpressingtointerestedpartieschangesincapitalandexchanges of goods and services. A second assumption is that the monetary unitignores price-level changes, like inflation and deflation.d.Periodicity assumption—activities of an enterprise can be divided into artificialtime periods.e.Accrualbasisofaccounting—revenuesarerecognizedwhenearnedandexpensesare recognizedwhen incurred.2.(L.O. 7)Basic Principles of Accounting.a.Measurement principles(1)HistoricalCostPrinciple. Objective and verifiable.(2)Fair value. A market-based measure. TheIASB allows companies to choosethefair value optionto measure financial assets and financial liabilities,because they believe it to better assess future cash flows.b.Revenue recognition principle—revenue is recognizedin the accounting periodin which theperformance obligationis satisfied.c.Expenserecognitionprinciple—efforts(expenses)shouldbematchedwithaccomplishments (revenues),if feasible.

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Practical rules for expense recognition: Analyze costs to determine whether arelationship exists with revenue.(a)Whenadirect relationship exists,thenexpense costs against revenuesin the period when the revenue is recognized.(b)Whenarelationship exists but is difficult to identify,thenallocate costsrationally and systematically to expensesin the periods benefited.(c)When little if any relationship exists, expensecostsas incurred.d.Full disclosure principle—revealing in financial statements any facts of sufficientimportance to influence the judgment and decisions of an informed reader. (Developconcept of reasonably prudent investor.) Discusstheuse ofthenotesto thefinancial statementsandthesupplementary informationpresentedin financialreports.3.(L.O.8)CostConstraint:Financialinformationbenefitsmustoutweighthecostsofproducing the information.a.Cost-benefitrelationship—thebenefittobederivedfromhavingaccountinginformation should exceed the cost of providing it. Frequently it is easier to assessthe costs than it is to determine the benefits of providing a particular item ofinformation.b.The IASB’s due process procedure solicits cost-benefit information for proposedpronouncements.

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CHAPTER 3The Accounting Information SystemLEARNING OBJECTIVES1.Understand basic accounting terminology.2.Explain double-entry rules.3.Identify steps in the accounting cycle.4.Record transactions in journals, post to ledger accounts, and prepare a trial balance.5.Explain the reasons for preparing adjusting entries.6.Prepare financial statements from the adjusted trial balance.7.Prepare closing entries.8.Prepare financial statements for a merchandising company.*9.Differentiate the cash basis of accounting from the accrual basis of accounting.*10.Identify adjusting entries that may be reversed.*11.Prepare a 10-column worksheet.

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CHAPTER REVIEW*Note: All asterisked (*) items relate to material contained in the Appendices to the chapter.1.Chapter 3 presents a concise yet thorough review of the accounting process. The basicelements of the accounting process are identified and explained, and the way in whichthese elements are combined in completing the accounting cycle is described.Accounting Information System2.(L.O. 1)Theaccountinginformation systemcollects andprocesses transaction dataand disseminates the financial information to interested parties.Factors that shape thesesystems include: the nature ofthe business, the transactionsinwhichit engages, the sizeofthefirm,thevolumeofdatatobehandled,andtheinformationaldemandsofmanagement and other users.Financial accounting rests on a set of conceptsused inidentifying, recording, classifying,andinterpretinginformation related to the transactionsand other events of a business enterprise. To understand the accounting process, onemust be aware of the basic terminology employed incollecting accounting data. Thebasicterminologyincludes:event,transaction,account,realaccounts,nominalaccounts,ledger,journal,posting,trialbalance,adjustingentries,financialstatements,andclosing entries.These terms refer to the various activities that makeup theaccounting cycle.As we review the steps in the accounting cycle, the individualterms will be defined.3.(L.O. 2)Double-entry accountingrefers to the process used in recording transactions.The termsdebitandcreditare used in the accounting process to indicate the effecta transaction has on account balances. The debit side of any account is the left side; theright side is the credit side. Assets and expenses are increased by debits and decreasedby credits. Liabilities, equity, and revenues are decreased by debits and increased bycredits.4.In a double-entry system, for every debit there must be a credit and vice-versa. This leadsus to the accounting equation: Assets = Liabilities + Equity.5.The equity section of the statement of financial position reports the owners’ interest in theassets of the company. A corporation uses Share Capital, Share Premium, Dividends,and Retained Earnings. A sole proprietorship or a partnership uses a Capital account anda Drawing account.6.In a corporation, dividends, revenues, and expenses are transferred to retained earningsat the end of a period, so a change in any one of these three accounts affects equity.The Accounting Cycle7.(L.O. 3)The first step in the accounting cycle isanalysis of transactions and selectedother events.The purpose of this analysis is to determine which events representtransactions that should be recorded.

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8.Events can be classified asexternalorinternal.External events are those between anentity and its environment, whereas internal events relate to transactions totally within anentity.9.(L.O. 4)Transactions are initially recorded in ajournal,sometimes referred to asthebook of original entry.Ageneral journalis merely a chronological listing of transactionsexpressed in terms of debits and credits to particular accounts. No distinction is made ina general journal concerning the type of transaction involved. In addition to a generaljournal,specialized journalsare used to accumulate transactions possessing commoncharacteristics.10.The next step in the accounting cycle involves transferring amounts entered in the journalto thegeneral ledger.The ledger is a book that usually contains a separate page foreach account. Transferring amounts from a journal to the ledger is calledposting.Transactions recorded in a general journal must be posted individually, whereas entriesmade in specialized journals are generally posted by columnar total.11.The next step in the accounting cycle is the preparation of atrial balance.A trial balance isa list of all open accounts in the general ledger and their balances. An entity may preparea trial balance at any time in the accounting cycle. A trial balance prepared after postinghas been completed serves to check themathematical equality of debits and credits inthe posting process and provides a listing of accounts to be used in preparing financialstatements.A trial balance does not prove that a company recorded all transactions orthat the ledger is correct, because numerouserrors may exist even though the trialbalance columns agree.12.(L.O. 5)Preparation ofadjusting journal entriesis the next step in the accountingcycle. Adjusting entries are entries made at the end of accounting period to bring allaccounts up to date on an accrual accounting basis so that correct financial statementscanbeprepared.Adjustingentriesarenecessarytoachieveapropermatchingofrevenuesand expenses in the determination of net income for the current period and toachieve an accurate statement of the assets and equities existing at the end of theperiod. One common characteristic of adjusting entries is that they affect at leastone realaccount(asset, liability, or equity account) andone nominal account(revenue orexpense account). Adjusting entries can be classified asprepaid expenses, unearnedrevenues, accrued revenues,andaccrued expenses.13.Prepaid expenses and unearned revenues refer to situations where cash has been paidor received but the corresponding expense or revenue will not be recognized until a futureperiod. Accrued revenues and accrued expenses are revenues and expenses recognizedin the current period for which the corresponding payment or receipt of cash is to occur ina future period. Estimated items are expenses such as bad debts and depreciation whoseamounts are a function of unknown future events or developments.14.After adjusting entries are recorded and posted, anadjusted trial balanceis prepared.15.(L.O. 6)From the adjusted trial balance,a company can directly prepare its financialstatements.

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16.(L.O. 7)After financial statements have been prepared, nominal (revenues and expenses)accounts should be reduced to zero in preparation for recording the transactions of thenext period. Thisclosing processrequires recording and posting of closing entries. Allrevenue and expense accounts are reduced to zero by closing them through theIncomeSummaryaccount. The net balance in the Income Summary account is equal to netincome or net loss for the period. The net income or net loss for the period is transferred toanequity account. For a corporation, the equity account is Retained Earnings, for proprie-torships and partnerships, it is a capital account.In a corporation, dividends are closeddirectly to Retained Earnings.17.A third trial balance may be prepared after the closing entries are recorded and posted.Thispost-closing trial balanceshows that the company has properly journalized andposted the closing entries.18.A final step, preparing reversing entries, is optional.This stepis discussed in learningobjective10, see paragraph25below.19.In summary, the steps in the accounting cycle performed every fiscal period are as follows:a.Enter the transactions of the period in appropriate journals.b.Post from the journals to the ledger (or ledgers).c.Preparean unadjusted trial balance (trial balance).d.Prepare adjusting journal entries and post to the ledger(s).e.Preparea trial balance after adjusting (adjusted trial balance).f.Prepare the financial statements from the adjusted trial balance.g.Prepare closing journal entries and post to the ledger(s).h.Prepare a trial balance after closing (post-closing trial balance).i.Prepare reversing entries (optional) and post to the ledger(s).Financial Statements for a Merchandising Company20.(L.O. 8)The income statement for a merchandising company differs from that of aservice company because a product is being soldrather thana service. This differencerequires classifying amounts into categories such a gross profit on sales, income fromoperations, income before taxes, and net income. Earnings per share is still shown on thefaceof the income statement.

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21.The retained earnings statement is still formatted the same way: netincome is added tothe beginning retained earnings balance, and then dividendsare deducted to arrive atending retained earnings.22.The only change made to the statement of financial position is the inclusion of a newcurrent asset inventory.23.The closing entries for a merchandising company include a new revenue account,salesrevenue, and a new expense account, cost of goods sold.Cash-Basis AccountingVersus Accrual-Basis Accounting*24.(L.O.9)Cash-Basis Accounting Versus Accrual-Basis Accounting,is presented inAppendix A of Chapter 3 for the purpose of demonstrating the difference between cashbasis and accrual-basis accounting. Under the strict cash basis of accounting, revenueis recognized only when cash is received, and expenses are recorded only when cash ispaidor dispersed. The accrual basis of accounting recognizes revenue when it is earnedand expenseswhen incurred,without regard to the time of receipt or payment of cash.Using Reversing Entries*25.(L.O.10)Appendix B covers preparation and posting ofreversing entries,the finaloptionalstep in the accounting cycle. A reversing entry is made at the beginning of thenext accounting period and is the exact opposite of the adjusting entry made in thepreviousperiod. The recording of reversing entriesas an optional step in the accountingcycle may be performed at the beginning of the next accounting period. The entriessubject to reversal are the adjusting entries for accrued revenues and accrued expensesrecorded at the close of the previous accounting period.Using a Worksheet: The Accounting Cycle Revisited*26.(L.O.11)Appendix C covers the use of aten-columnworksheet,whichserves as an aid tothe accountant in adjusting the account balances and preparing the financial statements.The worksheet provides an orderly format for the accumulation of information necessary forpreparation of financial statements. Use of a worksheet does not replace any financialstatements, nor does it alter any of the steps in the accounting cycle.Instead,theworksheetis an informal tool that helps to accumulate and sort information needed for thefinancial statements.

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LECTURE OUTLINEChapter 3 provides a review of accounting procedures throughout the accounting cycle.Depending on time constraints and students’ accounting course background, Chapter 3 can beapproached in several different ways: (1) Spend 2-3 class sessions reviewing the chapter andAppendices 3-A through 3-C. (2) Spend 1-2 class sessions reviewing selected portions of thechapter and Appendix 3-A. (3) Omit the chapter entirely.It is assumed that all students have completed at least one course in financial accounting.Therefore, students should already be familiar with the mechanics of journalizing, posting, andpreparing adjusting entries and financial statements, etc. An important objective of a review ofthese procedural details is to prepare students: (1) to progress from mere memorization ofrequired journal entries to an understanding of the entries’ impact on the financial statements,and (2) to visualize the effect of errors (both the failure to record transactions and the improperrecording of transactions) on the financial statements.The following lecture outline can be expanded upon or reduced to suit the needs of your class.A.(L.O. 1)Basic Terminology. Review the 11 terms defined on text page3-4.B.(L.O. 2)Double-Entry Accounting.Review the mechanics of debits and creditsand theaccounting equation.C.(L.O. 3)The Accounting Cycle.1. Identifying and Recording Transactions and Other Events2.(L.O. 4)Journalization.a.General Journal.b.Special Journals.3.Posting to the Ledger.4.Trial Balance.5.(L.O. 5)Adjusting Entries.The ability to classify adjusting entries into one of these fourcategories is necessary to an understanding of reversing entries.a.Prepaid expenses.b.Unearned revenues.c.Accrued liabilities (expenses).d.Accrued assets (revenues).6.Prepare an adjusted trial balance.7.(L.O. 6)Prepare financial statements from adjusted trial balance.

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8.(L.O. 7)Prepare closing entries.a.Temporary accounts vs. permanent accounts.b.Post-closing trial balance.c.Reversing entries.D.(L.O. 8) Financial statements for a merchandising company.1.Income statementa.Net salesb.Cost of goods soldc.Gross profit on salesd.Selling and administrative expensese.Income from operationsf.Other revenues andgainsg.Other expenses and lossesh.Income before income taxesi.Income taxesj.Net income2.Retained earnings statementa. Beginning Retained Earnings plus Net incomeb. Less Dividends is equal to Ending Retained Earnings3.Statement of financial positiona.Non-current assetsb.Current assets–Inventoryc.Cashd.Equitye.Non-current liabilitiesf.Current liabilities

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4.Closing entriesa.Sales revenueclosed to Income Summaryb.Cost of goods soldand other expenses closed to Income Summaryc.Income Summary closed to Retained Earningsc.Dividendsclosed to Retained EarningsE.(L.O.9)APPENDIX 3-A.Cash basis versus accrual-basis accounting.1.Strict cash basis. Recognize revenue when cash is received and expenses when cashis paid.a.Used by small businesses and individual taxpayers.b.Not in conformity with IFRS.2.Modified cash basis. Recognize revenue when cash is received. Depreciable assetsare capitalized and depreciated; prepaid assets are capitalized and expensed as used;andallotherexpensesarerecognizedaspaid.Usedbyserviceorganizations(accountants, lawyers, doctors, and architects).3.Accrual basis. Revenues are recognized when earned and expenses when incurred.4.Conversion from cash to accrual basis.F(L.O.10)APPENDIX 3-B.Using reversing entries.1.Use of reversing entries is optional.2.In an accounting system which uses reversing entries, the following types ofadjusting entries should be reversed:a.adjusting entries for unearned and prepaid items where the original amountwas entered in a revenue or expense account.b.adjusting entries for all accrued items.G.(L.O.11)APPENDIX 3-C.Using a worksheet: The accounting cycle revisited.1.The worksheet does not replace the financial statements.2.Worksheet columns.3.Preparing the worksheet.4.Preparing the financial statements from a worksheet.

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