Lecture Notes for Intermediate Accounting, 9th Edition

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1-1Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.CHAPTER 1ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIALACCOUNTINGAuthors’ PerspectivesPART A: Financial Accounting EnvironmentLO1–1Describe the function and primary focus of financial accounting.LO1–2Explain the difference between cash and accrual accounting.LO1–3Define generally accepted accounting principles (GAAP) and discuss thehistoricaldevelopment of accounting standards, including convergencebetween U.S. and internationalstandards.LO1–4Explain why the establishment of accounting standards is characterized asa politicalprocess.LO1–5Explain factors that encourage high-quality financial reporting.LO1–11 Discuss the primary differences between U.S. GAAP and IFRS with respectto thedevelopment of accounting standards and the conceptual frameworkunderlying accountingstandards.Remind Students Why We Bother—Start Day 1byasking why we bother learning financialaccounting.All students have taken introductory accounting, butit’shelpful to point out that theyvery quicklyplungedinto the trees and might have lost sight of the forest.Why is financialaccounting important? What does it add?This is a nice opportunity for discussion, and inevitablythere will bethe chance tohighlightthe followingillustrations.•Illustration 1-1 presents the Pathways Commission visualization: “THIS is accounting!”Thepoint here is that we are focusing on providing useful information about a business’s economicactivity. That leads to some motivation for the conceptual framework, because itrequires thatwedefine terms like “useful” and determine what does and doesn’t qualify as economicactivity that is captured by accounting. Because decisions have consequences, this discussionthen brings up the idea that everyone in the financial reporting process has incentives,whichwe need to understand when navigating the many gray areas we will cover in this course, andwhich helps us understand that thestandard settingprocessis inevitably political. These areconversations to return to later,in Part Bof the chapter.[Be sure to note that this and most other Illustrations throughout the textbook are available toinstructors in the “Digital ImagesLibrary”for presentationas well as being incorporated intothe PowerPoint presentations,all of which are availablein the Instructor Resources section ofConnect.]•Illustrations 1-3 and 1-4 provide a simple contrast of cash-basis v. accrual accounting. Theseillustrations constitute a nice mini-review of some simple financial accounting transactions, butthe big takeaway is thatbothcash flows and accruals are important–having only one of themis not sufficient for the other.That can lead to a conversation of what decisions are informed

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1-2Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.by cash flows (e.g., liquidity, risk) v. accruals (e.g., profitability, prediction of future cashflows), which are decisions we will return to at various times in the course.Another point to make here is thatIntermediate is whereweget into thefun partsof accounting. Inthe introductory course, students learned the basics, similar to “SpanishI”. The focus was onrudimentarysyntax and the “do’s and don’t’s” of the language. Now they are in “SpanishII/III”(yes, Intermediate will feel like twice as much work as Intro!), and the focus will be on morecomplex conversations, with lots of interesting choices to be made, nuances to be communicated,and underlying meanings to be discerned. This is whereaccountinggets very interesting.Shakespeare didn’t work at the level of “See Spot run”, and neither willwe.StandardsBothGuide and Constrain—A simple question leads to a great conversation: What ifparticipants in capital markets don’t believe financial reports? Share prices tumble, banks won’tlend money, companies can’t get financing, etc.We have seen what happens when confidence isshaken (e.g, Enron; the financial crisis of 2008).Standards are importantbecause they clarifyagood way to account for events,which in turn provides a benchmark against which to assess whetheraccounting is of high quality, preserving confidence in financial markets and enabling people totransact.In fact, standards are so important that we have government oversight (the SEC), entitiesthat focus on standard setting (the FASB, the IASB),due process to get input from stakeholders, andpolitical pressures to achieve particular outcomes for particular stakeholders, as well as an auditindustry that provides assurance that companies are applying standards correctly.We also candiscuss somewhat different business and political environments facing the FASB and IASB, whichin turn affects the standards that these Boards produce and the extent and pace of convergence.Asfuturepractitioners,students will be requiredto navigate the complexity of financial reportingstandards. The FASB’scodification helps with that navigation. It also will be important thatstudentsconduct themselves ethicallyas practitioners, to avoid running afoul of the audit process orundermining the reputations of themselves and their organization, so applying an ethics frameworkis useful.Finally, it will be important to not lose sight of what accounting standards are intending tocommunicate. That leads us to considering the conceptual framework.PART B: The Conceptual FrameworkLO1–6Explain the purpose of the conceptual framework.LO1–7Identify the objective and qualitative characteristics of financial reportinginformation, andthe elements of financial statements.LO1–8Describe the four basic assumptions underlying GAAP.LO1–9Describe the recognition, measurement and disclosure concepts that guideaccountingpractice.LO1–10 Contrast a revenue/expense approach and an asset/liability approach toaccounting standardsetting.LO1–11 Discuss the primary differences between U.S. GAAP and IFRS with respectto thedevelopment of accounting standards and the conceptual frameworkunderlying accountingstandards.

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1-3Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.The Conceptual Frameworkis aConstitution—Students often gloss over theconceptualframework–it’swordy, haslots of definitions, and doesn’t seem likerealaccounting (no numbers!).However, we can make this topic seem more applicable to students by explaining that,like theUnited States’ Constitution, the conceptual framework is the source document from which standardsare derived, providing guidance to standard setters that helps them enhance the consistency offinancial accounting standards and withstand political pressures to provide exceptions for particularcircumstances. By understanding the conceptual framework, we understand the thought process thatgoes into setting accounting standards, which in turn helps us understand why standards are as theyare and to apply them in situations that are not clear cut.Threeillustrations clarify these points andare foundations for many future discussions throughout Intermediate Accounting.•Illustration 1-11helps us rigorously define what we meant earlier when we talked aboutfinancial information being “useful”.Studentsreally need to understand what these wordsmean.It’shelpful to walk through the definitions of Relevance and Faithful Representationand howthose concepts sometimes are in conflict with each other, as well asto discussthecomponents/aspects that underlie them and the enhancing characteristics of Comparability (andConsistency), Verifiability and Timeliness. Students pay more attention when they understandthat these are concepts that will appear again and again throughout the course—theymay aswellunderstand them now.•Illustration 1-15 is absolutely critical. Instructors canhighlight that Intermediate Accounting ismuch easier to learn and apply if we realize the distinction betweenrecognition(when an eventmerits inclusion in a journal entry and therefore the accounts) andmeasurement(what numberwe assign to the eventwe’rerecognizing). So recognition is aboutwhen, and measurement isabouthow much. Disclosure captures other useful information, such as amounts that aren’t yetrecognized butmightbe some day, or further insight into measurements, including alternativemeasurements that highlight different attributes from those used in the financial statements.•Illustration 1-14, the fair value hierarchy,flows well when discussed in class asa nice exampleof information that is disclosed but that is helpful in better understanding a particularmeasurement. The point here is that all fair values are not created equal, and usersmightchange their view of the representational faithfulness of a fair value based on theinputs used toestimate thatfair value. Students will see disclosures about fair value inputs in severalchapters.A final point to bring out is that the formal role of the conceptual framework differs slightly betweenU.S. GAAP and IFRS. In IFRS, the conceptual framework is specified as indicating GAAPwhenever an IFRS standard does not provide guidance. Think of it as the grout that fills in the gapsin IFRS guidance. In U.S. GAAP, the conceptual framework is intended more as guidance forstandard setters. Yet, even in U.S. GAAP, practitioners use the conceptual framework to help themgrapple with novel or confusing situations, so it isn’t clear that this distinction is that important.Certainly, regardless of whether we are talking about U.S. GAAP or IFRS, students need tounderstand and be prepared to apply the conceptual framework throughout Intermediate Accounting.

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1-4Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.PowerPoint SlidesPowerPoint presentations of the chapter are available in the Connect Library:1.With “Concept Checks” useful for classroom presentation, permitting the instructor tointersperse in the presentation short exercises students can be asked to solve individually or insmall groups before the solution is “revealed” by the instructor. {These are available onlywithin Instructor Resources.}2.Without the “Concept Checks” so students don’t have the solutions before being asked tosolve individually or in small groups.3.Accessible PowerPoint Presentations.Accessibility is becoming even more important in theeducation marketplace. Students and instructors with disabilities use many different assistivetechnologies, and McGraw-Hill Education is working to increase compatibility and accessthat will not only help those with disabilities achieve better learning outcomes, but also servethe institutions that are teaching these students. Accessible PowerPoint allows slide content tobe read by a screen reader and provides alternative text descriptions for any image files usedthat enrich the learning experience. Accessible PowerPoint is also designed with high-contrastcolor palettes and uses texture when possible, instead of color to denote different aspects ofthe imagery used within the slide.Note:The slides are intended to provide comprehensive coverage of the chapter, but can be easilyedited to allow instructors to change numbers andcontent in illustrationsor todelete slidespertaining to topics they choose to omit or deemphasize.(Using your students’ names forcompany names in the Concept Checks or Illustrations can be fun.)

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1-5Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.Suggestions for Class Activities1.Real World ScenarioAmerica Online (AOL) is a leader in the Internet access provider industry. In 1996, the companychanged a controversial accounting method involving the treatment of the cost of advertising andfree trials. The following is an excerpt from a May 15, 2000,CNET News.comarticle:America Online will pay a civil penalty of $3.5 million as part of a settlementwith the Securities and Exchange Commission over the accounting ofadvertising costs. According to the SEC, the Internet and media giantimproperly reported most of the costs of acquiring new subscribers–such asthe expense of sending computer disks to potential customers–as an asset. Asa result, the SEC said AOL posted a profit for six of eight quarters in 1995 and1996 but would have recorded a loss if the company followed recommendedaccounting practices.AOL, backed by its auditor, defended the accounting method of capitalizing these costs arguing thatspreading the costs over two years was a justifiable way to match expenses against revenue flowsthat would emerge later. In 1996, AOL switched to expensing these costs in the period incurred.SuggestionsHave the class consider the general treatment of advertising and promotion costs. Why are thesecosts normally expensed in the period incurred even though they are incurred with the intention ofgenerating future revenues? Why did they expense these costs over a two-year period? Thendiscuss the possible reasons why AOL chose a different approach followed by a discussion of thepossible reasons why the company decided to change its method. Another interesting discussion isthe civil penalty of $3.5 million leveled by the SEC four years after AOL changed its method. Thiscould lead to a general discussion of the SEC’s role in the financial reporting process.Points to notePerhaps an important factor prompting the switch was the increased competition in the industry andthe loss of customers that prompted AOL to implement a new pricing scheme. The loss ofcustomers creates significant uncertainty with respect to the realization of deferred advertising andpromotion costs. Another reason is pressure exerted by the SEC to make the switch and another isthat AOL’s competitors all expensed these costs.

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1-6Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.2.TargetAnalysisHave students, individually or in groups, go to the most recentTargetannual report using EDGARwhich can be located at:ww.sec.gov. Ask them to:1.Compare revenues, total costs and expenses, net income, total assets and total shareholders'equity with those in the2017reportin Appendix Bof the text(i.e., the report for the yearending February 3, 2018). Are there any discernible trends? How might they be interpreted?2.Use EDGAR to locate the most recent annual report information forWalmart,one ofTarget’schiefcompetitors. Using the most recent annual report information for both companies,compare:a.growth rates in revenues and net income, andb.the relationship between revenues and net income (profit margin).What could account for any differences you identify?

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1-7Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.3.Group/Research ActivityThe debate over principles-based versus rules-based accounting standards provides an excellentopportunity for class discussion, in-class debate, or for a writing assignment. One suggestion is toform groups of 4 or 5 students to research the issue. Assign half of the groups to defend aprinciples-based approach and the other half to defend the rules-based approach. There are numerousarticles written on the subject. A google search will find many hits. For example,the March 2005issue ofAccounting Horizonscontains a commentary entitled “Rules-Based Standards and the Lackof Principles in Accounting.”4.International Accounting ActivityWhat are the advantages and disadvantages to accounting convergence?Two5articles inAccounting Horizons provide an excellent overview of the research evidence:•Luzi Hail, Christian Leuz, and Peter Wysocki (2010) Global Accounting Convergence and thePotential Adoption of IFRS by the U.S. (Part I): Conceptual Underpinnings and EconomicAnalysis.Accounting Horizons: September 2010, Vol. 24, No. 3, pp. 355-394.•Luzi Hail, Christian Leuz, and Peter Wysocki (2010) Global Accounting Convergence and thePotential Adoption of IFRS by the U.S. (Part II): Political Factors and Futre Scenarios forU.S. Accounting Standards.Accounting Horizons: Decmber 2010, Vol. 24, No. 4, pp. 567-588.SuggestionsHave your students write a paper summarizing the issue and the papers’results.Alternatively, havea debate in which different groups of students take pro-vs. con-convergence positions.5.Professional Skills Development ActivitiesThe following are suggested assignments from the end-of-chapter material that will help yourstudents develop their communication, research, analysis and judgment skills.Communication Skills.In addition to Communication Case 1-6, Judgment Case 1-10can beadapted to ask students to write a letter to the client. Communication Case 1-5and ConvergenceCase 1-12 dowell asgroup assignmentsand/or class presentations. Ethics Case 1-7and JudgmentCases1-1,1-8and 1-9create good class discussions.Research Skills.In their careers, our graduates will be required to locate and extract relevantinformation from available resource material to determine the correct accounting practice, perhapsidentifying the appropriate authoritative literature to support a decision. Research Cases 1-2, 1-3,and 1-4and Exercises 1-3 and 1-4 provide excellent opportunitiesto help students develop this skillby introducing them to some important resources available on the Internet.Analysis Skills.Brief Exercise 1-1, Exercises 1-1 and 1-2, and Real World Case 1-11provideopportunities to develop and sharpen analytical skills.In addition, the Data Analytics case developsstudents’ ability to use Tableau in performing and presenting analyses.

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1-8Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.Judgment Skills.The “Decision Makers’ Perspective” section includes Judgment Cases that requirestudents to critically analyze issues to apply concepts learned to business situations in order toevaluate options for decision-making and provide an appropriate conclusion. This chapter includesJudgment Cases 1-1,1-8,1-9, 1-10,and1-11.6.Ethical DilemmaThe chapter contains the following ethical dilemma:ETHICALDILEMMAYou have recently been employed by a large retail chain that sells sporting goods. One of yourtasks is to help prepare periodic financial statements for external distribution. The chain's largestcreditor, National Savings & Loan, requires quarterly financial statements, and you are currentlyworking on the statements for the three-month period ending June 30,2021.During the months of May and June, the company spent $1,200,000 on a large radio and TVadvertising campaign. The $1,200,000 included the costs of producing the commercials as well asthe radio and TV time purchased to run the commercials. All of the costs were charged toadvertising expense. The company’s chief financial officer (CFO) has asked you to prepare a June30 adjusting entry to remove the costs from advertising expense and to set up an asset calledprepaid advertisingthat will be expensed in July. The CFO explained that “This advertisingcampaign has produced significant sales in May and June and I think it will continue to bring incustomers through the month of July. By recording the ad costs as an asset, we can match the costof the advertising with the additional July sales. Besides, if we expense the advertising in May andJune, we will show an operating loss on our income statement for the quarter. The bank requiresthat we continue to show quarterly profits in order to maintain our loan in good standing.”You may wish to discuss this in class. If so, discussion should include these elements.Step 1—The Facts:One of your tasks as an employee of a large sporting goods chain is to prepare financial statementsfor external use. You are currently preparing quarterly statements for the quarter ending June 30,2021, that will be given to the chain's largest creditor, National Savings & Loan. The CFO hasasked you to capitalize (charge to a prepaid asset) the $1,200,00 cost for an advertising campaignconducted in May and June of2021. The capitalization of advertising will prevent an operating lossfor the quarter and maintain the company's good standing with the creditor. The CFO believes thatthe commercials improved sales in May and June and expects the advertising effect to continue inJuly. The matching principle states that expenses are recognized in the same period as the relatedrevenue. In some situations it is impossible to determine in which periods revenues will be earnedfrom expenses such as advertising. Because of the difficulty in estimating the effect of advertisingexpenditures, accounting principles dictate that advertising should be recognized as an expense inthe period incurred.Step 2—The Ethical Issue and the Stakeholders:

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1-9Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.The ethical issue or dilemma is whether your obligation to challenge the CFO's request forcapitalization of the advertising expense is stronger than your obligation to your employer's financialinterests.Stakeholders include you, the accountant, the CFO, other corporate managers, company employees,the bank and other creditors, and current and future investors.Step 3—Values:Values include competence, honesty, integrity, objectivity, loyalty to your employer, andresponsibility to users of financial statements.Step 4—Alternatives:1.Follow the suggestion of the CFO to record the advertising costs as a prepaid asset.2.Record the advertising costs as an expense inthe quarter ending June 30,2021.3.Report the CFO's request to a higher level of management, the audit committee, or theauditors.4.Resign from the company and seek employment elsewhere.Step 5—Evaluation of Alternatives in Terms of Values:1.Alternative 1 illustrates loyalty to the employer.2.Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, andresponsibility to users of the financial statements.3.Alternative 3 illustrates loyalty to the employer at a level higher than that of the CFO,but also includes the values of honesty, integrity, and objectivity on the part of the accountant.4.Alternative 4 supports the values of honesty and integrity, but does not reflectcompetence or responsibility to financial statement users.Step 6—Consequences:Alternative 1Positive consequences: You would keep your job and please the CFO. The company would remainin good standing with the bank.Negative consequences: Users of the financial statements would be misinformed. Users of financialstatements may sue the company upon learning the truth if the amount of advertising is material andaffects their financial decisions. You may lose your self-respect and the respect of co-workers.Alternative 2Positive consequences: Users of financial statements would receive more conservative informationconcerning advertising costs. You would maintain your integrity.Negative consequences: You may incur disfavor with the CFO and other top management, resultingin a loss of future promotions or your job.You also may lose the trust of other employees.Alternative 3Positive consequences: You would maintain your integrity. Users may receive more conservativeinformation concerning advertising costs if upper management levels or the audit committee compelfair presentation in the financial statements.

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1-10Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.Negative consequences: You may incur disfavor with the CFO and other top management, resultingin a loss of future promotions or your job.You also may lose the trust of other employees. Whistleblowers often are not rewarded.Alternative 4Positive consequences: You maintain your integrity and avoid conflict with management and otheremployees.Negative consequences: You have no job and you may have difficulty getting references for a newjob. Users of financial statements still do not receive correct information regarding advertisingcosts.Step 7—Decision:Student(s) must decide their course of action.

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1-11Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.Assignment ChartAccess to the FASB codification is required for any exercises like 1-3 and 1-4. FASB controls access tothe codification, but they have an academic program that departments can sign up for. If your schoolhas paid for a site license of the Academic Accounting Access Program, faculty and students will havefree access to the FASB Codification. Check with your accounting department to determine if yourschool has registered for this program. All of the features available with the Professional View version (http://asc.fasb.org ) are included with the Academic Accounting Access Program.LearningEst. timeQuestionsObjective(s)Topic(min.)1-11-1Function and primary focus of financialaccounting51-21-1Efficient allocation of resources51-31-1Investment-credit decision51-41-1Investment-credit decision51-51-1Objective of financial accounting51-61-2Cash versus accrual accounting51-71-3Generally accepted accounting principles51-81-3Roles of the SEC and FASB51-91-5Role of the auditor51-101-5Sarbanes-Oxley Act51-111-4Economic consequences of accounting standards51-121-4FASB's standard-setting process51-131-6Purpose of the conceptual framework51-141-7Relevance and faithful representation51-151-7Components of relevance and faithfulrepresentation51-161-7Cost effectiveness51-171-7Materiality51-181-7Financial accounting elements51-191-8Assumptions underlying GAAP51-201-8Going concern assumption51-211-8Periodicity assumption51-221-9Broad accounting principles51-231-9Historical cost; justification51-241-9Revenue recognition criteria51-251-9Expense recognition criteria51-261-9Full-disclosure principle51-271-9Fair value hierarchy51-281-9Measurement attributes51-291-10Revenue/expense and asset/liability approaches51-301-11Conceptual framework under IFRS51-311-11International standard setting51-321-11Accounting convergence5

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1-12Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.BriefLearningEst. timeExercisesObjective(s)Topic(min.)1-11-2Accrual accounting151-21-7Financial statement elements51-31-7,1-8,1-9Basic assumptions and principles101-41-7,1-8,1-9Basic assumptions and principles101-51-7,1-8,1-9Basic assumptions and principles101-61-11IFRS organizations10LearningEst. timeExercisesObjective(s)Topic(min.)1-11-2Accrual accounting201-21-2Accrual accounting151-31-3FASB codification research151-41-3FASB codification research201-51-3Participants in establishing GAAP101-61-7Financial statement elements101-71-7Concepts; terminology; conceptual framework101-81-7Qualitative characteristics151-91-7Basic assumptions, principles, and constraints101-101-7,1-8,1-9Basic assumptions and principles101-111-7,1-8,1-9Basic assumptions and principles151-121-8,1-9Basic assumptions and principles151-131-7,1-8,1-9Basic assumptions, principles, and constraints151-141-7,1-8,1-9Basic assumptions, principles, and constraints151-151-7,1-8,1-9Multiple choice; concept statements, basicassumptions, principles15CPA/CMALearningEst. timeExam QuestionsObjective(s)Topic(min.)CPA-11-7Qualitative characteristics3CPA-21-7Qualitative characteristics3CPA-31-3Standard-setting3CPA-41-7Qualitative characteristics3CPA-51-7Qualitative characteristics3CPA-61-7Qualitative characteristics3CPA-71-1Objectiveof financial reporting3CPA-81-7Financial statement elements3CPA-91-11IFRS standard setting structure3CPA-101-11IFRS conceptual framework3CMA-11-3Standard-setting3CMA-21-7Qualitative characteristics3CMA-31-7Recognition concepts3

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1-13Copyright © 2020McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-HillEducation.LearningEst. timeCasesObjective(s)Topic(min.)Judgment Case 1-11-3The development of accounting standards30Research Case 1-21-3Accessing SEC information through the Internet35Research Case 1-31-4Accessing FASB information through theInternet40Research Case 1-41-3,1-11Accessing IASB information through the Internet40Research Case 1-51-3,1-4Accounting standards in China60Communication Case 1-61-7Relevance and reliability30Communication Case 1-71-4Accounting standard setting60Ethics Case 1-81-5The auditors' responsibility30Judgment Case 1-91-7Qualitative characteristics20Judgment Case 1-101-5,1-7GAAP; comparability and the role of the auditor20Judgment Case 1-111-7Cost effectiveness30Judgment Case 1-121-9The realization principle20Analysis Case 1-131-9The matching principle25Judgment Case 1-141-9Capitalize or expense?20Real World Case 1-151-7,1-9Elements; disclosures;The GAP20Judgment Case 1-161-11Convergence20Air France-KLM Case1-11Air France-KLM,Financial statements,accounting principles30

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12-1Copyright © 2020 McGraw-HillEducation.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-Hill Education.CHAPTER 2REVIEW OF THE ACCOUNTING PROCESSAuthors’ PerspectivesReexamination—The purpose of accounting is to provide information to decision makers. The purpose of thischapter is toreviewthe fundamentalaccounting processused to produce the financial statements that help toimpart that information.This review establishes a framework for the study of the concepts covered inintermediate accounting.The emphasis you place on this review and the class time you devote to it will dependin part on the depth and recency ofstudents’prior preparation in introductoryaccounting courses.LO2–1 Understand routine economic events—transactions—and determine their effects on a company’sfinancial position and on specific accounts.LO2–2 Describe the steps in the accounting processing cycle.LO2–3 Analyze and record transactions using journal entries.LO2–4 Post the effects of journal entries to general ledger accounts and prepare an unadjusted trial balance.LO2–5 Identify and describe the different types of adjusting journal entries.LO2–6 Record adjusting journal entries in general journal format, post entries, and prepare an adjusted trialbalance.LO2–7 Describe the four basic financial statements.LO2–8 Explain the closing process.LO2–9 Convert from cash-basis net income to accrual-basis net income.This Will Be a “Hands-On” Class—Ask your students to keep in mind astheystudy this chapter that theaccounting information systemsthat companiesuse are quite different fromfirm to firm. Largerbusinessestypicallyuse more complex systems than smaller companies use. We focus on the many features that tend to becommon to all accounting systems. It’s importantfor studentsto understand thatwe don’t intendto describeactual accounting systems.For most companies, the sheer volume of data that must be processed precludesusinga manual accounting system,somost businesses use acomputerized system. We describe and illustrate amanual accounting information system to provide an overview of the basic model that underlies the computersoftware programs actually used to process accountingdata.The Accounting Equation—Establish up front thatthe accounting equation underlies the process used tocapture the effect of economic eventsand isthe key to all we do in this chapter andbeyond:Assets = Liabilities + Owners’ EquityThis general expression portrays the equality between the total economic resources ofa business(its assets)—shown on the left side of the equation—and the total claims against thebusiness(liabilities and equity)—shownon the right side. In other words, the resources ofa companyareclaimedby creditors and owners.Shareholders’ Equity—Adviseyour students that weuse thecorporateformat throughoutthis chapter and therest of the book. Remind themthatowners of a corporation are its shareholders, so owners’ equity for acorporation is referred to as shareholders’ equity(or stockholders’ equity). Shareholders’ equity for a corpora-

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12-2Copyright © 2020 McGraw-Hill Education.All rights reserved.No reproduction or distribution without the prior written consent of McGraw-Hill Education.tion arises primarily from two sources: (a) amounts invested by shareholders in the corporation and (b) amountsearned by the corporation (on behalf of its shareholders). These are reported as (a) paid-in capital and (b)retained earnings.•Illustration 2–1 shows the basic accounting equation for a corporation with shareholders’ equity expandedto highlight its composition:Assets = Liabilities +Shareholders’EquityOne Step at a Time—After a reviewofthe basics of the double-entry system, we look closer at the processused to identify, analyze, record, andsummarize transactions and prepare financial statements. The 10 steps inthe accounting processing cycle are listed in Illustration 2–4. Steps 1–4 occurduringthe accounting periodwhile steps 5–8 are applied at theendof the accounting period. Steps 9 and 10 are needed only at theend of theyear.You might provide a brief overview of each step as on pages 53-54, and then explore each one in moredetail.Thisis demonstrated in Illustrations 2-6 and2-7 (journal entries); Illustration 2-8 (ledger); andIllustrations 2-9 (trial balance).Most ofthe illustrations in the chapter actually are parts of a single“incremental Illustration” in which we usea singlesituationandeach illustration buildsuponthe previous oneusing the same data set.Step 6 is the preparation ofadjusting entries.For many students,mastery of this step provides the “aha!”moment in their study of financialaccountingbecause itdrives home the point of accrual accounting.Emphasize thatadjusting entriesareneededto help ensure that all revenues are recognized in the period goodsor services are transferred to customers, regardless of when the cash is received.Similarly, they enable acompany to recognize all expenses incurred during a period, regardless of when cash payment is made.•Illustration 2–11 recaps adjusting entriesdemonstrated in the preceding paragraphs.•After the adjusting entries are posted to the general ledger accounts, the next step—step 7—in theprocessing cycle is to prepare an adjusted trial balanceasshown inIllustration 2–12. The termadjustedrefers to the fact that adjusting entries have now beenincorporated intothe account balances.ThePurposeFulfilled—Remind your students that the purpose of each of the steps in the processing cycle tothis point is to provide information for step 8—preparingthefinancial statements, and thatthe financialstatements are the primary means of communicating financial information to external parties. The adjusted trialbalance contains the information necessary to prepare the statements.•Illustration 2–13 shows the income statement,and Illustration 2-14shows the balance sheetforthehypothetical company we’ve used throughout the chapter. These are followed in Illustrations 2-15 and 2-16 for a basic statement of cash flows and statement of shareholders’ equity for that same company.The Closing—Students mighttend torelax after the financial statements are prepared, but remind them that westill have a couple things to wrap up.At the end of thereporting period, two final steps are necessary, closingthe temporary accounts—step 9—and preparing a post-closing trial balance—step 10. Theclosing processserves a dual purpose: (1) the temporary accounts (revenues, expenses, gains,losses, and dividends) are reducedto zero balances, ready to measure activity in the upcoming accounting period, and (2) these temporary accountbalances are closed (transferred) to retained earnings to reflect the changes that have occurred in that accountduring the period.Afterwe postthe closing entries to the ledger accounts,we prepareapost-closing trialbalance. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctlyand that the accounts are now ready for next year’s transactions.

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