LEARNING OBJECTIVES - Copyright © 2017 by Nelson Education Ltd. CHAP...

Chapter 2: The Accounting Information System and Financial Statements 1

Copyright © 2017 by Nelson Education Ltd.

CHAPTER 2

The Accounting Information System and Financial Statements

In this chapter, we will discuss the underlying concepts behind any accounting system. We will also begin a discussion of the procedures that companies use to record information about business activities and how this information is ultimately transformed into financial statements.We will discuss the basic concepts and procedures that underlie accounting systems and how the completion of each accounting procedure moves the accounting system toward its end product—the financial statements.

LEARNING OBJECTIVES

LO1. Describe the qualitative characteristics, assumptions, principles, and constraints that underlie accounting.

• The fundamental qualitative characteristics of accounting information are:

• Relevance—refers to whether information is capable of making a difference in

the decision-making process. Relevant information is material that helps predict the future or provides feedback about prior expectations.

• Faithful representation—refers to whether information faithfully represents the

economic event it is intending to portray. Faithfully presented information should be complete, neutral, and free from error.

• The enhancing qualitative characteristics are:

• Comparability—allows external users to identify similarities and differences

between two or more items. Consistency can be achieved by a company applying the same accounting principles for the same items over time.

• Verifiability—results when independent parties can reach a consensus on the

measurement of an activity.

• Timeliness—available to users before the information loses its ability to influence

decisions.

• Understandability—able to be comprehended (with reasonable effort) by users

who have a reasonable knowledge of accounting and business.

• The four assumptions are:

• Separate entity—each company is accounted for separately from its owners.
• Continuity (going concern)—assumption that a company will continue to operate

long enough to carry out its commitments.

• Periodicity or time-period—allows the life of a company to be divided into artificial

time periods.

• Unit of measure or monetary unit—requires financial information to be reported in

a national monetary unit.

• The three principles are:

• Historical cost—requires a business activity to be recorded at the exchange price

at the time the activity occurs.

• Revenue recognition—requires revenue to be recognized when it is earned and

cash collection is reasonably assured.Cornerstones of Financial Accounting Canadian 2nd Edition Rich Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Chapter 2: The Accounting Information System and Financial Statements 2

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• Full disclosure—requires that financial statements include all information required

for the financial statement users to make informed decisions (e.g., notes to the financial statements).

• Constraints:

• Cost—the benefit of users receiving information should exceed the cost of

producing the information.

• Prudence (conservatism)—assets and revenues should not be overstated and

liabilities and expenses should not be understated.

• The elements of financial statements are:

• Assets—economic resources of a business entity that are expected to provide

future benefit.

• Liabilities—existing obligations or debts of a business entity that will be satisfied

by payment with assets or the provision of services.

• Equity—capital provided to the company by its shareholders combined with

undistributed earnings of the business entity.LO2. Explain the relationships among economic events, transactions, and the expanded basic accounting equation.• A company’s business activities (operating, investing, and financing) consist of many different economic events that are both external to the company and internal to the company. Accounting attempts to measure the economic effect of these events.However, not all events are recognized, or recorded, in the accounting system.• A transaction is an economic event that is recognized in the financial statements. An accounting transaction causes the elements of the accounting equation (assets, liabilities, contributed capital, retained earnings, revenues, expenses, or dividends declared) to change in a way that maintains the equality of their relationship.LO3. Analyze the effect of business transactions on the basic accounting equation.• This is Step 1 of the accounting cycle.• Transaction analysis is the process of determining the economic effects of a transaction on the elements of the accounting equation.

• Transaction analysis involves three steps:

o Step 1: Write down the accounting equation (basic or expanded version).

o Step 2: Identify the financial statement elements that are affected by the

transaction.

o Step 3: Determine whether the elements increased or decreased.

• Each transaction will have a dual effect on the accounting equation, and the accounting equation will remain in balance after the effects of the transaction are recorded.LO4. Discuss the role of accounts and show how debits and credits are used in the double-entry accounting system using T-accounts.• An account is a record of increases and decreases in each of the basic elements of the financial statements.• Each financial statement element is made up of a number of different accounts.• All transactions are recorded into accounts.• The final account balance, after all changes are recorded, is used in the preparation of the financial statements.• The left side of an account is referred to as a debit. The right side of an account is referred to as a credit.• All accounts have a normal balance, which is a positive account balance. Assets, expenses, and dividends have a normal debit balance. Liabilities, shareholders’ equity, and revenues have a normal credit balance.

Chapter 2: The Accounting Information System and Financial Statements 3

Copyright © 2017 by Nelson Education Ltd.• Increases or decreases to an account are based on the normal balance of an account.Normal debit balance accounts (assets, expenses, and dividends declared) are increased with debits and decreased with credits. Normal credit balance accounts (liabilities, equity, and shareholders’ equity) are increased with credits and decreased with debits.LO5. Prepare journal entries for transactions.• This is Step 2 of the accounting cycle.• A journal entry represents the debit and credit effects of a transaction in the accounting records.

• A journal entry is prepared by following three steps:

o Step 1: Analyzing the transaction.

o Step 2: Determining which accounts are affected.

o Step 3: Using the debit and credit procedures to record the effects of the

transaction.• A journal entry is recorded in chronological order and consists of the date of the transaction, the accounts affected, the amount of the transaction, and a brief explanation.LO6. Explain why transactions are posted to the general ledger.• This is Step 3 of the accounting cycle.• To overcome the difficulty of determining account balances listed chronologically in the journal, information in the journal is transferred to the general ledger in a process called posting.• As a result of posting, the general ledger accumulates the effects of transactions in individual financial statement accounts.LO7. Prepare a trial balance and explain its purpose.• This is Step 4 of the accounting cycle.• The trial balance is a list of all active accounts, in the order they appear in the ledger (assets first, followed by liabilities, shareholders’ equity, revenue, and expenses), and each account’s debit or credit balance.• The trial balance is used to prove the equality of debits and credits and helps uncover errors in journalizing or posting transactions.• The trial balance is a useful tool in preparing the financial statements.

CORNERSTONES

Cornerstone 2.1 Applying the conceptual framework Cornerstone 2.2 Performing transaction analysis Cornerstone 2.3 Determining increases or decreases to a statement of financial position account Cornerstone 2.4 Determining increases or decreases to revenues, expenses, and dividends declared Cornerstone 2.5 Preparing a journal entry Cornerstone 2.6 Preparing a trial balance

CHAPTER OUTLINE

Discussion Question: After students read the opening George Weston Limited scenario, ask them whether a company should maintain a single accounting system for its diversified

Chapter 2: The Accounting Information System and Financial Statements 4

Copyright © 2017 by Nelson Education Ltd.business. Also ask them how easy or difficult it is to maintain an accounting system and what measures could be taken to keep the accounting system error free.

1. FUNDAMENTAL ACCOUNTING CONCEPTS

Reviewing financial statements means assessing a company’s performance, cash flows, and financial position, which in turn is called the accounting cycle.The accounting cycle is a simple and orderly process, based on a series of steps and conventions. Proper operation of the accounting cycle is essential in order to present the effects of a company’s activities.

• The Conceptual Framework

To make it easier to use financial statements over time and across companies, a common set of rules and conventions has been developed to guide the preparation of financial statements called Generally Accepted Accounting Principles (GAAP).GAAP rests on a conceptual framework of accounting that derives from the fundamental objective of financial reporting, which is to provide information that is useful in making business and economic decisions.The conceptual framework is designed to support the development of accounting standards and to provide a consistent body of thought for financial reporting that will help in understanding complex accounting standards by providing a logical structure to financial accounting.

• Qualitative Characteristics of Useful Information

Relevance and faithful representation (the enhancing characteristics are comparability, verifiability, timeliness, and understandability). Two pervasive constraints are cost and prudence constraints.

• Assumptions

Separate entity assumption, continuity (or going concern) assumption, periodicity (or time- period) assumption, and unit of measure (or monetary unit) assumption.

• Principles

Historical cost principle, revenue recognition principle, full disclosure principle, and prudence (conservatism) principle.

• Elements of the Financial Statements

• Assets—Assets are economic resources of a business entity that are controlled by a business entity and are expected to provide a future benefit.• Liabilities—Liabilities are existing obligations or debts of a business entity that will be satisfied by payment with assets or the provision of services.• Equity—Shareholders’ equity in a corporation consists of the capital provided to the company by its shareholders combined with undistributed earnings of the company.The elements of revenues, expenses, gains, and losses are discussed in Chapters 3 and 4.