Module 01

Module 1: Introduction to accounting conceptsOverview

Topics 1.1 to 1.7 of this module set the stage for the course by introducing some basic concepts of accounting. Various forms of organizations are briefly introduced and their basic features are compared. The module identifies a wide spectrum of users for whom accounting information is useful. You will also study some basic ethical standards that guide the work of a professional accountant. The major fields of accounting are highlighted. The financial statements of a proprietorship income statement, balance sheet, statement of changes in owners equity, and cash flow statement are previewed. You will also take a brief look at a recently introduced statement the statement of comprehensive income and determine the effects of business transactions on the accounting equation.

Topics 1.8 to 1.12 explain the conceptual framework of accounting. These topics preview the principles and concepts that are integrated throughout the ensuing module notes and enable you to define the essential characteristics of accounting information and to identify the fundamental concepts used in preparing external financial reports. Topic 1.13 describes the elements of financial statements.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives

1.1

Describe the function of accounting and the nature and purpose of the information it provides, and identify users of accounting information. (Level 1)

1.2 Distinguish between sole proprietorships, partnerships, and corporations. (Level 2)1.3 Explain the importance of ethics in accounting, and the key ethical standards expected of

professional accountants. (Level 1)1.4 Compare the fields of accounting and the kinds of work performed in each field. (Level 2)1.5 Differentiate among the different kinds of financial statements. (Level 1)1.6 Explain each of the GAAP introduced. (Level 2)1.7 Analyze business transactions to determine their effects on the accounting equation. (Level 1)1.8 Describe the major areas of the conceptual framework of accounting. (Level 2)1.9 Describe the essential characteristics of accounting information. (Level 2)1.10 Describe the trade-off of qualitative characteristics. (Level 2)1.11 Describe the assumptions of accounting. (Level 2)1.12 Describe the basic principles of accounting. (Level 2)1.13 Describe the elements of financial statements. (Level 2) Module summary

Print this module

Assignment reminder

Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). You may wish to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in advance.

Note: Please review the Exemplar located here. The Exemplar provides a sample question along with two sample answers: one answer demonstrates a poor response and the second answer represents a good response. To maximize your learning as well as your grade on each of the three assignments in this course, it is highly recommended that you take the time to understand the differences between the two sample answers provided as part of this Exemplar.

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Textbook errata

When textbook errors are discovered after printing, the publisher makes every effort to notify students of the error by posting an errata on their online learning centre. When students come across a potential textbook and/or solution error, they are encouraged to check the publishers Website for the latest errata. The errata is found at http://highered.mcgraw-hill.com/sites/9970951713/student_view0/errata.html.

Examination reminder

Students may use their own calculators in examinations, provided they meet the following guidelines:

The calculator is silent, battery-operated, and non-printing. The calculator has only one line of display. The calculator does not have alpha keys (keys allowing text entry).

Students are responsible for ensuring that the calculator batteries are fully operational. There will be no exchange or borrowing of calculators or batteries during the examination. No operating instructions will be allowed in the examination room.

No other mechanical, electronic, or other type of aid or material is permitted in the examination room.

As of 2010-2011, present value tables will no longer be included on any examinations. Students should be able to use their financial calculators proficiently.

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Module 1 Test your knowledge

1. Which financial statement shows whether the business earned a profit and also lists the types and amounts of the revenues and expenses?

1. Balance sheet2. Statement of changes in owners equity3. Statement of cash flows4. Income statement

2. Which of the following is another term for equity?

1. Net income2. Expenses3. Net assets4. Revenue

3. Which accounting guideline requires that an entity report all of its financial statement information in the same currency?

1. Business entity principle2. Monetary unit principle3. Going-concern principle4. Revenue recognition principle

4. If the liabilities of a business increased $12,000 during a period of time and owners equity in the business decreased $2,000 during the same period, the assets of the business must have increased or decreased by how much?

1. Decreased $10,0002. Decreased $14,0003. Increased $10,0004. Increased $14,000

5. A purchase of office equipment for cash of $130 was recorded as an addition to Office equipment and an addition to Liabilities. By what amounts are the accounts under- or overstated as a result of this error? (Understated means too low, and overstated means too high.)

1. Assets, understated $130; Liabilities, overstated $130 2. Office equipment, understated $260; Liabilities, overstated $130 3. Office equipment, overstated $130; Liabilities, overstated $130 4. Assets, overstated $130; Liabilities, overstated $130

Solutions

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1.1 What is accounting?

Learning objective

Describe the function of accounting and the nature and purpose of the information it provides, and identify users of accounting information. (Level 1)

Required reading

Chapter 1, pages 1-4 and 7-10

LEVEL 1

The function of accounting is to provide quantitative information, primarily financial in nature, about economic entities. Accounting involves analyzing economic events and determining how they should be recorded. Bookkeeping, on the other hand, is the part of accounting that deals only with the physical recording of transactions and events.

This course includes a lot of bookkeeping activities. You start off by learning how economic activities are recorded according to the rules of accounting, and why accountants do things the way they do them. Throughout the course, spend time on the why aspect to deepen your understanding and to help you learn to deal with situations that are not specifically covered by the rules.

Accounting information is needed to answer day-to-day questions about business operations. Financial statements report accounting information that provides answers to questions about a firms resources, earning prospects, expected cash collections, debt-paying ability, and other related information.

There are two broad classes of users of financial information: internal users and external users. The types of questions that will be asked by different users are almost limitless. For example, an investor might ask How profitable is the business? while a manager might query How well is the business doing compared to the competitors?

In order to answer these questions appropriately, accounting information must meet certain criteria such as understandability, relevance , reliability , and comparability.

Accounting information that is understandable is useful to users with reasonable knowledge of accounting as well as business and economic activities.

Accounting information should be relevant because it can affect the types of decisions made by those who rely on the information.

Accounting information should be reliable for decision makers to depend on it. Faithful representation , substance over form , neutrality , prudence and completeness are all necessary for information to be reliable. Faithful representation means transactions must be reported truthfully. In addition, transactions are to be reported based on their essence: substance over form. Information that is neutral is free from bias. To be complete, there can be no material omissions.

Accounting information should be comparable in the sense that companies use similar practices so that users are able to compare companies and their information.

The provision of understandable, relevant, reliable, and comparable information requires both expertise and integrity. First, expertise acquired through training and experience is needed to gather and analyze information that is understandable, relevant, reliable, and comparable. For example, in the age of the Internet where huge amounts of information are but a few clicks away, it requires expertise to cut through the peripheral materials and focus on the most relevant information.1 Second, for financial information users to rely on the information provided by accountants, there has to be a strong element of trust in the accountants integrity. Accordingly, a large part of accounting ethics centres on the development of the moral

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character trait of integrity.

Expertise and integrity go hand in hand. An expert who lacks integrity is morally untrustworthy the sort of person who would distort the truth to pursue personal advantage at the expense of the client. However, an individual with personal integrity but lacking expertise would not have the practical skills for providing financial information that is relevant, objective, and feasible. Thus, what is required in an accountant is a combination of expertise and integrity.

Textbook activities

Checkpoint Questions 1 and 2 on page 4 (Solutions on page 17)

Quick Study 1-1 and 1-2 on page 20 (Solutions)

Checkpoint Questions 5 and 6 on page 14 (Solutions on page 17)

Activity 1.1 Quality of information

You are a lending officer in a bank. A business owner comes to you with a loan proposal and brings you two sets of financial information:

The business's financial information for the year ending December 31, 2009, which has been audited (reviewed in detail) by a trained accountant who is not an employee of the firm.

Financial information for the 10 months ending October 31, 2010, prepared by an employee of the firm.

a. Which statement do you think is more reliable? Why?

b. Which statement do you think is more relevant? Why?

c. Which statement do you think is more comparable to industry information? Why?

Solution

1 IFRS 2009, Framework, para. 24.


1.2 Forms of organization

Learning objective

Distinguish between sole proprietorships, partnerships, and corporations. (Level 2)

Required reading

Chapter 1, pages 4-6

LEVEL 2

Accountants provide services to all types of business entities. It is important, therefore, that you are familiar with the characteristics of the different forms of business organization. The three forms of business ownership sole proprietorship, partnership, and corporation are clearly presented in the text. In addition, non-business organizations exist, which operate not-for-profit (for example, schools, hospitals and churches).

Textbook activities

Judgement Call on page 6 (Solution on page 17)

Checkpoint Questions 3 and 4 on page 6 (Solution on page 17)

Quick Study 1-3 on page 21 (Solution)

Mid-Chapter Demonstration Problem on page 7


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1.3 Ethics in accounting

Learning objective

Explain the importance of ethics in accounting and the key ethical standards expected of professional accountants. (Level 1)

Required reading


CGA-Canada Code of Ethical Principles and Rules of Conduct [available from the Ethics Readings Handbook (ERH) under the Resources tab]

Extend Your Knowledge (EYK) 1-3: Codes of Ethics and Professional Conduct

LEVEL 1

(For all ethics-related readings in this course, it is assumed that you have become familiar with Section A of the ERH . Section A clarifies important concepts and terms used throughout the ERH and is necessary background knowledge for the ERH readings referred to in this course. If you have not read this section, do it now before proceeding.)

Ethics is essentially the study of right and wrong and has been a prominent and sensitive issue in the accounting profession for years. In North America, all major accounting associations have a code of professional conduct. CGA-Canada expects its members and students to act according to its Code of Ethical Principles and Rules of Conduct (the Code) in their professional activities.

Ethical codes serve as a foundation for developing ethical behaviour in professions. They also provide a framework for ethical practice (refer to the Did You Know? at the bottom of page 11). However, codes alone are not enough and can never serve as the final moral authority. If codes become the focus of morality, one may just follow the codes and lose sight of fundamental principles. An overemphasis on codes could preclude criticism of the codes from a broader moral framework. What is needed, therefore, is moral character and ethical reasoning ability .

In recent years, there has been widespread interest in accounting ethics, due partly to wide media coverage of a host of misdeeds, including insider trading, tax evasion, audit failure, and fraud. Reports of unethical behaviour undermine public confidence in the accounting profession. For example, in the fall of 2001, the media focused a spotlight on energy giant Enron, which was forced to declare bankruptcy amid charges of insider trading, deceitful accounting, and corrupt management. To find out more, go to the FindLaw page on Enron.

One possible cause of ethical problems in the profession is the trend toward the commercialization of accounting. Management consulting and tax preparation have become major sources of revenue for accounting firms. This raises the possibility that some accountants may compromise auditing standards in order to attract other non-audit revenues. As professionals, however, accountants have a responsibility to the public that takes precedence over the demands of commercialization. Accountants have a special duty to the public because of the rights and privileges accountants enjoy, and because the public has confidence in the profession.

CGA-Canadas Code of Ethical Principles and Rules of Conduct outlines its members commitment to the public interest.

Textbook activities




Demonstration Problem on page 18 The case in the demonstration problem is one example of the many ethical issues facing accountants. In these module notes, they have been labelled as Ethics challenges. However, in real life, ethical issues or challenges usually do not come labelled as such. For example, would you have identified the ethical challenge in this case if the question was What could Rupert Jones do to maximize the audit fee from ShadowTech? rather than What are the ethical factors in this situation? Would you have answered by suggesting various ways in which Rupert could create a favourable impression of ShadowTechs financial situation, for example, by pretending that inventory in the warehouse was already sold? Or would you have noticed the real problem: the conflict of interest situation created when audit fees are tied to the statement of reported profits? In real life, this is the sort of ethical challenge that accountants have to deal with. In short, for every question, you will need to ask yourself, What are the ethical issues in this case? You will need to address both accounting and ethics issues in your answers to every case. As you practise asking yourself this question, you will ingrain the practice into your approach to problem-solving, and it will become easier.

Checkpoint questions 7-9 on page 14 (Solutions on page 17)

Quick Study 1-5 on page 21 (Solution)


1.4 Types of accountants and fields of accounting

Learning objective

Compare the fields of accounting and the kinds of work performed in each field. (Level 2)

Required reading


LEVEL 2

Accountants can be classified according to the services they provide. Exhibit 1.6 on page 14 of the text provides a summary of the activities performed by accountants and the fields in which these activities occur financial accounting, managerial accounting, and tax accounting. Note that both financial and managerial accountants can work in for-profit enterprises such as the Royal Bank and not-for-profit organizations such as hospitals and CGA-Canada. This course focuses on financial accounting for the for-profit enterprises.

As a CGA, you will likely work in one of these three fields of accounting. One of the activities in financial accounting is auditing. In most jurisdictions in Canada, a CGA may audit a companys financial statements. An audit expresses an opinion on the fairness of the statement presentation.

Textbook activity

Checkpoint questions 10-13 on page 16 (Solutions on page 17)



1.5 Financial statements

Updated Sept. 14/10, FA1-10-TU01

Learning objective

z Differentiate among the different kinds of financial statements. (Level 1)

Required reading

z Chapter 2, pages 25-31

LEVEL 1

Financial statements are an end product of the accounting process. After financial information has been accumulated and summarized, the information is reported in the form of financial statements. They are used to fulfill the function of accounting to provide quantitative information useful for decision-making. Financial statements are also used for external reporting and for internal management.

The text presents four financial statements that a sole proprietorship (also referred to as a single proprietorship or just proprietorship) prepares:

z Income statement (also known as statement of earnings and statement of income)

z Statement of changes in owners equity (Note: the textbook uses the term statement of owners equity. Because the components of the statement of changes in equity as required by IFRS are different for a corporation than what is presented in the textbook and detailed in Module 9, students will be required to use the term statement of changes in equity or statement of changes in owners equity for a sole proprietorship.1)

z Balance sheet (also known as statement of financial position)

z Cash flow statement (also known as statement of cash flows)

As you progress through this course, you will learn the use and detailed preparation of the income statement, statement of changes in owners equity, balance sheet, and cash flow statement. In this module, the format and basic content of these financial statements will be introduced.

The statement of comprehensive income is a relatively new statement. Comprehensive income will be explained briefly in Module 9 after you have learned some of the prerequisite terminology and concepts.

A brief note about terminology: As you progress in your study of accounting, you will find that there are synonyms for many frequently referred to items (a synonym is a word that has the same meaning as another word). The actual name that you use is not as important as unambiguously describing the economic event that is being recorded. Thus statement of earnings and income statement are both acceptable.

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Accounting is undergoing significant changes in Canada because of the adoption of International Financial Reporting Standards (IFRS). IFRS are the new accounting laws or Generally Accepted Accounting Principles (GAAP) that must be applied by accountants to publicly accountable enterprises (PAEs) in Canada starting January 1, 2011, when recording and reporting accounting information. A PAE is a corporation that sells its shares openly on a stock exchange. Privately-held enterprises (PEs) will have the option of adopting IFRS or using PE GAAP. Privately-held enterprises include sole proprietorships and corporations that do not sell their shares on the open market.

Some of the financial statement terminology under IFRS differs from current Canadian standards. However, IFRS does not mandate the terms used to name financial statements. The following is a list of financial statement terminology under IFRS (along with terminology used in the textbook, if different):

z The statement of financial position (the balance sheet) z The statement of changes in equity (the statement of retained earnings) z The statement of cash flows (the cash flow statement) z The income statement z The statement of comprehensive income

IFRS terms and material covered in the course are examinable. Students should be aware of these differences. On assignments and exams, students will be required to use either statement of changes in equity or statement of changes in owners equity for sole proprietorships. For corporations, discussed in detail in Module 9, students must use statement of changes in equity or statement of changes in shareholders equity in place of the statement of retained earnings used in the textbook. For partnerships, also discussed in detail in Module 9, students must use statement of changes in partnership equity or statement of changes in equity in place of statement of partnership equity.

Income statement

The income statement conveys a concise picture of profitability (net income or net loss) for a period of time, such as a month, a quarter, or a year. Notice that in Exhibit 2.2 on page 28, the statement has the following heading:

Finlay Interiors Income Statement

For Month Ended January 31, 2011

This type of information is an integral part of any financial statement because it tells the reader which economic entitys financial result is being reported; the type of information that is being reported; and the period the information covers (for income statements, cash flow statements, and statements of changes in owners equity) or the point in time to which it applies (for balance sheets). Insufficiently identified information is almost useless to the reader. See Example 1-1.

Statement of changes in owners equity

The statement of changes in owners equity summarizes the changes in the owners capital over a period of time for a sole proprietorship. Exhibit 2.3 on page 28 illustrates how this statement is headed up and

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formatted.

Note: Because of the publication date of the textbook, the incorrect name is used in the text for the statement of changes in owners equity. Students are required to replace all occurrences of the statement of owners equity with either the statement of changes in equity or the statement of changes in owners equity.

Balance sheet

The balance sheet is a concise picture of financial position (assets, liabilities, and owners equity) on a specific date. A balance sheet can be thought of as a snapshot at a point in time that captures what the firm has (assets), what it owes (liabilities), and what belongs to the owners (equity).

Note in Exhibit 2.4 on page 28 that the balance sheet date is specific. This contrasts with the income statement, the statement of changes in owners equity, and the cash flow statement, all of which report results over a period of time. This presentation then shows the format and the types of accounts that are included in Finlay Interiors balance sheet. Note how assets, liabilities, and equity are presented on the balance sheet.

As you can see from the exhibit, assets equal the sum of liabilities and owners equity. This is typically expressed as A = L + E.

Assets are: (1) properties or economic resources controlled by the business; and (2) the result of past transactions or events; and (3) from which future economic benefits may be obtained.2 Simply put, assets are things that the entity owns.

Note that all three criteria must be present to classify a resource as an asset. See Example 1-2.

Liabilities are obligations of the company: they are what the company owes. IFRS define a liability as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.3

See Example 1-3 for an illustration.

In the example, the process of determining that a car is an asset and a car loan is a liability may seem to be simplistic. However, this methodology is fundamental to establishing how to classify more complex financial statement elements and how to deal with situations that are not specifically covered by the rules.

Owners equity represents the residual interest in the assets of the entity after deducting all its liabilities.4Owners equity is sometimes referred to as net assets.

Cash flow statement

The primary objective of the cash flow statement (also called the statement of cash flows) is to reconcile the change in cash from the beginning of the period to the end of the period. The statement categorizes cash inflows and outflows into three groups: operating activities, investing activities, and financing activities, as shown in Exhibit 2.5 on page 28. A comprehensive knowledge of the interactivity between the income statement, the balance sheet, and the statement of changes in owner's equity is required in order to complete the cash flow statement.

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Textbook activities

z Checkpoint Questions 1 to 4 on page 31 (Solutions on page 45)

z Quick Study 2-1 on page 50 (Solution)

The order of the various financial statements in Exhibits 2.2 to 2.5 on page 28 is deliberate. As you go through these exhibits, you will note that information from the first statement (the income statement) is necessary to construct the second (the statement of changes in owners equity), which in turn is necessary to create the third (the balance sheet). Information from the first three statements is then required to produce the cash flow statement.

1 IFRS 2009, IAS 1, par. 1

2 IFRS 2009, Framework, par. 49(a).

3 IFRS 2009, Framework, par.49(b).

4 IFRS 2009, Framework, par. 49(c).

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1.6 Generally accepted accounting principles (GAAP)

Learning objective

Explain each of the GAAP introduced. (Level 2)

Required reading


NOTE: Omit the section titled Objectivity Principle on page 32.

LEVEL 2

The IFRS 2009 Framework lists the primary sources of Generally accepted accounting principles (GAAP) for publically accountable entities (PAEs) in Canada. Privately-held entities (PEs) in Canada may choose IFRS GAAP or PE GAAP. GAAP comprise both broad and specific principles adopted by the accounting profession as guidelines for measuring, recording, and reporting the financial transactions and activities of a business. Broad principles describe basic assumptions and general guidelines for preparing financial statements. Specific principles provide more detailed reporting rules for handling various accounting transactions.

This topic presents an explanation of some important accounting principles that provide a framework for accounting.

Introducing some GAAP

GAAP provide the foundation for how to record business transactions that you will study in this course, as well as in more advanced financial accounting courses. These principles are listed in Exhibit 2.8 on page 31 and explained on pages 31-32. In addition, the GAAP are summarized on the inside back cover of the textbook for quick reference. Click on the following links for more details on the principles. Some of these principles will be covered in greater detail in later modules.

Business entity principle Cost principle Going-concern principle Revenue recognition principle Time period principle Materiality principle Matching principle Consistency principle Prudence principle Full-disclosure principle Monetary unit principle

Example 1-4 shows how GAAP is used to guide accounting practice.

As already noted, Canada is in the process of incorporating IFRS. This convergence with IFRS, as it is commonly known, will result in some changes to GAAP. For example, conservatism will be replaced with prudence. Although prudence is similar to conservatism, it emphasizes the exercise of caution and that assets or income are not overstated and liabilities or expenses are not understatedwhereas conservatism suggests that it is better to understate than overstate assets and equity.1




Textbook activities

Checkpoint Questions 5-7 on page 33 (Solutions on page 45)

Quick Study 2-3 and 2-4 on page 51 (Solution)

1IFRS 2009, Framework, par. 37.


1.7 The accounting equation

Learning objective

Analyze business transactions to determine their effects on the accounting equation. (Level 1)

Required reading


LEVEL 1

The relationship between assets and the claims against the assets can be conveniently summarized in the following equation:

Assets = Liabilities + Owners equity

A business transaction is an exchange of goods or services that affects this equation. It is essential to understand the effects of transactions on the accounting equation in order to understand the accounting function.

Effects of transactions on the accounting equation

The accounting equation applies to all economic and legal entities from a proprietorship such as the local barbershop to large corporations such as Canadian Tire. Study carefully how various transactions affect the accounting equation for Finlay Interiors (see textbook pages 34-38). Activities 1 to 11 illustrate the following points, which you must understand for your accounting work:

1. The accounting equation remains in balance after each transaction.

2. Every transaction affects at least two items in the accounting equation (double-entry accounting). Think of a transaction as any economic exchange that causes a change in assets, liabilities, or owners equity.

3. Revenues and owner investments increase owners equity. Expenses and owner withdrawals decrease owners equity. Therefore, revenues, expenses, investments, and withdrawals directly affect owner's equity.

4. Not all activities result in an economic exchange, in which case the accounting equation would be unaffected. For example, see Activity 7 on page 36.

Understanding more about financial statements

In this section, you will see how the financial statements relate to each other. Each statement provides users such as owners and managers with relevant financial information. Review Exhibit 2.11 on page 42. The income statement and statement of changes in owners equity (shown as statement of owners equity) are for a period of time, but the balance sheet is for a point in time. Notice from Exhibit 2.11 that the net income of $2,400 is added to the beginning balance of owners capital. Also, the owners equity of $11,800 on January 31 in the statement of changes in owners equity is the same figure that is reported on the balance sheet as Carol Finlay, capital. In practice, the financial statements of a business are accompanied by explanatory notes and supporting schedules. (Refer to Appendix I at the back of the text, pages I-23 to I-39, to view an example of explanatory notes for WestJet.) These are considered to be an integral part of the financial statements.

Textbook activities

Mid-Chapter Demonstration Problem on pages 40-41 (Note: Be sure to always do the Analysis component when one is included in a question to help develop your analytical skills.)

Judgement Call on page 43 (Solution on page 44)




Checkpoint Questions 8 to 15 on

page 39 and Checkpoint Questions 16 and 17 on page 43 (Solutions on page 45)

Quick Study 2-5 to 2-14 on pages 51-54 (Solutions)

Demonstration Problem on pages 46-48 (Note: The income statement and statement of changes in owners equity in Exhibit 2.11 on page 42 reflect a net income, while the income statement and statement of changes in owners equity in the demonstration problem show the effects of a net loss.)


1.8 The conceptual framework of accounting

Learning objective

Describe the major areas of the conceptual framework of accounting. (Level 2)

Required reading

Reading 1-1: CICA Handbook , Part II section 1000. (This reading is for Topics 1.8 to 1.13.)

LEVEL 2

In this introductory course to financial accounting, you will obtain an overview of the principles and concepts that comprise the conceptual framework. In this topic, you review the essential characteristics of accounting information and look at section 1000 of the CICA Handbook on financial statement concepts (Reading 1-1).

Note: Although a Level 2 understanding has been assigned to topics 1.8 to 1.13, that is not the learning expectation at this point in the course. Topics 1.8 to 1.13 provide the reasons why financial accounting is applied in certain ways in different situations. It is suggested that students should read through the material in topics 1.8 to 1.13 briefly now, and then continue to refer back to these topics in each module. The goal will be to go beyond mere number crunching and understand the whys of the financial accounting specifics that are introduced in each module. The expectation is that by the conclusion of module 10, students will have acquired a Level 2 understanding of topics 1.8 to 1.13.

In the preceding sections of Module 1 you learned that accounting is a service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities. Accounting involves identifying economic events and then measuring, recording, summarizing, and reporting information to users. The aim of accounting is to provide useful information for making economic decisions.

The conceptual framework of accounting includes two major areas:

Defining the essential characteristics of accounting information Identifying the fundamental concepts of accounting used in preparing external financial reports



1.9 Essential characteristics of accounting information

Learning objective

Describe the essential characteristics of accounting information. (Level 2)

LEVEL 2

Accountants must determine the purpose and ultimate use for the financial reports they prepare. The reports assist users in making financial decisions by disclosing information. Financial reports should be presented in a manner that will be understood by users who have a reasonable level of knowledge of business and economics. In other words, financial statements are not designed for the nave investor. Read paragraphs .01 to .14 of Reading 1-1, which expand on the characteristics that make accounting information useful.

Paragraph .15 of Reading 1-1 identifies four qualitative characteristics or qualities that make accounting information useful:

Understandability Relevance Reliability Comparability

Of these, relevance and reliability are considered the primary qualities that must be present for accounting information to be useful.

Each of these four qualitative characteristics is connected to the ethical foundations of accounting, and they make it possible to provide useful information to financial users by setting ethical parameters on acceptable accounting information. All of them require good judgement and expertise.

Understandability (paragraph .16 of Reading 1-1)

The primary criterion for selecting accounting reporting methods is decision usefulness. That is, the information should be helpful to users in making investment, financing, and operating decisions. For the information to be useful, it must be understandable by users. Information is understandable if a user can perceive the significance of the information. In some cases, however, when a user doesnt understand the information, it does not mean that the information is not relevant. It may mean that the particular user does not have sufficient accounting knowledge to be able to interpret the information. Remember that accounting reports are prepared for informed users who have a reasonable understanding of business and are willing to study the information.

Relevance (paragraph .17 of Reading 1-1)

Accounting information must be relevant to, or useful for, the decision-making needs of users. Information is relevant if it has the capacity to make a difference in the decision-making process. Relevance is enhanced by the following:

Predictive value: the quality of financial information that enhances the users ability to forecast an entitys future income and cash flows.

Feedback value: the quality of financial information that confirms or corrects prior expectations relating to past decisions and events.

Timeliness: the availability of information in time to influence users decisions. Financial statements issued late lose the quality of timeliness.

Reliability (Paragraph .18 of Reading 1-1)

Accounting information must be reliable (free from error and bias) in order to reduce the level of risk to those who base decisions on it. Reliability is improved if information possesses the following qualities:




Faithful representation (or representational faithfulness): the degree to which the information accurately measures or describes the real-world situation it represents. In other words, the information says what it appears to say. This quality of faithful representation is sometimes referred to as validity. Amounts reported on financial statements should be a faithful representation of the economic resources of an organization, the claims to these resources, and the residual equity of the enterprise.

Verifiability: the measurement methods allow others to arrive at the same quantitative result without error or bias. Information is considered verifiable if there is a high degree of consensus on the measurement of financial statement items when the same measurement methods are being used.

Neutrality: freedom from bias and attempts to influence decisions on the part of preparers of financial reports.

Prudence: when there are uncertainties, a degree of caution is included such that assets or income are not overstated and liabilities or expenses are not understated. It simply means that when there is risk or uncertainty, the preference for possible accounting measurement errors should be in the direction of neutrality and reliability, rather than in the direction of overstatement or understatement of financial statement elements.

Comparability (paragraphs .19 and .20 of Reading 1-1)

There are two dimensions of comparability. One dimension is the users ability to make comparisons between different entities, such as between different companies in the same industry. For example, investors frequently evaluate and compare the performance of competitors by analyzing the results found in their financial reports. Accounting standards facilitate comparability by requiring specific treatments of certain transactions. For example, all companies must record accrued revenues, that is, revenues that have been earned but not yet received (Note: Accrued revenues are discussed in detail in Module 3).

The second dimension of comparability is the users ability to compare the results of one specific entity from year to year. Consistent use of the same accounting procedures and policies over time allows users to identify significant trends. Without consistency, there is a chance that changes in reported results of operations are simply due to changes in accounting procedures, rather than actual changes in performance. Consistency within a specific entity is generally achieved. However, to date accountants have had only limited success in achieving comparability between firms. This is partly because the conceptual framework does not give clear guidance for situation where alternative methods to account for various events exist. As you will learn in subsequent modules, there are alternative acceptable methods of inventory valuation FIFO, weighted-average (discussed in detail in Module 5); alternative methods of depreciation straight-line, declining-balance (discussed in detail in Module 7); and considerable discretion in the recording of various expenses bad debt expense (discussed in detail in Module 6) and warranty expense (discussed in detail in Module 8).


1.10 Trade-off of qualitative characteristics

Learning objective

Describe the trade-off of qualitative characteristics. (Level 2)

LEVEL 2

The essential characteristics of accounting information understandability, relevance, reliability, and comparability do not always support each other; nor are all four always present. For example, relevant information may not always be reliable. What users especially want are data about the future, but such data generally cannot be considered reliable (because data cannot be verified until the future event has occurred). Accountants must therefore make trade-offs or compromises between these essential characteristics; compromises are a natural factor in the accounting process.

That compromises have to be made may give rise to a disquieting question: Is there any principled way of making such compromises, or is this simply a free-for-all where anything goes? There is a good answer to this question that brings out some of the basic principles of ethics in accounting.

First, the overall objective in accounting is to provide useful financial information for stakeholders (users of the financial information). Therefore, if a particular compromise cant be justified in terms of its usefulness, then it is highly suspect. Second, it is important to make compromises between one objective (such as relevance) and another (such as reliability) as transparent to all stakeholders as possible. Such transparency treats users of financial information fairly by disclosing important limitations on the accounting information provided to them. Third, accounting has developed conventional modes of providing financial information, as reflected in generally accepted accounting principles and standards. These principles and standards provide guidance as to acceptable compromises.

These compromises often require accountants to generally consider two constraints when implementing accounting procedures and reporting information. These constraints are practical application guidelines related to the usefulness of accounting information and should be assessed on an individual basis:

Benefit versus cost constraint Materiality



1.11 Fundamental concepts of accounting Assumptions

Learning objective

Describe the assumptions of accounting. (Level 2)

LEVEL 2

The fundamental concepts of accounting promote and guide the objective of providing users with information that is relevant and reliable while recognizing the fact that accounting must operate in a risky, real-world environment. The conceptual framework distinguishes between assumptions, principles, and detailed practices and procedures.

Assumptions of accounting

The four assumptions of accounting described below require knowledge about the nature and complexities of the environment in which accounting operates. These assumptions provide a fundamental basis for the principles and procedures of accounting. Since accounting is an attempt to tell the story of an entity using primarily quantitative data, it is necessary to presume certain conditions about the business. Assumptions define the playing field of accounting, establishing the limitations and orientations of the financial accounting process. Some of these assumptions have been introduced as generally accepted accounting principles in Section 1.6 of this module.

The four assumptions of accounting are:

Separate-entity assumption (or business entity principle as discussed in section 1.6 of this Module) Going-concern assumption (or going-concern principle) Unit-of-measure assumption (or monetary unit principle as discussed in section 1.6 of this Module) Time period assumption (or time period principle, also known as timeliness or periodicity)

The Four Assumptions of Accounting

Assumption Equivalent Principle

separate-entity assumption business entity principle

going-concern assumption going-concern principle

unit-of-measure assumption monetary unit principle

time period assumption time period principle, also known as timeliness or periodicity



1.12 Fundamental concepts of accounting Basic principles

Learning objective

Describe the basic principles of accounting. (Level 2)

LEVEL 2

The conceptual framework provides four basic principles of accounting to guide the implementation of accounting procedures. These principles are based on the assumptions described above. The principles of accounting establish

The basis for valuing items on the financial statements (cost principle);

When to deem an event to have occurred for accounting purposes (revenue recognition principle);

What cause and effect relationships exist between revenues and expenses in the financial statements (matching principle); and

What additional information should be reported in the annual financial reports to make them useful to external users (full-disclosure principle).

In short, these four principles are:

Cost principle Revenue recognition principle Matching principle Full-disclosure principle

Accounting principles have a strong ethical element in that they are directed to providing useful and true information to users of financial information. This requires accountants to exercise their expertise with integrity in the interests of clients and other stakeholders.



1.13 Fundamental concepts of accounting Elements of financial statements

Learning objective

Describe the elements of financial statements. (Level 2)

LEVEL 2

Read paragraphs .22 to .35 of Reading 1-1. The elements of financial statements are the broad account classifications. These are the building blocks used in accounting. Whenever a transaction is processed through the accounting system, specific ledger accounts are affected. A conceptual understanding of the various classifications of accounts (assets, liabilities, owners equity, revenues and expenses, gains and losses) is essential in order to understand the merit of proposed treatments.

For example, consider the following definition: assets are probable future economic benefits owned by the entity as a result of past transactions. This definition may be clear, but when you consider the issue of which costs to include in the valuation of inventory or property, plant, and equipment, the reasoning behind the required treatment hinges on the implementation and interpretation of the definition.

Reminders:

The conceptual framework of accounting covered in sections 1.8 to 1.13 inclusive pervades all material covered in subsequent modules. In order to understand and apply accounting in practice it is critical to continually refer back to these sections. For example, as you read through Module 2, ask yourself what assumptions and principles are involved and why. A common error students make when learning accounting is that they do accounting but dont understand why they are doing it. By continually asking yourself why as you do accounting, you will learn to understand accounting and how to apply it in decision-making situations.

Remember to use the various self-study tools in the online Student Success Centre to review the chapter material in different ways. You are encouraged to use these tools to the greatest extent possible to help you solidify your understanding of the material. You may wish to bookmark the URL to this valuable resource: http://highered.mcgraw-hill.com/sites/9970951713/student_view0/index.html.

Using your access password, you can access the iStudy content of the online Student Success Centre such as TetrAccounting (the accounting videogame), Interactive Exercises, and Conceptual Objects at http://highered.mcgraw-hill.com/classware/infoCenter.do?isbn=0070951713. (Click on Self Study near the top on the left-hand side of the screen under Course-wide Content.) Put this URL into your favourites for ease of access in the future. Please refer to page xxvi of the Preface in Volume 1 of the text for more details. You are encouraged to practise with these interactive tools to deepen your understanding of the course material.

The text readings and the module notes are what you will be tested on. CGA-Canada is not responsible for any errors that may occur in the online Student Success Centre. For technical support issues related to the online Student Success Centre, please contact the publisher at [email protected].



Module 1 summaryIntroduction to accounting concepts

Describe the function of accounting and the nature and purpose of the information it provides, and identify users of accounting information.

Accounting is a service activity that includes the measurement, recording, summarization, and reporting of economic information to external financial statement users to assist in rational investment, credit, and other business decisions. Accounting is also essential for the internal functions of a business.

Users of accounting information include

External users m Users outside of the entitym Examples: banks, government, creditors, unions, investors

Internal users m Users within the entitym Examples: Marketing Manager, Accounts Receivable Manager, Accounts Payable Manager, Operations Manager,

company executives

Distinguish between sole proprietorships, partnerships, and corporations.

Single or sole proprietorship m Owner is personally responsible for business debts.

Partnership m Partners are personally responsible for all partnership debts.

Corporation m A corporation is a separate legal entity.m It is responsible for its own debts.

Explain the importance of ethics in accounting and the key ethical standards expected of professional accountants.

Accountants must perform their responsibilities according to the highest ethical standards because many users rely on financial reports.

Some of the basic ethical standards expected of professional accountants include m confidentialitym competencem objectivitym integrity

Compare the fields of accounting and the kinds of work performed in each field.

There are three basic types of accountants: m Private accountants work for a single employer.m Public accountants are available to the public.m Government accountants work for local, provincial, and federal government agencies.

Accountants can be classified according to the services they provide.

Fields of accounting include

m financial accountingm managerial accountingm tax accounting

Both financial and managerial accountants can work in for-profit enterprises and not-for-profit organizations.

Differentiate among the different kinds of financial statements.

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The income statement summarizes net income (or net loss) resulting from revenues less expenses.

The statement of changes in owner's equity reconciles changes in owners equity (increases are caused by owner investments and net income, while decreases result from owner withdrawals and net losses).

The balance sheet details assets, liabilities, and owners equity.

The cash flow statement shows the cash inflows and outflows from operating activities, investing activities, and financing activities.

Explain each of the GAAP introduced.

International Financial Reporting Standards (IFRS) are the accounting standards to be used by publically accountable enterprises (PAEs) in Canada effective January 1, 2011. Privately held enterprises (PEs) will use PE GAAP established by the Accounting Standards Board (AcSB) after consultation with various interest groups.

GAAP include m Business entity principlem Cost principlem Going-concern principlem Revenue recognition or realization principlem Time period principlem Materiality principlem Matching principlem Consistency principlem Prudence principlem Full-disclosure principlem Monetary unit principle

Analyze business transactions to determine their effects on the accounting equation.

Business transactions always affect at least two elements in the accounting equation.

The accounting equation is Assets = Liabilities + Owners equity

After a transaction is recorded, the accounting equation must be in balance.

The conceptual framework of accounting

Describe the major areas of the conceptual framework of accounting.

The conceptual framework of accounting includes two major areas:

Defining the essential characteristics of accounting information

Identifying the fundamental concepts of accounting used in preparing external financial reports

Describe the essential characteristics of accounting information.

The primary qualitative characteristics that make accounting information useful are relevance, reliability, understandability, and comparability.

To meet the relevance test, information should have predictive value, feedback value, and be timely.

The components of reliability are faithful representation, verifiability, neutrality, and prudence.

Describe the trade-off of qualitative characteristics.

The overall objective in accounting is to provide useful financial information for stakeholders (users of the financial information). To achieve this objective, it is sometimes necessary to compromise between some of the competing



objectives. In doing so, use the principles of usefulness and transparency, and be guided by the conventional principles and standards reflected in GAAP.

Accountants generally consider two constraints when implementing accounting procedures and reporting information: benefit versus cost constraint and materiality.

Describe the assumptions of accounting.

The fundamental concepts of accounting include assumptions that establish the limitations and orientations of the financial accounting process.

The separate-entity assumption assumes that the owner and the business are viewed for accounting purposes as being separate and distinct.

The going-concern assumption assumes that a business has an indefinite life.

The unit-of-measure assumption assumes that transactions are expressed in common units of money, and that these are stable.

The time period assumption assumes that periodic reports are required so that the firms results may be evaluated on a regular basis. The Four Assumptions of Accounting Assumption Equivalent Principle

separate-entity assumption business entity principle

going-concern assumption Going-concern principle

unit-of-measure assumption monetary unit principle

time period assumption time period principle, also known as timeliness or periodicity

Describe the basic principles of accounting.

The principles of accounting establish

The basis for valuing items on the financial statements (cost principle)

When revenues are deemed to have been earned (revenue recognition principle)

When costs should be expensed (matching principle)

What additional information should be reported in the annual financial reports to make them useful to external users (full-disclosure principle)

Describe the elements of financial statements.

The basic elements of financial statements are

Assets Liabilities Equity Revenues Expenses Gains Losses


Exemplar of Assignment Question and Answer

An exemplar is a model. The following exemplar provides a sample question along with two sample answers: one answer demonstrates a poor response and the second answer represents a good answer. For each of the sample answers, explanations of key footnoted answer points are detailed as to what made one poor versus the other being good. To maximize your learning as well as your grade on each of the three assignments in this course, it is highly recommended that you take the time to understand the differences between the two sample answers provided as part of this exemplar.

Sample Question Level of Difficulty: Challenging (50 marks):

Jason Budd owns and operates JB Sales, which has just finished its first year of business. Jason is hoping to hire you, a recent CGA graduate, to help him manage the business as well as keep the accounting in order. During your interview, the owner explains that sales and net income have been exceptionally good and, as a result, he will be making a personal withdrawal of $100,000: not bad after only one year! He offers to pay you an annual salary of $150,000 plus bonuses. You ask to see the financial statements, which follow:

JB Sales Income Statement

Year Ended December 31, 2008 Sales $1,800,000Cost of goods sold 1,100,000Operating & other expenses 500,000Net income $ 200,000

JB Sales Balance Sheet

December 31, 2008 Cash $ 14,000 Accounts & accrued payables $1,350,000Accounts receivable 1,325,000 Notes payable, due 2009 400,000Merchandise inventory 350,000 Jason Budd, capital 664,000Property, plant, and equipment 775,000 Accumulated depreciation (50,000) Total assets $2,414,000 Total liabilities and owners equity $2,414,000

Other information:

Cash sales for the year totalled $50,000 with the balance on account; sales occurred evenly throughout the year.

$1,450,000 of inventory was purchased during the year; all on account.

Property, plant, and equipment were acquired by issuing a note payable.

Operating expenses were paid throughout the year.

You thank Jason for the interview, and indicate that you will give him a response within the next 24 hours.

Required:

1. In order to respond to Jason Budd, you perform some calculations using the financial information received. Show these calculations and provide explanations as to why they might be valid in helping you make a decision regarding the employment offer made to you by JB Sales. [25 marks]

2. Prepare your response to Jason Budd, explaining why you will or will not be accepting the position with JB Sales. Use the industry benchmark ratios on textbook (page 1017) to assess and compare the financial condition of JB Sales (assuming the industry benchmark ratios are for the same industry and time period). [25 marks]

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Sample of a Poor Answer

1. Four ratios have been covered by the end of Module 5: current ratio, merchandise turnover, days sales in inventory, and gross profit ratio. Each of these ratios is calculated below. Current ratio: 14,000 + 1,325,000 + 350,000

1,350,000 + 400,000= 0.97 (rounded to 2 decimal places)

Merchandise turnover: 1,100,000

(350,000 + 0)/2= 6.29 times per year or 58 days (365/6.29 = 58 days)

Days' sales in inventory: 350,000 365 1,100,000

= 116 days Gross profit ratio: 1,800,000 1,100,000 100 1,800,000

=38.89% (rounded to 2 decimal places) Explanation of why this is a poor response: The calculations are correct but have no value without an explanation as to why they might be valid in helping make a decision regarding the employment offer. Therefore, no points are awarded for part (a) of this answer. The critical aspect of FA1 is to be able to demonstrate an understanding of how accounting information can be used and applied in decision-making. Calculations by themselves do not demonstrate such an understanding, especially given that the question specifically asked for explanations. Be sure to always read the question carefully, and in your answer address all of the requirements completely.

2. Given that the market rate for this kind of position is $200,000,1 I am not accepting this position. Besides, the company doesnt have any cash, so how are they going to pay me? This is true because the current ratio shows that they arent even able to pay the current liabilities.2 The owner is right that there was lots of net income in 2008, but after he makes his $100,000 of withdrawals there wont be enough left to pay me, let alone the current liabilities!3 Explanation of why this is a poor answer: 1 This may be valid information but it is impossible to tell because the source has not been included. Did this come from an article in a credible magazine/newspaper? Any statements made as part of the answer that do not come from the information provided in the question must be referenced. If this had been referenced, it would be a valid comment. 2 This is a correct interpretation of the current ratio calculated in part (a) of the question. However, it needs to be stated in a more explicit manner. For example, it would be better to say that the current ratio for the year ended December 31, 2008, indicates that there is $0.97 to cover each $1.00 of current liability as it comes due. This means that JB Sales has liquidity issues. If the company is having difficulty paying existing obligations, there are concerns as to whether JB Sales will be able to pay my salary. 3 This statement reflects a misunderstanding. Net income as reported on the income statement is based on accrual accounting and therefore, when converted to a cash basis could show higher or lower cash income than the accrual income.

Sample of a Good Answer

1. Four ratios have been covered by the end of Module 5: current ratio, merchandise turnover, days sales in inventory, and gross profit ratio. Each of these ratios is calculated below for JB Sales year ended December 31, 2008. An explanation as to how each ratio might be valid in helping making an employment decision is also included. Current ratio: 14,000 + 1,325,000 + 350,000

1,350,000 + 400,000= 0.97 (rounded to 2 decimal places)



The current ratio is a measure of liquidity indicating whether a business has the current assets available such as cash, accounts receivable, prepaids, and inventory, to cover current obligations, such as accounts payable, current notes payable, interest payable, and other short-term liabilities.4 A current ratio of greater than "1" means that there is more than $1 of current assets available to cover each $1 of current liabilities as they come due. This ratio is valid in this decision-making because it will tell me whether JB Sales has sufficient resources to pay the salary and bonuses promised.5 A ratio related to the current ratio but which has not been covered in the course yet is the quick ratio, also known as the acid-test. The acid-test is a more strict measure of liquidity than the current ratio because it excludes less liquid current assets such as inventory and prepaids. The quick ratio would be (14,000 + 1,325,000)/(1,350,000 + 400,000) = $0.77.6 In other words, for every $1 in current debt there should be $0.77 in quick assets (the most liquid current assets).

Merchandise turnover: 1,100,000

(350,000 + 0)/2= 6.29 times per year or 58 days (365/6.29 = 58 days) The merchandise turnover measures how quickly inventory is sold. A high turnover means the business is selling inventory quickly, which is generally considered to be good. It is good because inventory uses cash (it has to be paid for); excessive levels of inventory mean cash is not being used effectively. However, levels of inventory that are too low could mean that customer demands are not being met resulting in lost sales. This ratio is valid in the decision-making process because it will tell me whether JB Sales uses inventory, a current asset that is part of the current ratio, well.

Days' sales in inventory:

350,000 365 1,100,000 = 116 days This ratio measures how many days worth of sales are sitting in inventory. As with the merchandise turnover, if days sales in inventory is too high, it may be an indicator that excessive levels of inventory are being held. However, sufficient inventory needs to be on hand to meet customer demands. This ratio is valid in this decision-making because, as already noted for the merchandise turnover, it will tell me whether JB Sales uses inventory efficiently.

Gross profit ratio:

1,800,000 1,100,000 100 1,800,000=38.89% (rounded to 2 decimal places) The gross profit ratio measures how much profit is generated from the sale of inventory before considering operating and other expenses. This ratio may be valid in this decision-making process because it is an indicator of whether there is sufficient profit available to cover operating expenses. The promise to pay $150,000 plus bonuses will cause operating expenses to increase so it is important to see if gross profit is sufficient to cover this increase.

Explanation of why this is a good answer: 4 An explanation of what the current ratio is has been provided, along with examples to demonstrate the students understanding. A common error students make is to copy definitions into an answer without expanding on the definition to show their understanding. 5 Notice that this answer specifically addresses the question being asked. Another common error that students make is they memory dump lots of information but never answer the question quantity is not necessarily quality! Be concise and to the point when preparing answers. 6 This answer demonstrates that the student is exercising critical thinking by appropriately using resources beyond what has been covered in the course modules up to this point in time. This type of effort above and beyond would earn a student extra marks.

2. I will not accept7 the position being offered to me by JB Sales for the following reasons:

The current ratio is 0.97 which means that JB Sales may have difficulty meeting its current obligations so



there is a question as to whether it will be able to pay an additional $150,000 salary plus bonuses. Assuming that the industry average ratios shown on page 1017 of the textbook are for the same industry as that of JB Sales, JB Sales current ratio of 0.97 is significantly less than the industry average of 1.6.8 The information provided also indicates that the owner wants to make a $100,000 withdrawal which would reduce the current ratio further.9

If sales occurred evenly throughout the year then why is the accounts receivable balance 74% of total sales (1,325,000/1,800,000)? Is there an issue with collections and/or is there a credit issue with one or more customers?10 If receivables are not collected because of credit issues with customers then the liquidity position will become even worse.

The merchandise inventory turnover is higher than the industry average shown on page 1017 of the textbook which is generally considered to be a favourable position (although the industry averages on page 1017 are for 2011, my assumption, is that the years can be compared for the purpose of demonstration; I recognize that in the real world, industry averages for the same year should be used).11 However, the days sales in inventory for JB Sales of 116 days is significantly higher than the industry average of 70 days shown on page 1017. This indicates that excessive inventory levels are on hand reflecting an inefficient use of resources.

The gross profit ratio of 38.89% is very favourable relative to the industry average of 18% indicating that JB Sales has sufficient profit from sales to cover operating expenses. However, given that there is a question about the collectability of sales (as pointed out earlier), this may be misleading.12

Accounts payable are 93% of what total merchandise purchases were ($1,350,000/$1,450,000) indicating poor accounts payable management and/or the inability to pay suppliers (which might be the case given the current ratio).13

The owner is under the impression that the $200,000 income represents cash which it does not; it is based on accrual accounting.14 When the $200,000 is converted to cash income, it shows that $75,000 was used by operations (Cash sales of $50,000 + $425,000 collection of accounts receivable $100,000 paid regarding accounts payable $450,000 paid for operating expenses the $50,000 depreciation is a non-cash expense so not part of the paid operating expenses). Therefore, the wisdom of making a $100,000 withdrawal is in question.

Explanation of why this is a good answer: 7 The student could accept or not accept the position; either is correct provided the student can justify their position. What one student might see as an insurmountable challenge, another might see as an opportunity to explore an interesting challenge. 8 This is going beyond what is expected, since this comes from a chapter in the textbook covered subsequent to Module 5. However, students are encouraged to look beyond the lesson notes and textbook for information to supplement and support their position. Therefore, this type of answer would earn a student points, since it clearly demonstrates the efforts associated with critical thinking. 9 This is an excellent point showing that a student understands the impact of transactions on ratios. 10 Instead of making assumptions and/or jumping to conclusions, the student has asked very good questions that reflect a deep understanding of accounting concepts. 11 This answer demonstrates that the student is exercising critical thinking by appropriately using resources beyond what has been covered in the course modules up to this point in time. This type of effort above and beyond would earn a student extra marks. 12 This shows excellent insight through the application of concepts. 13 The student has carefully analyzed the numbers on the balance sheet in relation to the income statement, and as a result gained important insights for decision-making. 14 Although this analysis is beyond the scope of Module 5 (not covered until Module 10), this student has taken the time to seek alternate sources of information which will earn points.


Module 1 Test your knowledge solutions

1. Incorrect. The balance sheet details the financial position of the business at a given point in time.

2. Incorrect. The statement of changes in owners equity shows how equity changed during the accounting period.

3. Incorrect. The statement of cash flows details how cash changed during the accounting period; namely, the sources and uses of cash.

4. Correct. The income statement shows the profit earned by a business during the accounting period by subtracting expenses from revenues.

1. Incorrect. Net income causes equity to change but it is not another term for equity (net income and owner investment cause equity to increase while net loss and owner withdrawals cause equity to decrease).

2. Incorrect. An expense is not another term for equity. However, because expenses are included in the calculation of net income, they do cause equity to change (decrease).

3. Correct. Net assets, or assets less liabilities, is another term for equity.

4. Incorrect. Revenue is not another term for equity. However, because revenues are included in the calculation of net income, they do cause equity to change (increase).

1. Incorrect. The business entity principle is a GAAP that requires each entity to keep separate records.

2. Correct. The monetary unit principle is a GAAP stating that all values on a set of financial statements are assumed to be constant and of the same currency (for example, Canadian dollars).

3. Incorrect. The going-concern principle is a GAAP that assumes a business entity is operational unless information is provided to the contrary.

4. Incorrect. The revenue recognition principle is a GAAP that requires revenue to be recorded at the time that it is earned regardless of whether cash or another asset has been exchanged.

1. Incorrect. If the net result is an increase on the liability and equity side of the accounting equation, then it is logical that assets must increase (not decrease) by that net change.

2. Incorrect. Because equity decreased by $2,000 and liabilities increased by $12,000, the net change is determined by taking the difference and not by adding these two values.

3. Correct. A = L + E, therefore, if L increases $12,000 and E decreases $2,000, the net change on the right-hand side of the equation is an increase of $10,000. If the right-hand side of the equation increased by a total of $10,000, then the left-hand side of the equation, assets, must have also increased by $10,000.

4. Incorrect. It is correct that assets increased but not by $14,000. Because equity decreased by $2,000 and liabilities increased by $12,000, the net change is determined by taking the difference and not by adding these two values.

1. Incorrect. Liabilities are overstated by $130 but assets are overstated by $130, not understated, because cash should have been reduced by $130.

2. Incorrect. Liabilities are overstated by $130 but Office equipment is neither overstated nor understated.

3. Incorrect. Liabilities are overstated by $130 but Office equipment is neither overstated nor understated.

4. Correct. The addition of $130 to Office equipment is correct. However, the addition to Liabilities is incorrect, causing a $130 overstatement of liabilities. Cash should have been reduced by $130, which means assets are overstated by $130.

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Activity 1.1 solution

a. The December 31, 2009, year-end information is more reliable: it has been reviewed by an external accountant who would have taken steps to ensure that the financial information presents fairly the underlying economic activity of the firm.

b. The financial information for the 10 months ending October 31, 2010, is more relevant, albeit less reliable. The October 31, 2010, statements present the most recent economic activity of the firm. Timeliness is an important component of relevancy. To put things in perspective, if you were considering investing in a bank such as CIBC, would you be more interested in its 2009 year-end statement or its 1981 year-end statement? The answer is 2009 because it more accurately reflects what has recently happened, and is thus more relevant to the decision.

c. The December 31, 2009, year-end information is likely more comparable to industry information: It has been reviewed by an external accountant, who is almost always more knowledgeable about accounting policies and procedures than an internal employee.

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Example 1-1

Imagine that you are the owner of two companies, A & B. Your accountant gives you a piece of paper with some numbers on it, simply headed income statement. Will it make a difference to you that you do not know whether you are reviewing A or Bs performance? Will it matter if the recorded information represents one month or one years results? Do you care if the period of time represented ended this month or 25 years ago? Of course you do. Thus, insufficiently identified information is of little use.

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Example 1-2

If you own a car, the car is your asset because 1) you own it, 2) your ownership occurred as a result of a past transaction, and 3) future economic benefits may be obtained.

Dealing with each of these criteria individually:

1. Your neighbours car is also an asset, but it is not your asset because your neighbour owns it, not you.

2. You own the car as a result of a past transaction. You bought it, won it in a lottery, or someone gave it to you some time in the past. If you had not acquired the car in the past, you would not own it today.

3. Future economic benefits may be obtained from the car. You can sell it tomorrow for cash; you can use it to drive to work, or to drive to California on vacation (known as value in use); or you can use it for a period of time and then sell it. In all three cases, the car will be providing a future economic benefit.



Example 1-3

If you have a car loan, the loan is your liability because

a. You have a duty today (a present obligation) to transfer assets (outflow of resources) in the future you will pay cash to the bank on the payment dates; and

b. You borrowed the money previously (past event). If you intend to borrow it next week, you do not owe the bank the money today, and it is therefore not a liability (yet).



Business entity principle

The business entity principle requires that every business is perceived to be, and is treated as, an entity, separate and distinct from its owner(s) and from every other business. An entity could be all of the TELUS Communications, Inc. stores in Canada, or one particular TELUS store in an Edmonton shopping mall. The basic idea is that economic events must be identified with a particular unit of accountability. The records of one entity should not be mingled with the records of other entities for the purpose of determining its performance.

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Cost principle

The cost principle holds that assets and services must be recorded in a companys books on the basis of cash (or cash equivalent) paid for them, on the date they are acquired. This amount is referred to as the book value of the asset. With the passage of time, the value of an asset often changes. Uninformed users often mistakenly assume that the values of assets shown in published reports are market values when in fact they reflect historical costs . In reality, the fair value of assets may differ significantly from their book value. Market values are considered to be more relevant than book values. The cost principle thus sacrifices relevance in favour of reliability . Later in this course, you will see that not all assets remain on the books at historical cost. For example, the book value of some assets is reduced in a rational and systematic way by a process known as depreciation (to be explained in detail in Module 3).

file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06cost.htm

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Going-concern principle

A business is a going concern if it will continue to operate for an indefinite period. It will use its assets to carry on its operations and, with the exception of merchandise, not offer the assets for sale. Current market values of individual assets such as equipment and buildings do not need to be measured because there is no intention of selling them. It is assumed that such assets will be used in the business and the resulting goods or services provided will be sold. If an entity is not a going concern and thus will not continue into the future (for example, due to bankruptcy), then historical cost figures will be irrelevant and liquidation values will be reported.

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Revenue recognition principle

The revenue recognition principle requires that revenue be recognized at the time it is earned. The following three points are essential to understanding the revenue recognition principle:

1. The inflow of assets associated with revenue does not have to be in the form of cash.

2. Revenue is earned at the time services are rendered or at the time title to goods sold is transferred.

3. The amount of revenue equals cash received plus the cash equivalent (fair value) of other assets received.

It is important that you understand that revenue is recognized when earned and expenses are recognized when consumed , not when cash is exchanged.

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Time period principle

The time period principle, also known as periodicity or timeliness, identifies a business activities during a specific time period. The time periods covered by financial reports are called accounting periods. An organization usually uses one year as its primary accounting period. However, an organization can also prepare interim financial reports that cover one month or a three-month period (a quarter). Periodic reports at regular intervals ensure that decision-makers obtain timely information. In Module 3 you will apply the time period principle.

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Documents

Module 01