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CHAPTER REVIEW
1.
Chapter 1 describes the environment that has influenced both the
development and use of the financial accounting process. The chapter
traces the development of financial accounting standards, focusing on
the groups that have had or currently have the responsibility for
developing such standards. Certain groups other than those with direct
responsibility for developing financial accounting standards have
significantly influenced the standard-setting process. These various
pressure groups are also discussed in Chapter 1.
Global Markets
2. World markets are becoming increasingly intertwined. And, due to
technological advances and less onerous regulatory requirements,
investors are able to engage in financial transactions across national
borders, and to make investment, capital allocation, and financing
decisions involving many foreign companies. As a result, an increasing
number of investors are holding securities of foreign companies, and a
significant number of foreign companies are found on national exchanges.
The move toward adoption of international financial reporting standards
has and will continue to facilitate this movement.
3. (S.O. 1) Financial accounting is the process that culminates in the
preparation of financial reports on the enterprise for use by both internal
and external parties.
4. Financial statements are the principal means through which a company
communicates its financial information to those outside it. The financial
statements most frequently provided are (1) the statement of financial
position, (2) the income statement are statement of comprehensive
income, (3) the statement of cash flows, and (4) the statement of
changes in equity. Note, disclosures are an integral part of each financial
statement. Other means of financial reporting include the president’s letter
or supplementary schedules in the corporate annual report,
prospectuses, and reports filed with government agencies.
5. (S.O. 2) Accounting is important for markets, free enterprise, and
competition because it assists in providing information that leads to
capital allocation. The better the information, the more effective the
process of capital allocation and then the healthier the economy.
6. (S.O. 3) To facilitate efficient capital allocation, investors need relevant
information and a faithful representation of that information to enable
them to make comparisons across borders. A single, widely accepted set
of high-quality accounting standards is a necessity to ensure adequate
comparability. In order to achieve this goal the following must be
accomplished:
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a. Single set of high-quality accounting standards established by a
single standard-setting body.
b. Consistency in application and interpretation.
c. Common disclosures.
d. Common high-quality auditing standards and practices.
e. Common approach to regulatory review and enforcement.
f. Education and training of market participants.
g. Common delivery systems (e.g., eXtensible Business Reporting
Language—XBRL).
h. Common approach to corporate governance and legal frameworks
around the world.
7. The major standard-setters of the world, coupled with regulatory
authorities, now recognize that capital formation and investor
understanding is enhanced if a single set of high-quality accounting
standards is developed.
8. (S.O. 4) The objective of general-purpose financial reporting is to
provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers.
a. General-purpose financial statements provide at the least cost the
most useful information possible to a wide variety of users.
b. Capital providers (investors) are the primary user group and have
the most critical and immediate need for information in the financial
statements. Investors need this information to assess a company’s
ability to generate net cash inflows and to understand management’s
ability to protect and enhance the assets of a company.
c. The entity perspective means that the company is viewed as being
separate and distinct from its creditors and owners (shareholders).
Therefore, the assets of the company belong to the company, not a
specific creditor or shareholder. Financial reporting focused only on the
needs of the shareholder—the proprietary perspective—is not
considered appropriate.
d. Decision-usefulness means that information contained in the
financial statements should help investors assess the amounts,
timing, and uncertainty of prospective cash inflows from dividends or
interest, and the proceeds from the sale, redemption, or maturity of
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securities or loans. In order for investors to make these assessments,
the financial statements and related explanations must provide
information about the company’s economic resources, the claims to
those resources, and the changes in them.
9. Information generated using the accrual basis of accounting provides a
better indication of a company’s present and continuing ability to
generate favorable cash flows than the cash basis.
Standard-Setting Organizations
10. (S.O. 5) Since 2000, two major standard-setting bodies have emerged
as the primary standard-setting bodies in the world. The International
Accounting Standards Board (IASB), based in London, United
Kingdom and the Financial Accounting Standards Board (FASB),
based in the United States.
11. Both boards believe that a single set of high-quality global accounting
standards is needed to enhance comparability. It is generally felt that
IFRS has the best potential to provide a common platform on which
companies can report and investors can compare financial information.
12. The two organizations that have a role in international standard-setting
are the International Organization of Securities Commissions
(IOSCO) and the IASB.
a. The IOSCO does not set accounting standards, it is dedicated to
ensuring that the global markets can operate in an efficient and
effective basis. In 2005 the IOSCO Memorandum of Understanding
(MOU) was endorsed to facilitate cross-border cooperation, reduce
global systemic risk, protect investors, and ensure fair and efficient
securities markets.
b. The member agencies have agreed to:
(1) Cooperate together to promote high standards of regulation in
order to maintain just, efficient, and sound markets.
(2) Exchange information on their respective experiences in order to
promote the development of domestic markets.
(3) Unite their efforts to establish standards and an effective
surveillance of international securities transactions.
(4) Provide mutual assistance to promote the integrity of the
markets by a rigorous application of the standards and by
effective enforcement against offenses.
13. The international standard-setting structure is composed of four
organizations: the International Accounting Standards Committee
Foundation (IASCF), the International Accounting Standards Board, a
Standard Advisory Council (SAC), and an International Financial
Reporting Interpretations Committee (IFRIC).
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a. The trustees of the IASCF select the members of the IASB and the
SAC, fund their activities, and oversee the IASB’s activities.
b. The IASB develop, in the public interest, a single set of high-quality
and understandable IFRS for general-purpose financial statements.
The IASB relies on the expertise of various task force groups formed
for various projects and on the SAC.
c. The SAC consults with the IASB on major policy and technical issues
and also helps select task force members.
d. The IFRIC acts as the “problem filter” for the IASB, leaving the IASB
to work on more pervasive long-term problems. It addresses
controversial accounting problems as they arise, and determines
whether it can quickly resolve them or whether to involve the IASB in
solving them.
14. The IASB has a thorough, open and transparent due process in
establishing financial accounting standards. It consists of the following
elements:
a. An independent standard-setting board overseen by geographically
and professionally diverse body of trustees.
b. A thorough and systematic process for developing standards.
c. Engagement with investors, regulators, business leaders, and the
global accountancy profession at every stage of the process.
d. Collaborative efforts with the worldwide standard-setting community.
15. To implement its due process, the IASB follows specific steps to develop
a typical IFRS.
a. Topics are identified and placed on the Board’s agenda.
b. Research and analysis are conducted and discussion papers are
issued on the preliminary views of pros and cons.
c. Public hearings are held on the proposed standard.
d. Board evaluates research and public response and issues an
exposure draft.
e. Board evaluates responses and changes exposure draft, if
necessary. Then final standard is issued.
16. The following characteristics of the Board are meant to insulate its
members as much as possible from the political process, favored
industries, and national or cultural bias.
a. Membership: The Board consists of 14 members, from 9 different
countries, serving 5-year renewable terms. Two members are parttime.
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b. Autonomy: The IASB is not part of any professional organization. It
is appointed by and answerable only to the IASCF.
c. Independence: Full-time members must sever all ties with their
former employer. Members are selected for their expertise rather
than to represent a given country.
d. Voting: Nine of 14 votes are needed to issue a new IFRS.
17. The IASB issues three major types of pronouncements.
a. International Financial Reporting Standards: To date the IASB
has issued 8 standards. In addition, the previous international
standard-setting body, the International Accounting Standards
Committee (IASC) issued 40 International Accounting Standards
(IAS). Those that have not been amended or superseded are
considered under the umbrella of IFRS.
b. Framework for Financial Reporting: The IASC issued the
Framework for the Preparation and Presentation of Financial
Statements (referred to as the Framework) with the intent to create a
conceptual framework that would serve as a tool for solving existing
and emerging problems in a consistent manner. However, the
Framework is not an IFRS and does not define standards for any
particular measurement of disclosure issue. Nothing in the
Framework overrides and specific IFRS.
c. International Financial Reporting Interpretations: Interpretations
are issued by the IFRIC and are considered authoritative and must
be followed. Seventeen have been issued to date. These
interpretations cover (1) newly identified financial reporting issues not
specifically dealt with in IFRS, and (2) issues where unsatisfactory or
conflicting interpretations have developed, or seem likely to develop,
in the absence of authoritative guidance.
18. The IASB has no regulatory mandate and no enforcement mechanism. It
relies on other regulators to enforce the use of its standards. For
example, the European Union requires publicly traded member country
companies to use IFRS. Any company indicating that it prepares its
financial statements in conformity with IFRS must use all of the
standards and interpretations. The hierarchy of authoritative
pronouncements is: IFRS, IAS, Interpretations issued by either the IFRIC
or its predecessor the SIC, the requirements and guidance in standards
and interpretations dealing with similar and related issues, the
Framework, and most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to develop accounting
standards.
Financial Reporting Challenges
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19. (S.O. 7) Although IFRS are developed by using sound research and a
conceptual framework that has its foundation in economic reality, a
certain amount of pressure and influence is brought to bear by groups
interested in, affected by, IFRS. The IASB does not exist in a vacuum,
and politics and special-interest pressure remains a part of the standardsetting process.
20. The expectations gap—what the public thinks accountants should do
and what accountants think they can do, has been highlighted by the
many accounting scandals that have occurred. In an effort to restore
investor confidence in the financial reporting practices of companies, the
United States passed the Sarbanes-Oxley Act that requires public
companies to attest to the effectiveness of their internal controls over
financial reporting.
21. The significant financial reporting challenges facing the accounting
profession are:
a. Non-financial measurements such as customer satisfaction
indexes, backlog information, and reject rates on goods purchased.
b. Forward-looking information.
c. Soft assets (intangibles).
d. Timeliness.
22. In accounting, ethical dilemmas are encountered frequently. The whole
process of ethical sensitivity and selection among alternatives can be
complicated by pressures that may take the form of time pressure, job
pressures, client pressures, personal pressures, and peer pressures.
And, there is no comprehensive ethical system to provide guidelines.
23. The IASB and FASB issued a memorandum of understanding, the
Norwich Agreement, agreeing to use their best efforts to:
a. Make their existing financial reporting standards fully converge as
soon as practicable, and
b. Coordinate their future work programs to ensure that once achieved,
convergence is maintained.
24. In addition, U.S. and European regulators have agreed to recognize each
other’s standards for listing on the various world securities exchanges.
As a result, costly reconciliation requirements will be eliminated and
hopefully lead to greater comparability and transparency.
The U.S. Standard-Setting Environment
*25. (S.O. 8) After the stock market crash in 1929 and the Great Depression,
there were calls for increased government regulation and supervision—
especially of financial institutions and the stock market. As a result, the
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federal government established the Securities and Exchange
Commission (SEC). The SEC is a federal agency and administers the
Securities Exchange Act of 1934 and several other acts. Most companies
that issue securities to the public or are listed on a stock exchange are
required to file audited financial statements with the SEC. In addition, the
SEC has broad powers to prescribe the accounting practices and
standards to be employed by companies that fall within its jurisdiction.
*26. At the time the SEC was created, it encouraged the creation of a private
standards-setting body. As a result, accounting standards have generally
been developed in the private sector either through the American
Institute of Certified Public Accountants (AICPA) or the Financial
Accounting Standards Board (FASB). The SEC has affirmed its support
for the FASB by indicating that financial statements conforming to
standards set by the FASB will be presumed to have substantial
authoritative support.
*27. Over its history, the SEC’s involvement in the development of accounting
standards has varied. In some cases, the private sector has attempted to
establish a standard, but the SEC has refused to accept it. In other
cases, the SEC has prodded the private sector into taking quicker action
on setting standards.
*28. If the SEC believes that an accounting or disclosure irregularity exists
regarding a company’s financial statements, the SEC sends a deficiency
letter to the company. If the company’s response to the deficiency letter
proves unsatisfactory, the SEC has the power to issue a “stop order,”
which prevents the registrant from issuing securities or trading securities
on the exchanges. Criminal charges may also be brought by the
Department of Justice.
*29. Similar to the IASB, the standard-setting structure of the U.S. is
composed of three organizations: The Financial Accounting
Foundation (FAF), the Financial Accounting Standards Board
(FASB), and the Financial Accounting Standards Advisory Council
(FASAC). The Financial Accounting Foundation selects the members of
the FASB and the FASAC, funds their operations, and generally
oversees the FASB’s activities.
*30. The mission of the FASB is to establish and improve standards of
financial accounting and reporting for the guidance and education of the
public, which includes issuers, auditors, and users of financial
information. The FASB differs from the predecessor APB in the following
ways:
a. Smaller membership: 5 versus 18 on the APB.
b. Full-time remunerated membership: APB members were unpaid
and part-time.
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c. Greater autonomy: APB was a senior committee of the AICPA. The
FASB is not part of any single professional organization. Their
technical reasons are subject only to SEC oversight.
d. Increased independence: FASB members must sever all ties with
firms, companies, or institutions.
e. Broader representation: it is not necessary to be a CPA to be a
member of the FASB.
Two basic premises of the FASB are that in establishing financial
accounting standards: (a) it should be responsive to the needs and
viewpoints of the entire economic community, not just the public
accounting profession, and (b) it should operate in full view of the public
through a “due process” system that gives interested persons ample
opportunity to make their views known.
*31. The FASB issues three major types of pronouncements:
a. Standards, Interpretations, and Staff Positions.
b. Financial Accounting Concepts.
c. Emerging Issues Task Force Statements.
The Standards, Interpretations, and Staff Positions are considered
GAAP and must be followed in practice in the same manner as APB
Opinions. The Statements of Financial Accounting Concepts (SFAC)
represent an attempt to move away from the problem-by-problem
approach to standard setting that has been characteristic of the
accounting profession. The Concept Statements are intended to form a
cohesive set of interrelated concepts, a conceptual framework, that will
serve as tools for solving existing and emerging problems in a consistent
manner. Unlike FASB statements, the Concept Statements do not
establish GAAP.
*32. In 1984, the FASB created the Emerging Issues Task Force (EITF).
The purpose of the Task Force is to reach a consensus on how to
account for new and unusual financial transactions that have the
potential for creating differing financial reporting practices. The EITF can
deal with short-term accounting issues by reaching a consensus and
thus avoiding the need for deliberation by the FASB and the issuance of
an FASB Statement.
*33. (S.O. 7) Generally accepted accounting principles (GAAP) are those
principles that have substantial authoritative support. Accounting
principles that have substantial authoritative support are those found in
FASB Statements, Interpretations, and Staff Positions; APB Opinions;
and Accounting Research Bulletins (ARBs). If an accounting transaction
is not covered in any of these documents, the accountant may look to
other authoritative accounting literature for guidance.
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*34. The FASB developed the Financial Accounting Standards Board
Accounting Standards Codification to provide in one place all the
authoritative literature related to a particular topic. The Codification
changes the way GAAP is documented, presented, and updated. The
Codification is a major restructuring of accounting and reporting
standards.
*35. The SEC recognizes that the establishment of a single, widely accepted
set of high-quality accounting standards benefits both global capital
markets and U.S. investors. The SEC appears committed to move to
IFRS assuming that certain conditions are met. These are spelled out in
the Roadmap for the Potential Use of Financial Statements
Prepared in Accordance with International Financial Reporting
Standards by U.S. Issuers (the Roadmap).
*36. The Roadmap establishes a set of milestones that, if achieved, could
lead to the required use of IFRS by U.S. issuers as early as 2014.
a. Improvements in Accounting Standards: The IASB and the FASB
have agreed to work together to establish one set of world-class
international standards by signing the Norwalk Agreement in 2002
and a memorandum of understanding (MOU) in 2006. And, in
2009, the Boards agreed on a process to complete a number of
major projects by 2011.
b. Accountability and Funding of the IASC Foundation: The IASC
Foundation has proposed that a Monitoring Group be established,
composed of securities authorities charged with the adoption and
recognition of accounting standards used in their respective
jurisdictions. This is an important issue because not only must highquality standards be developed, but some enforcement mechanism
must be in place to ensure that they are not abused.
c. Use of Interactive Data for IFRS Reporting: The SEC requires
companies to provide their financial statements in an interactive
format using eXtensible Business Reporting Language (XBRL). It is
expected that IFRS will be easily adaptable to use this methodology
as well.
d. Education and Training: Mandating the use of IFRS for financial
reporting in the U.S. will necessitate additional education.
e. Limited Early Use of IFRS: The SEC intends to make a decision in
2011 regarding the mandated use of IFRS. The SEC wishes to
experiment by allowing a limited number of U.S. companies to file
IFRS statements earlier than this date.
f. Anticipated Timing of Future Rule-Making: Sometime in 2011 the
SEC will decide whether to mandate the use of IFRS. It is likely that
there will be a transition period in which this will be accomplished.
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CHAPTER REVIEW
1.
Chapter 2 outlines the development of a conceptual framework for
financial accounting and reporting by the IASB. The entire conceptual
framework is affected by the environmental aspects discussed in Chapter
1. It is composed of the basic objective, fundamental concepts, and
operational guidelines. These notions are discussed in Chapter 2 and
should enhance your understanding of the topics covered in intermediate
accounting.
Conceptual Framework
2. (S.O. 1) A conceptual framework in accounting is important because it
can lead to consistent standards and it prescribes the nature, function,
and limits of financial accounting and financial statements. The benefits
its development will generate can be characterized as follows: (a) it
should be easier to promulgate a coherent set of standards and rules;
and (b) practical problems should be more quickly solved.
3. (S.O. 2) The IASB recognized the need for a conceptual framework upon
which a consistent set of financial accounting standards could be based.
The FASB and the IASB are currently working on a joint project to
develop a common conceptual framework that provides a sound
foundation for developing future accounting standards. The framework
will consist of three levels. The first level identifies the objective of
financial reporting. The second level provides the qualitative
characteristics that make accounting information useful and the elements
of financial statements. The third level identifies the assumptions,
principles and constraints that describe the reporting environment.
First Level: Basic Objective
4. (S.O. 3) The objective of financial reporting is the foundation of the
Framework. The objective of general-purpose financial reporting is to
provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers.
5. An implicit assumption is that users need reasonable knowledge of
business and financial accounting matters to understand the information
contained in financial statements. This means that financial statement
preparers assume a level of competence on the part of users, which
impacts the way and the extent to which companies present information.
Second Level: Fundamental Concepts
6. (S.O. 4) The fundamental qualities that make accounting information
useful for decision making are relevance and faithful representation.
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a. Relevance: Accounting information is relevant if it is capable of
making a difference in a decision. Financial information is capable of
making a difference when it has predictive value, confirmatory value,
or both.
b. Faithful Representation: Means that the numbers and descriptions
contained in the financial statements match what really existed or
happened. To be a faithful representation, information must be
complete, neutral, and free of material error.
(1) Completeness: The financial statements include all the
information that is necessary for faithful representation of the
economic phenomena that it purports to represent.
(2) Neutrality: Information is neutral if it is unbiased, i.e., it is not
presented in a manner that favors one set of interested parties
over another.
(3) Free from error: Does not mean total freedom from error. It
means that the information presented is as accurate as possible,
given any estimates are based on the best information available
at the time.
7. The enhancing qualities are complementary to the fundamental
qualitative characteristics. They include comparability, verifiability,
timeliness, and understandability.
a. Comparability: Information that is measured and reported in a
similar manner for different companies is considered comparable. It
enables users to identify the real similarities and differences in
economic events between companies. Consistency is present when
a company applies the same accounting treatment to similar events,
from period to period.
b. Verifiability: Occurs when independent measurers, using the same
methods, obtain similar results.
c.
Timeliness: Means having information available to decision-makers
before it loses its capacity to influence decisions.
d. Understandability: Is the quality of information that lets reasonably
informed users to see the connection between their decisions and
the information contained in the financial statements.
Understandability is enhanced when information is classified,
characterized, and presented clearly and concisely.
8. (S.O. 5) The IASB classifies the elements of the financial statements
into two groups. The first group describes amounts of resources and
claims to resources at a moment in time. The second group describes
transactions, events and circumstances that affect a company during a
period time.
a. Resources and claims to resources at a moment in time.
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(1) Asset: A resource controlled by the entity as a result of past
events and from which future economic benefits are expected to
flow to the entity.
(2) Liability: 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) Equity: The residual interest in the assets of the entity after
deducting all its liabilities.
b. Transactions, events, and circumstances that affect a company during
a period of time.
(1) Income: Increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants.
(2) Expenses: Decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets
or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.
Third Level: Recognition, Measurement, and Disclosure Concepts
9. (S.O. 6) In the practice of financial accounting, certain basic
assumptions are important to an understanding of the manner in which
information is presented. The following five basic assumptions underlie
the financial accounting structure.
a. Economic Entity Assumption: Means that economic activity can
be identified with a particular unit of accountability. In other words, a
company keeps its activity separate and distinct from its owners and
any other business unit.
b. Going Concern Assumption: In the absence of information to the
contrary, a company is assumed to have a long live. The legitimacy
of the cost principle is dependent upon the going concern
assumption.
c.
Monetary Unit Assumption: Money is the common denominator of
economic activity and provides an appropriate basis for accounting
measurement and analysis. The monetary unit is assumed to remain
relatively stable over the years in terms of purchasing power.
Therefore, this assumption disregards any inflation or deflation in the
economy in which the company operates.
d. Periodicity Assumption: The life of a company can be divided into
artificial time periods for the purpose of providing periodic reports on
the economic activities of the company.
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e. Accrual Basis of Accounting: Transactions that change a
company’s financial statements are recorded in the periods in which
the events occur. The cash basis of accounting is prohibited under
IFRS because it violates both the revenue recognition principle and
the expense recognition principle.
10. (S.O. 7) The basic principles of accounting are used to record and report
assets, liabilities, equity, revenues, and expenses. The four basic
principles of accounting are:
a. Measurement Principles: We currently have two acceptable
measurement principles: cost and fair value. Choosing which
principle to follow generally reflects the trade off between relevance
and faithful representation.
(1) Cost Principle: IFRS requires many assets and liabilities be
reported at their acquisition price, or cost, sometimes referred to
as historical cost. It is thought to be a faithful representation of
the amount paid for a given item. Many users favor the cost
principle because it is verifiable.
(2) Fair Value: Is a market based measure. At acquisition historical
cost and fair value are identical. In subsequent periods, as
market and economic conditions change, the two diverge. It is
felt that where fair value information is available, it provides
more relevant information about the expected future cash flows
related to an asset or liability. The IASB allows companies the
option to use fair value, the fair value option, as the basis for
measurement of financial assets and financial liabilities.
b. Revenue Recognition Principle: Revenue is recognized (1) when
realized or realizable and (2) when earned. Recognition at the time
of sale provides a uniform and reasonable test. Certain variations in
the revenue recognition principle include: certain long-term
construction contracts, end-of-production recognition, and
recognition upon receipt of cash.
c.
Expense Recognition Principle: Recognition of expenses is
related to net changes in assets and earning revenues. The expense
recognition principle is implemented in accordance with the definition
of expense by matching efforts (expenses) with accomplishment
(revenues). Some costs are difficult to associate with revenues and
must be allocated to expense based on a “rational and systematic”
policy. Product costs are expense when the units they are attached
to are sold. Period costs are expense as incurred.
d. Full Disclosure Principle: Financial statements should include
sufficient information to permit a knowledgeable user to make an
informed decision about the financial condition of the company in
question. Users can find information (1) within the main body of the
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financial statements, (2) in the notes to those statements, or (3) as
supplementary information.
11. (S.O. 8) In providing information with the qualitative characteristics that
make it useful, companies, must consider two overriding factors that limit
the reporting: the cost-benefit relationship and materiality.
a. Cost-Benefit Relationship: This constraint relates to the notion that
the benefits to be derived from providing certain accounting
information should exceed the costs of providing that information.
The difficulty in cost-benefit analysis is that the costs and especially
the benefits are not always evident or measurable.
b. Materiality: In the application of basic accounting theory, an amount
may be considered less important because of its size in comparison
with revenues and expenses, assets and liabilities, or net income.
Deciding when an amount is material in relation to other amounts is a
matter of judgment and professional expertise. Companies must
consider both quantitative and qualitative factors in determining
whether an item is material.
CHAPTER REVIEW
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*Note: All asterisked (*) items relate to material contained in the Appendices to
the chapter.
1.
Chapter 3
presents a concise yet thorough review of the
accounting process. The basic elements of the accounting process are
identified and explained, and the way in which these elements are
combined in completing the accounting cycle is described.
Accounting Information System
2. (L.O. 1) The accounting process can be described as a set of
procedures used in identifying, recording, classifying, and interpreting
information related to the transactions and other events of a business
enterprise. To understand the accounting process, one must be aware of
the basic terminology employed in the process. The basic terminology
includes: event, transaction, account, real accounts, nominal
accounts, ledger, journal, posting, trial balance, adjusting entries,
financial statements, and closing entries. These terms refer to the
various activities that make up the accounting cycle. As we review the
steps in the accounting cycle, the individual terms will be defined.
3. (L.O. 2) Double-entry accounting refers to the process used in
recording transactions. The terms debit and credit are used in the
accounting
process
to
indicate
the
effect
a transaction has on account balances. The debit side of any account is
the left side; the right side is the credit side. Assets and expenses are
increased by debits and decreased by credits. Liabilities, equity, and
revenues are decreased by debits and increased by credits.
4. In a double-entry system, for every debit there must be a credit and viceversa. This leads us to the accounting equation: Assets = Liabilities +
Stockholders’ Equity.
5. The equity section of the statement of financial position reports the
owners’ interest in the assets of the company. A corporation uses Share
Capital, Share Premium, Dividends, and Retained Earnings. A sole
proprietorship or a partnership uses a Capital account and a Drawing
account.
6. In a corporation, dividends, revenues, and expenses are transferred to
retained earnings at the end of a period, so a change in any one of these
three accounts affects equity.
The Accounting Cycle
7. (L.O. 3) The first step in the accounting cycle is analysis of
transactions and selected other events. The purpose of this analysis
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is to determine which events represent transactions that should be
recorded.
8. Events can be classified as external or internal. External events are
those between an entity and its environment, whereas internal events
relate to transactions totally within an entity.
9. (L.O. 4) Transactions are initially recorded in a journal, sometimes
referred to as the book of original entry. A general journal is merely a
chronological listing of transactions expressed in terms of debits and
credits to particular accounts. No distinction is made in
a general journal concerning the type of transaction involved. In addition
to a general journal, specialized journals are used to accumulate
transactions possessing common characteristics.
10. The next step in the accounting cycle involves transferring amounts
entered in the journal to the general ledger. The ledger is a book that
usually contains a separate page for each account. Transferring
amounts from a journal to the ledger is called posting. Transactions
recorded in a general journal must be posted individually, whereas
entries made in specialized journals are generally posted by columnar
total.
11. The next step in the accounting cycle is the preparation of a trial balance.
A trial balance is a list of all open accounts in the general ledger and their
balances. An entity may prepare a trial balance at any time in the
accounting cycle. A trial balance prepared after posting has been
completed serves to check the mechanical accuracy of the posting
process and provides a listing of accounts to be used in preparing
financial statements.
12. (L.O. 5) Preparation of adjusting journal entries is the next step in the
accounting cycle. Adjusting entries are entries made at the end of
accounting period to bring all accounts up to date on an accrual
accounting basis so that correct financial statements can be prepared.
Adjusting entries are necessary to achieve a proper matching of revenues
and expenses in the determination of net income for the current period
and to achieve an accurate statement of the assets and equities existing
at the end of the period. One common characteristic of adjusting entries
is that they affect at least one real account (asset, liability, or equity
account) and one nominal account (revenue or expense account).
Adjusting entries can be classified as: prepaid expenses, unearned
revenues, accrued revenues, and accrued expenses.
13. Prepaid expenses and unearned revenues refer to situations where cash
has been paid or received but the corresponding expense or revenue will
not be recognized until a future period. Accrued revenues and accrued
expenses are revenues and expenses recognized in the current period
for which the corresponding payment or receipt of cash is to occur in a
future period. Estimated items are expenses such as bad debts and
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depreciation whose amounts are a function of unknown future events or
developments.
14. After adjusting entries are recorded and posted, an adjusted trial
balance is prepared.
15. (L.O. 6) From the adjusted trial balance a company can directly prepare
its financial statements.
16. (L.O. 7) After financial statements have been prepared, nominal (revenues
and expenses) accounts should be reduced to zero in preparation for
recording the transactions of the next period. This closing process
requires recording and posting of closing entries. All revenue and
expense accounts are reduced to zero by closing them through the
Income Summary account. The net balance in the Income Summary
account is equal to net income or net loss for the period. The net income or
net loss for the period is transferred to an equity account. For a
corporation, the equity account is Retained Earning, for proprietorships
and partnerships, it is a capital account. Dividends are closed directly to
Retained Earning.
17. A third trial balance may be prepared after the closing entries are
recorded and posted. This post-closing trial balance shows that the
company has properly journalized and posted the closing entries.
18. A final step, preparing reversing entries, is optional. It is discussed in
learning objective 9, see paragraph 21 below.
19. In summary, the steps in the accounting cycle performed every fiscal
period are as follows:
a. Enter the transactions of the period in appropriate journals.
b. Post from the journals to the ledger (or ledgers).
c. Take an unadjusted trial balance (trial balance).
d. Prepare adjusting journal entries and post to the ledger(s).
e. Take a trial balance after adjusting (adjusted trial balance).
f. Prepare the financial statements from the adjusted trial balance.
g. Prepare closing journal entries and post to the ledger(s).
h. Prepare a trial balance after closing (post-closing trial balance).
i.
Prepare reversing entries (optional) and post to the ledger(s).
Cash Versus Accrual-Basis Accounting
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*20. (L.O. 8) Cash-Basis Accounting Versus Accrual-Basis Accounting,
is presented in Appendix A of Chapter 3 for the purpose of demonstrating
the difference between cash basis and accrual-basis accounting. Under
the
strict
cash
basis
of
accounting,
revenue
is recognized only when cash is received, and expenses are recorded
only when cash is paid. The accrual basis of accounting recognizes
revenue when it is earned and expenses when incurred without regard to
the time of receipt or payment of cash.
Using Reversing Entries
*21. (L.O. 9) Appendix B covers preparation and posting of reversing
entries, the final step in the accounting cycle. A reversing entry is made
at the beginning of the next accounting period and is the exact opposite
of the adjusting entry made in the previous period. The recording of
reversing entries is an optional step in the accounting cycle that may be
performed at the beginning of the next accounting period. The entries
subject to reversal are the adjusting entries for accrued revenues and
accrued expenses recorded at the close of the previous accounting
period.
Using a Worksheet
*22. (L.O. 10) Appendix C covers the use of a multicolumn (8, 10, 12, etc.)
worksheet, which serves as an aid to the accountant in adjusting the
account balances and preparing the financial statements. The worksheet
provides an orderly format for the accumulation of information necessary
for preparation of financial statements. Use of a worksheet does not
replace any financial statements, nor does it alter any of the steps in the
accounting cycle.
CHAPTER REVIEW
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intermediate accounting 1
Chapter 4
presents a detailed discussion of the concepts and
techniques that underlie the preparation of the Income Statement and
Retained Earnings Statement and the reporting of other comprehensive
income. The requirements for adequate presentation of reported net
income are described and illustrated throughout the chapter.
2. (S.O. 1) The income statement helps users of financial statements (1)
evaluate the past performance of the company, (2) provide a basis for
predicting future performance, and (3) help assess the risk or uncertainty
of achieving future cash flows. The limitations of the income statement
include (1) items from the income statement that they cannot measure
reliably, (2) income numbers are affected by the accounting methods
employed, and (3) income measurement involves judgment.
3. Quality of earnings is important because markets are based on trust and
it is imperative that investors have faith in the numbers reported. If that
trust is damaged, capital markets will be damaged.
Elements of the Income Statement
4. The two major elements of income statement are income and
expenses. The definition of income includes both revenues (sales,
interest) and gains (gains on sale of long-term assets). The definition of
expenses includes both, expenses (depreciation, salaries) and losses
(losses on sale of long-term assets).
Minimum Disclosures
5. (S.O. 2) The following items are required to be presented on the income
statement:
(1) revenue, (2) finance costs, (3) share of profit (loss) of associates
accounted for using the equity method, (4) tax expense, (5) amounts the
post-tax profit or loss of discontinued operations and the post-tax gain or
loss recognized on disposal of a discontinued operation, and (6) net
income or net loss.
6. An income statement is composed of various sections that relate to
different aspects of the earning process. Companies may prepare some
or all of the following sections.
a.
Sales or revenue section.
b.
Cost of goods sold section.
c.
Selling expenses.
d.
Administrative or general expenses.
e.
Other Income and Expense.
f.
Financing Costs.
g.
Income Tax.
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Discontinued Operations. Gains and losses resulting from
disposal of a component of a company.
Non-Controlling Interest. Shows an allocation of net income to the
primary shareholders and to the non-controlling interest.
Earnings Per Share.
The informative content of the income statement may be further
enhanced by adding additional subsections to the above major sections.
Income Statement Illustration
7. (S.O. 3) In arriving at net income, the statement presents the following
subtotals: gross profit, income from operations, income before income tax,
and net income. A company includes only the totals of components in
condensed income statements, but prepare supplementary schedules to
support the totals.
Reporting within the Income Statement
8. (S.O. 4) Companies generally provide some detail on revenues and
expenses on the face of the income statement, but may prepare a
condensed income statement with details presented in the notes to the
financial statements. Companies are required to present expenses
classified either by their nature (nature-of-expense method) or their
function (function-of-expense method). The function-of-expense method
is generally used in practice, but then the individual expenses are
itemized in the notes to the financial statements.
9. The IASB takes the position that both revenues and expenses and other
income and expenses should be reported as part of income from
operations. Companies can provide additional line items, headings, and
subtotals when such presentation is relevant to an understanding of the
entity’s financial performance.
10. When the parent company’s interest in the subsidiary company is less
than 100 percent the ownership of the subsidiary is divided into (a) the
majority interest who own the controlling interest and (b) the noncontrolling interest (the minority interest).
Earnings per Share
11. (S.O. 5) In general, earnings per share represents the ratio of net
income minus preference dividends (income available to common
shareholders) divided by the weighted average number of common
shares outstanding. It is considered by many financial statement users to
be the most significant statistic presented in the financial statements,
and must be disclosed on the face of the income statement. Per
share amounts for gain or loss on discontinued operations must be
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disclosed on the face of the income statement or in the notes to the
financial statements.
Discontinued Operations
12. The IASB defines a discontinued operation as a component of an
entity that either has been disposed of or is classified as held-for-sale,
and (a) represents a major line of business or geographical area of
operations, or (b) is part of a single, co-ordinated plan to dispose of a
major line of business or geographical area of operations, or (c) is a
subsidiary acquired exclusively with a view to resell. When an entity
decides to dispose of a component of its business, a separate income
statement category for gain or loss from disposal of a component of a
business must be provided. In addition, the results of operations of a
component that has been or will be disposed of are also reported
separately from continuing operations.
Intraperiod Tax Allocation
13. (S.O. 6) Intraperiod tax allocation is the process of relating the income
tax effect of an unusual item to that item when it appears on the income
statement. Income tax expense related to continuing operations is
shown on the income statement at its appropriately computed amount.
All other items included in the determination of net income should be
shown net of their related tax effect. The tax amount may be disclosed in
the income statement or in a footnote.
Changes in Accounting Principles
14. (S.O. 7) A change in accounting principle results when a company
adopts a new accounting principle that is different from the one previously
used. A company recognizes a change in accounting principle by making
a retrospective adjustment to the financial statements. Such an
adjustment recasts the prior years’ statements on a basis consistent with
the newly adopted principle. The company records the cumulative effect of
the change for prior periods as an adjustment to beginning retained
earnings of the earliest year presented.
Changes in Estimates
15. Accountants make extensive use of estimates in preparing financial
statements. Adjustments that grow out of the use of estimates in
accounting are used in the determination of income for the current period
and future periods and are not charged or credited directly to Retained
Earnings. It should be noted that changes in estimates are not
considered errors (prior period adjustments) or extraordinary items.
Corrections of Errors
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16. Companies must correct errors by making proper entries in the accounts
and reporting corrections in the financial statements. Corrections of
errors are treated as prior period adjustments, similar to changes in
accounting principles. Companies record an error in the year in which it
is discovered. They report the effect of the error as an adjustment to the
beginning balance of retained earnings. If a company prepares
comparative financial statements, it should restate the prior statements
for the effects of the error.
Retained Earnings statement
17. (S.O. 8) The retained earnings statement serves to reconcile the
balance of the retained earnings account from the beginning to the end of
the year. The important information communicated by the retained
earnings statement includes: (a) prior period adjustments (income or loss
related to corrections of errors in the financial statements of a prior period
net of tax), (b) changes in accounting principle, (c) the relationship of
dividend distributions to net income for the period, and (d) any transfers to
and from retained earnings.
Comprehensive Income
18. (S.O. 9) Items that bypass the income statement are included under the
concept of comprehensive income. Comprehensive income includes all
changes
in
equity
during
a period except those resulting from investments by owners and
distributions to owners. The IASB evaluated approaches to providing more
information about other comprehensive income items. It decided that the
components of other comprehensive income must be displayed in one of
two ways: (1) a second income statement or (2) a combined statement of
comprehensive income.
Statement of Changes in Equity
19. The statement of changes in equity reports the change in share capital,
retained earnings, and the accumulated balances in other
comprehensive items. This statement discloses comprehensive income
for the period and contributions (issuances of shares) and distributions
(dividends) to owners.