978-0136115274 Chapter 2 Lecture Notes

CHAPTER 2

QUALITIES OF ACCOUNTING INFORMATION

CHAPTER OVERVIEW

The chapter begins with a discussion of the qualities of accounting information. First, the point is

made that accounting information is used to make decisions. Next, the qualitative characteristics

of accounting information are discussed: relevance, reliability, consistency, and comparability, all

mitigated by cost-benefit and materiality.

The second part of the chapter reviews the basic financial statements introduced in Chapter 1:

balance sheet, income statement, statement of changes in shareholders’ equity, statement of cash

flows, and notes to the financial statements. The elements of the financial statements are each

discussed in turn: assets (including current and noncurrent), liabilities (including current and

noncurrent), equity (including contributed and earned), revenues, and expenses. The following

principles and assumptions are discussed: unit-of-measure assumption, historical-cost principle,

going-concern assumption, revenue recognition principle, and matching principle. Next, accrual

basis accounting is introduced, along with explanations of accruals and deferrals. Timing and

cut-off issues, as compared to cash basis accounting, are also discussed.

The next part of the chapter introduces the concept of risk and return tradeoff and explains how

financial statements are used by owners and creditors to make decisions about the level of risk

and the amounts of expected returns. Basic ratio analysis is introduced as a way of helping the

financial statement user make decisions about risk and potential return.

The last part of the chapter discusses how businesses minimize information processing risks and

ensure the reliability of financial information through the use of internal controls. Preventive,

detective, and corrective controls are explained.

LEARNING OBJECTIVES

After completing Chapter 2, your students should be able to answer these questions:

1. Define generally accepted accounting principles and explain why they are necessary.

2. Explain the objective of financial reporting and the qualities necessary to achieve

this objective.

3. Identify the elements of the financial statements and describe their characteristics.

4. Define accrual accounting, explain how it differs from cash basis accounting, and

identify examples of accrual accounting on actual financial statements.

5. Compute and explain the meaning of the current ratio.

6. Identify the risks and potential frauds related to financial accounting records, and

explain the controls needed to ensure their accuracy.

CHAPTER OUTLINE

Information for Decision Making (LO 1)

I. Financial reporting provides information for decision making.

a. The income statement reports net income (or profit).

b. Net profit, also known as net income, equals all revenues minus all expenses.

c. The income statement shows business activity during a period.

II. For financial information to be useful, the same rules must be applied consistently.

a. Across time (comparing financial information for the same entity over multiple

periods)

b. Across companies (comparing financial information of different entities)

III. Generally accepted accounting principles (GAAP) provides consistency.

a. Rules that companies follow when preparing financial statements.

b. Historically developed through common usage.

IV. International Financial Reporting Standards (IFRS) are set by the International

Accounting Standards Board (IASB)

a. IFRS are concept-based and less detailed than GAAP.

b. GAAP is rule-based and more detailed than IFRS.

Characteristics of Accounting Information (LO 2)

I. Accounting information should be useful for evaluating the past and predicting the future.

II. Usefulness is the most important characteristic of accounting information.

III. To be useful, information must be relevant, reliable, comparable, and consistent.

a. Relevant

i. Must be significant enough to influence business decisions.

ii. Should help confirm or correct users’ expectations.

iii. Must be timely to be relevant.

iv. Can be used to evaluate the past and predict the future.

b. Reliable

i. Can depend on it and can verify its accuracy.

ii. Information must be completely independent of the person reporting it.

iii. Must be a faithful representation of what it intends to convey

iv. Truthfulness of the information can be verified.

Teaching Tip

Provide examples of information and ask the students if it is relevant and reliable. This can be

done with both financial and nonfinancial information (e.g., information for planning a Spring

Break trip). Demonstrate how information can be relevant, but not reliable and how information

can be reliable, but not relevant. In either case, it’s not useful.

c. Comparability

i. Investors can compare financial information between two similar companies.

d. Consistency

i. Makes it possible to track a company’s result from one year to the next

ii. Must use same accounting methods from period to period

Teaching Tip

Use Exhibit 2.2, Characteristics of Accounting Information, to illustrate the concepts of useful

information.

e. Separate-entity assumption means that the firm’s financial records and financial

statements are completely separate from those of the firm’s owners.

f. Monetary unit assumption means that the items on the financial statements are

measured in monetary units (dollar in the U.S.).

g. The time-period assumption means that the life of a business can be divided into

meaningful time periods for financial reporting.

h. The historical-cost principle means that transactions are recorded at actual cost.

i. The revenue-recognition principle says that revenue should be recognized when it is

earned and collection is reasonably assured.

Teaching Tip

Ask students for examples of situations where cash outflows and expense recognition do not

occur at the same time (e.g., buying a building or piece of machinery, or in their own lives when

they pay rent or last month’s phone bill).

j. The matching principle says that expenses should be recognized – shown on the

income statement – in the same period as the revenue they helped generate.

Teaching Tip

Often, students are confused about what we mean by “matched.” Assure them that we do not

mean that the dollar amounts have to be equal. It has to do with the time period. Remind them

that revenues, expenses, and therefore net income, start out at zero every year. Probably the

biggest challenge in accounting is to figure out when the revenue is actually earned and what

expenses should be matched with the revenue of a particular period. Tell them matching simply

means “let the expenses follow the revenues.” Students should note that these are issues we will

be revisiting time after time this semester.

Teaching Tip

Ask the students for examples of situations where cash inflow and revenue recognition do not

occur at the same time (e.g., selling on credit or receiving cash in advance).

k. The full-disclosure principle means that the firm must disclose any circumstances

and events that would make a difference to the users of the financial statements.

l. Constraints are limits or controls imposed by GAAP. There are two constraints in

financial accounting.

i. Materiality is whether or not an item or transaction is large enough to have an

influence on decisions.

ii. Conservatism refers to the choices accountants make when preparing the

financial statements.

Teaching Tip

Use Exhibit 2.10 as a summary of assumptions, principles, and constraints of financial reporting.

Elements of the Financial Statements (LO 3)

I. A complete set of financial statements includes:

a. Income statement

b. Balance sheet

c. Statement of changes in shareholders’ equity

d. Statement of cash flows

e. Notes to the financial statements

Teaching Tip

Remind students that the financial statements must be completed in the order presented above.

II. Recording accounting information in a worksheet

a. Accounting equation: Assets = Liabilities + Equity

b. All transactions affect the worksheet in at least two places.

c. A worksheet is used to prepare financial statements.

d. On account means on credit. The expression applies to either buying or selling on

credit. If a customer buys a product from you on credit, you have an account

receivable. If you buy a product on credit, you have an account payable.

Teaching Tip

Help students see the difference in the four ways “on account” is used in these transactions:

1. Performed services on account means Accounts Receivable increases.

2. Collected on account means Accounts Receivable decreases.

3. Purchased on account means Accounts Payable increases.

4. Paid on account means Accounts Payable decreases.

e. Accounts payable are accounts that a company owes its vendors. They are liabilities

and are shown on the balance sheet.

f. Adjusting the books means to make changes in the accounting records, at the end of

the period, just before the financial statements are prepared, to make sure the amounts

reflect the financial condition of the company at that date.

Teaching Tip

Illustrate transactions by reviewing the worksheet in Exhibit 2.4 with students.

III. Assets

a. Assets are the economic resources owned or controlled by a company, resulting from

past transactions.

b. Current assets are the assets the company plans to turn into cash or use to generate

revenue in the next fiscal year.

c. Noncurrent assets (long-term assets) are assets that will last for more than a year.

d. Current assets are listed on the balance sheet in order of liquidity. Liquidity refers to

how easily an asset can be converted into cash.

e. Prepaid insurance is the name for insurance a business has purchased but has not yet

used. It is an asset.

Teaching Tip

As students begin to use many different accounts, remind them that a receivable is always an

asset because it represents an amount that will be received in the future and a payable is always

a liability because it represents an amount that will be paid in the future. Explain that

receivables often are related to customers while payables often are related to vendors.

Teaching Tip

Remind students that accounts are not always entitled the same. Revenues may often be

identified by looking for words such as sales, revenues, and earned. Expenses may often be

located by watching for words such as expense or used.

IV. Liabilities

a. Liabilities are obligations the company has incurred to obtain the assets it has

acquired.

b. Current liabilities are liabilities the company will settle, or pay off, in the next fiscal

year.

c. Noncurrent liabilities (long-term liabilities) are liabilities that will take longer than a

year to settle.

d. A classified balance sheet shows a subtotal for many items, including current assets

and current liabilities.

Teaching Tip

Ask students to think of claims that may be settled with something other than cash (e.g.,

“Unearned Revenue.”)

V. Shareholders’ Equity

a. Sometimes called net assets (Assets – Liabilities = Equity).

b. Equity is the name for owners’ claims to the assets of the firm. It includes both

contributed capital and retained earnings.

c. Contributed capital, sometimes called paid-in capital, is the amount the owners

have put into the business.

d. Retained earnings are the total net income the company has earned minus the

dividends it has declared since it began.

VI. Accrual accounting refers to the way we recognize revenues and expenses.

i. Based on economic substance of the transaction

ii. We don’t rely on receipt or payment of cash to determine recognition.

iii. We recognize revenue when it is earned and an expense when it is incurred.

Accruals and Deferrals (LO 4)

I. Accrual basis accounting includes two kinds of transactions in which the exchange of

cash does not coincide with the economic substance of the transaction.

a. Accrual transaction – a transaction in which the revenue is earned or the expense is

incurred before the exchange of cash.

b. Deferral transaction – a transaction in which the exchange of cash takes place

before the revenue is earned or the expense incurred.

Teaching Tip

Use Exhibit 2.11 to point out the meanings of accrual and deferral.

II. Cash basis accounting is a system based on the exchange of cash.

a. Revenue is recognized when cash is collected.

b. Expenses are recognized when cash is disbursed.

c. Not a generally accepted method of accounting according to GAAP

d. Some businesses (especially small businesses) use cash basis, because it is easy to

apply and easy to understand.

III. Accounting periods and cut-off issues

a. Matching principle makes financial statements comparable and consistent.

b. Companies may prepare financial statements monthly or quarterly, in addition to

annually.

How Investors – Owners and Creditors – Use Accrual Accounting Information

I. Owners and creditors invest their money into a business in order to make money.

II. There is a risk in investing in a business.

a. Risk

i. Uncertainty associated with the amount of future returns (how much will I

make?)

ii. Uncertainty associated with the timing of future returns (when will I make

it?)

b. Risk is positively correlated with the expected return.

i. Higher risk means higher expected return.

ii. Lower risk means lower expected return.

III. Information contained in the financial statements helps the investor determine the level of

risk and the expected returns.

Teaching Tip

Use Exhibits 2.12 through 2.17 to illustrate the information provided by financial statements.

Applying Your Knowledge: Ratio Analysis (LO 5)

I. Financial ratios are comparisons of different amounts on the financial statements.

II. Current ratio is a liquidity ratio that measures a firm’s ability to meets its short-term

obligations.

a. Measures the short-term financial health of a company

b. Current ratio = current assets divided by current liabilities

c. Gives information about the company’s ability to pay its bills

d. Measures liquidity – how easily a company can turn its current assets into cash and

pay its debts as they come due

e. Provides a way to compare companies

Business Risk, Control, and Ethics (LO 6)

I. How do companies make sure information in financial statements is reliable?

II. Internal controls are policies and procedures used to protect the firm’s assets and ensure

the accuracy and reliability of the accounting records.

a. Preventive controls help prevent errors.

b. Detective controls help find errors.

c. Corrective controls are policies and procedures that correct any errors that have

been discovered.

d. Remember, an internal control system is only as effective as the people who execute

it.

e. Collusion – two or more people working together to circumvent a policy or

procedure – and changing conditions will weaken internal control.

CHAPTER 2 NAME

___________________________________

TEN-MINUTE QUIZ Section _____________

Date____________

_______________________________________________________________________

_______

_____ 1. Generally accepted accounting principles (GAAP) are established by:

a. Internal Revenue Service (IRS)

b. U.S. Congress

c. Financial Accounting Standards Board (FASB)

d. GAAP Commission

_____ 2. The information in a financial statement relates to a specific business or

company. The owner’s personal financial records are not part of the financial statements

of the business. This is called the:

a. GAAP assumption

b. Matching principle

c. Going-concern assumption

d. Separate-entity assumption

_____ 3. To be useful, information must be:

a. Relevant

b. Reliable

c. Both A and B

d. Expensive

_____ 4. Assets:

a. Are economic resources owned by the company

b. Result from past events or transactions

c. Provide future benefit to the company

d. All of the above

_____ 5. Current assets:

a. Will be used or converted into cash within one year

b. Will not be used within one year

c. Include only cash

d. None of the above

_____ 6. Amazing Toy Company owes Northern Plastics Company $1,000. Amazing Toy

would reflect this on its:

a. Balance sheet

b. Income statement

c. Statement of shareholders’ equity

d. Statement of cash flows

_____ 7. Revenue is recognized when:

a. Cash is received

b. It is earned

c. Expenses are recognized

d. Cash is paid

_____ 8. Expenses are recognized when:

a. Cash is received

b. Cash is paid

c. They are earned

d. They are incurred

_____ 9. Risk and return are:

a. Negatively correlated (when risk increases, expected return

decreases)

b. Positively correlated (when risk increases, expected return

increases)

c. Always equal

d. Not related

_____ 10. Noncurrent assets include:

Accounts receivable

Cash

Inventory

None of the above

ANSWER KEY – CHAPTER 2 – TEN-MINUTE QUIZ

C

D

C

D

A

B

D

B

D