Accounting: Making Sense of Business 1/e CHAPTER 2 file7. Identify the underlying constraints of accounting and describe how they affect accounting decisions and reporting. CHAPTER

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Accounting: Making Sense of Business 1/e

CHAPTER 2

BASIC CONCEPTS OF

ACCOUNTING AND FINANCIAL REPORTING

LEARNING OBJECTIVES

1. Describe the objectives of accounting and useful accounting

information.

2. Define the qualitative characteristics of accounting information and

determine the effect of each on information.

3. Define the elements of accounting and construct the accounting

equation.

4. Recognize a balance sheet, income statement, statement of equity, and

statement of cash flows and determine which accounting elements

comprise each statement.

5. Identify the underlying assumptions of accounting and describe how

they affect financial reporting.

6. Define the underlying principles of accounting and determine the

appropriate application of each.

7. Identify the underlying constraints of accounting and describe how they

affect accounting decisions and reporting.

CHAPTER OVERVIEW

This chapter focuses on the basic information needed to understand

accounting and the financial reporting process. It begins by introducing students to

FASB’s Conceptual Framework as a broad overview. The chapter then takes that

overview and introduces students to the accounting elements, as well as the four

basic financial statements - balance sheet, income statement, statement of equity,

and the statement of cash flows. It has students identify which elements are found

on which statement. It also gives students an understanding of the principles and

constraints in accounting information.

Video: Amy’s Ice Cream shows the student some of the decisions necessary in opening a business as well as how “Community” plays into the success of the business. Running Time: 10:49.


Instructors Manual - Chapter 2

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LO 1: DESCRIBE THE OBJECTIVES OF ACCOUNTING AND USEFUL ACCOUNTING

INFORMATION.

Accounting data - raw results of economic transactions and events.

Information - data that are put into some useful form for decision making.

Accounting information - the product of accountants’ organization, classification,

and summarization of economic transactions and events so that it is useful to

economic decision makers.

Accounting objectives - to provide stakeholders with information

1. Useful for credit and investment decisions.

2. To assess future cash flows.

3. About entity resources, claims to the resources, and changes in

each over time.

LO 2: DEFINE THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING

INFORMATION AND DETERMINE THE EFFECT OF EACH ON INFORMATION.

Primary Characteristics:

A. Relevance - requires that accounting information pertain to and make

a difference in a particular decision situation. Relevant information

must possess at least two characteristics.

1. Timeliness - information provided before it is too

late to influence the decision.

2. Predictive value - information quality assists users

to increase probability of correctly forecasting the results of

past or future events.

3. Feedback value - information quality allows users

to substantiate or amend prior expectations.

B. Reliability - requires that information be reasonably unbiased

Teaching Hint: Use a copy of Exhibit 2-13, located at the end of these chapter

notes, to show how the objectives make the “roof” of the structure.



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and accurate. Reliable information must possess three characteristics.

3. Verifiability - information can be substantiated by

unbiased measures.

4. Representational faithfulness - validity or

agreement between a measure or description and the event that

it represents.

5. Neutrality - absence of bias intended to influence

reported information.

Secondary Characteristics:

A. Comparability - allows users to identify similarities in and

differences between two sets of accounting information.

B. Consistency - conformity from period to period with

accounting policies and procedures.

LO 3: DEFINE THE ELEMENTS OF ACCOUNTING AND CONSTRUCT THE

ACCOUNTING EQUATION.

Assets - things an entity owns or controls that have future value.

Liabilities - obligations of an entity to transfer assets to, or perform services for, a

third party.

Equity - difference between entity’s assets and liabilities. Also known as what the

entity owners claim free and clear.

A. Investments by owners - amount the company’s owner invests

to get it started or to finance expansion.

B. Earned equity - total amount the company has earned since the

Teaching Hint: Use WDYT 2-1 and 2-2 to get students to think about how

relevance and reliability impact decisions that they make on a daily basis.

Teaching Hint: Use Exhibit 2-13 to show these characteristics support the left

side of the structure.



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beginning, less any amounts distributed to the owners.

Revenues - increases in net assets that occur as a result of an entity selling or

producing products and performing services for its customers.

Expenses - sacrifices of the future value of assets used to generate revenues from

customers.

Cost of goods sold - cost of merchandise transferred to customers in the entity’s

primary business activities.

Gains - increases in net assets that result from incidental or other peripheral events

that affect the entity, except for normal revenues and investments by owners.

Losses - decreases in net assets that result from incidental or other peripheral

events that affect the entity, except for normal expenses and distributions to

owners.

Net income - difference between the rewards (revenues and gains) and sacrifices

(expenses and losses) for a given period of activity. The net reward of doing

business.

Net loss - when the expenses and losses for the period are greater than the revenues

and gains for the period.

LO 4: RECOGNIZE A BALANCE SHEET, INCOME STATEMENT, STATEMENT OF

EQUITY, AND STATEMENT OF CASH FLOWS AND DETERMINE WHICH ACCOUNTING

ELEMENTS COMPRISE EACH STATEMENT.

Balance Sheet - provides information about the present condition of a business at a

specific point in time. Consists of three elements:

1. Assets

2. Liabilities

3. Equity

a) Investments by owners

b) Earned equity



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Accounting Equation - constant relationship among the assets, liabilities, and

equity on the balance sheet. Relationship can be stated as mathematical equation

called the accounting equation.

ASSETS = LIABILITIES + EQUITY

Teaching Hint: Use the copy of Exhibit 2-5 at the end of these chapter materials

to cover the form and elements of the balance sheet.

Teaching Hint: Use WDYT 2-3 for getting students to recognize their own assets.

You can have students share an item from their list, and see how many other

students have the same item, or should have included the item on their own list.

Teaching Hint: Use WDYT 2-4 to get students to recognize their own liabilities.

Students can again share items from their lists to let classmates compare items

they included or may have forgotten or not thought about.

Teaching Hint: Use WDYT 2-5 to show how to determine their own net worth.

This would not be a question that you’d want to have students give their answer to

specifically. You can do a general survey, how many had a positive equity versus a

negative equity.

Teaching Hint: A good illustration of the equation is to take a transaction the

student is likely to engage in (like a car/loan transaction) and show how that

would impact the equation, and that like any mathematical equation, it can be

manipulated algebraically.



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Balance sheet characteristics

1. Few details

2. Specific point in time - like a snapshot

3. Stays “in balance”

Note to Instructor: The text presents only the corporate form of the balance

sheet. Refer students to the Web site if you wish them to see other forms.

Income Statement - provides information about the entity’s performance during a

specific time period. Elements include

1. Revenues

2. Expenses

3. Cost of goods sold

4. Gains

5. Losses

Income Statement Equation - difference between rewards and sacrifices for a

given period of time.

Revenues - Expenses + Gains - Losses = Net Income (or Net Loss)

Teaching Hint: Use WDYT 2-6 to have students prepare their own balance sheet.

This should only be done if you had students do questions 2-3, 2-4, and 2-5.

Teaching Hint: Use WDYT 2-7 to give students a chance to practice making the

balance sheet equation balance in the different algebraical forms.

Teaching Hint: Use WDYT 2-9 to have students identify their income and expense

items for the past month. This allows the student to relate to what is a revenue or

expense versus items that are not income statement items. Use WDYT 2-10 to then

have the student determine if they had income or a loss for the period.



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Income statement characteristics:

1. Specific period of time

2. Few specific details

3. Expanded format

a) Revenues

b) Cost of goods sold

c) Gross profit - sales minus cost of goods sold

d) Operating expenses

e) Operating income

f) Other revenues and expenses

g) Income taxes

h) Net income (loss)

Statement of Stockholders’ Equity - reports the change in the entity’s equity

during a period of time. Has three components that are comprised of seven

elements.

1. Investment by owners

2. Comprehensive income - change in equity arising from any

non-owner source.

a) Revenues

b) Gains

c) Expenses

d) Losses

e) Other comprehensive income

3. Distribution to owners - transfers of cash or other company

assets to the owners that result in a reduction of equity.

Teaching Hint: Use Exhibit 2-7 to demonstrate the expanded income statement.

Teaching Hint: Use Exhibit 2-9 to illustrate the components of stockholders’

equity, and point out where each of the elements included appear.

Teaching Hint: At this point you can use Exhibit 2-13 to show that it now has the

right supporting column completed.



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Statement of Cash Flows - cash is critical for the business to continue. If it runs

out of cash, then it can’t pay the bills. The cash flow statement is organized into

three functional areas of the business.

1. Operating activities - sources and uses of cash from operations.

2. Investing activities - investments purchased and sold.

3. Financing activities - investments by owners, borrowing and

repaying of debt, and distributions to owners.

Articulation - the linkage between the financial statements. Net income is shown

on the statement of equity. Equity is shown on the balance sheet. Cash change

from the beginning to end of the period is shown on the cash flow statement.

LO 5: IDENTIFY THE UNDERLYING ASSUMPTIONS OF ACCOUNTING AND DESCRIBE

HOW THEY AFFECT FINANCIAL REPORTING.

Separate Entity Assumption - economic transactions of the entity are accounted

for separately and apart from the personal activities of the owners.

Going-Concern Assumption - absent any information to the contrary, a business

entity will continue to remain in existence for an indefinite period of time.

Monetary Unit Assumption - economic activities are measured and expressed in

terms of the appropriate currency for a business.

Periodicity Assumption - measuring of economic activity over an arbitrary time

period for the purpose of providing useful information.

LO 6: DEFINE THE UNDERLYING PRINCIPLES OF ACCOUNTING AND DETERMINE

THE APPROPRIATE APPLICATION OF EACH.

Historical Cost Principle - requires that balance sheet items be reported at the

total cost at acquisition instead of current value.

Teaching Hint: Use Exhibit 2-10 to illustrate the basics of a cash flow statement

and the information that it provides.



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Revenue Recognition Principle - revenue recognition occurs when the revenue is

earned and an enforceable claim exists to receive the asset traded for the revenue.

Must meet both criteria to recognize revenue.

Asset traded for - cash or account receivable.

Matching Principle - requires matching revenue with the expenses of producing

that revenue.

No direct cause and effect between revenue and expense, may either expense

when incurred, or allocate over time.

No discernible future benefit, then recognize cost of item immediately as

expense.

Long-lived asset cost must be allocated over periods benefited by such asset.

This process is known as depreciation.

Full Disclosure Principle - all information necessary for an informed user of the

financial statements of a business entity to make economic decisions must be made

available to the statement user.

LO 7: IDENTIFY THE UNDERLYING CONSTRAINTS OF ACCOUNTING AND DESCRIBE

HOW THEY AFFECT ACCOUNTING DECISIONS AND REPORTING.

Materiality - something that will influence the judgment of a reasonable person.

Usually requires professional judgment to determine.

Cost-benefit relationship - benefit of knowing the information should exceed the

cost of providing the information.

Conservatism - choosing the alternative that is least likely to overstate assets and

income, or understate liabilities when uncertainty or doubt exist.

Industry practices - certain industries may require departure from basic

accounting principles because of the peculiar nature of the industry or a particular

transaction, to ensure fair presentation of the financial information within the

industry.



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Teaching Hint: Use Exhibit 2-13 to show how these items make up the foundation

of accounting information. This now completes the make-up of accounting

information as displayed on the exhibit.



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What Do You Think? (Suggested Answers)

2-1. Assume that you will soon graduate from college and two firms have offered

you attractive positions. One firm is a Fortune 500 company and the other is a

local company. If you could ask only five questions of one person in each

company, what would they be, and what is the title of the person you would

select to answer the questions?

Student answers will vary depending on their individual working background,

and the type of degree that they are working towards. A student who is

traditional age, 22 or so, may be looking for money, freedom, ability to travel,

so that student is more likely to focus on talking with someone who holds an

executive position in the area for which he/she is applying. A student who is

older or who has a family is likely to be more concerned about stability and

ability to move up within the firm, rather than just financial aspects.

Relocation may or may not be an issue for this student. This student will be

more concerned about the financial stability of the company, and may wish to

talk with the president or another executive in his/her area for asking questions.

Some sample questions might include:

1. What are the prospects for and usual time frame for advancement

within the firm?

2. What type of work environment and assignments can I expect to

be given in the first year of the position?

3. What are the firm’s employee development and training options?

4. What type of benefits does the company provide for employees

and their families?

5. How many individuals have been hired/laid off by the firm in the

past two years?

6. What is the average tenure of individuals working in this firm?

7. What are the travel requirements for this position?

8. How much has the company expanded during the past two years?

9. What are the future expectations for growth of the firm?

10. How much money will I make, and when do I get reviewed for an

increase?

11. What type of feedback on performance is provided?

2-2. What part did relevance and reliability play in your choice of questions and

the person you selected?

Each student will again have varying answers. The key is to get students to



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realize that both relevance and reliability did have a part in what they

selected and asked. Relevance impacted the questions that were selected.

Based upon students’ goals, this position would impact which questions they

chose to ask. Students want information that will assist them in selecting

which firm can provide them the best opportunity to achieve their goals.

Reliability will impact how much confidence that they place in the answers

that they receive. Did the person have the knowledge to answer the

questions accurately, or was he/she making guesses or trying to answer what

he/she thought the student wanted to hear.

2-3. Think about the things of value you own. Prepare a list of your personal

assets. Your list should include two columns with the descriptions of the

assets in the left column and the cost of the assets in the right column.

This will vary widely depending upon the students’ background and age. A

younger student is likely to list items like a vehicle, a stereo, TV, computer,

clothes, cell phone, books, microwave, and things he/she would have in a

dorm room, or furnished apartment. On the other hand a student who is

older or has a family will likely have a different list that would include

furniture, lawn equipment, kitchen equipment and supplies, appliances, and

may also have stocks/bonds/retirement accounts listed as well. The students

may or may not think about including checking and/or savings accounts in

their assets - especially when it asks about costs of those assets.

2-4. Think about any debts you owe. Prepare a list of your personal liabilities

similar to the list you prepared in 2-3.

This will again vary by student. The biggest one that might appear will be

student loans! Others would include car loan, credit cards, possibly parental

loans, home loans, and loans for the TV, stereo, computer, etc., taken

directly from the store.

2-5. Calculate your equity using the answers to 2-3 and 2-4.

This will be student specific. The key is to get students to see that this is the

difference between what they have and what they owe. For younger

students, it is very possible that they will have a negative equity - especially

if they have credit card and student loan debt, since education doesn’t appear

as an asset, and most consumer credit exceeds “used” asset values!



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2-6. Using Exhibit 2-4 as a guide, prepare your personal balance sheet from the

information you provided in 2-3, 2-4, and 2-5.

Again this is student specific. This can be a great opportunity to get students

to look at what they would need to obtain loans from a bank for larger

purchases. It also lets students see where they stand from a financial

standpoint.

2-7. Use the accounting equation to determine the missing amounts in the

following information.

Assets Liabilities Equity

A $ 50,000 $ 35,000 $15,000

B $120,000 $ 95,000 $ 25,000

C $325,000 $230,000 $ 95,000

D $278,000 $317,000 $(35,000)

2-8. If you were a banker, would it be useful for you to know the assets,

liabilities, and stockholders’ equity of a company applying to you for a

$500,000 loan? Why or why not?

YES! In order to determine if the banker wants to loan a company money,

the banker would want to know what the firm’s resources were, who else

had creditors’ claims to those resources, and what the owners’ stake in the

business was. If the firm already has outside creditors with significant

claims, then that would mean this creditor would be less likely to be repaid

in a timely fashion. If the owners have a higher holding in the firm, then

more resources will be available for repaying a loan.

2-9. Consider your personal transactions for the past month. Identify those that

resulted in revenues and those that resulted in expenses.

For most students the main source of revenue will be income from a job

which they hold. A few of them might have income from savings accounts

or dividends, but this will be rare. A key point to make is that loan

proceeds are not a revenue item. On the expense side the student will

likely have tuition payments, books, rent, food, utilities, vehicle loan

payments (point out that only the interest is really an expense), credit

card payments, gas, and may have gifts to charity, presents, dating costs etc.



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2-10. Use the income statement equation to determine whether you had a gain or a

loss for the month.

This again will be student specific. Some students will have a gain and other

students will have a loss.

Reading Level Quiz solutions:

1 - A; 2 - C; 3 - B; 4 - D; 5 - B; 6 - C; 7 - A; 8 - C; 9 - D; 10 - B;



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Reading Level Quiz

1. A characteristic of accounting information that requires it to make a

difference in the particular decision situation is

a. relevance.

b. reliability.

c. consistency.

d. comparability.

1. When several individuals working independently arrive at similar

conclusions using the same data, the information is said to be

a. relevant.

b. consistent.

c. verifiable.

d. neutral.

1. A qualitative characteristic of accounting information is

a. matching.

b. consistency.

c. conservatism.

d. full disclosure.

1. The financial statement which provides a snapshot of the business’s

financial position is the

a. income statement.

b. statement of stockholders’ equity.

c. cash flow statement.

d. balance sheet.

1. Things that an entity controls that have future value are known as

a. revenues.

b. assets.

c. liabilities.

d. expenses.

2. The accounting equation can be expressed as

a. Assets + Liabilities = Equity

b. Assets = Liabilities - Equity

c. Assets = Liabilities + Equity

d. Equity - Liabilities = Assets



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1. An increase in net assets resulting from a peripheral event is reported as a(n)

a. gain.

b. expense.

c. revenue.

d. loss.

1. The assumption that economic activities will be expressed in the relevant

currency for the business is the

a. periodicity assumption.

b. going-concern assumption.

c. monetary unit assumption.

d. separate entity assumption.

1. The accounting principle that requires that all relevant information be

provided so that decision makers can make informed decisions is the

a. historical cost principle.

b. revenue recognition principle.

c. matching principle.

d. full disclosure principle.

10. A constraint that requires disclosure of an item when it is considered

something that will influence the judgment of a reasonable person is the

constraint of

a. relevancy.

b. materiality.

c. full disclosure.

d. conservatism.



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Exhibit 2-5 Balance Sheet for a Corporation

Jason’s Furniture Gallery, Inc. Balance Sheet

December 31, 2004 Assets Liabilities Cash $ 50,000 Accounts Payable $100,000 Investments 75,000 Mortgage Payable 200,000 Inventory 200,000 Total Liabilities $300,000 Land 80,000 Building 300,000 Stockholders’ Equity

Equipment 60,000 Common Stock $200,000 Retained Earnings 265,000 Total Stockholders’ Equity 465,000 Total Liabilities Total Assets $765,000 and Stockholders’ Equity $765,000



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Exhibit 2-7 Income Statement for a Corporation

Jason’s Furniture Gallery, Inc. Income Statement

For the Year Ended December 31, 2004 Sales Revenues $455,000

Cost of Goods Sold 245,000 Gross Profit $210,000 Operating Expenses Selling Expenses $105,000 Administrative Expenses 60,000 Total Operating Expenses 165,000 Operating Income $ 45,000 Other Revenues and Expenses

Gain on the sale of equipment $ 25,000 Loss on investments sold (8,000) 17,000 Income before Taxes $ 62,000 Income Taxes 21,000 Net Income $ 41,000



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Exhibit 2-9 Statement of Stockholders’ Equity

Jason’s Furniture Gallery, Inc. Statement of Stockholders’ Equity

For the Year Ended December 31, 2004

Total Common Retained Stockholders’

Stock Earnings Equity Balance, January 1, 2004 $150,000 $233,000 $383,000 Stock Issued 50,000 50,000 Net Income 41,000 41,000 Dividend Distributions 30,000 30,000

Balance, December 31, 2004 $200,000 $244,000 $444,000



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Exhibit 2-10 Statement of Cash Flows

Exhibit 2-13

Conceptual Framework of Accounting

Jason’s Furniture Gallery, Inc. Statement of Cash Flows

For the Year Ended December 31, 2004 Operating Activities: Cash Received from Customers $455,000 Cash Paid for: Merchandise $160,000 Operating Expenses 150,000 Income Taxes 21,000 331,000 Cash provided by operating activities $124,000 Investing Activities: Purchase of Equipment $( 35,000) Purchase of Building (300,000)

Cash used by investing activities (335,000) Financing Activities: Sale of Common Stock $ 50,000 Proceeds of Mortgage on Building 200,000 Dividends Paid (30,000) 220,000 Cash provided by financing activities Net change in cash $ 9,000 Cash balance, January 1, 2004 20,000

Cash balance, December 31, 2004 $ 29,000

OBJECTIVES

To provide stakeholders with information

useful for credit and investment decisions.

useful for credit and investment decisions.

to assess future cash flows.

about entity resources, claims to resources,

and changes in each over time.



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Qualitative

Characteristics of

Accounting

Information

Relevance

Timeliness

Predictive Value Feedback Value

Reliability

Verifiability

Representational

Faithfulness

Neutrality

Comparability Consistency

Accounting

Elements

Assets

Liabilities

Equity

Investment by

Owners

Comprehensive

Income

Distributions to

Owners

Revenues

Expenses

Gains

Losses

Assumptions Principles Constraints Separate Entity Historical Cost Materiality

Going Concern Revenue Recognition Cost-benefit relationship

Monetary Unit Matching Conservatism Periodicity Full Disclosure Industry Practices

Accounting: Making Sense of Business 1/e CHAPTER 2 file7. Identify the underlying constraints of accounting and describe how they affect accounting decisions and reporting. CHAPTER

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