Chapter 2:
The Accounting
Information System
and Financial
Statements
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Conceptual Framework
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Qualitative Characteristics of Useful Information
• Two fundamental characteristics that useful information should possess—
• Relevance: Information is relevant if it is capable of making a difference in a business decision by helping users:
• predict future events (predictive value) or
• providing feedback about prior expectations (confirmatory value).
• Faithful representation: Accounting information should be a faithful representation of the real-world economic event that it
is intending to portray. Faithfully represented information should be:
• complete (includes all necessary information for the user to understand the economic event)
• neutral (unbiased), and
• free from error (as accurate as possible)
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Four Enhancing Characteristics
1. Comparability: Comparable information allows external users to identify similarities and
differences between two or more items. Included within comparability is consistency.
Consistency can be achieved by a company applying the same accounting principles for the
same items over time.
2. Verifiability: Information is verifiable when independent parties can reach a consensus on
the measurement of the activity.
3. Timeliness: Information is timely if it is available to users before it loses its ability to
influence decisions.
4. Understandability: If users who have a reasonable knowledge of accounting and business
can, with reasonable study effort, comprehend the meaning of the information, it is
considered understandable.
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Four Enhancing Characteristics (Continued)
• Enhancing characteristics should be maximized to the extent possible.
• These qualitative characteristics are bound by two pervasive constraints—the cost and
prudence (conservatism) constraints.
• The cost constraint states that the benefit received from accounting information should be
greater than the cost of providing that information.
• The prudence constraint states that extra care should be taken to ensure that assets and
revenues are not overstated, and that liabilities and expenses are not understated.
• If the cost exceeds the benefit, the information is not considered useful.
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The Four Basic Assumptions Underlying Accounting
1. Separate entity assumption: Under this assumption, each company is accounted for separately from
its owners.
2. Continuity (or going-concern) assumption: This assumption assumes that a company will continue
to operate long enough to carry out its existing commitments.
3. Periodicity or time period assumption: This assumption allows the life of a company to be divided
into artificial time periods so that net income can be measured for a specific period of time (e.g.,
monthly, quarterly, annually).
4. Unit-of-measure assumption: This assumption requires that a company account for and report its
financial results in the national monetary unit which is assumed to have a constant purchasing
power over time (such as Canadian dollar, euro, Japanese yen).
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Accounting Principles
• Accounting principles are general approaches that are used in the measurement and recording of
business activities.
• The three basic principles of accounting are as follows:
1. Historical cost principle: This principle requires that the activities of a company are initially measured at
their cost—the exchange price at the time the activity occurs.
2. Revenue recognition principle: This principle is used to determine when revenue is recorded and
reported.
3. Full disclosure principle: This principle requires that financial statements include all information required
for the financial statement users to make informed decisions about the company's financial position,
operating results, and cash flows.
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Measuring Business Activities:
The Accounting Cycle
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Transaction Identification
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Elements of
Financial
Statements
Basic elements of financial
statements include the following:
◦ Assets
◦ Liabilities
◦ Equity
◦ Revenues
◦ Expenses
◦ Gains
◦ Losses
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The Accounting Equation
Assets = Liabilities + Shareholders’ Equity*
*Shareholder’s Equity =
Common Shares + Retained Earnings
+Accumulated Other Comprehensive Income
Assets = Liabilities + Common Shares + (Retained Earnings –
Dividends + Revenues – Expenses) +Accumulated Other
Comprehensive Income
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Step 1:
Analyze Transactions
►Transaction analysis is the process of determining the
economic effects of a transaction on the elements of the
basic accounting equation.
►Transaction analysis involves three steps:
1. Write down the basic accounting equation.
2. Identify the financial statement elements that are
affected by the transaction.
3. Determine whether the elements increased or
decreased.
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• On March 1, HighTech issued 1,000 of its common shares to
Transaction 1: several investors for cash of $12,000. The effect of this
transaction on the basic accounting equation is:
Issuing Common
Shares
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• On March 2, HighTech raised additional funds by borrowing
Transaction 2: $3,000 from the Royal Bank in Winnipeg. HighTech
Borrowing Cash promised to pay the amount borrowed plus 8% interest to
Royal Bank in one year.
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• On March 3, HighTech purchased office equipment (such as
Transaction 3: computer equipment) from MicroCentre Inc. for $4,500 in
cash. The effect of this transaction on the accounting
Purchase of equation is:
Equipment for Cash
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Transaction 4: • On March 4, HighTech purchased a six-month insurance
Purchasing policy for $1,200 cash. The effect of this transaction on the
accounting equation is:
Insurance
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• On March 6, HighTech purchased office supplies from Hamilton
Office Supply for $6,500. Hamilton Office Supply agreed to
Transaction 5: accept full payment in 30 days.
Purchase of Supplies • As a result of this transaction, HighTech received an asset
(supplies) but also incurred a liability to pay for these supplies
on Credit in 30 days.
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Transaction 6:
• On March 10, HighTech sold advertising services to Regina
Sale of Services for Valley Products in exchange for $8,800 in cash.
Cash
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Transaction 7: • On March 15, HighTech sold advertising services to the
Winnipeg Enquirer for $3,300. HighTech agreed to accept
Sale of Services for full payment in 30 days.
Credit
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Transaction 8: • On March 19, HighTech received $9,000 from the Winnipeg
Receipt of Cash in News for advertising services to be completed in the next
three months.
Advance
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Transaction 9: • On March 23, HighTech pays $6,000 cash for the supplies
Payment to a previously purchased from Hamilton Office Supply on credit
in Transaction 5.
Supplier
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Transaction 10: • On March 26 (a Friday), HighTech paid weekly employee
salaries of $1,800.
Payment of Salaries
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Transaction 11: • On March 29, HighTech collected $3,000 cash from the
Collection from a Winnipeg Enquirer for services sold earlier on credit in
transaction 7.
Customer
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• On March 30, HighTech paid its utility bill of $5,200 for
Transaction 12: March. Because an asset (cash) is consumed by HighTech as
part of the operations of the business, the cost of utilities
Payment of Utilities used during the month is an expense.
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Transaction 13:
• On March 31, HighTech declared and paid a cash dividend
Declaration and of $500 to its shareholders.
Payment of a Dividend
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Summary of Transactions
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Double-Entry Accounting
• Double-entry accounting describes the system used by companies to record
the effects of transactions on the accounting equation.
• The effects of transactions are recorded in accounts.
• Under double-entry accounting, each transaction affects at least two
accounts.
ASSETS = LIABILITIES + EQUITY
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• An account is a record of increases and decreases in each of
the basic elements of the financial statements.
Accounts • The list of accounts used by the company is termed a chart
of accounts.
• Below is a typical list of accounts.
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Debits and Credits
Debit (Dr.) Credit (Cr.)
To record or enter an To record or enter an
amount on the left side amount on the right side
of a general ledger of a general ledger
account account
• This system of recording transactions is referred to as the double-entry
accounting system; the two-sided effect of each transaction is recorded in
appropriate accounts
• When a transaction is “in balance”, the debits equal the credits
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Debits and Credits
Describe where entries are made in the accounts:
◦ Debit (DR)
◦ Credit (CR)
If debit amounts exceed credit amounts, account has a debit balance
If credit amounts exceed debit amounts, account has a credit balance
T-Account is a tool used for recording transactions
Debit refers to the LEFT and Credit to the RIGHT side of the T-Account.
Debit and Credit are neutral terms and. Neither is “good” or “bad”!
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To increase the balance of any account, record the
amount in the normal balance column
The Rules of
To decrease the balance of any account, record the
Debit and amount in the column opposite to its normal balance
Credit When any transaction is correctly recorded, the
accounting equation will remain in balance
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Normal Balances
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Normal Balances (Continued)
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Summary of Debit and Credit
Procedures
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Step 2:
Journalize Transactions
• A journal is a chronological record showing the debit and credit effects of transactions on a company.
• Each transaction is represented by a journal entry so that the entire effect of a transaction is contained
in one place.
• The process of making a journal entry is often referred to as journalizing a transaction.
• The three parts of a journal entry are
1. the date of the transaction
2. the accounts and amounts to be increased or decreased
3. a brief explanation of the transaction
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Journal Entries:
Transactions 1 & 2
• Transaction 1: On March 1,
HighTech sold 1,000 shares of
common shares to several
investors for
cash of $12,000.
• Transaction 2: On March 2,
HighTech raised additional funds
by borrowing $3,000 on a one-
year, 8% note payable to the Royal
Bank in Winnipeg.
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Journal Entries:
Transactions 3 & 4
• Transaction 3: On March 3,
HighTech purchased office
equipment (computer equipment)
from MicroCentre Inc. for $4,500
in cash.
• Transaction 4: On March 4,
HighTech purchased a six-
month insurance policy for $1,200
in cash.
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Journal Entries:
Transactions 5 & 6
• Transaction 5: On March 6,
HighTech purchased office
supplies from Hamilton Office
Supply for $6,500. Hamilton Office
Supply agreed to accept full
payment in 30 days.
• Transaction 6: On March 10,
HighTech sold advertising services
to Regina Valley Products in
exchange for $8,800 in cash.
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Journal Entries:
Transactions 7 & 8
• Transaction 7: On March 15,
HighTech sold advertising services
to the Winnipeg Enquirer for
$3,300. HighTech agreed to accept
full payment in 30 days.
• Transaction 8: On March 19,
HighTech received $9,000 in
advance for advertising services to
be completed in the next three
months.
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Journal Entries:
Transactions 9 & 10
• Transaction 9: On March 23,
HighTech paid $6,000 cash for the
supplies previously purchased
from Hamilton Office Supply
(transaction 5).
• Transaction 10: On March 26,
HighTech paid employees their
weekly salary of $1,800 cash.
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Journal Entries:
Transactions 11 & 12
• Transaction 11: On March 29,
HighTech collected $3,000 cash
from the Winnipeg Enquirer for
services sold earlier on credit
(transaction 7).
• Transaction 12: On March 30,
HighTech paid its utility bill of
$5,200 for March.
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Journal Entries:
Transaction 13
• Transaction 13: On March 31,
HighTech declared and paid a cash
dividend of $500 to its
shareholders.
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Step 3:
Post to the Ledger
• Because a journal lists each transaction in chronological order, it can be quite difficult to use a journal to
determine the balance in any specific account.
• Step 3 in the accounting cycle is to post to a ledger.
• Using a general ledger helps keep track of the balances of specific accounts.
• A general ledger is simply a collection of all the individual financial statement accounts that a company
uses.
• The process of transferring the information from the journalized transaction to the general ledger is
called posting.
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The Posting Process
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General Ledger
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Step 4:
Prepare a Trial Balance
• To aid in the preparation of financial statements, some companies will prepare a trial balance for review
before they prepare financial statements.
• The trial balance is a list of all active accounts and each account's debit or credit balance.
• The accounts are listed in the order they appear in the ledger—assets first, followed by liabilities,
shareholders' equity, revenues, and expenses.
• A trial balance whose debits equal credits does not mean that all transactions were recorded correctly.
• A trial balance will not detect errors of analysis or amounts.
• It will only prove the equality of debits and credits.
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• Significant differences exist between IFRS and ASPE with respect to the
accounting information system regarding financial statement
Significant Differences presentation and valuation of assets.
• Financial Statement Presentation:
between IFRS and • IFRS allows publicly accountable enterprises to present assets,
liabilities, and shareholders’ equity under two alternative forms
ASPE of presentation as follows:
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Significant Differences between IFRS and ASPE
• Valuation of Assets
• IFRS allows companies to record assets based upon their historical cost or to record their assets
at fair value (referred to as the revaluation model).
• Under IFRS, whichever method is used, that method must be used consistently for financial
reporting purposes.
• ASPE requires assets to be recorded using the historical cost model.
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