Instructor's Resource Manual for Harrison et al.

, Financial Accounting, 5ce

LEARNING OBJECTIVES
After studying Chapter 1, you should be able to:
1. Explain why accounting is the language of business
2. Explain accounting’s conceptual framework and underlying assumptions
3. Describe the purpose of each financial statement and explain the elements of each one
4. Explain the relationships among the financial statements
5. Make ethical business decisions

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce

OBJECTIVE 1: Explain why accounting is the language of business

A. Accounting is an information system that measures business activities, processes data into
reports, and reports results to decision makers. Exhibit 1-1 illustrates the flow of information
in an accounting system. Financial statements report this information to users.

B. Accounting information is used by

1. Managers to set goals, evaluate those goals, and take corrective action.
2. Investors to decide whether to invest in a business or evaluate an investment.
3. Creditors to evaluate a borrower’s ability to make required payments.
4. Government and regulatory bodies such as Canada Revenue Agency (CRA) to ensure
organizations pay the correct amount of taxes.
5. Individuals to make investment decisions and/or manage a bank account.
6. Not-for-profit organizations, which use accounting information in virtually the same
way as profit organizations.

C. Accounting information can be classified into two categories:

1. Financial accounting provides information for managers inside the business and for
decision makers outside the organization, such as investor and creditors.
2. Managerial accounting generates inside information for internal use by management.

D. Types of business organizations (summarized in Exhibit 1-2):

1. Proprietorship—an unincorporated business with a single owner. The owner has
unlimited liability which means that the owner assumes personal responsibility for the
debts of the business.
2. Partnership—an unincorporated business with two or more owners. Each partner has
unlimited liability.
3. Corporation—an incorporated business owned by shareholders whose ownership is
evidenced by the number of shares held. Shareholders elect the members of the board of
directors, which sets policy for the corporation and appoints officers. A shareholder has
limited liability. A corporation is distinct from its owners and has many of the rights
entitled to a person.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce

OBJECTIVE 2: Explain accounting’s conceptual framework and underlying assumptions

A. Generally Accepted Accounting principles (or GAAP) are the professional guidelines that
govern how accountants record, measure, and report financial information.
1. The Canadian Institute of Chartered Accountants (CICA) establishes GAAP.
2. There are multiple sets of GAAP and each is applicable according to the type of entity or
organization.
a. Publicly accountable enterprises (PAEs) must apply International Financial
Reporting Standards (IFRS) which are standards set by the International
Accounting Standards Board (IASB) to enhance the comparability of financial
information reported by public enterprises around the world. IFRS was effective
January 1, 2011 for Canadian public companies.
b. Private enterprises apply the Accounting Standards for Private Enterprises
(ASPE). However, private enterprises have the option of using IFRS or ASPE.
c. Other sets of GAAP are applicable to not-for-profit organizations, pension plans and
government entities.
3. A summary of IFRS-ASPE differences is presented at the end of the chapter.

B. The overall objective of financial reporting is to provide useful information to users to make
investing and lending decisions. The characteristics of useful information include: relevance,
faithful representation, comparability, verifiability, timeliness and understandability. (Exhibit
1-3 provides an overview of accounting’s conceptual framework.)
1. The relevance characteristic must be considered to ensure the financial statements
provide information to the user that is useful. To be relevant, financial information must
provide predictive and/or confirmatory value and must be material in nature or magnitude
that omitting or misstating it could affect the decisions of an informed user.
2. The faithful representation (or reliability) characteristic states that accounting records
should be based on accurate data. The actual cost of assets or services is usually more
reliable than market value.
NOTE: Consider the conflict between information that is timely (based on
estimates) and reliable that may require additional time to ensure accuracy
that may render the statements irrelevant.

C. There are four accounting assumptions underlying the conceptual framework.

1. The going-concern assumption assumes that the entity will remain in operation for the
foreseeable future. The market values of assets may vary from year to year, and for
this reason cost is deemed to be preferable to market value for measurement
purposes.
2. The separate-entity assumption states that each entity is an economic unit and is kept
separate from other entities including the activities of its owners.

Assume that you own three businesses and maintain one chequebook for all three. How can this
situation prevent you from maximizing your profits? (If one or two of the businesses are
unprofitable, then you would make more money without them. However, you would have no way
of knowing.) The entity concept would require a separate set of records for each business.

3. The historical-cost assumption states that assets should be recorded at actual cost.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
You purchased some land on January 1 of the current year. You had to borrow $100,000 for 2
years at 10% interest at the local bank that appraised the land for $105,000. You will eventually
pay $100,000 plus $20,000 for the interest. On December 31 of the current year, you receive an
offer for the land for $110,000, but you do not want to sell the land. At what value should the
land be reported on the balance sheet? The original cost (excluding interest) of $100,000.

4. The stable-monetary-unit assumption allows accountants to ignore the effect of

inflation in the accounting records thus reporting under the assumption that the value of
the currency is stable.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
OBJECTIVE 3: Describe the purpose of each financial statement and explain the elements of
each one

A. The financial statements provide a company’s financial results for users to make decisions.
The income statement for TELUS Corporation is presented.

B. The financial statements provide answers to four basic questions. The financial statements
that would be used to answer these questions are summarized in Exhibit 1-4.
1. How well did the company perform during the year? (The answer is found on the income
statement)
2. Why did the company’s retained earnings change during the year? (The answer is found
on the statement of retained earnings.)
3. What is the company’s financial position at the end of the year? (The answer is found on
the balance sheet.)
4. How much cash did the company generate and spend during the year? (The answer is
found on the statement of cash flows.)

C. The Income Statement (or statement of profit or loss) reports the revenues, expenses, and
net income or net loss of a company for a specified period of time. (The Consolidated
Statements of Income for TELUS Corporation is illustrated in Exhibit 1-5.)
1. TELUS Corporation has chosen a fiscal year ending at the same time as the calendar year.
However, a company can choose a fiscal year that is not the same as a calendar year.
Most of Canada’s big banks have a fiscal year-end of October 31.
2. TELUS Corporation reports operating results for two fiscal years for comparability
purposes enabling users to detect any trends.
3. The income statement has two main elements: income and expenses.
a. Income includes revenue earned through the sale of goods and services and gains.
b. Gains reflect an increase in the economic benefits to a company usually due to a
transaction outside of the company’s ordinary business activities. For example, the
sale of a long-lived asset which exceeds the carrying amount on a company’s books.
c. Expenses consist of costs incurred to purchase goods and services to run a business
and losses.
d. Losses are the opposite of gains and reflect a decrease in the economic benefits to a
company usually due to a transaction outside of the company’s ordinary business
activities. For example, the sale of a long-lived asset which does not exceed the
carrying amount on a company’s books.
4. The major expense for TELUS Corporation is called Cost of Goods Sold, which
represents the cost of the goods TELUS Corporation sold to its customers.
5. The Income Statement reports net income or net loss which is equal to Total Revenues
and Gains less Total Expenses and Losses or the amount of income or loss that is left
after total expenses have been deducted from total income.
6. Net income is sometimes known as net earnings or net profit.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce

D. The Statement of Retained Earnings reports the changes in a company’s retained earnings
during a specified period and reflects the accumulated net income of the company since it
started business. (The Consolidated Statements of Retained Earnings for TELUS
Corporation is illustrated in Exhibit 1-6.)
1. The Net Income reported on the income statement is added to the opening balance of
retained earnings.
2. After a company earns net income, the board of directors must decide whether to retain
the income for use in the business or to pay dividends. Dividends reduce retained
earnings. TELUS Corporation declared dividends of $715 million in 2011.

E. The Balance Sheet (or statement of financial position under IFRS) reports a company’s
financial position at a moment in time. (The Consolidated Balance Sheets of TELUS
Corporation is illustrated in Exhibit 1-7.)
1. The balance sheet is dated as of the last day of the period. The amount of assets reported
is the amount of assets TELUS Corporation owned as of the last day of the accounting
period. The other financial statements cover a period of time.
2. The balance sheet reports three main categories: Assets, Liabilities, and Shareholders’
Equity (TELUS Corporation’s term for owners’ equity). The relationship between these
categories is known as the accounting equation where assets always equal the sum of
liabilities and owners’ equity: A=L+OE. Exhibit 1-8 illustrates the accounting equation
using the 2011 figures from the Balance Sheet of TELUS Corporation.

Beginning assets and shareholders’ equity are $120,000 and $30,000, respectively. Liabilities
increased $15,000 during the year, and the ending assets are $145,000. What was the ending
shareholders’ equity?
Assets = Liabilities + Shareholders’ Equity
Beginning of year $120,000 = X+ $30,000
X= $90,000
End of year $145,000 = (90,000+15000) + X
X=$40,000

3. Assets are economic resources owned by a business that are expected to be of benefit in
the future. Assets are divided into two categories: current and non-current (long-term)
assets.
a. Current assets are those assets that the company expects to convert to cash, sell, or
consume during the next 12 months or within the business’s normal operating
cycle if longer than a year.
i. The operating cycle is the time span during which (a) cash is used to acquire
goods and services, and (b) these goods and services are sold to customers,
from whom the business collects cash.
ii. Examples of current assets are:
Cash.
Receivables--the amount that a company expects to collect from its
customers who bought merchandise on credit.
Inventory--the merchandise TELUS Corporation sells to its customers.
Prepaid expenses--the amount of advertising, rent, insurance, and/or
supplies that TELUS Corporation has already paid for but has not yet
used.
b. Non-current assets (or long-term assets) consist mainly of property, plant, and
equipment. These assets are partially used, or amortized. TELUS Corporation also

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reports Goodwill and Intangible Assets. Intangible Assets are assets with no physical
form such as patents and trademarks. Other Assets is a category for assets not
reported elsewhere on the balance sheet.

How a business comes up with the funds to acquire additional assets? A company can borrow
(liabilities), or use invested funds (owners’ equity), or hopefully, earn it (also owners’ equity).

4. Liabilities are debts the entity owes as a result of a past event, and which it expects to pay
off in the future using some of its assets. Liabilities are also divided into current and non-
current/long-term categories.
a. Current liabilities are debts that are payable within one year or within the entity’s
normal operating cycle if longer than a year.
i. Examples of current liabilities are:
Accounts payable represents amounts owed for goods and services that
have been purchased but not yet paid for. The word payable indicates a
liability.
Notes payable—amounts borrowed with a promise to pay back within
the year
Income taxes payable is the amount owed to the government for income
taxes.
b. Non-current liabilities (or long-term liabilities) are due in periods beyond the next
twelve months.
5. Owners’ Equity is the owners’ remaining interest in the assets of the company after
deducting all its liabilities.
a. Owners’ equity or shareholders’ equity in the case of a corporation like TELUS
Corporation has four common components:
i. Share capital refers to the amounts contributed by shareholders in exchange
for shares.
ii. Contributed surplus which consists of amounts contributed by shareholders
in excess of share capital.
iii. Retained earnings which comes from the statement of retained earnings
represents the amount of net income that has been reinvested in the business.
Revenues are amounts earned by delivering goods or services.
Revenues increase net income and therefore also increase retained
earnings.
Expenses are the costs of operating a business. Expenses decrease
net income and therefore also decrease retained earnings.
If expenses exceed revenues, the result is a net loss.
Dividends are distributions of assets (usually cash) to the
shareholders. The amount of dividends declared is determined after
net income is computed. Dividends decrease retained earnings
because they represent the amount of the net income that is not
reinvested in the business.
iv. Accumulated other comprehensive income which is an accumulation of past
earnings not included in retained earnings and is required under IFRS.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
g
e
b. The owners’ equity of n
proprietorships and of e
partnerships makes no r
distinction between a
what is invested and t
what is earned. The e
equity of each owner is
accounted for under the s
single heading, Capital. a
l
F. The Statement of Cash Flows e
reports the sources and uses of s
cash from the three major .
activities of a business-- b. Investing Activities relate to the purchase
operating, investing, and and sale of long-term assets that a
financing. (The Consolidated company uses to conduct is operations.
Statements of Cash Flows for TELUS Corporation pays cash to
TELUS Corporation is purchase assets and receives cash when
illustrated in Exhibit 1-9.) assets are sold.
1. The three major activities c. Financing Activities relate to the way a
include: company acquires the funds used for
a. Operating Activities investing and operating activities. A
relate to the business can finance its activities by
transactions and other borrowing from a bank or other lender,
events that determine issuing shares to its owners, and paying
net income/ (loss). dividends.
i. Cash
receipts from a Operating activities are the most important because
company’s sales without them there is no need for the other two.
of its primary Investing activities are of secondary importance
goods and because a company’s current and future operating
services. ii. Cash effectiveness is determined by wise investment
payments to decisions.
suppliers and
employees for the G. Notes to the financial statements are provided as
goods and an integral part of the financial statements and
services should be read carefully as part of a review of the
t financial statements.
h
e
y

p
r
o
v
i
d
e

t
o

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
OBJECTIVE 4: Explain the decision making process.
relationships among the financial
statements

A. Exhibit 1-10 summarizes the

relationships among the financial
statements
1. The income statement is
the only financial statement
that lists revenues and
expenses. a. Net income
(or net loss), the difference
between revenues and
expenses, is reported
on the income statement.
b. This amount is then used
on the statement of retained
earnings.
2. The statement of retained
earnings reports the following:
a. The beginning balance of
retained earnings;
b. The addition of net income
or the subtraction of net loss to
that beginning balance;
c. The subtraction of
dividends; and
d. The ending balance of
retained earnings.
e. The ending balance is used
on the balance sheet.
3. The balance sheet is the
only financial statement
that reports all assets,
liabilities, and owners’
equity. The balance sheet
must show that the assets
equal the sum of liabilities
and owners’ equity.
4. The statement of cash
flow reports cash flows
from three types of
business activities--
operating, investing, and
financing.
a. A net cash flow is reported
for each activity.
b. The ending cash balance
is reported. This amount
should also be reported
on balance sheet.

B. The Decision Guidelines

summarize how people use
financial statements in their
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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
CHAPTER 1

Circle the letter of the best response.

1. Which of the following statements is false?
A. Accounting is the information system that measures business activities, processes that
information into reports, and communicates the results to decision makers.
B. Financial statements report financial information about a business entity to decision
makers.
C. Owners of a corporation are not personally liable for the debts of the corporation.
D. The purpose of financial accounting is to provide information to people inside the
entity, such as the owners and managers.

2. Mary owns and operates a fabric shop. Mary needs to borrow money to expand;
therefore, she prepared financial statements to present to her banker. Mary recorded the
assets of her store at the cost she paid for them 2 years ago rather than when she
transferred them to her business this year. Mary has violated which of the following
principles or concepts?
A. Reliability principle
B. Entity Assumption
C. Going-concern principle
D. Stable-monetary-unit concept

3. Which of the following is false?

A. Owners’ Equity - Assets = Liabilities
B. Assets = Owners’ Equity + Liabilities
C. Owners’ Equity = Assets - Liabilities
D. Liabilities = Assets - Owners’ Equity

4. SMT Inc. experienced an increase in total assets of $2,000 during the current year.
During the same year, total liabilities decreased $6,000. If dividends for the year were
$10,000 and the owners made no additional investment, how much was net income?
A. $14,000
B. $6,000
C. $18,000
D. $2,000

5. Which of the following statements is true?

A. The cash flow statement reports all changes in assets, liabilities, and shareholders’
equity of the business during the period.
B. Revenues and expenses are reported only on the balance sheet.
C. The income statement reports cash flows from three types of business activities--cash
receipts, cash payments, and investing.
D. On the statement of retained earnings, any dividends for the period are subtracted from
the beginning balance of retained earnings.

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Table 1-1
The following information is taken from the accounting records after current period
operations and presented in random order.

Accounts payable $ 9
Service revenue 38
Cash 25
Equipment 110
Common shares 200
Retained earnings (ending balance) ??
Dividends 15
Accounts receivable 4
Land 100
Office supplies 5
Utilities expense 2
Salary expense 18
Cash receipts: Cash payments:
Collections from customers 30 Acquisition of land 50
Sale of equipment 15 Issuance of shares to owners 90
Dividends 15
To suppliers 5

6. Total assets
are: A. $150.
B.
$181.
C.
$244.
D.
$158.

7. Net income
is: A. $18.
B. $36.
C.
$120.
D. $20.

8. Cash flow from financing activities

is: A. $(85).
B.
$(55).
C. $75.
D.
$(15).

9. The ending balance in Retained Earnings

is: A. $35.
B.
$55.
C.

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
$75.
D.
$15.

10. On which financial statement can the Beginning balance in retained earnings be found?
A. Balance sheet
B. Income statement
C. Statement of retained earnings
D. Both A and C

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 Instructor's Resource Manual for Harrison et al., Financial Accounting, 5ce
ANSWER KEY
1. D
2. B
3. A
4. C
5. D
6. C
7. A
8. C
9. A
Explanation: The answer to Q9 is $35, which is the amount needed to get the balance sheet to
balance (Total Assets = $244; Total Liabilities and Shareholder's Equity, excluding Retained
Earnings = $209).
10. C

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