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FA2 Module 1. Financial reporting/accounting concepts. What is accounting? Objectives of financial reporting Accounting choice process Accounting concepts The accounting cycle Closing entries Adjusting entries. Who is your instructor?. Cameron Morrill, PhD, CGA

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fa2 module 1 financial reporting accounting concepts
FA2Module 1. Financial reporting/accounting concepts
  • What is accounting?
  • Objectives of financial reporting
  • Accounting choice process
  • Accounting concepts
  • The accounting cycle
  • Closing entries
  • Adjusting entries
who is your instructor
Who is your instructor?

Cameron Morrill, PhD, CGA

Associate Professor of Accounting

I. H. Asper School of Business

University of Manitoba


E-mail: Cameron.Morrill@ad.umanitoba.ca

Tel: (204) 474-8435

Office hours: Wednesdays 9:30 AM – 11:30 AM

1 what is accounting
1. What is accounting?

Accounting involves:

  • the recognition, measurement, and disclosure of financial information about
  • economic entities to
  • interested persons.
what is financial accounting
What is financial accounting?

Financial accounting is concerned with the classification, recording, analysis, and interpretation of the overall financial position and operating results of an organization and providing such information to owners, managers and third parties.

It includes the processes and decisions that culminate in the preparation of financial statements.

financial statements and business reporting
Financial statements and business reporting

Financial statements are an important source of information about economic organizations (required by Canadian corporations legislation and securities commissions), but are only one of several, which include:

  • Other information in the annual report
  • Reports required by securities commissions
  • Reports/releases issued voluntarily
what do users do with financial statement information
What do users do with financial statement information?
  • Contracting

Accounting information plays a key role in debt agreements, executive compensation and turnover, etc.

Emphasis on accounting as it helps to explain past performance.

what do users do with financial statement information7
What do users do with financial statement information?

2. Investment/resource allocation

Accounting information plays a key role in investing (buying and selling shares and other equity instruments) and credit (lending money) decisions.

Emphasis on accounting as it helps to predict future performance, especially future cash flows.

gaap in canada in 2012
GAAP in Canada in 2012

Different standards for different organizations, but underlying principles are the same

  • Publicly accountable enterprises (PAE) – IFRS (CICA Handbook Part I)
  • Private enterprises –
    • IFRS (like PAEs)
    • Canadian accounting standards for private enterprises or ASPE (CICA Handbook Pt II)
    • Disclosed basis of accounting
gaap in canada in 20129
GAAP in Canada in 2012
  • Not-for-profit (NFP) Organizations – (CICA Handbook Part III)
  • Pension Plans – (CICA Handbook Part IV)
  • Public Sector – (Public Sector Accounting Standards)
2 objectives of financial reporting
2. Objectives of financial reporting

. . . to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. (IASB)

Users? Target is investors (equity and debtholders) – hopefully, what is good for investors will also work for most everyone else

objectives of financial reporting
Objectives of financial reporting

External users

Assessing (performance appraisal) and predicting (investment decisions) cash flows

Why cash flows?

Generate return, pay debts

Why accrual accounting?

Cash flows are volatile, often independent of economic performance of entity; accrual accounting provides better long-run view

objectives of financial reporting12
Objectives of financial reporting

External users (continued)

  • Income tax minimization/deferral
  • Contract compliance (debt covenants)
  • Stewardship
objectives of financial reporting13
Objectives of financial reporting


  • Earnings management
    • Maximize earnings
      • Accounting-based performance measures
      • Market-based performance measures
    • Minimize earnings
  • Minimum disclosure (proprietary information)
  • Expanded disclosures
3 accounting choice process
3. Accounting choice process

To make accounting choices, must identify financial reporting objectives which are a function of:

  • Preparer/user needs and motivations
  • Organizational facts (public or private, debt covenants, legal/economic environment)
  • Constraints (GAAP, audit, regulatory requirements)
4 accounting concepts
4. Accounting concepts

Accounting concepts (conceptual framework) provide criteria to guide accounting choices and, hopefully, achieve financial reporting objectives. Concepts are:

  • Underlying assumptions
  • Qualitative criteria
  • Measurement methods
  • Elements of financial statements
i underlying assumptions universal
I. Underlying assumptions (universal)
  • Time period: meaningful information can be reported for a time period less than the entity’s life span
  • Separate entity: entity can be reported independently of its owners
  • Unit of measure: entity results can meaningfully be measured in monetary terms
i underlying assumptions entity specific
I. Underlying assumptions (entity-specific)
  • Continuity: enterprise will continue in operation for reasonable future period
  • Proprietary approach: entity results should be reported from point of view of its owners
  • Stable currency: value of measurement currency does not change from year to year (no inflation or exchange rate fluctuation); profit occurs if revenues are higher than historical cost of resources used
ii qualitative criteria
II. Qualitative criteria
  • Relevance
  • Faithful representation
  • Comparability
  • Verifiability
  • Timeliness
  • Understandability
  • Materiality constraint
  • Cost constraint

Information is relevant when it can influence the decisions of users.

  • Predictive value: helps predict future events (especially cash flows)
  • Confirmatory (feedback) value: confirms or corrects prior expectations
representational faithfulness

Information is a sufficiently accurate measure of what it purports to measure (economic substance over form).

  • Completeness
  • Neutrality (free from bias)
  • Free from material error

Two pieces of information are comparable if they are consistent and/or uniform

  • Uniformity

Information measured and reported in a similar manner for different entities in a given year

  • Consistency

Information is measured and reported in the same way for a given entity, from period to period. Changes occur only if justified.


Knowledgeable and independent observers can measure an economic event and arrive at the same result

  • Accounting measure is a reasonable measure of economic event (related to representational faithfulness)
  • Independent observers, using the same measurement methods, would reach the same result

Information should be available to users in time to make a difference in their decisions.

Note potential conflict between timeliness and some aspects of representational faithfulness (but not verifiability).

  • Information must be understandable to be helpful to users
  • Assumes that users have reasonable understanding of business and economic activity and of accounting; or get advice from people who have such understanding
  • Assumes that users will study information with reasonable diligence

Significance of an item – an item is material if its omission or misstatement would probably influence or change a decision.

  • Size: e. g., 5% of income
  • Nature: something small might still be indicative of a larger potential problem (e. g., small fine for environmental legislation violation)

Also implies occasional deviation from theoretically correct treatment, e. g., expense $5 stapler rather than capitalize and depreciate.

cost cost vs benefit
Cost (Cost vs. Benefit)

The cost of an accounting measurement or disclosure should not exceed the benefit of such measurement/disclosure to the user (e. g., ASPE).

iii measurement methods
III. Measurement methods


Inclusion of an item in one or more of the financial statements (not just note disclosure)


The process of determining the amount at which an item is recognized in the financial statements

measurement methods
Measurement methods

Historical cost: Transactions/events recorded at amount of cash or equivalent received or given up at the time the event took place

Alternatives to historical cost: Fair value

  • Quoted prices in active markets for identical assets
  • Quoted prices in active markets for similar assets
  • Valuation techniques (e. g., PV)
measurement methods29
Measurement methods

Revenue recognition

Revenue is increases in economic resources (increase in assets and/or settlement of liabilities) of an entity resulting from delivering or producing goods, rendering service or performing other activities that constitute a company’s ongoing business operation.

measurement methods30
Measurement methods

Revenue recognition

Revenue is recognized when

  • performance achieved (seller has performed all significant acts required and risks and reward of ownership are transferred to, and accepted by, buyer) and
  • proceeds are measurable and collectibility assured
measurement methods31
Measurement methods

Expense recognition

An expense is recognized when an event that is part of ongoing operating activities of entity occurs which results in a decrease in an asset or an increase in a liability. For example, sale of a car creates:

Cost of goods sold: decrease in inventory

Warranty expense: increase in warranty liability

measurement methods32
Measurement methods

Expense recognition (continued)

If there is no clear event that causes a decrease in net assets, then

  • Use some arbitrary cost allocation rule (e. g., depreciation), and/or
  • Check regularly for asset impairment (e. g., goodwill)
measurement methods33
Measurement methods

Full disclosure

Financial statements should report all relevant information, i. e., all information that might be expected to have an impact on user decisions.


Under uncertainty, should be careful not to overstate net assets or income. Does not mean that net assets/income should be systematically understated.

Examples: A2-8, A2-20

iv elements of financial statements and recognition
IV. Elements of financial statements and recognition


An element is recognized and included in the accounts when it meets the definition of an element; can be measured with reasonable precision; and, for assets and liabilities, it is probable that the economic benefits will be received or given up (realized)

elements of financial statements
Elements of financial statements
  • Assets: economic resources controlled by entity by virtue of past transaction or event and from which future economic benefits may be obtained
  • Liabilities: obligations arising from past transactions or events which will result in future transfer or use of assets, services or other economic benefits
  • Owners equity: ownership interest in entity assets after deducting liabilities
elements of financial statements continued
Elements of financial statements (continued)
  • Income (Revenues/gains): increases in economic resources resulting from ordinary activities of entity
  • Expenses/losses: decreases in economic resources resulting from income-generating activities of entity
  • Other comprehensive income: increases and decreases in net assets that are excluded from income by IFRS and do not reflect transactions with owners in their capacity as owners
5 the accounting cycle
5. The accounting cycle

The accounting cycle refers to the process of recognizing and recording economic events up to the production of financial statements. The accounting cycle is based on the double-entry bookkeeping system (debits and credits).

Assets = Liabilities + Owners’ Equity

Debits = Credits

steps of the accounting cycle
Steps of the accounting cycle

1. Journal entries to record transactions and events

2. Post journal entries to ledger

3. Prepare unadjusted trial balance to ensure that debits = credits

4. Prepare and post adjusting entries to update accounts, e. g.

  • proportion of assets consumed (insurance, equipment)
  • expenses incurred but not yet invoiced (interest, purchases, salaries, etc.)
  • revenues earned but not yet recorded (interest, investment)
steps of the accounting cycle cont d
Steps of the accounting cycle (cont’d)

5. Prepare adjusted trial balance

6. Prepare income statement from income statement accounts

7. Prepare statement of retained earnings/statement of changes in equity

8. Prepare closing entries

9. Prepare postclosing trial balance

10. Prepare balance sheet and cash flow statement

debits credits and the accounting equation
Debits, credits and the accounting equation

Debit (Dr.)

Increases assets and expenses

Decreases liabilities, owners’ equity and revenues

Credit (Cr.)

Decreases assets and expenses

Increases liabilities, owners’ equity and revenues

Under double-entry bookkeeping, any event that affects the financial position of the firm is recorded by (at least) one debit and (at least) one credit; the total value of the debits must equal the total value of the credits.

Example: A-20 (p. 673)

a 20 journal entries
A-20: Journal entries


Dr. Cash 60,000

Dr. Accounts receivable 30,000

Cr. Sales revenue 90,000

Dr. Cost of goods sold 58,500

Cr. Inventory 58,500

a 20 journal entries43
A-20: Journal entries


Dr. Cash 51,000

Cr. Accounts receivable 51,000


Dr. Income taxes payable 12,000

Cr. Cash 12,000

a 20 journal entries44
A-20: Journal entries


Dr. Inventory 120,000

Cr. Accounts payable 24,000

Cr. Cash 96,000


Dr. Accounts payable 18,000

Cr. Cash 18,000

a 20 journal entries45
A-20: Journal entries


Dr. Cash 216,000

Cr. Sales revenue 216,000

Dr. Cost of goods sold 140,400

Cr. Inventory 140,400


Dr. Operating expenses 57,000

Cr. Cash 57,000

a 20 journal entries46
A-20: Journal entries


Dr. Cash 3,000

Cr. Common shares 3,000


Dr. Inventory 300,000

Cr. Cash 219,000

Cr. Accounts payable 81,000

a 20 journal entries47
A-20: Journal entries


Dr. Cash 204,000

Dr. Accounts receivable 90,000

Cr. Sales revenue 294,000

Dr. Cost of goods sold 191,100

Cr. Inventory 191,100


Dr. Cash 78,000

Cr. Accounts receivable 78,000

a 20 journal entries48
A-20: Journal entries


Dr. Accounts payable 84,000

Cr. Cash 84,000


Dr. Operating expenses 54,000

Cr. Cash 54,000

6 closing entries
6. Closing entries

Closing entries are recorded at the end of each period to “close” income statement and dividend accounts to retained earnings, in order to

  • transfer balances in revenue, expense and dividend accounts (which are really owners’ equity sub-accounts) to retained earnings; and
  • reset these balances to zero for the next period

Closing entry steps

1. Close revenue accounts to income summary

Dr. Revenue

Cr. Income summary

6 closing entries continued
6. Closing entries (continued)

2. Close expense accounts to income summary

Dr. Income summary

Cr. COGS, Salaries expense, etc.

3. Close income summary account to retained earnings

Dr. Income summary net income

Cr. Retained earnings net income


Dr. Retained earnings loss

Cr. Income summary loss

4. Close dividend accounts to retained earnings

Dr. Retained earnings

Cr. Dividends