Module 1: Introduction To Accounting Concepts

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Module 1: Introduction to accounting concepts

Overview
Topics 1.1 to 1.7 of this module set the stage for the course by introducing some basic concepts of accounting. Various forms
of organizations are briefly introduced and their basic features are compared. The module identifies a wide spectrum of users
for whom accounting information is useful. You will also study some basic ethical standards that guide the work of a
professional accountant. The major fields of accounting are highlighted. The financial statements of a proprietorship
income statement, balance sheet, statement of changes in owners equity, and cash flow statement are previewed. You
will also take a brief look at a recently introduced statement the statement of comprehensive income and determine the
effects of business transactions on the accounting equation.
Topics 1.8 to 1.12 explain the conceptual framework of accounting. These topics preview the principles and concepts that are
integrated throughout the ensuing module notes and enable you to define the essential characteristics of accounting
information and to identify the fundamental concepts used in preparing external financial reports. Topic 1.13 describes the
elements of financial statements.
Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
required.
Learning objectives
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
Describe the function of accounting and the nature and purpose of the information it provides, and
identify users of accounting information. (Level 1)
Distinguish between sole proprietorships, partnerships, and corporations. (Level 2)
Explain the importance of ethics in accounting, and the key ethical standards expected of
professional accountants. (Level 1)
Compare the fields of accounting and the kinds of work performed in each field. (Level 2)
Differentiate among the different kinds of financial statements. (Level 1)
Explain each of the GAAP introduced. (Level 2)
Analyze business transactions to determine their effects on the accounting equation. (Level 1)
Describe the major areas of the conceptual framework of accounting. (Level 2)
Describe the essential characteristics of accounting information. (Level 2)
Describe the trade-off of qualitative characteristics. (Level 2)
Describe the assumptions of accounting. (Level 2)
Describe the basic principles of accounting. (Level 2)
Describe the elements of financial statements. (Level 2)
Module summary
Print this module
Assignment reminder
Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). You may wish to take a look at it now in
order to familiarize yourself with the requirements and to prepare for any necessary work in advance.
Note: Please review the Exemplar located here. The Exemplar provides a sample question along with two sample
answers: one answer demonstrates a poor response and the second answer represents a good response. To maximize your
learning as well as your grade on each of the three assignments in this course, it is highly recommended that you take the
time to understand the differences between the two sample answers provided as part of this Exemplar.
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Textbook errata
When textbook errors are discovered after printing, the publisher makes every effort to notify students of the error by
posting an errata on their online learning centre. When students come across a potential textbook and/or solution error, they
are encouraged to check the publishers Website for the latest errata. The errata is found at http://highered.mcgraw-hill.com/
sites/9970951713/student_view0/errata.html.
Examination reminder
Students may use their own calculators in examinations, provided they meet the following guidelines:
The calculator is silent, battery-operated, and non-printing.

The calculator has only one line of display.
The calculator does not have alpha keys (keys allowing text entry).
Students are responsible for ensuring that the calculator batteries are fully operational. There will be no exchange or
borrowing of calculators or batteries during the examination. No operating instructions will be allowed in the examination
room.
No other mechanical, electronic, or other type of aid or material is permitted in the examination room.
As of 2010-2011, present value tables will no longer be included on any examinations. Students should be able to use their
financial calculators proficiently.
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Module 1 Test your knowledge

1. Which financial statement shows whether the business earned a profit and also lists the types and amounts of the
revenues and expenses?
1.
2.
3.
4.
Balance sheet
Statement of changes in owners equity
Statement of cash flows
Income statement
2. Which of the following is another term for equity?

1.
2.
3.
4.
Net income
Expenses
Net assets
Revenue
3. Which accounting guideline requires that an entity report all of its financial statement information in the same
currency?
1.
2.
3.
4.
Business entity principle

Monetary unit principle
Going-concern principle
Revenue recognition principle
4. If the liabilities of a business increased $12,000 during a period of time and owners equity in the business decreased
$2,000 during the same period, the assets of the business must have increased or decreased by how much?
1.
2.
3.
4.
Decreased $10,000
Decreased $14,000
Increased $10,000
Increased $14,000
5. A purchase of office equipment for cash of $130 was recorded as an addition to Office equipment and an addition to
Liabilities. By what amounts are the accounts under- or overstated as a result of this error? (Understated means too
low, and overstated means too high.)
1.
2.
3.
4.
Assets, understated $130; Liabilities, overstated $130

Office equipment, understated $260; Liabilities, overstated $130
Office equipment, overstated $130; Liabilities, overstated $130
Assets, overstated $130; Liabilities, overstated $130
Solutions
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1.1 What is accounting?

Learning objective
Describe the function of accounting and the nature and purpose of the information it provides, and identify users of
accounting information. (Level 1)
Required reading
Chapter 1, pages 1-4 and 7-10
LEVEL 1
The function of accounting is to provide quantitative information, primarily financial in nature, about economic entities.
Accounting involves analyzing economic events and determining how they should be recorded. Bookkeeping, on the other
hand, is the part of accounting that deals only with the physical recording of transactions and events.
This course includes a lot of bookkeeping activities. You start off by learning how economic activities are recorded according
to the rules of accounting, and why accountants do things the way they do them. Throughout the course, spend time on the
why aspect to deepen your understanding and to help you learn to deal with situations that are not specifically covered by
the rules.
Accounting information is needed to answer day-to-day questions about business operations. Financial statements report
accounting information that provides answers to questions about a firms resources, earning prospects, expected cash
collections, debt-paying ability, and other related information.
There are two broad classes of users of financial information: internal users and external users. The types of questions that
will be asked by different users are almost limitless. For example, an investor might ask How profitable is the business?
while a manager might query How well is the business doing compared to the competitors?
In order to answer these questions appropriately, accounting information must meet certain criteria such as
understandability,
relevance
,
reliability
, and comparability.
Accounting information that is understandable

knowledge of accounting as well as business and economic activities.
Accounting information should be relevant
those who rely on the information.
is useful to users with reasonable
because it can affect the types of decisions made by
Accounting information should be reliable

for decision makers to depend on
it. Faithful representation
,
substance over form
, neutrality
,
prudence
and completeness
are all necessary for information to
be reliable. Faithful representation means transactions must be reported truthfully. In addition, transactions are to be
reported based on their essence: substance over form. Information that is neutral is free from bias. To be complete,
there can be no material omissions.
Accounting information should be comparable
in the sense that companies use similar
practices so that users are able to compare companies and their information.
The provision of understandable, relevant, reliable, and comparable information requires both expertise and integrity. First,
expertise acquired through training and experience is needed to gather and analyze information that is understandable,
relevant, reliable, and comparable. For example, in the age of the Internet where huge amounts of information are but a few
clicks away, it requires expertise to cut through the peripheral materials and focus on the most relevant information.1
Second, for financial information users to rely on the information provided by accountants, there has to be a strong element
of trust in the accountants integrity. Accordingly, a large part of accounting ethics centres on the development of the moral
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character trait of integrity.

Expertise and integrity go hand in hand. An expert who lacks integrity is morally untrustworthy the sort of person who
would distort the truth to pursue personal advantage at the expense of the client. However, an individual with personal
integrity but lacking expertise would not have the practical skills for providing financial information that is relevant, objective,
and feasible. Thus, what is required in an accountant is a combination of expertise and integrity.
Textbook activities
Checkpoint Questions 1 and 2 on

page 4
(Solutions on page 17)
Quick Study 1-1 and 1-2 on page 20
(Solutions)

page 14
Activity 1.1 Quality of information
You are a lending officer in a bank. A business owner comes to you with a loan proposal and brings you two sets of financial
information:
The business's financial information for the year ending December 31, 2009, which has been audited (reviewed in
detail) by a trained accountant who is not an employee of the firm.
Financial information for the 10 months ending October 31, 2010, prepared by an employee of the firm.
a. Which statement do you think is more reliable? Why?

b. Which statement do you think is more relevant? Why?
c. Which statement do you think is more comparable to industry information? Why?
Solution
IFRS 2009, Framework, para. 24.
1.2 Forms of organization

Learning objective
Distinguish between sole proprietorships, partnerships, and corporations. (Level 2)
Required reading
Chapter 1, pages 4-6
LEVEL 2
Accountants provide services to all types of business entities. It is important, therefore, that you are familiar with the
characteristics of the different forms of business organization. The three forms of business ownership sole proprietorship,
partnership, and corporation are clearly presented in the text. In addition, non-business organizations exist, which operate
not-for-profit (for example, schools, hospitals and churches).
Textbook activities
Judgement Call on page 6
(Solution on page 17)

page 6
Quick Study 1-3 on
page 21
Mid-Chapter Demonstration
Problem on page 7
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(Solution)
1.3 Ethics in accounting

Learning objective
Explain the importance of ethics in accounting and the key ethical standards expected of professional accountants.
(Level 1)
Required reading

CGA-Canada Code of Ethical Principles
and Rules of Conduct
Readings Handbook
[available from the Ethics

(ERH) under the Resources tab]
Extend Your Knowledge (EYK) 1-3: Codes of Ethics and Professional Conduct
LEVEL 1
(For all ethics-related readings in this course, it is assumed that you have become familiar with Section A of the ERH
.
Section A clarifies important concepts and terms used throughout the ERH
and is necessary background knowledge for
readings referred to in this course. If you have not read this section, do it now before proceeding.)
the ERH
Ethics is essentially the study of right and wrong and has been a prominent and sensitive issue in the accounting profession
for years. In North America, all major accounting associations have a code of professional conduct. CGA-Canada expects its
members and students to act according to its Code of Ethical
Principles and Rules of Conduct
(the Code) in
their professional activities.
Ethical codes serve as a foundation for developing ethical behaviour in professions. They also provide a framework for ethical
at the bottom of page 11). However, codes alone are not
practice (refer to the Did You Know?
enough and can never serve as the final moral authority. If codes become the focus of morality, one may just follow the
codes and lose sight of fundamental principles. An overemphasis on codes could preclude criticism of the codes from a
broader moral framework. What is needed, therefore, is moral character
and
ethical reasoning ability
.
In recent years, there has been widespread interest in accounting ethics, due partly to wide media coverage of a host of
misdeeds, including insider trading, tax evasion, audit failure, and fraud. Reports of unethical behaviour undermine public
confidence in the accounting profession. For example, in the fall of 2001, the media focused a spotlight on energy giant
Enron, which was forced to declare bankruptcy amid charges of insider trading, deceitful accounting, and corrupt
management. To find out more, go to the FindLaw page on Enron.
One possible cause of ethical problems in the profession is the trend toward the commercialization of accounting.
Management consulting and tax preparation have become major sources of revenue for accounting firms. This raises the
possibility that some accountants may compromise auditing standards in order to attract other non-audit revenues. As
professionals, however, accountants have a responsibility to the public that takes precedence over the demands of
commercialization. Accountants have a special duty to the public because of the rights and privileges accountants enjoy, and
because the public has confidence in the profession.
CGA-Canadas Code of Ethical Principles and Rules of Conduct outlines its members commitment to the public interest.
Textbook activities
Demonstration Problem on page 18

The case in the demonstration problem is one example of the many ethical issues facing accountants. In these
module notes, they have been labelled as Ethics challenges. However, in real life, ethical issues or challenges
usually do not come labelled as such. For example, would you have identified the ethical challenge in this case if the
question was What could Rupert Jones do to maximize the audit fee from ShadowTech? rather than What are the
ethical factors in this situation?
Would you have answered by suggesting various ways in which Rupert could create a favourable impression of
ShadowTechs financial situation, for example, by pretending that inventory in the warehouse was already sold? Or
would you have noticed the real problem: the conflict of interest situation created when audit fees are tied to the
statement of reported profits? In real life, this is the sort of ethical challenge that accountants have to deal with.
In short, for every question, you will need to ask yourself, What are the ethical issues in this case? You will need to
address both accounting and ethics issues in your answers to every case. As you practise asking yourself this
question, you will ingrain the practice into your approach to problem-solving, and it will become easier.
Checkpoint questions 7-9 on page 14

Quick Study 1-5 on page 21
(Solution)
1.4 Types of accountants and fields of accounting

Learning objective
Compare the fields of accounting and the kinds of work performed in each field. (Level 2)
Required reading
LEVEL 2
Accountants can be classified according to the services they provide. Exhibit 1.6 on page 14 of the text provides a summary
of the activities performed by accountants and the fields in which these activities occur financial accounting,
managerial accounting, and tax accounting. Note that both financial and managerial accountants can work in for-profit
enterprises such as the Royal Bank and not-for-profit organizations such as hospitals and CGA-Canada. This course focuses
on financial accounting for the for-profit enterprises.
As a CGA, you will likely work in one of these three fields of accounting. One of the activities in financial accounting is
auditing. In most jurisdictions in Canada, a CGA may audit a companys financial statements. An audit expresses an opinion
on the fairness of the statement presentation.
Textbook activity
Checkpoint questions 10-13 on page

16 (Solutions on page 17)
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1.5 Financial statements

Updated Sept. 14/10, FA1-10-TU01
Learning objective
z
Differentiate among the different kinds of financial statements. (Level 1)
Required reading
z
LEVEL 1
Financial statements are an end product of the accounting process. After financial information has been
accumulated and summarized, the information is reported in the form of financial statements. They are used
to fulfill the function of accounting to provide quantitative information useful for decision-making. Financial
statements are also used for external reporting and for internal management.
The text presents four financial statements that a sole proprietorship (also referred to as a single
proprietorship or just proprietorship) prepares:
z
Income statement (also known as statement of earnings and statement of income)

Statement of changes in owners equity (Note: the textbook uses the term statement of
owners equity. Because the components of the statement of changes in equity as required by IFRS
are different for a corporation than what is presented in the textbook and detailed in Module 9,
students will be required to use the term statement of changes in equity or statement of
changes in owners equity for a sole proprietorship.1)
Balance sheet (also known as statement of financial position)
Cash flow statement (also known as statement of cash flows)
As you progress through this course, you will learn the use and detailed preparation of the income statement,
statement of changes in owners equity, balance sheet, and cash flow statement. In this module, the format
and basic content of these financial statements will be introduced.
The statement of comprehensive income is a relatively new statement. Comprehensive income will be
explained briefly in Module 9 after you have learned some of the prerequisite terminology and concepts.
A brief note about terminology: As you progress in your study of accounting, you will find that there are
synonyms for many frequently referred to items (a synonym is a word that has the same meaning as another
word). The actual name that you use is not as important as unambiguously describing the economic event
that is being recorded. Thus statement of earnings and income statement are both acceptable.
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Accounting is undergoing significant changes in Canada because of the adoption of International Financial
Reporting Standards (IFRS). IFRS are the new accounting laws or Generally Accepted Accounting Principles
(GAAP) that must be applied by accountants to publicly accountable enterprises (PAEs) in Canada starting
January 1, 2011, when recording and reporting accounting information. A PAE is a corporation that sells its
shares openly on a stock exchange. Privately-held enterprises (PEs) will have the option of adopting IFRS or
using PE GAAP. Privately-held enterprises include sole proprietorships and corporations that do not sell their
shares on the open market.
Some of the financial statement terminology under IFRS differs from current Canadian standards. However,
IFRS does not mandate the terms used to name financial statements. The following is a list of financial
statement terminology under IFRS (along with terminology used in the textbook, if different):
z
z
z
z
z
The
The
The
The
The
statement of financial position (the balance sheet)

statement of changes in equity (the statement of retained earnings)
statement of cash flows (the cash flow statement)
income statement
statement of comprehensive income
IFRS terms and material covered in the course are examinable. Students should be aware of these
differences. On assignments and exams, students will be required to use either statement of changes in
equity or statement of changes in owners equity for sole proprietorships. For corporations, discussed in
detail in Module 9, students must use statement of changes in equity or statement of changes in
shareholders equity in place of the statement of retained earnings used in the textbook. For partnerships,
also discussed in detail in Module 9, students must use statement of changes in partnership equity or
statement of changes in equity in place of statement of partnership equity.
Income statement
The income statement conveys a concise picture of profitability (net income or net loss) for a period of
time, such as a month, a quarter, or a year. Notice that in Exhibit 2.2 on page 28, the statement has the
following heading:
Finlay Interiors
Income Statement
For Month Ended January 31, 2011
This type of information is an integral part of any financial statement because it tells the reader which
economic entitys financial result is being reported; the type of information that is being reported; and the
period the information covers (for income statements, cash flow statements, and statements of changes in
owners equity) or the point in time to which it applies (for balance sheets). Insufficiently identified information
is almost useless to the reader. See Example 1-1.
Statement of changes in owners equity

The statement of changes in owners equity summarizes the changes in the owners capital over a period
of time for a sole proprietorship. Exhibit 2.3 on page 28 illustrates how this statement is headed up and
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formatted.
Note: Because of the publication date of the textbook, the incorrect name is used in the text for the
statement of changes in owners equity. Students are required to replace all occurrences of the statement of
owners equity with either the statement of changes in equity or the statement of changes in owners
equity.
Balance sheet
The balance sheet is a concise picture of financial position (assets, liabilities, and owners equity) on a
specific date. A balance sheet can be thought of as a snapshot at a point in time that captures what the firm
has (assets), what it owes (liabilities), and what belongs to the owners (equity).
Note in Exhibit 2.4 on page 28 that the balance sheet date is specific. This contrasts with the income
statement, the statement of changes in owners equity, and the cash flow statement, all of which report
results over a period of time. This presentation then shows the format and the types of accounts that are
included in Finlay Interiors balance sheet. Note how assets, liabilities, and equity are presented on the
balance sheet.
As you can see from the exhibit, assets equal the sum of liabilities and owners equity. This is typically
expressed as A = L + E.
Assets are: (1) properties or economic resources controlled by the business; and (2) the result of past
transactions or events; and (3) from which future economic benefits may be obtained.2 Simply put, assets are
things that the entity owns.
Note that all three criteria must be present to classify a resource as an asset. See Example 1-2.
Liabilities are obligations of the company: they are what the company owes. IFRS define a liability as a
present obligation of the entity arising from past events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic benefits.3
See Example 1-3 for an illustration.
In the example, the process of determining that a car is an asset and a car loan is a liability may seem to be
simplistic. However, this methodology is fundamental to establishing how to classify more complex financial
statement elements and how to deal with situations that are not specifically covered by the rules.
Owners equity represents the residual interest in the assets of the entity after deducting all its liabilities.4
Owners equity is sometimes referred to as net assets.
Cash flow statement

The primary objective of the cash flow statement (also called the statement of cash flows) is to reconcile
the change in cash from the beginning of the period to the end of the period. The statement categorizes cash
inflows and outflows into three groups: operating activities, investing activities, and financing activities, as
shown in Exhibit 2.5 on page 28. A comprehensive knowledge of the interactivity between the income
statement, the balance sheet, and the statement of changes in owner's equity is required in order to complete
the cash flow statement.
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Textbook activities
z
Checkpoint Questions 1 to 4 on page 31 (Solutions on page 45)
Quick Study 2-1 on page 50 (Solution)
The order of the various financial statements in Exhibits 2.2 to 2.5 on page 28 is deliberate. As you go through
these exhibits, you will note that information from the first statement (the income statement) is necessary to
construct the second (the statement of changes in owners equity), which in turn is necessary to create the
third (the balance sheet). Information from the first three statements is then required to produce the cash
flow statement.
1 IFRS 2009, IAS 1, par. 1
2 IFRS 2009, Framework, par. 49(a).
3 IFRS 2009, Framework, par.49(b).
4 IFRS 2009, Framework, par. 49(c).
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1.6 Generally accepted accounting principles (GAAP)

Learning objective
Explain each of the GAAP introduced. (Level 2)
Required reading
NOTE: Omit the section titled Objectivity Principle on page 32.

LEVEL 2
The IFRS 2009 Framework

lists the primary sources of Generally accepted
accounting principles (GAAP) for publically accountable entities (PAEs) in Canada. Privately-held entities (PEs) in Canada
may choose IFRS GAAP or PE GAAP. GAAP comprise both broad and specific principles adopted by the accounting profession
as guidelines for measuring, recording, and reporting the financial transactions and activities of a business. Broad principles
describe basic assumptions and general guidelines for preparing financial statements. Specific principles provide more
detailed reporting rules for handling various accounting transactions.
This topic presents an explanation of some important accounting principles that provide a framework for accounting.
Introducing some GAAP

GAAP provide the foundation for how to record business transactions that you will study in this course, as well as in more
advanced financial accounting courses. These principles are listed in Exhibit 2.8 on page 31 and explained on pages 31-32. In
addition, the GAAP are summarized on the inside back cover of the textbook for quick reference. Click on the following links
for more details on the principles. Some of these principles will be covered in greater detail in later modules.

Cost principle
Time period principle
Materiality principle
Matching principle
Consistency principle
Prudence principle
Full-disclosure principle
Example 1-4 shows how GAAP is used to guide accounting practice.
As already noted, Canada is in the process of incorporating IFRS. This convergence with IFRS, as it is commonly known, will
result in some changes to GAAP. For example, conservatism will be replaced with prudence. Although prudence is similar to
conservatism, it emphasizes the exercise of caution and that assets or income are not overstated and liabilities or expenses
are not understatedwhereas conservatism suggests that it is better to understate than overstate assets and equity.1
Textbook activities
1IFRS
Checkpoint Questions 5-7 on page 33

Quick Study 2-3 and 2-4 on page 51
2009, Framework, par. 37.
(Solution)
1.7 The accounting equation

Learning objective
Analyze business transactions to determine their effects on the accounting equation. (Level 1)
Required reading
LEVEL 1
The relationship between assets and the claims against the assets can be conveniently summarized in the following equation:
Assets = Liabilities + Owners equity
A business transaction is an exchange of goods or services that affects this equation. It is essential to understand the
effects of transactions on the accounting equation in order to understand the accounting function.
Effects of transactions on the accounting equation

The accounting equation applies to all economic and legal entities from a proprietorship such as the local barbershop to
large corporations such as Canadian Tire. Study carefully how various transactions affect the accounting equation for Finlay
Interiors (see textbook pages 34-38). Activities 1 to 11 illustrate the following points, which you must understand for your
accounting work:
1. The accounting equation remains in balance after each transaction.
2. Every transaction affects at least two items in the accounting equation (double-entry accounting). Think of a
transaction as any economic exchange that causes a change in assets, liabilities, or owners equity.
3. Revenues and owner investments increase owners equity. Expenses and owner withdrawals decrease owners equity.
Therefore, revenues, expenses, investments, and withdrawals directly affect owner's equity.
4. Not all activities result in an economic exchange, in which case the accounting equation would be
unaffected. For example, see Activity 7 on page 36.
Understanding more about financial statements

In this section, you will see how the financial statements relate to each other. Each statement provides users such as owners
and managers with relevant financial information. Review Exhibit 2.11 on page 42. The income statement and statement of
changes in owners equity (shown as statement of owners equity) are for a period of time, but the balance sheet is for a
point in time. Notice from Exhibit 2.11 that the net income of $2,400 is added to the beginning balance of owners capital.
Also, the owners equity of $11,800 on January 31 in the statement of changes in owners equity is the same figure that is
reported on the balance sheet as Carol Finlay, capital. In practice, the financial statements of a business are accompanied by
explanatory notes and supporting schedules. (Refer to Appendix I at the back of the text, pages I-23 to I-39, to view an
example of explanatory notes for WestJet.) These are considered to be an integral part of the financial statements.
Textbook activities
Mid-Chapter Demonstration
Problem on pages 40-41
(Note: Be sure to always
the Analysis component when one is included in a question to help develop your analytical skills.)
Judgement Call on page 43
do
Checkpoint Questions 8 to 15 on
page 39 and Checkpoint
Questions 16 and 17 on page 43
Quick Study 2-5 to 2-14 on pages 51-54

(Solutions)
Demonstration Problem on pages 4648 (Note: The income statement and statement of changes in owners equity in Exhibit 2.11 on page 42 reflect a
net income, while the income statement and statement of changes in owners equity in the demonstration problem
show the effects of a net loss.)
1.8 The conceptual framework of accounting

Learning objective
Describe the major areas of the conceptual framework of accounting. (Level 2)
Required reading
Reading 1-1: CICA Handbook

1.13.)
, Part II section 1000. (This reading is for Topics 1.8 to
LEVEL 2
In this introductory course to financial accounting, you will obtain an overview of the principles and concepts that comprise
the conceptual framework. In this topic, you review the essential characteristics of accounting information and look at section
1000 of the CICA Handbook
on financial statement concepts (Reading 1-1).
Note: Although a Level 2 understanding has been assigned to topics 1.8 to 1.13, that is not the learning expectation at this
why financial accounting is applied in certain
point in the course. Topics 1.8 to 1.13 provide the reasons
ways in different situations. It is suggested that students should read through the material in topics 1.8 to 1.13 briefly now,
and then continue to refer back to these topics in each module. The goal will be to go beyond mere number crunching and
understand the whys of the financial accounting specifics that are introduced in each module. The expectation is that by
the conclusion of module 10, students will have acquired a Level 2 understanding of topics 1.8 to 1.13.
In the preceding sections of Module 1 you learned that accounting is a service activity whose function is to provide
quantitative information, primarily financial in nature, about economic entities. Accounting involves identifying economic
events and then measuring, recording, summarizing, and reporting information to users. The aim of accounting is to provide
useful information for making economic decisions.
The conceptual framework of accounting includes two major areas:
Defining the essential characteristics of accounting information

Identifying the fundamental concepts of accounting used in preparing external financial reports
1.9 Essential characteristics of accounting information

Learning objective
Describe the essential characteristics of accounting information. (Level 2)
LEVEL 2
Accountants must determine the purpose and ultimate use for the financial reports they prepare. The reports assist users in
making financial decisions by disclosing information. Financial reports should be presented in a manner that will be
understood by users who have a reasonable level of knowledge of business and economics. In other words, financial
statements are not designed for the nave investor. Read paragraphs .01 to .14 of Reading 1-1, which expand on the
characteristics that make accounting information useful.
Paragraph .15 of Reading 1-1 identifies four qualitative characteristics or qualities that make accounting information useful:
Understandability
Relevance
Reliability
Comparability
Of these, relevance and reliability are considered the primary

information to be useful.
qualities that must be present for accounting
Each of these four qualitative characteristics is connected to the ethical foundations of accounting, and they make it possible
to provide useful information to financial users by setting ethical parameters on acceptable accounting information. All of
them require good judgement and expertise.
Understandability (paragraph .16 of Reading 1-1)
The primary criterion for selecting accounting reporting methods is decision usefulness. That is, the information should be
helpful to users in making investment, financing, and operating decisions. For the information to be useful, it must be
understandable by users. Information is understandable if a user can perceive the significance of the information. In some
cases, however, when a user doesnt understand the information, it does not mean that the information is not relevant. It
may mean that the particular user does not have sufficient accounting knowledge to be able to interpret the information.
Remember that accounting reports are prepared for informed users who have a reasonable understanding of business and
are willing to study the information.
Relevance (paragraph .17 of Reading 1-1)
Accounting information must be relevant to, or useful for, the decision-making needs of users. Information is relevant if it
has the capacity to make a difference in the decision-making process. Relevance is enhanced by the following:
Predictive value: the quality of financial information that enhances the users ability to forecast an entitys future
income and cash flows.
Feedback value: the quality of financial information that confirms or corrects prior expectations relating to past
decisions and events.
Timeliness: the availability of information in time to influence users decisions. Financial statements issued late lose
the quality of timeliness.
Reliability (Paragraph .18 of Reading 1-1)
Accounting information must be reliable (free from error and bias) in order to reduce the level of risk to those who base
decisions on it. Reliability is improved if information possesses the following qualities:
Faithful representation (or representational faithfulness): the degree to which the information accurately
measures or describes the real-world situation it represents. In other words, the information says what it appears to
say. This quality of faithful representation is sometimes referred to as validity. Amounts reported on financial
statements should be a faithful representation of the economic resources of an organization, the claims to these
resources, and the residual equity of the enterprise.
Verifiability: the measurement methods allow others to arrive at the same quantitative result without error or bias.
Information is considered verifiable if there is a high degree of consensus on the measurement of financial statement
items when the same measurement methods are being used.
Neutrality: freedom from bias and attempts to influence decisions on the part of preparers of financial reports.
Prudence: when there are uncertainties, a degree of caution is included such that assets or income are not
overstated and liabilities or expenses are not understated. It simply means that when there is risk or uncertainty, the
preference for possible accounting measurement errors should be in the direction of neutrality and reliability, rather
than in the direction of overstatement or understatement of financial statement elements.
Comparability (paragraphs .19 and .20 of Reading 1-1)
There are two dimensions of comparability. One dimension is the users ability to make comparisons between different
entities, such as between different companies in the same industry. For example, investors frequently evaluate and compare
the performance of competitors by analyzing the results found in their financial reports. Accounting standards facilitate
comparability by requiring specific treatments of certain transactions. For example, all companies must record accrued
revenues, that is, revenues that have been earned but not yet received (Note: Accrued revenues are discussed in detail in
Module 3).
The second dimension of comparability is the users ability to compare the results of one specific entity from year to year.
Consistent use of the same accounting procedures and policies over time allows users to identify significant trends. Without
consistency, there is a chance that changes in reported results of operations are simply due to changes in accounting
procedures, rather than actual changes in performance. Consistency within a specific entity is generally achieved. However,
to date accountants have had only limited success in achieving comparability between firms. This is partly because the
conceptual framework does not give clear guidance for situation where alternative methods to account for various events
exist. As you will learn in subsequent modules, there are alternative acceptable methods of inventory valuation FIFO,
weighted-average (discussed in detail in Module 5); alternative methods of depreciation straight-line, declining-balance
(discussed in detail in Module 7); and considerable discretion in the recording of various expenses bad debt expense
(discussed in detail in Module 6) and warranty expense (discussed in detail in Module 8).
1.10 Trade-off of qualitative characteristics

Learning objective
Describe the trade-off of qualitative characteristics. (Level 2)
LEVEL 2
The essential characteristics of accounting information understandability, relevance, reliability, and comparability do not
always support each other; nor are all four always present. For example, relevant information may not always be reliable.
What users especially want are data about the future, but such data generally cannot be considered reliable (because data
cannot be verified until the future event has occurred). Accountants must therefore make trade-offs or compromises between
these essential characteristics; compromises are a natural factor in the accounting process.
That compromises have to be made may give rise to a disquieting question: Is there any principled way of making such
compromises, or is this simply a free-for-all where anything goes? There is a good answer to this question that brings out
some of the basic principles of ethics in accounting.
First, the overall objective in accounting is to provide useful financial information for stakeholders (users of the financial
information). Therefore, if a particular compromise cant be justified in terms of its usefulness, then it is highly suspect.
Second, it is important to make compromises between one objective (such as relevance) and another (such as reliability) as
transparent to all stakeholders as possible. Such transparency treats users of financial information fairly by disclosing
important limitations on the accounting information provided to them. Third, accounting has developed conventional modes
of providing financial information, as reflected in generally accepted accounting principles and standards. These principles
and standards provide guidance as to acceptable compromises.
These compromises often require accountants to generally consider two constraints when implementing accounting
procedures and reporting information. These constraints are practical application guidelines related to the usefulness of
accounting information and should be assessed on an individual basis:
Benefit versus cost constraint

Materiality
1.11 Fundamental concepts of accounting Assumptions

Learning objective
Describe the assumptions of accounting. (Level 2)
LEVEL 2
The fundamental concepts of accounting promote and guide the objective of providing users with information that is relevant
and reliable while recognizing the fact that accounting must operate in a risky, real-world environment. The conceptual
framework distinguishes between assumptions, principles, and detailed practices and procedures.
Assumptions of accounting
The four assumptions of accounting described below require knowledge about the nature and complexities of the
environment in which accounting operates. These assumptions provide a fundamental basis for the principles and procedures
of accounting. Since accounting is an attempt to tell the story of an entity using primarily quantitative data, it is necessary to
presume certain conditions about the business. Assumptions define the playing field of accounting, establishing the
limitations and orientations of the financial accounting process. Some of these assumptions have been introduced as
generally accepted accounting principles in Section 1.6 of this module.
The four assumptions of accounting are:
Separate-entity assumption (or business entity principle as discussed in section 1.6 of this Module)
Going-concern assumption (or going-concern principle)
Unit-of-measure assumption (or monetary unit principle as discussed in section 1.6 of this Module)
Time period assumption (or time period principle, also known as timeliness or periodicity)
The Four Assumptions of Accounting

Assumption
Equivalent Principle
separate-entity assumption
business entity principle
going-concern assumption
going-concern principle
unit-of-measure assumption
monetary unit principle
time period assumption
time period principle, also known as timeliness or

periodicity
1.12 Fundamental concepts of accounting Basic principles

Learning objective
Describe the basic principles of accounting. (Level 2)
LEVEL 2
The conceptual framework provides four basic principles of accounting to guide the implementation of accounting
procedures. These principles are based on the assumptions described above. The principles of accounting establish
The basis for valuing items on the financial statements (cost principle);
When to deem an event to have occurred for accounting purposes (revenue recognition principle);
What cause and effect relationships exist between revenues and expenses in the financial statements (matching
principle); and
What additional information should be reported in the annual financial reports to make them useful to external
users (full-disclosure principle).
In short, these four principles are:
Cost principle
Matching principle
Accounting principles have a strong ethical element in that they are directed to providing useful and true information to users
of financial information. This requires accountants to exercise their expertise with integrity in the interests of clients and
other stakeholders.
1.13 Fundamental concepts of accounting Elements of financial

statements
Learning objective
Describe the elements of financial statements. (Level 2)
LEVEL 2
Read paragraphs .22 to .35 of Reading 1-1. The elements of financial statements are the broad account classifications. These
are the building blocks used in accounting. Whenever a transaction is processed through the accounting system, specific
ledger accounts are affected. A conceptual understanding of the various classifications of accounts (assets, liabilities, owners
equity, revenues and expenses, gains and losses) is essential in order to understand the merit of proposed treatments.
For example, consider the following definition: assets are probable future economic benefits owned by the entity as a result
of past transactions. This definition may be clear, but when you consider the issue of which costs to include in the valuation
of inventory or property, plant, and equipment, the reasoning behind the required treatment hinges on the implementation
and interpretation of the definition.
Reminders:
The conceptual framework of accounting covered in sections 1.8 to 1.13 inclusive pervades all material covered in
subsequent modules. In order to understand and apply accounting in practice it is critical to continually refer back to
these sections. For example, as you read through Module 2, ask yourself what assumptions and principles are
involved and why. A common error students make when learning accounting is that they do accounting but dont
understand why they are doing it. By continually asking yourself why as you do accounting, you will learn to
understand accounting and how to apply it in decision-making situations.
Remember to use the various self-study tools in the online Student Success Centre to review the chapter material in
different ways. You are encouraged to use these tools to the greatest extent possible to help you solidify your
understanding of the material. You may wish to bookmark the URL to this valuable resource: http://highered.mcgrawhill.com/sites/9970951713/student_view0/index.html.
Using your access password, you can access the iStudy content of the online Student Success Centre such as
TetrAccounting (the accounting videogame), Interactive Exercises, and Conceptual Objects at http://highered.
mcgraw-hill.com/classware/infoCenter.do?isbn=0070951713. (Click on Self Study near the top on the left-hand side
of the screen under Course-wide Content.) Put this URL into your favourites for ease of access in the future.
Please refer to page xxvi of the Preface in Volume 1 of the text for more details. You are encouraged to practise with
these interactive tools to deepen your understanding of the course material.
The text readings and the module notes are what you will be tested on. CGA-Canada is not responsible for any errors
that may occur in the online Student Success Centre. For technical support issues related to the online Student
Success Centre, please contact the publisher at olcsupport@mcgrawhill.ca.
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Module 1 summary
Introduction to accounting concepts
Describe the function of accounting and the nature and purpose of the information it
provides, and identify users of accounting information.
Accounting is a service activity that includes the measurement, recording, summarization, and reporting of economic
information to external financial statement users to assist in rational investment, credit, and other business decisions.
Accounting is also essential for the internal functions of a business.
Users of accounting information include
External users
Users outside of the entity
Examples: banks, government, creditors, unions, investors

Internal users
Users within the entity
Examples: Marketing Manager, Accounts Receivable Manager, Accounts Payable Manager, Operations Manager,
company executives
Distinguish between sole proprietorships, partnerships, and corporations.
Single or sole proprietorship
Owner is personally responsible for business debts.

Partnership
Partners are personally responsible for all partnership debts.

Corporation
A corporation is a separate legal entity.
It is responsible for its own debts.
Explain the importance of ethics in accounting and the key ethical standards expected of
professional accountants.
Accountants must perform their responsibilities according to the highest ethical standards because many users rely on
financial reports.
Some of the basic ethical standards expected of professional accountants include
confidentiality
competence
objectivity
integrity
Compare the fields of accounting and the kinds of work performed in each field.
There are three basic types of accountants:
Private accountants work for a single employer.
Public accountants are available to the public.
Government accountants work for local, provincial, and federal government agencies.
Accountants can be classified according to the services they provide.
Fields of accounting include
financial accounting
managerial accounting
tax accounting
Both financial and managerial accountants can work in for-profit enterprises and not-for-profit organizations.
Differentiate among the different kinds of financial statements.

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The income statement summarizes net income (or net loss) resulting from revenues less
expenses.
The statement of changes in owner's equity reconciles changes in owners equity (increases are caused by owner
investments and net income, while decreases result from owner withdrawals and net losses).
The balance sheet details assets, liabilities, and owners equity.
The cash flow statement shows the cash inflows and outflows from operating activities, investing activities, and
financing activities.
Explain each of the GAAP introduced.
International Financial Reporting Standards (IFRS) are the accounting standards to be used by publically accountable
enterprises (PAEs) in Canada effective January 1, 2011. Privately held enterprises (PEs) will use PE GAAP established
by the Accounting Standards Board (AcSB) after consultation with various interest groups.
GAAP include
Cost principle
Revenue recognition or realization principle
Matching principle
Prudence principle
Analyze business transactions to determine their effects on the accounting equation.
Business transactions always affect at least two elements in the accounting equation.
The accounting equation is
Assets = Liabilities + Owners equity
After a transaction is recorded, the accounting equation must be in balance.
The conceptual framework of accounting

Describe the major areas of the conceptual framework of accounting.
The conceptual framework of accounting includes two major areas:
Defining the essential characteristics of accounting information
Identifying the fundamental concepts of accounting used in preparing external financial reports
Describe the essential characteristics of accounting information.

The primary qualitative characteristics that make accounting information useful are relevance, reliability, understandability, and
comparability.
To meet the relevance test, information should have predictive value, feedback value, and be timely.
The components of reliability are faithful representation, verifiability, neutrality, and prudence.
Describe the trade-off of qualitative characteristics.
The overall objective in accounting is to provide useful financial information for stakeholders (users of the financial
information). To achieve this objective, it is sometimes necessary to compromise between some of the competing
objectives. In doing so, use the principles of usefulness and transparency, and be guided by the conventional principles
and standards reflected in GAAP.
Accountants generally consider two constraints when implementing accounting procedures and reporting information:
benefit versus cost constraint and materiality.
Describe the assumptions of accounting.

The fundamental concepts of accounting include assumptions that establish the limitations and orientations of the financial
accounting process.
The separate-entity assumption assumes that the owner and the business are viewed for accounting purposes as being
separate and distinct.
The going-concern assumption assumes that a business has an indefinite life.
The unit-of-measure assumption assumes that transactions are expressed in common units of money, and that these
are stable.
The time period assumption assumes that periodic reports are required so that the firms results may be evaluated on a
regular basis.
The Four Assumptions of Accounting
Assumption
Equivalent Principle
separate-entity assumption
business entity principle
going-concern assumption
unit-of-measure assumption
monetary unit principle
time period assumption
time period principle, also known as timeliness or

periodicity
Describe the basic principles of accounting.

The principles of accounting establish
The basis for valuing items on the financial statements (cost principle)
When revenues are deemed to have been earned (revenue recognition principle)
When costs should be expensed (matching principle)
What additional information should be reported in the annual financial reports to make them useful to external
users (full-disclosure principle)
Describe the elements of financial statements.

The basic elements of financial statements are
Assets
Liabilities
Equity
Revenues
Expenses
Gains
Losses
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Exemplar of Assignment Question and Answer

An exemplar is a model. The following exemplar provides a sample question along with two sample answers: one answer
demonstrates a poor response and the second answer represents a good answer. For each of the sample answers,
explanations of key footnoted answer points are detailed as to what made one poor versus the other being good. To
maximize your learning as well as your grade on each of the three assignments in this course, it is highly
recommended
that you take the time to understand the differences between the two sample
answers provided as part of this exemplar.
Sample Question Level of Difficulty: Challenging (50 marks):

Jason Budd owns and operates JB Sales, which has just finished its first year of business. Jason is hoping to hire you, a
recent CGA graduate, to help him manage the business as well as keep the accounting in order. During your interview, the
owner explains that sales and net income have been exceptionally good and, as a result, he will be making a personal
withdrawal of $100,000: not bad after only one year! He offers to pay you an annual salary of $150,000 plus bonuses. You
ask to see the financial statements, which follow:
JB Sales
Income Statement
Year Ended December 31, 2008
Sales
Cost of goods sold
Operating & other expenses
Net income
$1,800,000
1,100,000
500,000
$ 200,000
JB Sales
Balance Sheet
December 31, 2008
Cash
Accounts receivable
Merchandise inventory
Property, plant, and equipment
Accumulated depreciation
Total assets
14,000
1,325,000
350,000
775,000
(50,000)
$2,414,000
Accounts & accrued payables

Notes payable, due 2009
Jason Budd, capital
Total liabilities and owners equity
$1,350,000
400,000
664,000
$2,414,000
Other information:
Cash sales for the year totalled $50,000 with the balance on account; sales occurred evenly throughout the year.
$1,450,000 of inventory was purchased during the year; all on account.
Property, plant, and equipment were acquired by issuing a note payable.
Operating expenses were paid throughout the year.
You thank Jason for the interview, and indicate that you will give him a response within the next 24 hours.
Required:
1. In order to respond to Jason Budd, you perform some calculations using the financial information received. Show
these calculations and provide explanations as to why they might be valid in helping you make a decision regarding
the employment offer made to you by JB Sales. [25 marks]
2. Prepare your response to Jason Budd, explaining why you will or will not be accepting the position with JB Sales. Use
the industry benchmark ratios on textbook (page 1017) to assess and compare the financial condition of JB Sales
(assuming the industry benchmark ratios are for the same industry and time period). [25 marks]
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Sample of a Poor Answer

1. Four ratios have been covered by the end of Module 5: current ratio, merchandise turnover, days sales in inventory,
and gross profit ratio. Each of these ratios is calculated below.
Current ratio:
14,000 + 1,325,000 + 350,000

1,350,000 + 400,000
= 0.97 (rounded to 2 decimal places)
Merchandise turnover:
1,100,000
(350,000 + 0)/2
= 6.29 times per year or 58 days (365/6.29 = 58 days)
Days' sales in inventory:
350,000
365
1,100,000
= 116 days
Gross profit ratio:
1,800,000 1,100,000
100
1,800,000
=38.89% (rounded to 2 decimal places)
Explanation of why this is a poor response:

The calculations are correct but have no value without an explanation as to why they might be valid in helping make
a decision regarding the employment offer. Therefore, no points are awarded for part (a) of this answer. The critical
aspect of FA1 is to be able to demonstrate an understanding of how accounting information can be used and applied
in decision-making. Calculations by themselves do not demonstrate such an understanding, especially given that the
question specifically asked for explanations. Be sure to always read the question carefully, and in your answer
address all of the requirements completely.
2. Given that the market rate for this kind of position is $200,000,1 I am not accepting this position. Besides, the
company doesnt have any cash, so how are they going to pay me? This is true because the current ratio shows that
they arent even able to pay the current liabilities.2 The owner is right that there was lots of net income in 2008, but
after he makes his $100,000 of withdrawals there wont be enough left to pay me, let alone the current liabilities!3
Explanation of why this is a poor answer:
1
This may be valid information but it is impossible to tell because the source has not been included. Did this come
from an article in a credible magazine/newspaper? Any statements made as part of the answer that do not come
from the information provided in the question must be referenced. If this had been referenced, it would be a valid
comment.
2 This is a correct interpretation of the current ratio calculated in part (a) of the question. However, it needs to be
stated in a more explicit manner. For example, it would be better to say that the current ratio for the year ended
December 31, 2008, indicates that there is $0.97 to cover each $1.00 of current liability as it comes due. This means
that JB Sales has liquidity issues. If the company is having difficulty paying existing obligations, there are concerns as
to whether JB Sales will be able to pay my salary.
3
This statement reflects a misunderstanding. Net income as reported on the income statement is based on accrual
accounting and therefore, when converted to a cash basis could show higher or lower cash income than the accrual
income.
Sample of a Good Answer

1. Four ratios have been covered by the end of Module 5: current ratio, merchandise turnover, days sales in inventory,
and gross profit ratio. Each of these ratios is calculated below for JB Sales year ended December 31, 2008. An
explanation as to how each ratio might be valid in helping making an employment decision is also included.
Current ratio:
14,000 + 1,325,000 + 350,000
1,350,000 + 400,000
= 0.97 (rounded to 2 decimal places)
The current ratio is a measure of liquidity indicating whether a business has the current assets
available such as cash, accounts receivable, prepaids, and inventory, to cover current obligations,
such as accounts payable, current notes payable, interest payable, and other short-term
liabilities.4 A current ratio of greater than "1" means that there is more than $1 of current assets
available to cover each $1 of current liabilities as they come due. This ratio is valid in this decisionmaking because it will tell me whether JB Sales has sufficient resources to pay the salary and
bonuses promised.5 A ratio related to the current ratio but which has not been covered in the
course yet is the quick ratio, also known as the acid-test. The acid-test is a more strict measure of
liquidity than the current ratio because it excludes less liquid current assets such as inventory and
prepaids. The quick ratio would be (14,000 + 1,325,000)/(1,350,000 + 400,000) = $0.77.6 In
other words, for every $1 in current debt there should be $0.77 in quick assets (the most liquid
current assets).
Merchandise turnover:
1,100,000
(350,000 + 0)/2
= 6.29 times per year or 58 days (365/6.29 = 58 days)
The merchandise turnover measures how quickly inventory is sold. A high turnover means the
business is selling inventory quickly, which is generally considered to be good. It is good because
inventory uses cash (it has to be paid for); excessive levels of inventory mean cash is not being
used effectively. However, levels of inventory that are too low could mean that customer demands
are not being met resulting in lost sales. This ratio is valid in the decision-making process because
it will tell me whether JB Sales uses inventory, a current asset that is part of the current ratio,
well.
Days' sales in inventory:
350,000
365
1,100,000
= 116 days
This ratio measures how many days worth of sales are sitting in inventory. As with the
merchandise turnover, if days sales in inventory is too high, it may be an indicator that excessive
levels of inventory are being held. However, sufficient inventory needs to be on hand to meet
customer demands. This ratio is valid in this decision-making because, as already noted for the
merchandise turnover, it will tell me whether JB Sales uses inventory efficiently.
Gross profit ratio:
1,800,000
1,100,000
100
1,800,000
=38.89% (rounded to 2 decimal places)
The gross profit ratio measures how much profit is generated from the sale of inventory before
considering operating and other expenses. This ratio may be valid in this decision-making process
because it is an indicator of whether there is sufficient profit available to cover operating
expenses. The promise to pay $150,000 plus bonuses will cause operating expenses to increase so
it is important to see if gross profit is sufficient to cover this increase.
Explanation of why this is a good answer:
4 An explanation of what the current ratio is has been provided, along with examples to demonstrate the students
understanding. A common error students make is to copy definitions into an answer without expanding on the
definition to show their understanding.
5
Notice that this answer specifically addresses the question being asked. Another common error that students make
is they memory dump lots of information but never answer the question quantity is not necessarily quality! Be
concise and to the point when preparing answers.
6 This answer demonstrates that the student is exercising critical thinking by appropriately using resources beyond
what has been covered in the course modules up to this point in time. This type of effort above and beyond would
earn a student extra marks.
2. I will not accept7 the position being offered to me by JB Sales for the following reasons:
The current ratio is 0.97 which means that JB Sales may have difficulty meeting its current obligations so
there is a question as to whether it will be able to pay an additional $150,000 salary plus bonuses. Assuming
that the industry average ratios shown on page 1017 of the textbook are for the same industry as that of JB
Sales, JB Sales current ratio of 0.97 is significantly less than the industry average of 1.6.8 The information
provided also indicates that the owner wants to make a $100,000 withdrawal which would reduce the current
ratio further.9
If sales occurred evenly throughout the year then why is the accounts receivable balance 74% of total sales
(1,325,000/1,800,000)? Is there an issue with collections and/or is there a credit issue with one or more
customers?10 If receivables are not collected because of credit issues with customers then the liquidity
position will become even worse.
The merchandise inventory turnover is higher than the industry average shown on page 1017 of the textbook
which is generally considered to be a favourable position (although the industry averages on page 1017 are
for 2011, my assumption, is that the years can be compared for the purpose of demonstration; I recognize
that in the real world, industry averages for the same year should be used).11 However, the days sales in
inventory for JB Sales of 116 days is significantly higher than the industry average of 70 days shown on page
1017. This indicates that excessive inventory levels are on hand reflecting an inefficient use of resources.
The gross profit ratio of 38.89% is very favourable relative to the industry average of 18% indicating that JB
Sales has sufficient profit from sales to cover operating expenses. However, given that there is a question
about the collectability of sales (as pointed out earlier), this may be misleading.12
Accounts payable are 93% of what total merchandise purchases were ($1,350,000/$1,450,000) indicating
poor accounts payable management and/or the inability to pay suppliers (which might be the case given the
current ratio).13
The owner is under the impression that the $200,000 income represents cash which it does not; it is based on
accrual accounting.14 When the $200,000 is converted to cash income, it shows that $75,000 was used by
operations (Cash sales of $50,000 + $425,000 collection of accounts receivable $100,000 paid regarding
accounts payable $450,000 paid for operating expenses the $50,000 depreciation is a non-cash expense
so not part of the paid operating expenses). Therefore, the wisdom of making a $100,000 withdrawal is in
question.
Explanation of why this is a good answer:

7 The student could accept or not accept the position; either is correct provided the student can justify their
position. What one student might see as an insurmountable challenge, another might see as an opportunity to
explore an interesting challenge.
8 This is going beyond what is expected, since this comes from a chapter in the textbook covered subsequent
to Module 5. However, students are encouraged to look beyond the lesson notes and textbook for information
to supplement and support their position. Therefore, this type of answer would earn a student points, since it
clearly demonstrates the efforts associated with critical thinking.
9
This is an excellent point showing that a student understands the impact of transactions on ratios.
10 Instead of making assumptions and/or jumping to conclusions, the student has asked very good questions
that reflect a deep understanding of accounting concepts.
11 This answer demonstrates that the student is exercising critical thinking by appropriately using resources
beyond what has been covered in the course modules up to this point in time. This type of effort above and
beyond would earn a student extra marks.
12
This shows excellent insight through the application of concepts.
13 The student has carefully analyzed the numbers on the balance sheet in relation to the income statement,
and as a result gained important insights for decision-making.
14 Although this analysis is beyond the scope of Module 5 (not covered until Module 10), this student has
taken the time to seek alternate sources of information which will earn points.
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Module 1 Test your knowledge solutions

1. Incorrect. The balance sheet details the financial position of the business at a given point in time.
2. Incorrect. The statement of changes in owners equity shows how equity changed during the accounting
period.
3. Incorrect. The statement of cash flows details how cash changed during the accounting period; namely, the
sources and uses of cash.
4. Correct. The income statement shows the profit earned by a business during the accounting period by
subtracting expenses from revenues.
1. Incorrect. Net income causes equity to change but it is not another term for equity (net income and owner
investment cause equity to increase while net loss and owner withdrawals cause equity to decrease).
2. Incorrect. An expense is not another term for equity. However, because expenses are included in the
calculation of net income, they do cause equity to change (decrease).
3. Correct. Net assets, or assets less liabilities, is another term for equity.
4. Incorrect. Revenue is not another term for equity. However, because revenues are included in the calculation
of net income, they do cause equity to change (increase).
1. Incorrect. The business entity principle is a GAAP that requires each entity to keep separate records.
2. Correct. The monetary unit principle is a GAAP stating that all values on a set of financial statements are
assumed to be constant and of the same currency (for example, Canadian dollars).
3. Incorrect. The going-concern principle is a GAAP that assumes a business entity is operational unless
information is provided to the contrary.
4. Incorrect. The revenue recognition principle is a GAAP that requires revenue to be recorded at the time that it
is earned regardless of whether cash or another asset has been exchanged.
1. Incorrect. If the net result is an increase on the liability and equity side of the accounting equation, then it is
logical that assets must increase (not decrease) by that net change.
2. Incorrect. Because equity decreased by $2,000 and liabilities increased by $12,000, the net change is
determined by taking the difference and not by adding these two values.
3. Correct. A = L + E, therefore, if L increases $12,000 and E decreases $2,000, the net change on the righthand side of the equation is an increase of $10,000. If the right-hand side of the equation increased by a total
of $10,000, then the left-hand side of the equation, assets, must have also increased by $10,000.
4. Incorrect. It is correct that assets increased but not by $14,000. Because equity decreased by $2,000 and
liabilities increased by $12,000, the net change is determined by taking the difference and not by adding
these two values.
1. Incorrect. Liabilities are overstated by $130 but assets are overstated by $130, not understated, because cash
should have been reduced by $130.
2. Incorrect. Liabilities are overstated by $130 but Office equipment is neither overstated nor understated.
3. Incorrect. Liabilities are overstated by $130 but Office equipment is neither overstated nor understated.
4. Correct. The addition of $130 to Office equipment is correct. However, the addition to Liabilities is incorrect,
causing a $130 overstatement of liabilities. Cash should have been reduced by $130, which means assets are
overstated by $130.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01tyksol.htm [12/07/2010 3:57:23 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t01activity1.1sol.htm
Activity 1.1 solution
a. The December 31, 2009, year-end information is more reliable: it has been reviewed by an external accountant who
would have taken steps to ensure that the financial information presents fairly the underlying economic activity of the
firm.
b. The financial information for the 10 months ending October 31, 2010, is more relevant, albeit less reliable.
The October 31, 2010, statements present the most recent economic activity of the firm. Timeliness is an important
component of relevancy. To put things in perspective, if you were considering investing in a bank such as CIBC,
would you be more interested in its 2009 year-end statement or its 1981 year-end statement? The answer is 2009
because it more accurately reflects what has recently happened, and is thus more relevant
to
the decision.
c. The December 31, 2009, year-end information is likely more comparable to industry information: It has been
reviewed by an external accountant, who is almost always more knowledgeable about accounting policies and
procedures than an internal employee.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t01activity1.1sol.htm [12/07/2010 3:57:23 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t05example1-1.htm
Example 1-1
Imagine that you are the owner of two companies, A & B. Your accountant gives you a piece of paper with some numbers on
it, simply headed income statement. Will it make a difference to you that you do not know whether you are reviewing A or
Bs performance? Will it matter if the recorded information represents one month or one years results? Do you care if the
period of time represented ended this month or 25 years ago? Of course you do. Thus, insufficiently identified information is
of little use.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t05example1-1.htm [12/07/2010 3:57:24 PM]
Example 1-2
If you own a car, the car is your asset because 1) you own it, 2) your ownership occurred as a result of a past transaction,
and 3) future economic benefits may be obtained.
Dealing with each of these criteria individually:
1. Your neighbours car is also an asset, but it is not your
asset because your neighbour owns it, not you.
2. You own the car as a result of a past transaction. You bought it, won it in a lottery, or someone gave it to you some
time in the past. If you had not acquired the car in the past, you would not own it today.
3. Future economic benefits may be obtained from the car. You can sell it tomorrow for cash; you can use it to drive to
work, or to drive to California on vacation (known as value in use); or you can use it for a period of time and then sell
it. In all three cases, the car will be providing a future economic benefit.
Example 1-3
If you have a car loan, the loan is your liability because

a. You have a duty today (a present obligation) to transfer assets (outflow of resources) in the future you will pay
cash to the bank on the payment dates; and
b. You borrowed the money previously (past event). If you intend to borrow it next week, you do not owe the bank the
money today, and it is therefore not a liability (yet).
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06businessentity.htm
The business entity principle requires that every business is perceived to be, and is treated as, an entity, separate and
distinct from its owner(s) and from every other business. An entity could be all of the TELUS Communications, Inc. stores in
Canada, or one particular TELUS store in an Edmonton shopping mall. The basic idea is that economic events must be
identified with a particular unit of accountability. The records of one entity should not be mingled with the records of other
entities for the purpose of determining its performance.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06businessentity.htm [12/07/2010 3:57:27 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06cost.htm
Cost principle
The cost principle holds that assets and services must be recorded in a companys books on the basis of cash (or cash
equivalent) paid for them, on the date they are acquired. This amount is referred to as the book value of the asset. With
the passage of time, the value of an asset often changes. Uninformed users often mistakenly assume that the values of
assets shown in published reports are market values
when in fact they reflect
historical costs
. In reality, the fair value of assets may differ significantly from
their book value. Market values are considered to be more relevant than book values. The cost principle thus sacrifices
relevance
in favour of reliability
. Later in this course, you will see that
not all assets remain on the books at historical cost. For example, the book value of some assets is reduced in a rational and
systematic way by a process known as depreciation (to be explained in detail in Module 3).
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06cost.htm [12/07/2010 3:57:27 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06going-concern.htm
A business is a going concern if it will continue to operate for an indefinite period. It will use its assets to carry on its
operations and, with the exception of merchandise, not offer the assets for sale. Current market values of individual assets
such as equipment and buildings do not need to be measured because there is no intention of selling them. It is assumed
that such assets will be used in the business and the resulting goods or services provided will be sold. If an entity is not a
going concern and thus will not continue into the future (for example, due to bankruptcy), then historical cost figures will be
irrelevant and liquidation values will be reported.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06going-concern.htm [12/07/2010 3:57:28 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06revenuerecognition.htm
The revenue recognition principle requires that revenue be recognized at the time it is earned. The following three points
are essential to understanding the revenue recognition principle:
1. The inflow of assets associated with revenue does not have to be in the form of cash.
2. Revenue is earned at the time services are rendered or at the time title to goods sold is transferred.
3. The amount of revenue equals
assets received.
cash received plus
It is important that you understand that revenue is recognized when earned

when consumed
, not when cash is exchanged.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06revenuerecognition.htm [12/07/2010 3:57:29 PM]
the cash equivalent (fair value) of other

and expenses are recognized
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06timeperiod.htm
The time period principle, also known as periodicity or timeliness, identifies a business activities during a specific time
period. The time periods covered by financial reports are called accounting periods. An organization usually uses one year
as its primary accounting period. However, an organization can also prepare interim financial reports that cover one month or
a three-month period (a quarter). Periodic reports at regular intervals ensure that decision-makers obtain timely information.
In Module 3 you will apply the time period principle.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06timeperiod.htm [12/07/2010 3:57:30 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06materiality.htm
The materiality principle indicates that the requirements of accounting principles may be ignored if their effects on the
financial statements are unimportant to users. An accountant makes a judgement that considers whether an amount is large
enough to influence or change the decisions of people who rely on certain information. If the amount does not affect the
decision, a more expedient accounting method may be used for that item (for example, ignore the item). The materiality
principle will be applied in Module 5.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06materiality.htm [12/07/2010 3:57:31 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06matching.htm
Matching principle
The matching principle requires that expenses be reported in the same accounting period as revenues that were earned as
a result of expenses. The matching of expenses with revenues will sometimes require a company to predict future events. It
is important to realize that financial statements are based on predictions which include measurements that are not precise
(because it is impossible to precisely predict the future). In Module 5, the matching principle will be applied in deciding how
much of cost of goods should be applied to a periods revenue.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06matching.htm [12/07/2010 3:57:31 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06consistency.htm
The consistency principle states that a company should use the same accounting methods period after period, so that the
financial statements of prior periods are comparable. The implication of this principle is that users of financial statements can
assume that the same procedures have been used in keeping records and preparing financial statements in previous years,
so as to ensure comparability. However, this does not mean that a company can never change from one accounting method
to another. Switching to a new method or procedure must be justified as an improvement in financial reporting. In Module 5
you will see how the consistency principle is applied to the pricing of inventory.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06consistency.htm [12/07/2010 3:57:32 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06conservatism.htm
Prudence principle
The prudence principle implies that when there are uncertainties, an accountant should include a degree of caution in the
exercise of the judgements needed.1 When risk or uncertainty exists, the preference for possible accounting measurement
errors should try to ensure that assets or income are not overstated and liabilities or expenses are not understated while
maintaining neutrality and reliability of the financial statements. In Module 5, you will see how prudence is used when
reporting inventory on the balance sheet.
IFRS 2009, Framework, par. 37.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06conservatism.htm [12/07/2010 3:57:33 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06full-disclosure.htm
The full-disclosure principle requires that financial statements and their accompanying financial notes include all relevant
information about the operations, financial position, and cash flows of the entity. In other words, significant information
should not be withheld and sufficient information should be included to make the financial report understandable. In Module
8, you will see how the full-disclosure principle is used to report liabilities on the financial statements and their accompanying
financial notes. WestJet Airlines Ltd.'s fiscal 2005 audited financial statements have been reproduced on pages I-17 to I-39 in
Appendix I at the back of the textbook. Read them now and see how thorough these statements are. Pay particular attention
to the notes to the financial statements (beginning on page I-23) and observe how much information they provide to the
reader.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06full-disclosure.htm [12/07/2010 3:57:34 PM]
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06monetary.htm
The monetary unit principle (also called stable-dollar principle or unit-of-measure

principle) requires transactions to be expressed in common units of money. It is also assumed
that the unit of money is stable so that inflationary or deflationary trends are not adjusted for
and the original amounts recorded stand.
file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01t06monetary.htm [12/07/2010 3:57:34 PM]
Example 1-4
Application of generally accepted accounting principles
Complete Quick Study 2-2 on page 51. Compare your answers to the following suggested solution:
requires that every
a. The business entity principle
business be accounted for separately and distinctly from its owner(s). As a result, transactions from Second Time
Around Clothing should be separated from Antique Accents.
b. The revenue recognition principle
that revenue must be recognized at the time it is earned, which, in this case, is March 2009.
states
c. The cost principle

requires that financial statement information must be based on
costs incurred in business transactions. Therefore, the purchase of the land is to be recorded at the actual cost of
$30,000, and reported on the balance sheet at the same value.
Accounting >> Accounting Handbook Part II >> Accounting Standards >> General accounting [Sections
1000 1800] >> 1000 - Financial Statement Concepts
Accounting standards
general accounting
[sections 1000 1800]
GENERAL ACCOUNTING
SECTION 1000
financial statement concepts
TABLE OF CONTENTS
Paragraph
Purpose and scope
.01-.06
Financial statements
Objective of financial statements
Objective
.04-.06
.07-.12
.12
Benefit versus cost constraint
.13
Materiality
.14
Qualitative characteristics
.15-.21
Understandability
.16
Relevance
.17
Reliability
.18
Comparability
.19-.20
Qualitative characteristics trade-off
.21
Elements of financial statements
.22-.35
Assets
.24-.27
Liabilities
.28-.30
Equity
.31
Revenues
.32
Expenses
.33
Gains
.34
Losses
.35
Recognition criteria
.36-.47
Measurement
.48-.52
PURPOSE AND SCOPE

.01
This Section describes the concepts underlying the development and use of accounting principles in general
purpose financial statements (hereafter referred to as financial statements). Such financial statements are
designed to meet the common information needs of external users of financial information about an entity.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Section 1100, establishes what constitutes
generally accepted accounting principles, and their sources, for private enterprises reporting in accordance
with Part II of the Handbook.
.02
The Board expects this Section to be used by preparers of financial statements and accounting practitioners in
exercising their professional judgment as to the application of generally accepted accounting principles and
in establishing accounting policies in areas in which accounting principles are developing.
.03
This Section does not establish standards for particular measurement or disclosure issues. Nothing in the
Section overrides any specific standards elsewhere in Part II of the Handbook or any other accounting
principle considered to be generally accepted.
Financial statements
.04
Financial statements of profit-oriented enterprises normally include a balance sheet, income statement,
statement of retained earnings and cash flow statement. Notes to financial statements and supporting
schedules to which the financial statements are cross-referenced are an integral part of such statements.
.05
The content of financial statements is usually limited to financial information about transactions and events.
Financial statements are based on representations of past, rather than future, transactions and events,
although they often require estimates to be made in anticipation of future transactions and events and
include measurements that may, by their nature, be approximations.
.06
Financial statements form part of the process of financial reporting that includes, for example, information in
other reports such as a funding proposal. While many financial statement concepts also apply to such
information, this Section deals specifically only with financial statements.
OBJECTIVE OF FINANCIAL STATEMENTS
.07
In the Canadian economic environment, the production of goods and the provision of services are, to a
significant extent, carried out by investor-owned business enterprises in the private sector and, to a lesser
extent, by government-owned business enterprises. Debt and equity markets and financial institutions act as
exchange mechanisms for investment resources used by these enterprises.
.08
Ownership of profit-oriented enterprises is often segregated from management, creating a need for external
communication of economic information about the entity to investors. For the purposes of this Section,
investors include present and potential debt and equity investors and their advisors. Creditors and others
who do not have internal access to entity information also need external reports to obtain the information
they require.
.09
It is not practicable to expect financial statements to satisfy the many and varied information needs of all
external users of information about an entity. Consequently, the objective of financial statements for profitoriented enterprises focuses primarily on information needs of investors and creditors. Financial statements
prepared to satisfy these needs are often used by others who need external reporting of information about an
entity.
.10
In making resource allocation decisions investors and creditors of profit-oriented enterprises are interested in
predicting the ability of the entity to earn income and generate cash flows in the future to meet its obligations
and to generate a return on investment.
.11
Investors also require information about how the management of an entity has discharged its stewardship
responsibility to those that have provided resources to the entity.
Objective
.12
The objective of financial statements is to communicate information that is useful to investors, creditors and
other users ("users") in making their resource allocation decisions and/or assessing management
stewardship. Consequently, financial statements provide information about:
(a)
an entity's economic resources, obligations and equity;
(b)
changes in an entity's economic resources, obligations and equity; and
(c)
the economic performance of the entity.
BENEFIT VERSUS COST CONSTRAINT

.13
The benefits expected to arise from providing information in financial statements should exceed the cost of
doing so. In developing accounting standards, the Board weighs the anticipated costs and benefits of its
proposals in general terms to assess whether they are justified on cost / benefit grounds. The benefits and
costs of applying accounting standards may differ between entities depending in part on the nature, number
and information needs of the users of their financial statements. Therefore, in developing an accounting
standard, the Board considers whether the requirements of that standard should apply to all entities or
whether different requirements should apply to different types of entities for which the cost / benefit trade-off
differs significantly. The cost / benefit trade-off is also a consideration for individual entities in the preparation
of financial statements in accordance with applicable standards (for example, in considering disclosure of
information beyond that required by the standards). The Board recognizes that the evaluation of the nature
and amount of benefits and costs is substantially a judgmental process.
MATERIALITY
.14
Users are interested in information that may affect their decision making. Materiality is the term used to
describe the significance of financial statement information to decision makers. An item of information, or an
aggregate of items, is material if it is probable that its omission or misstatement would influence or change a
decision. Materiality is a matter of professional judgment in the particular circumstances.
QUALITATIVE CHARACTERISTICS
.15
Qualitative characteristics define and describe the attributes of information provided in financial statements
that make that information useful to users. The four principal qualitative characteristics are understandability,
relevance, reliability and comparability.
Understandability
.16
For the information provided in financial statements to be useful, it must be capable of being understood by
users. Users are assumed to have a reasonable understanding of business and economic activities and
accounting, together with a willingness to study the information with reasonable diligence.
Relevance
.17
For the information provided in financial statements to be useful, it must be relevant to the decisions made by
users. Information is relevant by its nature when it can influence the decisions of users by helping them
evaluate the financial impact of past, present or future transactions and events or confirm, or correct,
previous evaluations. Relevance is achieved through information that has predictive value or feedback value
and by its timeliness.
(a)
Predictive value and feedback value

Information that helps users to predict an entity's future income and cash flows has predictive
value. Although information provided in financial statements will not normally be a prediction in itself,
it may be useful in making predictions. For example, the predictive value of the income statement is
enhanced if abnormal items are separately disclosed. Information that confirms or corrects previous
predictions has feedback value. Information often has both predictive value and feedback value.
(b)
Timeliness
For information to be useful for decision making, it must be received by the decision maker before
it loses its capacity to influence decisions. The usefulness of information for decision making
declines as time elapses.
Reliability
.18
For the information provided in financial statements to be useful, it must be reliable. Information is reliable
when it is in agreement with the actual underlying transactions and events, the agreement is capable of
independent verification and the information is reasonably free from error and bias. Reliability is achieved
through representational faithfulness, verifiability and neutrality. Neutrality is affected by the use of
conservatism in making judgments under conditions of uncertainty.
(a)
Representational faithfulness
Representational faithfulness is achieved when transactions and events affecting the entity are
presented in financial statements in a manner that is in agreement with the actual underlying
transactions and events. Thus, transactions and events are accounted for and presented in a
manner that conveys their substance rather than necessarily their legal or other form.
The substance of transactions and events may not always be consistent with that apparent from
their legal or other form. To determine the substance of a transaction or event, it may be necessary
to consider a group of related transactions and events as a whole. The determination of the
substance of a transaction or event will be a matter of professional judgment in the circumstances.
(b)
Verifiability
The financial statement representation of a transaction or event is verifiable if knowledgeable and
independent observers would concur that it is in agreement with the actual underlying transaction or
event with a reasonable degree of precision. Verifiability focuses on the correct application of a
basis of measurement rather than its appropriateness.
(c)
Neutrality
Information is neutral when it is free from bias that would lead users toward making decisions that
are influenced by the way the information is measured or presented. Bias in measurement occurs
when a measure tends to consistently overstate or understate the items being measured. In the
selection of accounting principles, bias may occur when the selection is made with the interests of
particular users or with particular economic or political objectives in mind.
Financial statements that do not include everything necessary for faithful representation of
transactions and events affecting the entity would be incomplete and, therefore, potentially biased.
(d)
Conservatism
Use of conservatism in making judgments under conditions of uncertainty affects the neutrality of
financial statements in an acceptable manner. When uncertainty exists, estimates of a conservative
nature attempt to ensure that assets, revenues and gains are not overstated and, conversely, that
liabilities, expenses and losses are not understated. However, conservatism does not encompass
the deliberate understatement of assets, revenues and gains or the deliberate overstatement of
liabilities, expenses and losses.
Comparability
.19
Comparability is a characteristic of the relationship between two pieces of information rather than of a
particular piece of information by itself. It enables users to identify similarities in and differences between the
information provided by two sets of financial statements. Comparability is important when comparing the
financial statements of two different entities and when comparing the financial statements of the same entity
over two periods or at two different points in time.
.20
Comparability in the financial statements of an entity is enhanced when the same accounting policies are used
consistently from period to period. Consistency helps prevent misconceptions that might result from the
application of different accounting policies in different periods. When a change in accounting policy is
deemed to be appropriate, disclosure of the effects of the change may be necessary to maintain
comparability.
Qualitative characteristics trade-off
.21
In practice, a trade-off between qualitative characteristics is often necessary, particularly between relevance
and reliability. For example, there is often a trade-off between the timeliness of producing financial
statements and the reliability of the information reported in the statements. Generally, the aim is to achieve
an appropriate balance among the characteristics in order to meet the objective of financial statements. The
relative importance of the characteristics in different cases is a matter of professional judgment.
ELEMENTS OF FINANCIAL STATEMENTS
.22
Elements of financial statements are the basic categories of items portrayed therein in order to meet the
objective of financial statements. There are two types of elements: those that describe the economic
resources, obligations and equity of an entity at a point in time, and those that describe changes in economic
resources, obligations and equity over a period of time. Notes to financial statements, which are useful for
the purpose of clarification or further explanation of the items in financial statements, while an integral part of
financial statements, are not considered to be an element.
.23
In the case of profit-oriented enterprises, net income is the residual amount after expenses and losses are
deducted from revenues and gains. Net income generally includes all transactions and events increasing or
decreasing the equity of the profit-oriented enterprise except those that result from equity contributions and
distributions.
Assets
.24
Assets are economic resources controlled by an entity as a result of past transactions or events and from
which future economic benefits may be obtained.
.25
Assets have three essential characteristics:

(a)
they embody a future benefit that involves a capacity, singly or in combination with other assets, in the
case of profit-oriented enterprises, to contribute directly or indirectly to future net cash flows;
(b)
the entity can control access to the benefit; and
(c)
the transaction or event giving rise to the entity's right to, or control of, the benefit has already
occurred.
.26
It is not essential for control of access to the benefit to be legally enforceable for a resource to be an asset,
provided the entity can control its use by other means.
.27
There is a close association between incurring expenditures and generating assets but the two do not
necessarily coincide. Hence, when an entity incurs an expenditure, this may provide evidence that future
economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset
has been obtained. Similarly, the absence of a related expenditure does not preclude an item from satisfying
the definition of an asset and thus becoming a candidate for recognition in the balance sheet. For example,
items that have been donated to the entity may satisfy the definition of an asset.
Liabilities
.28
Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may
result in the transfer or use of assets, provision of services or other yielding of economic benefits in the
future.
.29
Liabilities have three essential characteristics:
.30
(a)
they embody a duty or responsibility to others that entails settlement by future transfer or use of
assets, provision of services or other yielding of economic benefits, at a specified or determinable
date, on occurrence of a specified event, or on demand;
(b)
the duty or responsibility obligates the entity leaving it little or no discretion to avoid it; and
(c)
the transaction or event obligating the entity has already occurred.
Liabilities do not have to be legally enforceable provided that they otherwise meet the definition of liabilities;
they can be based on equitable or constructive obligations. An equitable obligation is a duty based on ethical
or moral considerations. A constructive obligation is one that can be inferred from the facts in a particular
situation as opposed to a contractually based obligation.
Equity
.31
Equity is the ownership interest in the assets of a profit-oriented enterprise after deducting its liabilities. While
equity of a profit-oriented enterprise in total is a residual, it includes specific categories of items (for example,
types of share capital, contributed surplus and retained earnings).
Revenues
.32
Revenues are increases in economic resources, either by way of inflows or enhancements of assets or
reductions of liabilities, resulting from the ordinary activities of an entity. Revenues of entities normally arise
from the sale of goods, the rendering of services or the use by others of entity resources yielding rent,
interest, royalties or dividends.
Expenses
.33
Expenses are decreases in economic resources, either by way of outflows or reductions of assets or
incurrences of liabilities, resulting from an entity's ordinary revenue generating or service delivery activities.
Gains
.34
Gains are increases in equity from peripheral or incidental transactions and events affecting an entity and from
all other transactions, events and circumstances affecting the entity except those that result from revenues or
equity contributions.
Losses
.35
Losses are decreases in equity from peripheral or incidental transactions and events affecting an entity and
from all other transactions, events and circumstances affecting the entity except those that result from
expenses or distributions of equity.
RECOGNITION CRITERIA
.36
Recognition is the process of including an item in the financial statements of an entity. Recognition consists of
the addition of the amount involved into statement totals together with a narrative description of the item (for
example, "inventory" or "sales") in a statement. Similar items may be grouped together in the financial
statements for the purpose of presentation.
.37
Recognition means inclusion of an item within one or more individual statements and does not mean
disclosure in the notes to the financial statements. Notes either provide further details about items
recognized in the financial statements, or provide information about items that do not meet the criteria for
recognition and thus are not recognized in the financial statements.
.38
The recognition criteria below provide general guidance on when an item is recognized in the financial
statements. Whether any particular item is recognized or not will require the application of professional
judgment in considering whether the specific circumstances meet the recognition criteria.
.39
The recognition criteria are as follows:

(a)
the item has an appropriate basis of measurement and a reasonable estimate can be made of the
amount involved; and
(b)
for items involving obtaining or giving up future economic benefits, it is probable that such benefits will
be obtained or given up.
.40
It is possible that an item will meet the definition of an element but still not be recognized in the financial
statements because it is not probable that future economic benefits will be obtained or given up or because a
reasonable estimate cannot be made of the amount involved. It may be appropriate to provide information
about items that do not meet the recognition criteria in notes to the financial statements. Not recognizing an
expenditure as an asset does not imply either that the intention of management in incurring the expenditure
was other than to generate future economic benefits for the entity or that management was misguided. The
only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current
accounting period is insufficient to warrant the recognition of an asset.
.41
Items recognized in financial statements are accounted for in accordance with the accrual basis of accounting.
The accrual basis of accounting recognizes the effect of transactions and events in the period in which the
transactions and events occur, regardless of whether there has been a receipt or payment of cash or its
equivalent.
.42
Revenues are generally recognized when performance is achieved and reasonable assurance regarding
measurement and collectibility of the consideration exists.
.43
Gains are generally recognized when realized.
.44
Expenses and losses are generally recognized when an expenditure or previously recognized asset does not
have future economic benefit. Expenses are related to a period on the basis of transactions or events
occurring in that period or by allocation.
.45
Expenses are recognized in the income statement on the basis of a direct association between the costs
incurred and the earning of specific items of income. This process, commonly referred to as the matching of
costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that
result directly and jointly from the same transactions or other events. For example, the various components
of expense making up the cost of goods sold are recognized at the same time as the income derived from
the sale of the goods. However, the application of the matching concept does not allow the recognition of
items in the balance sheet that do not meet the definition of assets or liabilities.
.46
When economic benefits are expected to arise over several accounting periods and the association with
income can only be broadly or indirectly determined, expenses are recognized in the income statement on
the basis of systematic and rational allocation procedures. This is often necessary in recognizing the
expenses associated with the using up of assets such as property, plant, equipment, patents and
trademarks. In such cases, the expense is referred to as depreciation or amortization. These allocation
procedures are intended to recognize expenses in the accounting periods in which the economic benefits
associated with these items are consumed or expire.
.47
An expense is recognized immediately in the income statement when an expenditure produces no future
economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to
qualify, for recognition in the balance sheet as an asset.
MEASUREMENT
.48
Measurement is the process of determining the amount at which an item is recognized in the financial
statements. There are a number of bases on which an amount can be measured. However, financial
statements are prepared primarily using the historical cost basis of measurement whereby transactions and
events are recognized in financial statements at the amount of cash or cash equivalents paid or received or
the fair value ascribed to them when they took place.
.49
Other bases of measurement are also used but only in limited circumstances. They include:
(a)
Replacement cost the amount that would be needed currently to acquire an equivalent asset. This
may be used, for example, when inventories are valued at the lower of historical cost and
replacement cost.
(b)
Realizable value the amount that would be received by selling an asset. This may be used, for
example, to value temporary and portfolio investments. Market value may be used to estimate
realizable value when a market for an asset exists.
(c)
Present value the discounted amount of future cash flows expected to be received from an asset or
required to settle a liability. This may be used, for example, to estimate the cost of pension benefits.
.50
Financial statements are prepared with capital maintenance measured in financial terms and with no
adjustment being made for the effect on capital of a change in the general purchasing power of the currency
during the period.
.51
The concept of capital maintenance used by profit-oriented enterprises in preparing financial statements
affects measurement because income in an economic sense exists only after the capital of an enterprise has
been maintained. Thus, income is the increase or decrease in the amount of capital at the end of the period
over the amount at the beginning of the period, excluding the effects of capital contributions and distributions.
.52
Financial statements are prepared on the assumption that the entity is a going concern, meaning it will
continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in
the normal course of operations. Different bases of measurement may be appropriate when the entity is not
expected to continue in operation for the foreseeable future.
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Benefit versus cost constraint (paragraph .13 of Reading 1-1)

The accountant evaluates the cost of producing accounting information and determines whether the usefulness and benefit
to be derived from having particular accounting information outweighs the cost of providing the information to users. The
cost/benefit tradeoff is the most pervasive constraint.
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Materiality (paragraph .14 of Reading 1-1)

The accountant makes a judgement about whether an amount is large enough to influence or change the decisions of people
who rely on certain information. If the amount will not affect the decision, a more expedient accounting method may be used
for that item (for example, ignore the item).
An accountant must exercise extreme care when considering the cost-benefit and materiality constraints because they have
the potential to undermine the relevance and reliability (the primary qualitative characteristics) of accounting information. For
example, too high a level of materiality may mislead users of financial information, since the reported net income is too
different from the true net income. Without fully understanding how readers use the information, an accountant may
misjudge whether the cost of preparing better information exceeds the benefit realized from the improved data.
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Separate-entity assumption (or business entity principle)
To prepare financial reports, an accountant must be able to clearly define which activities are to be included and which
activities are to be excluded. Since a transaction is generally an exchange between the entity and someone who is beyond
the entity, the boundaries of the entity need to be defined. For example, if you took a coin out of one pocket and put it
in another of your pockets, you would agree that no transaction has occurred. However, if the coin ended up in someone
elses pocket, a transaction has occurred because one entity has more money and the other less.
In the case of an unincorporated business (such as a proprietorship or a partnership), the owner and the business are viewed
for accounting purposes as being separate and distinct, even though the law does not recognize this distinction. An exchange
between the proprietor and the proprietorship is a transaction, although in a strictly legal sense, the two are one. Another
example of the application of this assumption is where the sole owner of an unincorporated business has debts from
borrowing money to finance buying a personal residence. The business-related debts would be included in the financial
reports of the proprietorship, but the debt on the residence would be excluded. On the other hand, unlike a proprietorship or
a legal entity and a separate accounting entity. Partnerships and corporations
partnership, a corporation is both
are discussed in detail in Module 9.
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Going-concern assumption (or going-concern principle)
When a business is a going concern, it is able to continue operations into the future. If there is a question as to
whether a business might be a going concern, this must be disclosed. IFRS 2009, Framework, par. 23, states that The
financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation
for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail
materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on
a different basis and, if so, the basis used is disclosed.
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Unit-of-measure assumption (or monetary unit principle)
Accountants record the financial results of an entity using the currency of the country in which the entity is
located. Normally, accountants do not revise the amounts to reflect the changing purchasing power of money due to
inflation or deflation. While this assumption of a stable measuring unit is convenient to use, it causes significant distortions to
some accounting information when long periods of inflation occur.
The unit-of-measure assumption also assumes that money is the valid unit to use in expressing the results of a business. If
you argued that tonnes of steel, litres of gas, kilometres driven, or another measure of output is a better measure of results,
you would not accept financial statements in monetary amounts as correct. In recent years, accountants are reporting more
of these other measures.
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Time period assumption (or time period principle)
The lifetime of a business is presumed to be indefinite (going-concern assumption); hence, periodic reports
are needed by users to judge the performance of a business during a specified period of time. A typical business
prepares annual financial reports for external users on a fiscal basis (one full reporting year). More frequent, or interim,
reports are prepared for management and other users who may have particular needs for them. Since business transactions
do not all conclude on a certain date, a time period over which to measure results must be arbitrarily established. If you
rejected the time period assumption, the only time you could report results would be when the business finally winds up and
goes out of business.
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Cost principle
The cost principle is based on the unit-of-measure assumption of a stable monetary unit. This principle has far-ranging
impact on how accountants measure and record the values of items that they report in financial statements. Traditionally, the
actual cash amount received or paid (cash cost valuation basis) has been used as the primary method of valuing the assets,
liability, and owners equity elements of the balance sheet, as well as the revenue and expense elements reported on the
income statement. Because it is very reliable, the cost principle provides a convenient and practical basis for valuation. Cash
cost valuations are usually easy to determine from business documents such as invoices and cheques.
Although the cost principle has considerable merit in terms of reliability, there is a trade-off in terms of relevance. After the
any applicable depreciation (Note:
acquisition date, for example, firms continue to use historical cost less
depreciation is introduced in Module 3). Since historical cost values remain unadjusted for inflation, the value of long-term
investments, such as land owned for many years, may not accurately portray current (fair market) value. Thus the historical
cost of the land reported in the financial statements would be less relevant. If financial statement users, such as lenders, are
interested in the current value of a property, they need to obtain an appraisers estimate. This example illustrates that
accountants need to make trade-offs in the implementation of the conceptual framework, as discussed in section 1.10 above.
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The measurement of revenues requires the answers to two key questions: when
and how much
?
Revenue should be recognized (recorded in the books) when it is earned. The point at which it is considered to be earned
varies for different types of businesses. At a conceptual level, the earnings process is continuous as value is added
throughout a products life up to the point of sale. In the case of goods sold to customers, sales revenue is usually considered
earned when the customer takes delivery of the item, regardless of whether the customer pays immediately or later. For
services, the date of the actual performance of the service is the central concern. For interest or rental income, the passage
of time governs the recognition of revenue. The amount of revenue is equal to the total cash equivalent due from the
customer. This amount is generally known from sales invoices or similar records.
The most common point of revenue recognition is at the point of sale. However, in special circumstances, alternative
methods are found in practice. For example, revenue can sometimes be recognized at the end of production, on receipt of
cash, during production, or on a cost recovery basis. In the case of scarce resources such as precious metals, revenue may
be recognized at the completion of production. GAAP would only permit this, however, if the scarce resources are easily
marketable at determinable prices. When collectability of assets is in serious doubt, revenue may be recognized as cash is
received.
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Matching principle
The matching principle requires that costs incurred to earn revenues should be reported as expenses in the same period that
the related revenue is reported, so that a reasonable determination of income can be established. In some cases, the
connection is obvious, such as sales revenue for a grocery store and the cost of groceries sold. In other cases, costs incurred
during a particular time period are matched to revenues recorded for the period; for example, monthly rental expense.
Although the rent expense is not directly related to the revenues recorded during the month, it is a necessary cost of
operating the business.
It is important to distinguish between the terms cost and expense. Cost refers to the amount paid or to be paid for an
item, which can be recorded either as an asset or an expense. Expense is the cost or portion of the cost that is recorded on
the income statement during the current period. For example, a building may cost $1,000,000 and is initially recorded on the
balance sheet as an asset. A portion of the cost is recorded as an expense (depreciation expense) each year as the asset is
used up.
The matching principle and the revenue recognition principle together govern the implementation of the time period
assumption, and both relate directly to the income statement model:
Net income = Revenues earned Expenses incurred
These two principles reflect the accrual basis of income measurement. Throughout this course, it will be emphasized that
accrual accounting requires that revenues be recorded when they are earned and expenses be recorded when they occur,
which may or may not coincide with when cash payments are received or paid out. Accrual accounting implies that the
recognition of events for accounting purposes need not be delayed until the cash consideration is received or paid.
Accountants record revenues and expenses when the event that gives rise to these exchanges occurs. They report an
accounts receivable or an accounts payable on the balance sheet. Matching and accrual accounting are discussed in detail in
Module 3.
Although the matching principle stresses a cause-and-effect relationship between revenues and expenses, this relationship is
not always easy to apply. There is clearly a cause-and-effect relationship between cost of goods sold and sales revenue, but
a cause-and-effect relationship with other costs such as depreciation and advertising is not so clear. The following three
guidelines are commonly used in practice:
Associating cause and effect. This should be done wherever possible as mentioned in the preceding paragraph.
Another example of applying this guideline is the obvious cause-and-effect relationship that exists between sales
commissions and sales.
Systematic and rational allocation. In the module on plant and equipment (Module 7), it will be shown that the
costs of some assets (such as buildings and equipment used in daily operating activities) benefit several accounting
periods. For example, a building used to house the administrative offices of a business contributes to revenue
generation, but there is no clear relationship of the building to specific revenues earned each period. If the building is
expected to contribute equal benefits each period, you have the option of choosing a rational allocation method such
as straight-line depreciation. You could also argue, however, that the declining-balance depreciation method would
be an appropriate allocation method because more expenditures would be made for repairs and maintenance in the
later years of the buildings life; the declining-balance method would therefore result in more evenly allocating the
cost of the building. Note: depreciation is discussed in detail in Module 7.
Immediate recognition. For some costs such as advertising, senior management salaries, and research costs, the
future benefits are very uncertain. These costs are to be expensed in the period in which they are incurred.
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When preparing financial statements, accountants must consider the information needs of users. Financial reports should be
sufficiently clear and complete (subject to reliability of the information) so that decisions that may be influenced by the
information are not inappropriately affected. Many important facts concerning a business cannot be communicated on the
statements themselves because they are qualitative, not quantitative, in nature. Accountants therefore make extensive use of
notes to the financial statements to clarify and expand the numeric content of the financial statements. A properly completed
set of financial statements always contains additional disclosures in the form of notes. For example, the existence of a major
unresolved lawsuit against a company would only be known by reviewing the notes to the financial statements.
Firms have a great deal of discretion as to how much detail to include in the notes. There is a world of difference, for
example, between simply disclosing the variety of inventory methods employed and giving detailed breakdowns of inventory
amounts.
Because a variety of accounting practices are permitted under GAAP, users need to be informed about which practices an
entity is using. With this information, users are better able to assess a companys financial performance.
Note how full disclosure ties into the qualitative characteristics. Both relevance and reliability are increased with full
disclosure. Current market values of assets can be provided in the notes, for example, while historical cost measures are
reported on the statements.
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Module 1: Introduction To Accounting Concepts

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file:////cgafs2/VOL1/Courses/2010-11/CGA/FA1/06course/m01intro.

Module 1: Introduction to accounting concepts

Test your knowledge

Print this module

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The calculator is silent, battery-operated, and non-printing.

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Module 1 Test your knowledge

2. Which of the following is another term for equity?

Business entity principle

Assets, understated $130; Liabilities, overstated $130

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1.1 What is accounting?

Chapter 1, pages 1-4 and 7-10

Accounting information that is understandable

is useful to users with reasonable

because it can affect the types of decisions made by

Accounting information should be reliable

character trait of integrity.

Checkpoint Questions 1 and 2 on

Checkpoint Questions 5 and 6 on

Activity 1.1 Quality of information

a. Which statement do you think is more reliable? Why?

IFRS 2009, Framework, para. 24.

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1.2 Forms of organization

Distinguish between sole proprietorships, partnerships, and corporations. (Level 2)

Chapter 1, pages 4-6

Judgement Call on page 6

(Solution on page 17)

Checkpoint Questions 3 and 4 on

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1.3 Ethics in accounting

Chapter 1, pages 11-14

[available from the Ethics

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Demonstration Problem on page 18

Checkpoint questions 7-9 on page 14

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1.4 Types of accountants and fields of accounting

Chapter 1, pages 14-16

Checkpoint questions 10-13 on page

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1.5 Financial statements

Differentiate among the different kinds of financial statements. (Level 1)

Chapter 2, pages 25-31

Income statement (also known as statement of earnings and statement of income)

Balance sheet (also known as statement of financial position)

Cash flow statement (also known as statement of cash flows)

statement of financial position (the balance sheet)

Statement of changes in owners equity

Cash flow statement

Checkpoint Questions 1 to 4 on page 31 (Solutions on page 45)

Quick Study 2-1 on page 50 (Solution)

1.6 Generally accepted accounting principles (GAAP)

Explain each of the GAAP introduced. (Level 2)

Chapter 2, pages 31-33

NOTE: Omit the section titled Objectivity Principle on page 32.

The IFRS 2009 Framework

Introducing some GAAP

Business entity principle

Example 1-4 shows how GAAP is used to guide accounting practice.

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