3 The Accounting Information

System

Kimmel ● Weygandt
Survey of Accounting, First Edition
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CHAPTER OUTLINE LEARNING

1 Discuss financial reporting concepts.
OBJECTIVE
LEARNING OBJECTIVES
THE STANDARD-SETTING ENVIRONMENT
1 Discuss financial reporting concepts.
Generally Accepted Accounting Principles (GAAP) - A set of rules
and practices, having substantial authoritative support, that the
Analyze the effect of business transactions on the basic
2 accounting equation. accounting profession recognizes as a general guide for financial
reporting purposes.
Standard-setting bodies determine these guidelines:
International Note
► Securities and Exchange Commission (SEC) Over 115 countries
use international
► Financial Accounting Standards Board (FASB) standards (called
IFRS).
► International Accounting Standards Board (IASB)
► Public Company Accounting Oversight Board (PCAOB)

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THE STANDARD-SETTING ENVIRONMENT INTERNATIONAL INSIGHT

The Korean Discount

Review Question
Generally accepted accounting principles are:
a. a set of standards and rules that are recognized as
a general guide for financial reporting.
b. usually established by the Internal Revenue Service.
c. the guidelines used to resolve ethical dilemmas.
d. fundamental truths that can be derived from the laws
of nature.
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If you think that accounting standards don’t matter, consider recent events in
South Korea. For many years, international investors complained that the
financial reports of South Korean companies were inadequate and inaccurate.
Accounting practices there often resulted in huge differences between stated
revenues and actual revenues. Because investors did not have faith in the
accuracy of the numbers, they were unwilling to pay as much for the shares of
these companies relative to shares of comparable companies in different
countries. This difference in share price was often referred to as the “Korean
discount.” In response, Korean regulators decided that companies would have to
comply with international accounting standards. This change was motivated by a
desire to “make the country’s businesses more transparent” in order to build
investor confidence and spur economic growth. Many other Asian countries,
including China, India, Japan, and Hong Kong, have also decided either to adopt
international standards or to create standards that are based on the international
standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March
16, 2007).
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 QUALITIES OF USEFUL INFORMATION QUALITIES OF USEFUL INFORMATION

According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Relevance Accounting information has relevance if it would
make a difference in a business decision. Information is
considered relevant if it provides information that has predictive
value, that is, helps provide accurate expectations about the
future, and has confirmatory value, that is, confirms or corrects
prior expectations. Materiality is a company-specific aspect of
relevance. An item is material when its size makes it likely to
influence the decision of an investor or creditor.
According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Faithful Representation Faithful representation means that
information accurately depicts what really happened. To
provide a faithful representation, information must be complete
(nothing important has been omitted), neutral (is not biased
toward one position or another), and free from error.

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QUALITIES OF USEFUL INFORMATION ACCOUNTING ACROSS THE ORGANIZATION

What Do These Companies Have in Common?
Enhancing Qualities Another issue related to comparability is the accounting time period. An
accounting period that is one-year long is called a fiscal year. But a fiscal
Comparability Information is Information has the
year need not match the calendar year. For example, a company could end
results when verifiable if quality of
its fiscal year on April 30 rather than on December 31. Why do companies
different companies independent understandability
choose the particular year-ends that they do? For example, why doesn’t
use the same observers, using the if it is presented in a
every company use December 31 as its accounting year-end? Many
accounting same methods, obtain clear and concise
principles. similar results. fashion. companies choose to end their accounting year when inventory or operations
are at a low point. This is advantageous because compiling accounting
Consistency means information requires much time and effort by managers, so they would rather
that a company uses For accounting information to do it when they aren’t as busy operating the business. Also, inventory is
the same accounting have relevance, it must be easier and less costly to count when its volume is low. Some companies
principles and methods timely. whose year-ends differ from December 31 are Delta Air Lines, June 30; The
from year to year. Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31.
In the notes to its financial statements, Best Buy states that its accounting
year-end is the Saturday nearest the end of January.
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ASSUMPTIONS IN FINANCIAL REPORTING ASSUMPTIONS IN FINANCIAL REPORTING

Monetary Unit Economic Entity Periodicity Going Concern

Requires that only those States that every economic The business will remain
States that the life of a
things that can be expressed entity can be separately in operation for the
business can be divided
in money are included in the identified and accounted for. foreseeable future.
into artificial time periods.
accounting records.
ILLUSTRATION 3-2 ILLUSTRATION 3-2
Key assumptions in financial reporting Key assumptions in financial reporting
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 PRINCIPLES IN FINANCIAL REPORTING PRINCIPLES IN FINANCIAL REPORTING

Measurement Principles
Historical Cost COST CONSTRAINT
Or cost principle, dictates that companies record assets at their cost. Accounting standard-setters
weigh the cost that companies
Fair Value
will incur to provide the
Indicates that assets and liabilities should be reported at fair value
information against the benefit
(the price received to sell an asset or settle a liability).
that financial statement users
will gain from having the
Full Disclosure Principle information available.
Requires that companies disclose all circumstances and events that
would make a difference to financial statement users.

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Financial Accounting Concepts and Financial Accounting Concepts and

DO IT! 1 Principles
DO IT! 1 Principles
The following items guide the FASB when it creates accounting standards. The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Relevance Periodicity assumption
Faithful representation Going concern assumption Faithful representation Going concern assumption
Comparability Historical cost principle Comparability Historical cost principle
Consistency Full disclosure principle Consistency Full disclosure principle
Monetary unit assumption Materiality Monetary unit assumption Materiality
Economic entity assumption Economic entity assumption
Match each item above with a description below. Match each item above with a description below.
1. Ability to easily evaluate one company’s results Comparability 4. The reporting of all information that would make a Full disclosure
relative to another’s. difference to financial statement users.
2. Belief that a company will continue to operate for the 5. The practice of preparing financial statements at
Going concern Periodicity
foreseeable future. regular intervals.
3. The judgment concerning whether an item is large 6. The quality of information that indicates the
Materiality Relevance
enough to matter to decision-makers. information makes a difference in a decision.
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Financial Accounting Concepts and Financial Accounting Concepts and

DO IT! 1 Principles
DO IT! 1 Principles
The following items guide the FASB when it creates accounting standards. The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption Relevance Periodicity assumption
Faithful representation Going concern assumption Faithful representation Going concern assumption
Comparability Historical cost principle Comparability Historical cost principle
Consistency Full disclosure principle Consistency Full disclosure principle
Monetary unit assumption Materiality Monetary unit assumption Materiality
Economic entity assumption Economic entity assumption
Match each item above with a description below. Match each item above with a description below.
7. Belief that items should be reported on the balance Historical cost 10. The desire to minimize errors and bias in financial Faithful
sheet at the price that was paid to acquire the item. statements. representation
8. A company’s use of the same accounting principles 11. Reporting only those things that can be measured in Monetary unit
Consistency
and methods from year to year. dollars.
9. Tracing accounting events to particular companies. Economic entity

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 THE STANDARD-SETTING ENVIRONMENT Analyze the effect of business transactions on
LEARNING
OBJECTIVE 2 the basic accounting equation.

Review Question
Accounting Information System
What is the primary criterion by which accounting information
can be judged? System of

a. Consistency. ► collecting and

b. Predictive value. ► processing transaction data and

c. Usefulness for decision making. ► communicating financial information to decision-makers.

d. Comparability.

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ACCOUNTING TRANSACTIONS ACCOUNTING TRANSACTIONS

Transactions are economic events that require recording in Question: Are the following events recorded in Illustration 3-3
Transaction
the financial statements. the accounting records? identification process

Discuss guided trip

 Not all activities represent transactions. Purchase
Event options with potential Pay rent
computer
customer
 Assets, liabilities, or stockholders’ equity items change
as a result of some economic events.
Criterion Is the financial position (assets, liabilities, or
 Dual effect on the accounting equation.
stockholders’ equity) of the company changed?

Record/ Don’t
Record

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ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS

The process of identifying the specific effects of economic

events on the accounting equation.

Basic Accounting Equation

Stockholders’
Assets = Liabilities +
Equity
Illustration 3-4
Expanded accounting equation

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 ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS
Event (1). On October 1, cash of $10,000 is invested in Sierra Corporation Event (2). On October 1, Sierra borrowed $5,000 from Castle Bank by
by investors in exchange for $10,000 of common stock. signing a 3-month, 12%, $5,000 note payable.

1. +10,000 +10,000 1. +10,000 +10,000

2. +5,000 +5,000

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ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS

Event (3). On October 2, Sierra purchased equipment by paying $5,000 Event (4). On October 2, Sierra received a $1,200 cash advance from R.
cash to Superior Equipment Sales Co. Knox, a client.

1. +10,000 +10,000 1. +10,000 +10,000

2. +5,000 +5,000 2. +5,000 +5,000
3. -5,000 +5,000 3. -5,000 +5,000
4. +1,200 +1,200

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ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS

Event (5). On October 3, Sierra received $10,000 in cash from Copa Event (6). On October 3, Sierra Corporation paid its office rent for the
Company for guide services performed. month of October in cash, $900.

1. +10,000 +10,000 1. +10,000 +10,000

2. +5,000 +5,000 2. +5,000 +5,000
3. -5,000 +5,000 3. -5,000 +5,000
4. +1,200 +1,200 4. +1,200 +1,200
5. +10,000 +10,000 5. +10,000 +10,000

Service 6. -900 -900

Revenue Rent
Expense

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 ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS
Event (7). On October 4, Sierra paid $600 for a one-year insurance policy Event (8). On October 5, Sierra purchased an estimated three months of
that will expire next year on September 30. supplies on account from Aero Supply for $2,500.

1. +10,000 +10,000 1. +10,000 +10,000

2. +5,000 +5,000 2. +5,000 +5,000
3. -5,000 +5,000 3. -5,000 +5,000
4. +1,200 +1,200 4. +1,200 +1,200
5. +10,000 +10,000 5. +10,000 +10,000
6. -900 -900 6. -900 -900
7. -600 +600 7. -600 +600
8. +2,500 +2,500

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ANALYZING TRANSACTIONS ANALYZING TRANSACTIONS

Event (9). On October 9, Sierra hired four new employees to begin work Event (10). On October 20, Sierra paid a $500 dividend.
on October 15.

1. +10,000 +10,000 1. +10,000 +10,000

2. +5,000 +5,000 2. +5,000 +5,000
3. -5,000 +5,000 3. -5,000 +5,000
4. +1,200 +1,200 4. +1,200 +1,200
5. +10,000 +10,000 5. +10,000 +10,000
6. -900 -900 6. -900 -900
7. -600 +600 7. -600 +600
8. +2,500 +2,500 8. +2,500 +2,500
10. -500 -500

An accounting transaction has not occurred.

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ANALYZING TRANSACTIONS INVESTOR INSIGHT

Event (11). Employees have worked two weeks, earning $4,000 in Why Accuracy Matters
salaries, which were paid on October 26. While most companies record transactions very carefully, the reality is that
mistakes still happen. For example, bank regulators fined Bank One
Corporation (now JPMorgan Chase) $1.8 million because they felt that the
unreliability of the bank’s accounting system caused it to violate regulatory
requirements. Also, in recent years Fannie Mae, the government chartered
1. +10,000 +10,000
mortgage association, announced a series of large accounting errors. These
2. +5,000 +5,000
3. -5,000 +5,000
announcements caused alarm among investors, regulators, and politicians
4. +1,200 +1,200 because they feared that the errors might suggest larger, undetected problems.
5. +10,000 +10,000 This was important because the home-mortgage market depends on Fannie
6. -900 -900 Mae to buy hundreds of billions of dollars of mortgages each year from banks,
7. -600 +600 thus enabling the banks to issue new mortgages. Finally, before a major
8. +2,500 +2,500 overhaul of its accounting system, the financial records of Waste Management
10. -500 -500 Company were in such disarray that of the company’s 57,000 employees,
11. -4,000 Sal./Wages Expense -4,000 10,000 were receiving pay slips that were in error. The Sarbanes-Oxley Act was
created to minimize the occurrence of errors like these by increasing every
employee’s responsibility for accurate financial reporting.
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 DO IT! 2 Transaction Analysis
A tabular analysis of the transactions for the month of August is
shown below. Describe each transaction.
1. Company issued shares of stock for $25,000 cash.
2. Company purchased $7,000 of equipment on account.
3. Company received $8,000 cash in exchange for services performed.
4. Company paid $850 for this month’s rent.
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