Chapter 2

Conceptual Framework

A coherent system of interrelated objectives and fundamentals that can lead to consistent standards.

Notes to Financial Statements

A set of disclosures in a company's financial statements that further explain the items presented in the main body of the statements. The additional information provided in the notes does not have to be quantifiable, nor does it need to qualify as an accounting element. Notes to the financial statements are considered an integral part of the statements.

Comparability

Ability to compare accounting information of different companies because they measure and report information in a similar manner.

Going Concern Assumption

Accounting assumption that a company will continue in operation for the foreseeable future. Only in situations in which liquidation appears imminent is the assumption inapplicable.

Historical Cost Principle

An accepted accounting principle that companies account for and report most assets and liabilities on the basis of acquisition price. To the extent that historical cost is free from error and neutral, it contributes to faithful representation.

Economic Entity Assumption

An assumption that economic activity can be identified with a particular unit of accountability, by keeping an enterprise's economic activity separate and distinct from that of its owners and any other business unit. The entity assumption refers to economic, rather than legal, entities.

Comparability and Verifiability

Enhancing qualities of accounting information include:

Confirmatory Value

Information that confirms or corrects prior expectations

Feedback value

Information that confirms or corrects prior expectations.

Completeness

One of the ingredients of the fundamental quality of faithful representation. It means that all the information necessary for faithful representation is provided.

Assets

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

(B)- Comparability between financial statements of different accounting periods presumes consistent application of GAAP.

The major objective of the quality of comparability is to: A. provide timely financial information for statement users. B. promote comparability between financial statements of different accounting periods. C. enable users to identify the real similarities and differences in economic events between companies. D. be sure the same information is disclosed in each accounting period.

True

True or False: Generally, confirmation of a sale to independent interests is used to indicate the point at which revenue is recognized.

Free From Error

View that information that is accurate will be more representationally faithful.

(A)- Ingredients of faithful representation are completeness, neutrality, and free from error.

What are the ingredients of faithful representation?

(A)- The cost constraint requires weighing the costs of providing the information with the benefits derived from using it. Conservatism or prudence reflects a general tendency toward early recognition of unfavorable events.

What is the constraint that supports considering that the benefits of the information outweigh the sacrifices to provide the information? A. Cost. B. Prudence. C. Consistency. D. Conservatism.

Observable inputs that reflect quoted prices for identical assets or liabilities.

With regard to fair value, which of the following measurements is considered the least subjective?

Materiality

A company-specific aspect of relevance, an item is said to be material if its inclusion or omission would influence or change the judgment of a reasonable person; it is immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. The point involved is one of relative size and importance; that is, both quantitative and qualitative factors should be considered.

(A)- The FASB classifies the elements of financial statements into two distinct groups. The first group of three elements—assets, liabilities, and equity—describes amounts of resources and claims to resources at a moment in time. The other seven financial statement elements describe transactions, events, and circumstances that affect an enterprise during a period of time. Thus, alternatives B, C, and D are incorrect.

According to the FASB Conceptual Framework, the elements—assets, liabilities, and equity—describe amounts of resources and claims to resources at/during a

(A)- Equity is the residual interest in the assets of an entity that remains after deducting its liabilities.

According to the FASB conceptual framework, equity A. is the residual interest in the assets of an entity that remains after deducting its liabilities. B. is the same thing as comprehensive income. C. is the net gains less the net loses for a period of time. D. is the net revenues and expenses for a period of time.

Periodicity (time period) Assumption

Accounting assumption that implies that a company can divide its economic activities into artificial time periods. These time periods vary, but the most common are monthly, quarterly, and yearly.

Monetary Unit Assumption

Accounting assumption that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis.

Full Disclosure Principle

Accounting principle that dictates that in deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. It recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs between sufficient detail that makes a difference to users, sufficient condensation to make the information understandable, and the costs and benefits of providing the information.

Expense Recognition Principle

Accounting principle that dictates that the recognition of expenses is related to net changes in assets and earning revenues, that is, "let the expenses follow the revenues."

(A)- Cost is still widely supported for financial reporting because it is an objectively determinable amount. Answer (B) is incorrect because cost and current value are generally not the same amount subsequent to the date of acquisition. Answers (C) and (D) are incorrect because it does not facilitate comparisons between years, nor does it take into account price-level adjusted information.

Although many objections have been raised about the "cost" principle, it is still widely supported for financial reporting because it A. is an objectively determinable amount. B. is a good measure of current value. C. facilitates comparisons between years. D. takes into account price-level adjusted information.

Consistency

An aspect of comparable information, which indicates that a company applied the same accounting treatment to similar events from period to period. A company can change methods, but it must first demonstrate that the newly adopted method is preferable to the old and then must disclose in the financial statements the nature and effect of the accounting change.

Understandability

An enhancing qualitative characteristic of accounting information that lets reasonably informed users see its significance

Timeliness

An enhancing qualitative characteristic of accounting information, indicating that information should be available to decision-makers before it loses its capacity to influence their decisions.

Verifiability

An enhancing qualitative characteristic of accounting information, indicating that similar results will occur when independent third parties (e.g., auditors) measure using the same methods.

Comparability

An enhancing qualitative characteristic of accounting information, which describes information that is measured and reported in a similar manner for different companies. It enables users to identify the real similarities and differences in economic activities between companies.

Consistency

An entity applies the same accounting treatment to similar events from period to period.

Comprehensive Income

Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from nonowner sources.

Qualitative Characteristics

Characteristics that make accounting information useful.

(B)- Comprehensive income includes net income and all other changes in equity, exclusive of owners' investments and distributions. Items A, C, and D fit into this broad definition.

Comprehensive income includes all changes in equity during a period except: A. sale of assets other than inventory. B. those resulting from investments by or distribution to owners. C. sales to a particular entity where ultimate payment by the entity is doubtful. D. those resulting from revenue generated by a totally owned subsidiary.

(C)- The going concern assumption in accounting implies that unless there is evidence to the contrary, an entity will continue to exist in order to carry out its objectives and fulfill its commitments. Consistency describes when an entity applies the same accounting treatment to similar events from period to period.

Continuation of an accounting entity in the absence of evidence to the contrary is an example of the basic concept of

Period Costs

Costs that attach to a specific accounting period. Examples are officers' salaries and other administrative expenses. Companies charge off such costs in the immediate period, even though benefits associated with these costs may occur in the future. They are not included as part of inventory cost; instead, they are expensed as incurred.

Product Costs

Costs that attach to a specific product. Examples are material, labor, and overhead. Companies carry these costs into future periods if they recognize the revenue from the product in subsequent periods.

Losses

Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

(C)- The concept of periodicity implies that economic activity can be divided into artificial time periods—months, quarters, and years for example.

During the lifetime of an entity accountants produce financial statements at artificial points in time in accordance with the concept of:

Conceptual Framework

For the accounting profession, a coherent system of objectives and fundamentals established by the FASB, which determine the nature, function, and limits of financial accounting and which lead to consistent accounting standards.

Fair Value Principle

GAAP-based principle that calls for the use of fair value measurements in the financial statements.

Objective of Financial Reporting

Goal for financial accounting and reporting, established by the accounting profession, which is to provide information about the reporting entity that is useful to present and potential to equity investors, lenders, and other creditors in decisions about providing resources to the entity.

(D)- To be a faithful representation, accounting information must possess three key characteristics: completeness, neutrality, and free from error.

If accounting information is complete, free from error, and neutral, it can be considered: A. relevant B. timely. C. comparable. D. a faithful representation

(D)- All of the alternatives (A, B, and C) are economic entities for accounting purposes.

In accounting an economic entity may be defined as: A. a business enterprise. B. an individual. C. a division within a business enterprise. D. all of the above

(C)- In deciding what information to report, accountants follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Alternatives A and D are wrong because they do not assume an informed user. Alternative B would result in disclosing a significant amount of extraneous information.

In complying with the full disclosure principle, an accountant must determine the amount of disclosure necessary. How much disclosure is enough? A. Information sufficient for a person without any knowledge of accounting to understand the statements. B. All information that might be of interest to an owner of a business enterprise. C. Information that is of sufficient importance to influence the judgment and decisions of an informed user. D. Information sufficient to permit most persons coming in contact with the statements to reach an accurate decision about the financial condition of the enterprise.

Monetary Unit Assumption

In the United States, inflation/deflation is ignored in accounting under which of the following assumptions?

Gains

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Revenues

Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, performing services, or other activities that constitute the entity's ongoing major or central operations.

Supplementary Information

Information included in the notes to financial statements, which includes details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in reliability and may include management's explanation of the financial information and its discussion of the significance of that information.

Predictive Value

One characteristic of relevant information, indicating that information must help users predict the ultimate outcome of past, present, and future events.

Revenue Recognition Principle

One of the basic principles of accounting, which dictates that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Generally, recognition at the time of sale provides a uniform and reasonable test.

Neutrality

One of the ingredients of the fundamental quality of faithful representation, it indicates that a company cannot select information to favor one set of interested parties over another. Unbiased information must be the overriding consideration.

Confirmatory Value

One of the ingredients of the fundamental quality of relevance, it helps to confirm or correct prior expectations based on previous evaluations of financial reporting information.

Principles of Accounting

One of the parts in the third level of the conceptual framework, which details recognition and measurement concepts. The accounting profession generally uses four basic principles of accounting to record transactions: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure.

Assumption

One of the parts in the third level of the conceptual framework; a concept that the accounting profession assumes as foundational for the financial accounting structure. There are four basic ones: (1) economic entity, (2) going concern, (3) monetary unit, and (4) periodicity.

Relevance

One of the qualitative characteristics of accounting information, which describes information capable of making a difference in a decision. Information with no bearing on a decision is irrelevant. To be relevant, information needs have predictive or feedback value and is material.

Faithful Representation

One of the qualitative characteristics of accounting information. Information must be complete, free from error, and neutral.

Expenses

Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, performing services, or other activities that constitute the entity's ongoing major or central operations.

Qualitative Characteristics

Part of the second level of the conceptual framework of accounting; the characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. The primary qualitative characteristics are relevance and faithful representation.

Economic Entity Assumption- Parent-subsidiary financials are an example of the economic entity assumption. The entity concept does not necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes does not violate the economic entity assumption.

Preparation of merged financial statements when a parent-subsidiary relationship exists does not violate the

Equity

Residual interest in the assets of an entity that remains after deducting its liabilities.

Fair Value Option

The choice allowed by the FASB to use fair value in the financial statements as the basis of measurement for financial assets and liabilities. Under the fair value option, the item is recorded at fair value at each reporting date, and unrealized holding gains or losses are reported as part of net income.

(D)- The expense recognition principle is the process of relating expenses with revenues on a cause and effect basis. Answer (A) is incorrect because the expense recognition principle is not related to the period of existence of current assets and current liabilities. Answer (B) is incorrect because the the expense recognition principle is not concerned with the timing of cash flows. Answer (C) is incorrect because the expense recognition principle is not concerned with a particular reporting period interval.

The concept referred to by the "expense recognition" principle is A. that current liabilities have the same period of existence as the current assets. B. that all cash disbursements for a period be matched to cash receipts for the period. C. that net income should be reported on a quarterly basis. D. that where possible the expenses to be included in the income statement were incurred to produce the revenues.

Materiality

The constraint of determining if an item is important enough to likely influence the decision of a reasonably prudent investor or creditor.

Cost Constraint

The constraint that states that information should be provided only if the benefits of providing such information outweigh the costs of providing it.

(C)- The economic entity assumption holds that economic activity can be identified with a particular unit of accountability. Alternative A represents the essence of the economic entity assumption not a violation. Alternative B is related to the periodicity assumption and alternative D is not a basic accounting assumption.

The economic entity assumption in accounting is best reflected by which of the following statements? A. When a parent and subsidiary company are merged for accounting and reporting purposes the economic entity assumption is violated. B. The best way to truly measure the results of enterprise activity is to measure them at the time the enterprise is liquidated. C. The activity of a business enterprise can be kept separate and distinct from its owners and any other business unit. D. A business enterprise is in business to enhance the economic well being of its owners.

Fair Value

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Full Disclosure Principle

The principle that information should be provided if it is of sufficient importance to influence the judgment and decisions of an informed user.

Financial Statements

The structured means of communicating financial information, through the balance sheet, income statement, statement of cash flows, and statement of owners' equity.

True

True or False: A conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements.

False- Development of a conceptual framework will not provide a solution to all future accounting problems, nor will it eliminate the need for a formal standard-setting body. However, a soundly developed conceptual framework should enable the FASB to issue more useful and consistent standards resulting in easier solutions to emerging practical problems

True or False: A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary.

False- The environment within which any discipline exists plays an integral role in shaping the theory of that discipline. The purpose of accounting is to serve the business environment through the issuance of timely and relevant financial information. To present such information, accounting theory must be developed with consideration being given to the business environment.

True or False: Accounting theory is developed without consideration of the environment within which it exists.

False- Consistency means that a company applies the same methods to similar accounting transactions from period to period. It does not mean that companies cannot switch from one method to another. Companies can change to a new method that is considered preferable to the old method as long as financial statement users are made aware of the change

True or False: Adherence to the concept of consistency requires that the same accounting principles be applied to similar transactions for a minimum of five years before any change in principle is adopted.

False- The cost principle requires that assets be accounted for on the basis of acquisition cost. Whatever it costs a particular entity to acquire an asset is that entity's acquisition cost.

True or False: If Company A wishes to acquire an asset owned by Company B, the cost principle would require Company A to record the asset at the original cost to Company B.

True

True or False: Information that has been measured and reported in a similar manner for different enterprises is considered comparable.

False- Product costs such as material, labor, and overhead attach to the product and are carried into future periods if the revenue from the product is recognized in subsequent periods. Period costs such as officers' salaries and other administrative expenses are charged off immediately, even though benefits associated with these costs occur in the future, because no direct relationship between cost and revenue can be determined.

True or False: Period costs such as officer salaries and administrative expenses attach to the product and are carried into future periods if the revenue from the product is recognized in subsequent periods.

True

True or False: Recognition of revenue when cash is collected is appropriate only when it is impossible to establish the revenue figure at the time of sale because of the uncertainty of collection.

True

True or False: Relevance and reliability are the two primary qualities that make accounting information useful for decision making.

True

True or False: The basis for determining whether an item is material is based on both quantitative and qualitative factors.

True

True or False: The difficulty in applying the cost constraint is that the costs and especially the benefits are not always evident or measurable.

False- The economic entity assumption holds that the activity of a business entity can be kept separate and distinct from its owners and any other business unit. This assumption has nothing to do with the nature of the business organization.

True or False: The economic entity assumption is useful only when the entity referred to is a profit-seeking business enterprise.

True

True or False: The fact that equity represents an ownership interest and a residual claim against the net assets of an enterprise means that in the event of liquidation, creditors have a priority over owners in the distribution of assets.

True

True or False: The full disclosure principle states that information should be provided when it is of sufficient importance to influence the judgment and decisions of an informed user.

True

True or False: The going-concern assumption is generally applicable in most business situations unless liquidation appears imminent.

True

True or False: The monetary unit assumption means that money is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis.

False- The notes to financial statements generally amplify or explain the items presented in the main body of the statements.

True or False: The notes to financial statements generally summarize the items presented in the main body of the statements.

True

True or False: The periodicity assumption is a result of the demands of various financial statement user groups for timely reporting of financial information.

False- The three elements—assets, liabilities, and equity—describe amounts of resources and claims to resources at a moment of time.

True or False: The three elements—assets, liabilities, and equity—describe transactions, events, and circumstances that affect an enterprise during a period of time.

True

True or False: To be relevant, accounting information must be capable of making a difference in a decision.

True

True or False: Under the expense recognition principle, it is possible to have an expense reported on the income statement in one period and the cash payment for that expense reported in another period.

False- Use of a sound conceptual framework will not eliminate alternative accounting methods for similar transactions. However, a sound conceptual framework should allow practitioners to dismiss certain alternatives quickly and focus on a logical and acceptable treatment.

True or False: Use of a sound conceptual framework in the development of accounting principles will make financial statements of all entities comparable because alternative accounting methods for similar transactions will be eliminated.

False- Because an item is deemed to be immaterial does not justify its deletion from financial statements. If an amount is so small that it is quite unimportant when compared with other items, application of a particular standard may be considered of less importance

True or False: When an amount is determined by the accountant to be immaterial in relation to other amounts reported in the financial statements, that amount may be deleted from the financial statements.

(A)- Revenue is generally recognized when a company satisfies its performance obligations.

Under the revenue recognition principle, revenue is generally recognized when: A. a company satisfies its performance obligations. B. the merchandise has been ordered. C. all expenses have been identified. D. the accounting process is virtually complete.

(A)- The monetary unit assumption holds that the unit of measure remains reasonably stable. Severe inflation would cause this assumption to lose its relevance.

Which of the following basic accounting assumptions is threatened by the existence of severe inflation in the economy? A. Monetary unit assumption. B. Periodicity assumption. C. Going-concern assumption. D. Economic entity assumption

(B)- For information to be relevant, it should have predictive or confirmatory value. Answer (A), materiality is a constraint which relates to the magnitude of an omission or misstatement that in light of the circumstances, may change or influence the decision of a person relying on the information. Answer (C) is incorrect because verifiability is an enhancing quality. Answer (D) is incorrect because understandability is an enhancing quality.

Which of the following is a characteristic describing the primary quality of relevance? A. Materiality. B. Predictive value. C. Verifiability. D. Understandability.

(D)- The expense recognition principle allows for letting the expense follow the revenue (expense is recognized when it makes a contribution to income); however, immediate expensing is appropriate when there's no apparent association between an expense and a revenue.

Which of the following is a correct statement regarding the expense recognition principle? A. Expenses are recognized when they make a contribution to revenue. B. Costs can be charged to the current period as an expense simply because no connection with revenue can be determined. C. In recognizing expenses, accountants attempt to follow the approach of let the expense follow the revenue. D. All of the choices are correct.

(D)- The financial reporting process will always require the expertise of a person trained in accounting. The development of a conceptual framework will aid the accountant because new and emerging practical problems should be more quickly solvable by reference to an existing framework. Alternatives A, B, and C are benefits of the Conceptual Framework Project.

Which of the following is not a benefit associated with the FASB Conceptual Framework Project? A. A conceptual framework should increase financial statement users' understanding of and confidence in financial reporting. B. Practical problems should be more quickly solvable by reference to an existing conceptual framework. C. A coherent set of accounting standards and rules should result. D. Business entities will need far less assistance from accountants because the financial reporting process will be quite easy to apply.

(B)- Accounting information is a faithful representation to the extent that it is complete, neutral, and is reasonably free of error and bias. An estimate of carrying amount of buildings is deemed unreliable, the buildings should be recorded at their cost at the date of purchase and subsequent depreciated.

Which of the following violates the concept of faithful representation? A. The management report refers to new discoveries and inventions made, but the financial statements never report the results. B. Financial statements included buildings with a carrying amount estimated by management. C. Financial statements were issued one year late. D. All of the choices violate faithful representation.