Chapter 2: Conceptual Framework for Financial Reporting (Questions)

Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them?

Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity's ongoing major or central operations. Losses arise from peripheral or incidental transactions.

What are the enhancing qualities of the qualitative characteristics? What is the role of enhancing qualities in the conceptual framework?

Enhancing qualities are qualitative characteristics that are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from less-useful information. Enhancing characteristics are comparability, verifiability, timeliness, and understandability.

What is the definition of fair value?

Fair value is defined as "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." Fair value is therefore a market-based measure.

Briefly describe the two fundamental qualities of useful accounting information.

Relevance and faithful representation are the two primary qualities of useful accounting information. For information to be relevant, it should be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations. Faithful representation of a measure rests on whether the numbers and descriptions match what really existed or happened.

Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Selane recognize revenue related to its catering service?

Revenues are recognized when a performance obligation is satisfied-in the case of services, revenue is recognized when the services are performed Therefore, revenue for Selane Eatery should be recognized at the time the luncheon is served.

What are the five steps used to determine the proper time to recognize revenue?

The five steps in the revenue recognition process are: Step 1​: Identify the contract(s) with the customer. A contract is an agreement between two parties that creates enforceable rights or obligations. Step 2: ​Identify the separate performance obligations in the contract. A performance obligation is either a promise to provide a service or deliver a product, or both. Step 3: Determine the transaction price. Transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service. Step 4: Allocate the transaction price to separate performance obligations. This is usually done by estimating the value of consideration attributable to each product or service. Step 5: Recognize revenue when each performance obligation is satisfied. This occurs when the service is provided or the product is delivered. ​Note that many revenue transactions pose few problems because the transaction is initiated and completed at the same time.

Statement of Financial Accounting Concepts No. 5 identifies four characteristics that an item must have before it is recognized in the financial statements. What are these four characteristics?

The four characteristics are: (1)​ Definitions—The item meets the definition of an element of financial statements. (2)​ Measurability—It has a relevant attribute measurable with sufficient reliability. (3)​ Relevance—The information is capable of making a difference in user decisions. (4)​ Reliability—The information is representationally faithful, verifiable, and neutral.

What is meant by the term "qualitative characteristics of accounting information"?

​"Qualitative characteristics of accounting information" are those characteristics which contribute to the quality or value of the information. The overriding qualitative characteristic of accounting information is usefulness for decision-making.

What is a performance obligation, and how is it used to determine when revenue should be recognized?

A performance obligation is a promise to deliver a product or provide a service to a customer. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered.

Why is it necessary to develop a definitional framework for the basic elements of accounting?

At present, the accounting literature contains many terms that have peculiar and specific meanings. Some of these terms have been in use for a long period of time, and their meanings have changed over time. Since the elements of financial statements are the building blocks with which the statements are constructed, it is necessary to develop a basic definitional framework for them.

What is the distinction between comparability and consistency?

Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency, a type of comparability, facilitates comparisons between information about the same enterprise at two different points in time.

Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them?

Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity's ongoing major or central operations. Gains arise from peripheral or incidental transactions.

What are the four basic assumptions that underlie the financial accounting structure?

The four basic assumptions that underlie the financial accounting structure are: ​(1)​An economic entity assumption. ​(2)​A going concern assumption. ​(3)​A monetary unit assumption. ​(4)​A periodicity assumption

The life of a business is divided into specific time periods, usually a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period. (a) This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption. (b) What has been the effect of this practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?

(a) ​In accounting it is generally agreed that any measures of the success of an enterprise for periods less than its total life are at best provisional in nature and subject to correction. Measurement of progress and status for arbitrary time periods is a practical necessity to serve those who must make decisions. It is not the result of postulating specific time periods as measurable segments of total life. ​(b) ​The practice of periodic measurement has led to many of the most difficult accounting problems such as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition tests. The accrual system calls for associating related revenues and expenses. This becomes very difficult for an arbitrary time period with incomplete transactions in process at both the beginning and the end of the period. A number of accounting practices such as adjusting entries or the reporting of corrections of prior periods result directly from efforts to make each period's calculations as accurate as possible and yet recognizing that they are only provisional in nature.

Describe the major constraint inherent in the presentation of accounting information.

Accounting information is subject to the cost constraint. Information is not worth providing unless the benefits exceed the costs of preparing it.

The treasurer of Landowska Co. has heard that conservatism is a doctrine that is followed in accounting and, therefore, proposes that several policies be followed that are conservative in nature. State your opinion with respect to each of the policies listed. (a) The company gives a 2-year warranty to its customers on all products sold. The estimated warranty costs incurred from this year's sales should be entered as an expense this year instead of an expense in the period in the future when the warranty is made good. (b) When sales are made on account, there is always uncertainty about whether the accounts are collectible. Therefore, the treasurer recommends recording the sale when the cash is received from the customers. (c) A personal liability lawsuit is pending against the company. The treasurer believes there is an even chance that the company will lose the suit and have to pay damages of $200,000 to $300,000. The treasurer recommends that a loss be recorded and a liability created in the amount of $300,000.

In general, conservatism should not be the basis for determining the accounting for transactions, because it is in conflict with the conceptual framework quality of neutrality. ​(a)​ Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can be estimated accurately, they should be recorded when an obligation exists, usually in the period of the sale. ​(b)​ Not acceptable. Most accounts are collectible or the company will be out of business very soon. Hence sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Landowska Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts. ​(c) ​Not acceptable. A provision for the po ssible loss can be made through an appropriation of retained earnings but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably an unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB ASC 450-10-05 for additional discussion if desired.) Note disclosure is required if the loss is not recorded; however, conservatism is not part of the conceptual framework.

According to the FASB conceptual framework, the objective of financial reporting for business enterprises is based on the needs of the users of financial statements. Explain the level of sophistication that the Board assumes about the users of financial statements.

In providing information to users of financial statements, the Board relies on general-purpose financial statements. The intent of such statements is to provide the most useful information possible at minimal cost to various user groups. Underlying these objectives is the notion that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that in the preparation of financial statements a level of reasonable competence can be assumed; this has an impact on the way and the extent to which information is reported.

The chairman of the board of directors of the company for which you are chief accountant has told you that he has little use for accounting figures based on historical cost. He believes that replacement values are of far more significance to the board of directors than "out-of-date costs." Present some arguments to convince him that accounting data should still be based on historical cost.

Some of the arguments which might be used are outlined below: ​(1)​Cost is definite and verifiable; other values would have to be determined somewhat arbitrarily and there would be considerable disagreement as to the amounts to be used. ​(2)​Amounts determined by other bases would have to be revised frequently. ​(3)​Comparison with other companies is aided if cost is employed. ​(4)​The costs of obtaining replacement values could outweigh the benefits derived.

How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement?

The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation. An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items. The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital. The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The FASB is proposing a definition of materiality in the Conceptual Framework, which will be aligned with that in the securities laws and which can used in disclosure decisions. There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income.

What are some of the costs of providing accounting information? What are some of the benefits of accounting information? Describe the cost-benefit factors that should be considered when new accounting standards are being proposed.

The costs of providing accounting information include costs of collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to competitors, and of analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. Occasionally new accounting standards require presentation of information that is not readily assembled by the accounting systems of most companies. A determination should be made as to whether the incremental or additional costs of providing the proposed information exceed the incremental benefits to be obtained. This determination requires careful judgment since the benefits of the proposed information may not be readily apparent.

Briefly describe the fair value hierarchy.

The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels. Level 1:​Observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Least Subjective Level 2: ​Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3:​Unobservable inputs (for example, a company's own data or assumptions). Most Subjective ​As indicated, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. At the least-reliable level, Level 3, much judgment is needed based on the best information available to arrive at a relevant and representationally faithful fair value measurement.

What is the fair value option? Explain how use of the fair value option reflects application of the fair value principle.

The fair value option gives companies the option to use fair value (referred to as the fair value option as the basis for measurement of financial assets and financial liabilities.) The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities.

In January 2018, Janeway Inc. doubled the amount of its outstanding stock by selling on the market an additional 10,000 shares to finance an expansion of the business. You propose that this information be shown by a footnote on the balance sheet as of December 31, 2017. The president objects, claiming that this sale took place after December 31, 2017, and therefore should not be shown. Explain your position.

The general guide followed with regard to the full disclosure principle is to disclose in the financial statements any facts of sufficient importance to influence the judgment of an informed reader. The fact that the amount of outstanding common stock doubled in January of the subsequent reporting period probably should be disclosed because such a situation is of importance to present stockholders. Even though the event occurred after December 31, 2017, it should be disclosed on the balance sheet as of December 31, 2017, in order to make adequate disclosure. (The major point that should be emphasized throughout the entire discussion on full disclosure is that there is normally no "black" or "white" but varying shades of grey and it takes experience and good judgment to arrive at an appropriate answer).

What is the basic accounting problem created by the monetary unit assumption when there is significant inflation? What appears to be the FASB position on a stable monetary unit?

The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so that dollars of different years can be added without any adjustment. When the value of the dollar fluctuates greatly over time, the monetary unit assumption loses its validity. ​The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be used to measure items recognized in financial statements. Only if circumstances change dramatically will the Board consider a more stable measurement unit.

Mogilny Company paid $135,000 for a machine. The Accumulated Depreciation—Equipment account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company president believes that the company has a "right to this gain." What does the president mean by this statement? Do you agree?

The president means that the difference between the fair value and the book value, should be recorded in the books as a 'gain'. This item should not be entered in the accounts, however, because no performance obligation related to this machine has been created or satisfied, GAAP will allow the company to record a gain once the machine is sold and delivered to a buyer.

Explain the revenue recognition principle.

The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered. Companies follow a five-step process to analyze revenue arrangements to determine when revenue should be recognized: (1) Identify the contract(s) with the customer; (2) Identify the separate performance obligations in the contract; (3) Determine the transaction price; (4) Allocate the transaction price to separate performance obligations; and (5) Recognize revenue when each performance obligation is satisfied.

Briefly describe the types of information concerning financial position, income, and cash flows that might be provided (a) within the main body of the financial statements, (b) in the notes to the financial statements, or (c) as supplementary information.

​(a)​ To be recognized in the main body of financial statements, an item must meet the definition of an element. In addition the item must have been measured, recorded in the books, and passed through the double-entry system of accounting. ​(b)​ Information provided in the notes to the financial statements amplifies or explains the items presented in the main body of the statements and is essential to an understanding of the performance and position of the enterprise. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. ​(c)​ Supplementary information includes information that presents a different perspective from that adopted in the financial statements. It also includes management's explanation of the financial information and a discussion of the significance of that information.

What is a conceptual framework? Why is a conceptual framework necessary in financial accounting?

​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. A conceptual framework is necessary in financial accounting for the following reasons: (1)​ It enables the FASB to issue more useful and consistent standards in the future. (2)​ New issues will be more quickly solvable by reference to an existing framework of basic theory. (3)​ It increases financial statement users' understanding of and confidence in financial reporting. (4) ​It enhances comparability among companies' financial statements.

What is the primary objective of financial reporting?

​The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

Three expense recognition methods (associating cause and effect, systematic and rational allocation, and immediate recognition) were discussed in the text under the expense recognition principle. Indicate the basic nature of each of these expense recognition methods and give two examples of each.

​The cause and effect relationship can seldom be conclusively demonstrated, but many costs appear to be related to particular revenues and recognizing them as expenses accompanies recognition of the revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and cost of products sold or services provided. ​Systematic and rational allocation means that in the absence of a direct means of associating cause and effect, and where the asset provides benefits for several periods, its cost should be allocated to the periods in a systematic and rational manner. Examples of expenses that are recognized in a systematic and rational manner are depreciation of plant assets, amortization of intangible assets, and allocation of rent and insurance. ​Some costs are immediately expensed because the costs have no discernible future benefits or the allocation among several accounting periods is not considered to serve any useful purpose. Examples include officers' salaries, most selling costs, amounts paid to settle lawsuits, and costs of resources used in unsuccessful efforts.