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Objectives,QualitativeCharacteristics

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Studytext
Objectives,QualitativeCharacteristics
I. ConceptualFrameworkOutline
A. TheFASB'sStatementsofFinancialAccountingConcepts,asamended,comprisetheconceptual
frameworkforfinancialaccounting.TheframeworkdoesnotconstituteGAAPbutratherprovides
consistentdirectionforthedevelopmentofspecificGAAP.Theconceptualframeworkisa
"constitution"fordevelopingspecificGAAP.
B. Alistingofthepartsoftheconceptualframeworkfollows.Thisoutlineliststhemajorsubsections
oftheframeworkinaprogressionleadingfromdefinitionsandgeneralconceptstospecific
accountingprinciples,theultimatepurposeoftheframework.
1. Objectiveoffinancialreporting
2. Qualitativecharacteristicsofaccountinginformation
3. Accountingassumptions
4. Basicaccountingprinciples
5. Accountingconstraints
6. Elementsoffinancialstatements.
II. ObjectiveofFinancialReporting
A. Theobjectiveofgeneralpurposefinancialreportingistoprovideinformationabouttheentity
usefultocurrentandfutureinvestorsandcreditorsinmakingdecisionsascapitalproviders.
B. Usefulinformationincludesinformationabout:
1. Theamount,timing,anduncertaintyofanentity'scashflows
2. Abilityoftheentitytogeneratefuturenetcashinflows
3. Anentity'seconomicresources(assets)andclaimstothoseresources(liabilities)which
providesinsightintotheentity'sfinancialstrengthsandweaknesses,anditsliquidityand
solvency
4. Theeffectivenesswithwhichmanagementhasmetitsstewardshipresponsibilities
5. Theeffectoftransactionsandothereventsthatchangeanentity'seconomicresourcesand
theclaimstothoseresources.
III. QualitativeCharacteristicsofAccountingInformation
A. Forfinancialstatementinformationtobeuseful,itshouldhaveseveralqualitativecharacteristics.
Therearetwoprimarycharacteristicsandfourenhancingcharacteristics,eachofwhichhas
subcomponents.Thefollowingdiagramshowstheprimaryandenhancingcharacteristicsandtheir
components,ascontributingtotheobjectiveoffinancialreporting.
Objectiveoffinancialreporting:decisionusefulness
Primaryqualitativecharacteristics
1.Relevance 2.Faithfulrepresentation
a.Predictivevalue a.Completeness
b.Confirmatoryvalue b.Neutrality
c.Freefrommaterialerror
Enhancingqualitativecharacteristics
1.Comparability
2.Verifiability
3.Timeliness
4.Understandability
B. Primarycharacteristics(relevance,faithfulrepresentation)Forinformationtobe
usefulfordecisionmaking,itmustbebothrelevantandafaithfulrepresentationoftheeconomic
phenomenathatitrepresents.
1. Relevance(primarycharacteristic)Informationisrelevantifitmakesadifference
todecisionmakersintheirroleascapitalproviders.Informationisrelevantwhenithas
predictivevalue,confirmatoryvalue,orboth.
a. PredictivevalueInformationhaspredictivevalueifitassistscapitalproviders
informingexpectationsaboutfutureevents.
b. ConfirmatoryvalueInformationhasconfirmatoryvalueifitconfirmsor
changespast(orpresent)expectationsbasedonpreviousevaluations.Forexample,
ifreportedearningsforaperiodbearoutmarketexpectations,thenithas
confirmatoryvalue.
2. Faithfulrepresentation(primarycharacteristic)Informationfaithfullyrepresents
aneconomicconditionorsituationwhenthereportedmeasureandtheconditionor
situationareinagreement.Financialinformationthatfaithfullyrepresentsaneconomic
phenomenonportraystheeconomicsubstanceofthephenomenon.Informationis
representationallyfaithfulwhenitiscomplete,neutral,andfreefrommaterialerror.
Faithfulrepresentationreplacesreliabilityasaprimaryqualitativecharacteristic.
a. Completeness:informationiscompleteifitincludesalldatanecessarytobe
faithfullyrepresentative.
b. Neutral:informationisneutralwhenitisfreefromanybiasintendedtoattaina
prespecifiedresult,ortoencourageordiscouragecertainbehavior.
c. Freefrommaterialerror:informationisfreefrommaterialerrorifitisaccurateand
truthful.
C. EnhancingcharacteristicsThesearecomplementarytotheprimarycharacteristicsand
enhancethedecisionusefulnessoffinancialreportinginformationthatisrelevantandfaithfully
represented.
1. ComparabilityThequalityofinformationthatenablesuserstoidentifysimilaritiesand
differencesbetweensetsofinformation.Consistencyinapplicationofrecognitionand
measurementmethodsovertimeenhancescomparability.
2. VerifiabilityInformationisverifiableifdifferentknowledgeableandindependent
observerscouldreachsimilarconclusionsbasedontheinformation.
3. TimelinessInformationistimelyifitisreceivedintimetomakeadifferencetothe
decisionmaker.Timelinesscanalsoenhancethefaithfulrepresentationofinformation.
4. UnderstandabilityInformationisunderstandableiftheusercomprehendsitwithin
thedecisioncontextathand.Usersareassumedtohaveareasonableunderstandingof
businessandaccountingandarewillingtostudytheinformationwithreasonablediligence.
D. RelevanceandfaithfulrepresentationmayconflictInsuchcases,atradeoffismade
favoringoneortheother.
Example:
1.Relevanceoverfaithfulrepresentation.Thepervasiveuseof
accountingestimates(depreciation,baddebtexpense,pension
estimates)isanexampleofemphasizingrelevanceoverfaithfulrepresentation.
Firmsareprovidingestimates,ratherthancertainamounts.Reasonable
approximations,althoughtheycannotbeperfectlyreliable,arepreferredby
financialstatementuserstoeither(1)perfectinformationissuedtoolatetomake
adifference,or(2)noinformationatall.
2.Faithfulrepresentationoverrelevance.Intheopinionofmany,theuseof
historicalcostasavaluationbaseisanexampleofemphasizingfaithful
representationoverrelevance.Historicalcostisveryreliablebecauseitisbased
onobjectivelyverifiablepastinformation.However,historicalcostisconsideredto
belesscurrentandthereforelessrelevantthanmarketvalue.
Note:
Candidatesshouldbeabletoidentifythecomponentsofrelevanceand
faithfulrepresentation.Ithelpstorememberthatthereismorethan
onecomponenttobothqualities.
Flashcards
Flashcard#1(FC5783)
WhoistheTargetAudienceofFinancialStatements? Decisionmakersmainlypotentialinvestors,creditors,
andregulators.
Flashcard#2(FC5782)
WhatareObjectivesofFinancialReporting? Toprovideinformationabouttheentitytocurrentand
futureusersofthefinancialstatementswhoare
makingcreditandinvestmentdecisions.
Flashcard#3(FC5781)
WhatisUnderstandability? Informationisunderstandableiftheuser
comprehendsitwithreasonableeffortanddiligence.
Flashcard#4(FC5780)
WhatisTimeliness? Toberelevant,accountinginformationmustbe
receivedintimetomakeadifferencetothedecision
maker.
Flashcard#5(FC5779)
WhatisVerifiability? Informationisverifiableifdifferentknowledgeableand
independentobserverscanreachsimilarconclusions.
Flashcard#6(FC5778)
WhatisComparability? Thequalityofinformationthatenablesusersto
identifysimilaritiesanddifferencesbetweensetsof
information.
Flashcard#7(FC5777)
Listtheenhancingqualitativecharacteristicsof
financialinformation.
1. Comparability
2. Verifiability
3. Timeliness
4. Understandability.
Flashcard#8(FC5776)
WhatisNeutrality? Tobeneutral,accountinginformationmustbefreeof
bias.
Flashcard#9(FC5775)
Whatdoesitmeantobefreefrommaterialerror? Informationisfreefrommaterialerrorifitisaccurate
andtruthful.
Flashcard#10(FC5774)
Whatiscompleteness? Informationiscompleteifitincludesalldatanecessary
tobefaithfullyrepresentative.
Flashcard#11(FC5773)
WhataretheingredientsofFaithfulrepresentation? Completeness,Freefrommaterialerror,Neutrality.
Flashcard#12(FC5772)
WhatisConfirmatoryValue? Toberelevant,accountinginformationshouldassist
decisionmakersinconfirmingpastpredictions.
Flashcard#13(FC5771)
WhatisPredictiveValue? Toberelevant,accountinginformationshouldassist
financialstatementusersinmakingpredictionsabout
futureevents.
Flashcard#14(FC5770)
WhataretheIngredientsofRelevance? Predictivevalue,Confirmatoryvalue.
Flashcard#15(FC5769)
WhatarethePrimaryQualitativeCharacteristicsof
FinancialInformation?
Relevance,Faithfulrepresentation.
PastExamQuestions
Question#1(AICPA.061205FAR)
Accordingtotheconceptualframework,thequalityofinformationthathelpsusersincreasethe
likelihoodofcorrectlyforecastingtheoutcomeofpastorpresenteventsiscalled:
A.Confirmatoryvalue.
B.PredictiveValue.
C.Representationalfaithfulness.
D.Faithfulrepresentation.
Question#2(AICPA.090636FARIA)
Whichofthefollowingcharacteristicsrelatestobothaccountingrelevanceandfaithful
representation?
A.Freefrommaterialerror.
B.Completeness.
C.Neutrality.
D.Comparability.
Question#3(AICPA.120623FAR)
Whichofthefollowingcharacteristicsofaccountinginformationprimarilyallowsusersof
financialstatementstogeneratepredictionsaboutanorganization?
A.Reliability.
B.Timeliness.
C.Neutrality.
D.Relevance.
Question#4(AICPA.900501FARTHFA)
AccordingtotheFASBconceptualframework,predictivevalueisaningredientof:
Relevance Faithfulrepresentation
No No
Yes Yes
No Yes
Yes No
Question#5(AICPA.901101FARTHFA)
Accordingtotheconceptualframework,theprocessofreportinganiteminthefinancial
statementsofanentityis:
A.Recognition.
B.Realization.
C.Allocation.
D.Matching.
Question#6(AICPA.921102FARTHFA)
AccordingtotheFASBconceptualframework,whichofthefollowingisnotanenhancing
qualitativecharacteristic?
A.Comparability.
B.Confirmatoryvalue.
C.Verifiability.
D.Timeliness.
Question#7(AICPA.931105FARTHFA)
Accordingtotheconceptualframework,theobjectivesoffinancialreportingforbusiness
enterprisesarebasedon:
A.Theneedforconservatism.
B.Reportingonmanagement'sstewardship.
C.GenerallyAcceptedAccountingPrinciples.
D.Theneedsoftheusersoftheinformation.
Question#8(AICPA.940502FARFA)
Whatistheconceptualframeworkintendedtoestablish?
A.GenerallyAcceptedAccountingPrinciplesinfinancialreportingbybusinessenterprises.
B.Themeaningof"presentfairlyinaccordancewithGenerallyAcceptedAccountingPrinciples."
C.Theobjectivesandconceptsforuseindevelopingstandardsoffinancialaccountingandreporting.
D.ThehierarchyofsourcesofGenerallyAcceptedAccountingPrinciples.
Question#9(AICPA.940504FARFA)
Duringtheperiodwhenanenterpriseisunderthedirectionofaparticularmanagement,its
financialstatementswilldirectlyprovideinformationabout:
A.Bothenterpriseperformanceandmanagementperformance.
B.Managementperformancebutdoesnotdirectlyprovideinformationaboutenterpriseperformance.
C.Enterpriseperformancebutnotdirectlyprovideinformationaboutmanagementperformance.
D.Neitherenterpriseperformancenormanagementperformance.
Question#10(AICPA.941101FARFA)
Accordingtotheconceptualframework,neutralityisaningredientof:
Faithfulrepresentation Relevance
Yes Yes
Yes No
No Yes
No No
Question#11(AICPA.951106FARFA)
Conceptually,interimfinancialstatementscanbedescribedasemphasizing:
A.Timelinessoverfaithfulrepresentation.
B.Faithfulrepresentationoverrelevance.
C.Relevanceovercomparability.
D.Comparabilityoverneutrality.
PastExamQuestionAnswers
Question#1(AICPA.061205FAR)
A.Althoughconfirmatoryvalueisaningredientofrelevance(alongwithpredictivevalue),confirmatoryvalue
referstotheusefulnessofinformationfordeterminingtheaccuracyofaprediction,andalsoformodifyinga
predictionmodel.Predictivevalueisthecharacteristicofinterestinthisquestion.
B.(Correct!)Predictivevalueistheingredientthathelpsusersincreasethelikelihoodofforecastingthe
outcomeofevents.Financialstatementinformationisusefulifithelpsusersmakedecisionsaboutinvestingand
extendingcredit.Thesedecisionsinvolvepredictionsofafirm'sfuturefinancialperformance,position,andcash
flows.
C.Representationalfaithfulnessisaprimaryqualitativecharacteristic.
D.Faithfulrepresentationisoneofthetwoprimarycharacteristicsoffinancialstatementinformation(theother
onebeingrelevance).Thequalityofinformationthathelpsusersincreasethelikelihoodofcorrectlyforecasting
theoutcomeofpastorpresenteventsispredictiveabilityandisoneoftheaspectsofrelevance,notfaithful
representation.
Question#2(AICPA.090636FARIA)
A."Freefrommaterial"errorisacharacteristicoffaithfulrepresentation.
B.Completenessisacharacteristicofafaithfulrepresentationenhancingqualitativecharacteristic.
C.Neutrality,orfreedomfrombias,isoneofthethreeingredients,orcomponents,offaithfulrepresentation.
D.(Correct!)Comparabilityisthequalityofinformationthatenablesuserstoidentifysimilaritiesand
differencesbetweensetsofinformation.Forinformationtobecomparable,itmustbebothrelevant(makea
differencetoauser)andreliable(beaccurateandtrustworthy).
Question#3(AICPA.120623FAR)
A.Thequestionisaskingwhichofthefollowingtermscapturespredictivevalue.Thetermreliabilityisnolonger
partoftheconceptualframework.Faithfulrepresentationisnowusedtocapturecompleteness,neutrality,and
freefrommaterialerror.Predictivevalueisacomponentofrelevance.
B.Thequestionisaskingwhichofthefollowingtermscapturespredictivevalue.Timelinessisanenhancing
characteristicoffinancialinformation.Timelinessisnotpartofrelevancewhichcapturespredictivevalue.
C.Thequestionisaskingwhichofthefollowingtermscapturespredictivevalue.Neutralityisacomponentof
faithfulrepresentation.Itisnotacomponentofrelevance.Relevancecapturespredictivevalue.
D.(Correct!)Thequestionisaskingwhichofthefollowingtermscapturespredictivevalue.Predictivevalue
alongwithconfirmatoryvalueisacomponentofrelevance.
Question#4(AICPA.900501FARTHFA)
A.Thefirstpartoftheanswerisincorrect.
Predictivevalueisoneofthetwoingredientsofrelevance,oneoftheprimarycharacteristicsofaccounting
information.Theotheringredientofrelevanceisconfirmatoryvalue.
Predictivevalueisnotaningredientoffaithfulrepresentation.Faithfulrepresentationistheotherprimary
characteristicofaccountinginformation.Itsthreemainingredientsarecompleteness,freefrommaterialerror,
andneutrality.
B.Thesecondpartoftheanswerisincorrect.
Predictivevalueisoneoftheingredientsofrelevance,oneoftheprimarycharacteristicsofaccounting
information.Theotheringredientofrelevanceisconfirmatoryvalue.
Predictivevalueisnotaningredientoffaithfulrepresentation.Faithfulrepresentationistheotherprimary
characteristicofaccountinginformation.Itsthreemainingredientsarecompleteness,freefrommaterialerror,
andneutrality.
C.Bothpartsoftheanswerareincorrect.
Predictivevalueisoneoftheingredientsofrelevance,oneoftheprimarycharacteristicsofaccounting
information.Theotheringredientofrelevanceisconfirmatoryvalue.
Predictivevalueisnotaningredientoffaithfulrepresentation.Faithfulrepresentationistheotherprimary
characteristicofaccountinginformation.Itsthreemainingredientsarecompleteness,freefrommaterialerror,
andneutrality.
D.(Correct!)Predictivevalueisoneoftheingredientsofrelevance,oneoftheprimarycharacteristicsof
accountinginformation.Theotheringredientofrelevanceisconfirmatoryvalue.
Predictivevalueisnotaningredientoffaithfulrepresentation.Faithfulrepresentationistheotherprimary
characteristicofaccountinginformation.Itsthreemainingredientsarecompleteness,freefrommaterialerror,
andneutrality.
Question#5(AICPA.901101FARTHFA)
A.(Correct!)Recognitionistheprocessofformallyrecordingandreportinganitemasoneoftheelementsof
financialstatements.Itisthe"strongest"applicationanitemcanreceive.Footnotedisclosuremayreportan
item,butitdoesnotincludetheiteminanaccountbalance.Whenanitemisrecognized,itaffectsanaccount
balancereportedinthefinancialstatements.Theitemmaynotbeseparatelylisted,butitwillbereflectedinone
oftheaccountsinthestatements.
B.Realizationisaneconomicconceptandreferstotheprocessofconvertingnoncashresourcesandrightsinto
money.Thusrealizationhasanarrowermeaning.Itisnottheprocessofreportinganiteminthefinancial
statements.Thatprocessiscalledrecognition.Many,ifnotmostfinancialstatementitemsarenotrealizedinthe
aboveprecisesense,buttheyareallrecognizedbecausetheyappearinthefinancialstatements.Allrealized
itemsarerecognized,butnotallrecognizeditemsarerealized.
C.Allocationreferstotheprocessofapportioningaresourceoranamounttoberecordedtoatimeperiod,toan
account,ortoanotherattribute.Forexample,theproceedsfromtheissuanceofabondwithdetachablewarrants
isallocatedtothebondsandwarrants.Depreciationexpenseonequipmentisallocatedtotimeperiodsona
systematicandrationalbasis.Allocationisnotthegeneralprocessofrecordinganitem.Thatprocessis
recognition.
D.Matchingistheprocessofassociatinganexpensetoarevenue.Ideally,thematchingconceptsignalswhena
costisrecognizedasanexpense.However,matchingisnotthegeneraltermappliedtorecordingandreporting
items.Thattermisrecognition.
Question#6(AICPA.921102FARTHFA)
A.Comparability,thequalityofinformationthatallowsuserstoidentifysimilaritiesanddifferencesbetween
differentsetsofdata,isanenhancingcharacteristicofaccountinginformation.Comparabilitycontributestoboth
relevance,thequalityofinformationthatmakesadifferenceindecisionmaking,andfaithfulrepresentation,the
qualityofinformationthatrendersitobjectiveandunbiased.Datathatiscomparablewithotherreporteddatais
moreusefulfordecisionmakingandthereforemorerelevant.Italsoimprovesthefaithfulrepresentationofthe
data.Datathatisnotcomparablewithotherdatasetsmaynotbeasfaithfularepresentationasdatathatis
comparable.
B.(Correct!)Confirmatoryvalueisaningredientofrelevance.Itdoesnotrelatetofaithfulrepresentation.
Faithfulrepresentationcanbebrokendownintocompleteness,freefrommaterialerror,andneutrality.
C.Verifiabilityisanenhancingcharacteristicofaccountinginformation.Relevancecanbebrokendowninto
predictivevalueandconfirmatoryvalue.Faithfulrepresentationcanbebrokendownintocompleteness,freedom
frommaterialerror,andneutrality.
D.Timelinessisanenhancingcharacteristicofaccountinginformation.Itdoesnotrelatetofaithful
representation.Faithfulrepresentationcanbebrokendownintocompleteness,freefrommaterialerror,and
neutrality.
Question#7(AICPA.931105FARTHFA)
A.Conservatismisaconstraintplacedoncertainaccountingmeasurementsandreporting.Itdoesnotformthe
basisfortheobjectivesoffinancialstatements.
B.Anevaluationofhowwellmanagementhascarriedoutitsstewardshipresponsibilitytoownersfortheuseof
enterpriseresourcesentrustedtoitisjustoneofmanyinformationneeds.Moreimportantaretheinformation
needsconcerningtheassessmentsoffutureperformanceandcashflowgeneration.
C.GAAPresultfromacleardefiningoftheobjectivesoffinancialstatements.GAAParesetwiththeseobjectives
inmind.
D.(Correct!)Userneedsdefinetheobjectivesoffinancialstatements.Financialstatementsexistsolelytosatisfy
theinformationneedsofusers.Oneoftheseinformationneedsmightbeanevaluationofhowwellmanagement
hascarriedoutitsstewardshipresponsibilitytoownersfortheuseofenterpriseresourcesentrustedtoit.
However,thatisjustoneofmanyinformationneeds.Moreimportantaretheinformationneedsconcerningthe
assessmentsoffutureperformanceandcashflowgeneration.Theobjectivesoffinancialstatementsaremore
involvedwithforwardlookingpurposesthanwithevaluationofthepast.
Question#8(AICPA.940502FARFA)
A.TheconceptsstatementsdonotestablishGAAP,butratherprovidebroadguidelinesfordevelopingspecific
GAAP.
B.Thisphraseologycomesfromthestandardauditreport.Conceptsstatementsprovidethegeneraltheoretical
guidelinesfordevelopingfuturespecificGAAP.
C.(Correct!)Theconceptsstatements,alsocollectivelycalledTheConceptualFramework,providethegeneral
underpinningsforspecificGAAP.Inaway,itisa"constitution"fordevelopingspecificaccountingprinciples.The
conceptsstatementsarenotGAAP,however.
D.ThecodificationistheauthoritativeresourceforallGAAP.
Question#9(AICPA.940504FARFA)
A.Financialstatementsonlyprovidedirectinformationaboutenterpriseperformance.Therearetoomanyfactors
affectingtheperformanceoftheenterprisetoisolatethecontributionofmanagement.
B.Justtheoppositeisthecase.Financialstatementsonlyprovidedirectinformationaboutenterprise
performance.Therearetoomanyfactorsaffectingtheperformanceoftheenterprisetoisolatethecontributionof
management.
C.(Correct!)Thefinancialstatementsprovideawealthofinformationabouttheperformanceandfinancial
positionoftheenterprise,buttheydonotdirectlyallowanevaluationofmanagement.Therearetoomany
factorsthataffectthefirm'sperformancetobeabletosingleoutmanagement'scontribution(orlackofit).Many
factorsinteracttodeterminetheperformanceoftheenterprise,oneofthembeingmanagement'sperformance.
Also,forexample,currententerpriseperformanceisaffectedbythepastactionsofmanagersthatmaynolonger
bewiththeenterprise.
D.Thefinancialstatementsprovideawealthofinformationabouttheperformanceandfinancialpositionofthe
enterprise.Thestatementsdonotprovidedirectinformationaboutmanagementperformance,however.
Question#10(AICPA.941101FARFA)
A.Neutralityisaningredientoffaithfulrepresentationonly.
B.(Correct!)Neutralityisoneoftheingredientsoffaithfulrepresentation,alongwithcompletenessandfree
frommaterialerror.Neutralitymeanslackofbiasthatfinancialreportingdoesnothaveapreconceivedobjective
oragenda.
C.Thecorrectanswerisjusttheopposite.Neutralityisaningredientoffaithfulrepresentation,notrelevance.
D.Neutralityisoneoftheingredientsoffaithfulrepresentation,alongwithcompletenessandfreefrommaterial
error.
Question#11(AICPA.951106FARFA)
A.(Correct!)Interimreportingemphasizestimelinessoverfaithfulrepresentation.Interimreportsaregenerally
moreaggregateandreflectestimatesthatareofamoreapproximatenaturethanthosefoundinannualreports.
Theobjectiveistoprovidereasonableinformationinatimelyfashion,ratherthanexactinformation.Thecostto
providethelatterwouldoftenbeprohibitiveonaquarterlybasis.
B.Thisansweristhedirectoppositeofthecorrectanswer.Ininterimreports,faithfulrepresentationisde
emphasizedrelativetotimeliness.Thesereportsreflectmoreestimatedinformationthanannualreports.
C.Thisanswerisnotcorrect,butcomparabilityshouldnotbecompromisedtoagreatdegreebecausethesame
processofgeneratingquarterlyfinancialstatementsisperformedeachquarter.
D.Neutralityshouldnotbecompromisedintheinterimoranyothertypeoffinancialreporting.Comparabilityis
notparticularlyemphasizedininterimreporting.Thecorrectansweristimelinessoverfaithfulrepresentation.
ProficiencyQuestions
Question#1(PQ2386)
Istheprimaryfocusoffinancialaccountinginformationonassistingtheevaluationofpast
performanceratherthanonassistinguserstoassessthefutureprospectsofafirm?
Yes
No
Question#2(PQ2385)
GAAPpertainsprimarilytogeneralpurposefinancialstatementsratherthanreportstailoredto
specificneeds.
True
False
Question#3(PQ2384)
GAAPassumesthatmostfinancialstatementusersareexpertssuchasstockanalysts.
True
False
Question#4(PQ8493)
Whenthereportedmeasureofaneconomicconditionorsituationalignswiththeeconomic
conditionorsituation,thenitisrepresentationallyfaithful.
True
False
Question#5(PQ8494)
Neutralitymeansvalid.
True
False
Question#6(PQ8495)
Relevancehasthreecomponents.
True
False
ProficiencyQuestionAnswers
Question#1: :False
Question#2: True
Question#3: False
Question#4: True
Question#5: False
Question#6: False
Assumptions,AccountingPrinciples
Slides
Studytext
Assumptions,AccountingPrinciples
I. AccountingAssumptions
A. EntityAssumptionWeassumethereisaseparateaccountingentityforeachbusiness
organization.
Example:
Theownersandthecorporationareseparate.Theownersownsharesin
thecorporationtheydonotowntheassetsofthefirm.Thecorporation
ownstheassets.Thefinancialstatementsrepresentthecorporation,not
theowners.Afirmcannotownitself.Treasurysharesarenotassetstothefirm
nooneownstreasuryshares.Afirmcansueandbesued.Ifafirmissued,the
ownersarenotliable.
B. GoingConcernAssumption
1. Intheabsenceofinformationtothecontrary,abusinessisassumedtohaveanindefinite
life,thatis,itwillcontinuetobeagoingconcern.Therefore,wedonotshowitemsattheir
liquidationorexitvalues.
2. Thisassumption,alsocalledthecontinuityassumption,supportsthehistoricalcostprinciple
formanyassets.Incomemeasurementisbasedonhistoricalcostofassetsbecauseassets
providevaluethroughuse,ratherthandisposal.Thus,netincomeisthedifferencebetween
revenueandthehistoricalcostofassetsusedingeneratingthatrevenue.Withoutthe
goingconcernprinciple,historicalcostwouldnotbeanappropriatevaluationbasis.
Example:
Prepaidassets,suchasprepaidrent,wouldnotbeassetswithoutthe
assumptionofcontinuity.
C. UnitofMeasureAssumptionAssets,liabilities,equities,revenues,expenses,gains,losses,
andcashflowsaremeasuredintermsofthemonetaryunitofthecountryinwhichthebusinessis
operated.Pricelevelchangescausetheapplicationofthisassumptiontoweakentherelevanceof
certaindisclosures.
Example:
Theamountsofallassetsareaddedtogethereventhough
amountsrecordedatdifferenttimesrepresentdifferentpurchasing
powerlevels.
1. Capitalmaintenanceanddeparturesfromtheunitofmeasureassumption
a. Theconceptofcapitalmaintenanceisrelatedtotheunitofmeasureassumption.
Capitalissaidtobemaintainedwhenthefirmhaspositiveearningsfortheyear,
assumingnochangesinpricelevels.Whenafirmhasincome,ithasrecognized
revenuesufficienttoreplacealltheresourcesusedingeneratingthatrevenue
(returnofcapital),andhasresourcesleftoverinaddition(income,whichisreturnon
capital).Thatincomecouldbedistributedasdividendswithouterodingthenetassets
(capital)existingatthebeginningoftheyear.GAAPisbasedontheconceptof
"financial"capitalmaintenance.Aslongasdividendsdonotexceedearnings,and
earningsisnotnegative,financialcapitalhasbeenmaintained.
b. Analternativeconceptofcapitalmaintenanceis"physical"capitalmaintenance.This
conceptholdsthatearningscannotberecognizeduntilthefirmhasprovidedforthe
physicalcapitalusedupduringtheperiod.Tomeasurethecapitalusedup,changes
inpricelevelmustbeconsidered.
Example:
Afirmusesup$5,000worthofsuppliesinprovidingitsservice
duringtheyear,buttoreplacethosesuppliesforusenextyear,
$5,500willhavetobepaid(10%increaseinspecificpriceof
supplies).The"financial"capitalmaintenancemodelusesthe$5,000cost
ofsuppliesasthemeasureofrevenueneededtomaintaincapital.If
revenueforthecurrentperiodis$5,000andthefirmhadnoother
expenses,earningswouldbezeroandcapitalwouldjustbemaintained.
The"physical"capitalmodelwouldrequirerevenueof$5,500forcapitalto
bemaintained.
GAAPdoesnotrequireadjustmentsforpricelevelchangesandthusapplies
the"financial"capitalmaintenanceconceptinfinancialreports.
D. TimePeriodAssumptionTheindefinitelifeofabusinessisbrokenintosmallertimeframes,
typicallyayear,forevaluationpurposesandreportingpurposes.Foraccountinginformationtobe
relevant,itmustbetimely.Thereliabilityoftheinformationoftenmustbesacrificedtoprovide
relevantdisclosures.Theuseofestimatesisrequiredfortimelyreportingbutalsoimpliesapossible
lossofreliability.
II. AccountingPrinciples
A. HistoricalCostAssetsandliabilitiesarerecordedathistoricalcost,thatis,theircash
equivalentamountattimeoforigination.Thisvalueisthemarketvalueoftheitemonthedateof
acquisition.Formanyassets,thisvalueisnotchangedeventhoughmarketvaluechanges.Other
assets,suchasplantassetsandintangibles,aredisclosedathistoricalcostlessaccumulated
depreciationoramortization.Giventhegoingconcernassumption,revaluationtomarketvalueis
inappropriateforplantassets,becausethevalueoftheseassetsisderivedthroughuse,rather
thanfromdisposal.
B. Therearemeasurementattributesotherthanhistoricalcostthatareusedtorepresentitems
reportedonthefinancialsstatements.Belowisabriefsummaryandexampleofeach
measurementattribute.
1. NetrealizablevalueThisvalueisusedtoapproximateliquidationvalueorsellingprice.
Itisthenetvaluetobereceivedafterthecostsofsalearedeductedfromthecurrent
marketvalue
a. Example:LowercostormarketforinventoryvaluationusesNRV.
2. CurrentreplacementcostThisvaluerepresentshowmuchyouwouldhavetopayto
replaceanasset.Currentreplacementcostwouldrepresentcurrentmarketvaluefromthe
buyer'sperspective.
a. Example:Replacementcostisalsousedininventoryvaluation.
3. CurrentmarketvalueThisvalueisalsoreferredtoasfairvalue.Itisthepricethat
wouldbereceivedtosellanasset(orthepricetosettlealiability)inanorderlytransaction
betweenmarketparticipantsatthemeasurementdate.
a. Example:Currentmarketvalue(orfairvalue)isusedtovaluetradingandavailable
forsalesecurities.
4. AmortizedcostThisvalueishistoricalcostlesstheaccumulatedamortizationor
depreciationoftheasset.
a. Example:Buildingsandequipmentarereportedathistoricalcostlessaccumulated
depreciation.
5. NetpresentvalueThisisthevaluedeterminedfromdiscountingtheexpectedfuture
cashflows.
a. Example:Thediscountedfuturecashflowsareusedinmanycapitalbudgeting
decisions.
C. RevenueRecognitionPrincipleThisprincipleaddressesthreeimportantissuesrelatedto
revenues.
1. RevenueDefinedWhatrevenueis:Revenuereferstoincreasesinassetsorthe
extinguishmentofliabilitiesstemmingfromthedeliveryofgoodsortheprovisionofservices
themainactivitiesofthefirm.
2. WhentoRecognizeRevenueWhentorecognizerevenue:Revenuesarerecognized
whentheyarerealized.Realizationoccursintheaccountingperiodinwhichthreeconditions
aremet:
a. Goodsorserviceshavebeenprovided(sellerperformanceissubstantiallycomplete)
b. Collectibilityofcashisassuredrevenueisrealizable(buyerperformanceiscomplete
orassured)
c. Expensesofprovidinggoodsandservicescanbedetermined.Thiscriterionbecomes
importantwhenserviceorproductionisprovidedoveranextendedperiodoftime.
3. Thesecondcondition:collectibilityofcashplaysakeyroleinseveralspecificmethodsof
revenuerecognition.Whenuncertaintyexistswithrespecttotheultimatecollectionof
cash,severalalternativemethodsofrevenuerecognitionareavailable.Twoimportant
methodsaretheinstallmentmethodandthecostrecoverymethod.
4. MeasureRevenueHowtomeasurerevenue:Revenuesaremeasuredatthecash
equivalentamountofthegoodorserviceprovided.
Example:
Anequipmentdealersellsequipmentandacceptsstockofthepurchasing
firminreturn.Theequipmentdoesnothaveareadymarketvalue,but
thestockacceptedhasacurrentmarketvalueof$30,000onthe
NASDAQexchange.Theequipmentdealerrecordsrevenueintheamountof
$30,000.
D. MatchingPrincipleThisprincipleaddresseswhentorecognizeexpenses.
1. Thematchingprinciplesays:recognizeexpensesonlywhenexpenditureshelptoproduce
revenues.Revenuesarerecognizedwhenearnedandrealizedorrealizabletherelated
expensesarerecognized,andtherevenuesandexpensesare"matched"todeterminenet
incomeorloss.
2. Expensesthataredirectlyrelatedtorevenuescanbereadilymatchedwithrevenuesthey
helpproduce.
3. Costofgoodssoldandsalescommissionsareexpensesthataredirectlyassociatedand
thereforematchedwithrevenue.Otherexpensesareallocatedbasedonthetimeperiodof
benefitprovided.Depreciationandamortizationareexamples.Suchexpensesarenot
directlymatchedwithrevenues.Stillotherexpensesarerecognizedintheperiodincurred
whenthereisnodeterminablerelationshipbetweenexpendituresandrevenues.Advertising
costsareanexample.
E. FullDisclosurePrincipleFinancialstatementsshouldpresentallinformationneededbyan
informedreadertomakeaneconomicdecision.Thisprincipleissometimesreferredtoasthe
adequatedisclosureprinciple.
Example:
Anaircraftmanufacturerentersintoacontracttobuild200airplanesfor
anairlinecompany.Asofthebalancesheetdate,productionhasnot
begun.Thus,thereisnorecognitionofthiscontractintheaccounts.
However,afootnoteshouldexplainthefinancialaspectsofthecontract.This
informationispotentiallyofgreaterinterestthanmanyitemsrecognizedinthe
accounts.
Flashcards
Flashcard#1(FC5757)
Whatistheentityassumption? Weassumethereisaseparateaccountingentityfor
eachbusinessorganization.
Flashcard#2(FC5758)
Whatisthegoingconcernassumption? Intheabsenceofinformationtothecontrary,a
businessisassumedtohaveanindefinitelife,thatis,
itwillcontinuetobeagoingconcern.
Flashcard#3(FC5759)
Whatistheunitofmeasurementassumption? Assets,liabilities,equities,revenues,expenses,gains,
losses,andcashflowsaremeasuredintermsofthe
monetaryunitofthecountryinwhichthebusinessis
operated.
Flashcard#4(FC5760)
Whatistheconceptofcapitalmaintenance? Capitalissaidtobemaintainedwhenthefirmhas
positiveearningsfortheyear,assumingnochangesin
pricelevels.
Flashcard#5(FC5761)
Whatisthetimeperiodassumption? Theindefinitelifeofabusinessisbrokenintosmaller
timeframes,typicallyayear,forevaluationpurposes
andreportingpurposes.
Flashcard#6(FC5762)
Whatdoesthehistoricalcostaccountingprinciple
state?
Assetsandliabilitiesarerecordedathistoricalcost,
thatis,theircashequivalentamountattimeof
origination.Thisvalueisthemarketvalueoftheitem
onthedateofacquisition.
Flashcard#7(FC5763)
Whatarerevenues? Revenuesareincreasesinassetsorextinguishmentof
liabilitiesstemmingfromdeliveryofgoodsorfrom
providingservicesthemainactivitiesofthefirm.
Flashcard#8(FC5764)
Whenshouldacompanyrecognizerevenues? Revenuesarerecognizedwhentheyareearnedand
collectabilityisreasonablyassured.
Flashcard#9(FC5765)
Whendoesrealizationoccurintheaccountingperiod? (1)Goodsorserviceshavebeenprovided,(2)
Collectabilityofcashisassured,(3)Expensesof
providinggoodsandservicescanbedetermined.
Flashcard#10(FC5766)
Howdowemeasurearevenue? Revenuesaremeasuredasthecashequivalent
amountofthegoodorserviceprovided.
Flashcard#11(FC5767)
Whatdoesthematchingprinciplestate? Recognizeexpensesonlywhenexpenditureshelpto
producerevenues.
Flashcard#12(FC5768)
Whatdoesthefulldisclosureprinciplestate? Financialstatementsshouldpresentallinformation
neededbyaninformedreadertomakeaneconomic
decision.Thisprincipleissometimesreferredtoasthe
adequatedisclosureprinciple.
PastExamQuestions
Question#1(AICPA.061241FAR)
Whichofthefollowingassumptionsmeansthatmoneyisthecommondenominatorofeconomic
activityandprovidesanappropriatebasisforaccountingmeasurementandanalysis?
A.Goingconcern.
B.Periodicity.
C.Monetaryunit.
D.Economicentity.
Question#2(AICPA.082114FARI.A.II)
AccordingtotheFASBconceptualframework,certainassetsarereportedinfinancialstatements
attheamountofcashoritsequivalentthatwouldhavetobepaidifthesameorequivalentassets
wereacquiredcurrently.Whatisthenameofthereportingconcept?
A.Replacementcost.
B.Currentmarketvalue.
C.Historicalcost.
D.Netrealizablevalue.
Question#3(AICPA.101043FAR)
AndeCo.estimatesuncollectibleaccountsexpenseusingtheratioofpastactuallossesfrom
uncollectibleaccountstopastnetcreditsales,adjustedforanticipatedconditions.Thepractice
followstheaccountingconceptof:
A.Consistency.
B.Goingconcern.
C.Matching.
D.Substanceoverform.
Question#4(AICPA.930503FARTHFA)
OnDecember31,2002,BrooksCo.decidedtoendoperationsanddisposeofitsassetswithin
threemonths.AtDecember31,2002,thenetrealizablevalueoftheequipmentwasbelow
historicalcost.WhatistheappropriatemeasurementbasisforequipmentincludedinBrooks'
December31,2002,BalanceSheet?
A.Historicalcost.
B.Currentreproductioncost.
C.Netrealizablevalue.
D.Currentreplacementcost.
Question#5(AICPA.930505FARTHFA)
Whenaparentsubsidiaryrelationshipexists,consolidatedfinancialstatementsarepreparedin
recognitionoftheaccountingconceptof:
A.Reliability.
B.Materiality.
C.Legalentity.
D.Economicentity.
Question#6(AICPA.940501FARFA)
Accordingtotheconceptualframework,theprocessofreportinganiteminthefinancial
statementsofanentityis:
A.Allocation.
B.Matching.
C.Realization.
D.Recognition.
Question#7(AICPA.940503FARFA)
Reportinginventoryatthelowerofcostormarketisadeparturefromtheaccountingprincipleof:
A.Historicalcost.
B.Consistency.
C.Conservatism.
D.Fulldisclosure.
Question#8(AICPA.951103FARFA)
WhatistheunderlyingconceptgoverningtheGenerallyAcceptedAccountingPrinciples
pertainingtorecordinggaincontingencies?
A.Conservatism.
B.Relevance.
C.Consistency.
D.Faithfulrepresentation.
PastExamQuestionAnswers
Question#1(AICPA.061241FAR)
A.Thegoingconcernassumptionstatesthatintheabsenceofinformationtothecontrary,thecorporateentity
hasanindefiniteexistencethereisnoforeseeableendtotheentityundercurrentcircumstances.
B.Theperiodicityassumptionstatesthatinorderforfinancialstatementinformationtobeuseful,itmustbe
availableonaperiodicbasisratherthanattheendofthereportingentity'sexistence.
C.(Correct!)Themonetaryunitassumptionprovidesthebasisforusingthehomecountrycurrencyasthe
reportingbasisinthefinancialstatementsandalsotendstoimplythattheunitofcurrencyisstable(littleorno
inflationordeflation).
D.Alsoknownastheseparateentityassumption,thisconceptrecognizesthatthecorporationisthereporting
entity,nottheowners.Thefinancialstatementsarethoseofthecorporation.Theshareholdersareseparatefrom
thecorporation.Thereportingfirmisaseparatelegalentity.
Question#2(AICPA.082114FARI.A.II)
A.(Correct!)Replacementcostistheamounttobepaidforanitematthecurrenttime.Thisconceptisusedin
thelowerofcostormarketinventoryvaluationprocedure.Replacementcostisanexampleofanentrypricethe
amountrequiredtobepaidcurrentlytoobtainanassetalreadyheld.
B.Currentmarketvalueisalsocalledfairvalue,whichisthepricethatwouldbereceivedtosellanassetinan
orderlytransactionbetweenmarketparticipantsatthemeasurementdate.Marketvalueisanexampleofanexit
pricetheamounttobereceivedonsaleoftheasset.
C.Historicalcostistheoriginalcostofacquiringanasset,plusanyassociatedcosts.Historicalcostisanentry
pricebut,usually,isnotequaltothecurrentpricerequiredtobepaidtoobtaintheassetcurrentlyheld.
D.Netrealizablevalueisanexampleofanexitprice.Itequalstheestimatedsellingpricelessthecostto
completeandsell.
Question#3(AICPA.101043FAR)
A.Consistencyisthedesiredcharacteristicsoftheapplicationofaccountingprinciplesinthesamemannerfrom
yeartoyear.Consistencypermitscomparisonwithinonecompanyoveraperiodoftime.Comparabilitypermits
comparisonbetweencompanies.
B.Goingconcernistheassumptionthattheentitywillcontinueintothefuture.
C.(Correct!)Thematchingprinciplerequiresthatwerecognizeandmatchexpenseswiththerevenues
generated.Forallsalesinagivenperiod,somewillbeuncollectible.Thecostofthoseuncollectibleaccountsis
matchedintheperiodthattherevenueisrecognized.
D.Substanceoverformisaneconomicconceptthatreferstotheeconomicsubstanceofatransactionorevent
ratherthanthewaythatthetransactionoreventispresented.
Question#4(AICPA.930503FARTHFA)
A.Thishistoricalcostoftheassetisnolongerrelevant.Thefirmisnolongeragoingconcerntheassumptionthat
supportsthehistoricalcostprinciple.AllthatmattersnowiswhatBrookscanreceivefortheequipment.
B.Afterthedecisionismadetoliquidatethebusiness,theonlyrelevantvaluesareexitvaluesthenetamounts
thatcanbereceivedfromsaleoftheassets.
C.(Correct!)Whenafirmisinliquidation,historicalcostandentryvalues(replacementcost)arenolonger
relevant.Thegoingconcernassumptionsupportsthehistoricalcostprinciple.Thefirmisnolongeragoing
concern.Theonlyamountsrelevantaretheamountstobereceivedonsaleoftheassets.Netrealizablevalueis
thenetvaluetobereceived,afterthecostsofgettingtheassetreadyforsalearededucted.
D.CurrentreplacementcostistheamountBrookswouldhavetopaytoreplaceitsassets.Brookshasnointerest
inreplacingitsassets,butratherwishestosellitsassets.Thus,therelevantvaluesarethenetamountsthatcan
berealizedonsale.
Question#5(AICPA.930505FARTHFA)
A.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Allfinancialstatementsneedtobereliable,butthatisnotrelatedtotheissueat
handandis,therefore,notthecorrectresponse.
B.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Materialityisamodifyingcriteriaforallfinancialstatements,butitisnotrelatedto
theissueathandandis,therefore,notthecorrectresponse.
C.Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythatcomprises
morethanonelegalentity.Actually,consolidationis,inherently,aviolationofthelegalentityconceptsinceitis
thecombinationofmorethanonelegalentityintoonereport.Therefore,thisisincorrect.
D.(Correct!)Consolidatedfinancialstatementsareanexampleoftryingtoaccountfortheeconomicentitythat
comprisesmorethanonelegalentity,makingthisthecorrectresponse.
Question#6(AICPA.940501FARFA)
A.Allocationmayaffecttheamountsofitemsreported,butallocationdoesnotnecessarilyimplyreportinginthe
financialstatements.Recognitionisthecorrectterm.
B.Matchingisonlyoneaccountingprinciplethatrequiresreporting.Inthiscase,expensesarerecognized
(reported)whentheycontributetothegenerationofrevenue.Butmatchingisnottheonlyreasonitemsare
recognizedintheaccounts.
C.Realizationimpliesthecompletionofatransactionandthereceiptofliquidassets(orotherresourcesif
acceptabletothetransferee).Mostrealizationsrequirereportingintheaccounts(recognition),butthereare
manyothereventsthatcauserecognition.Inotherwords,mostrealizationsarerecognitions,butnotall
recognitionsarerealizations.
D.(Correct!)Recognitionisthestrongestreportingactionthatcanbetaken.Whenanitemisrecognized,that
meansitwillappearinthefinancialstatements,perhapsnotasanindividuallineitem,butdefinitelypartofone.
Manyotheritemsfindtheirwayintothefootnotes,butarenotrecognized.
Question#7(AICPA.940503FARFA)
A.(Correct!)LCMdepartsfromhistoricalcostbecauseitprovidesanendingvaluationbelowcostwhenmarket
valueisbelowcost.Theinventoryisactuallywrittendowntoavaluebelowwhatwasoriginallypaid.Thisisoneof
thefewsuchdepartures.
B.LCMdoesnotimplyadeparturefromconsistency.Itisanaccountingprincipleappliedconsistentlywhenever
marketislessthancost,indicatingadeclineintheutilityoftheinventory.
C.Justtheopposite,LCMisanexampleofconservatism.Themarketvalueofinventory,evenifitisknowntobe
belowcost,isneveradefinitenumber.Underuncertainty,conservatismdemandsthatthelessoptimisticvalue
bereported.
D.LCMdoesnotviolatefulldisclosure.Itcanbearguedthat,givenadeclineinmarketvaluebelowcost,LCM
actuallyprovidesmorerelevantinformationthanmaintainingthehistoricalcostvaluation.
Question#8(AICPA.951103FARFA)
A.(Correct!)Gaincontingenciesarenotrecognized,butlosscontingenciesthatareprobableandestimableare
recognized.Thisisaclassicexampleofconservatism,whichsuppressespositiveinformationunderconditionsof
uncertaintybutrequiresthereportingofnegativeinformationwhenthenegativeoutcomeislikely.
B.Relevancepertainstothequalityofinformationthatcausesittobeusefulfordecisionmaking.Gain
contingenciesarenotrecognizedintheaccounts.Thus,thenonrecognitionofgaincontingenciesthatare
probableandestimablecouldbeconsideredacompromiseoftherelevancecharacteristicofaccounting
information.Usersmightbenefitfromknowingaboutgaincontingencies.
C.Consistencyisnotanissuehere.Gaincontingenciesarenotrecognizedintheaccounts.Itisnotaquestionof
whenoriftheyarerecognized,soconsistencyisnotafactor.
D.Faithfulrepresentationreferstounbiasedinformation.Faithfulrepresentationisnotafactorintherecognition
ofgaincontingenciesbecausegaincontingenciesarenotrecognizedintheaccounts.Recognitionisnot
dependentonwhethertheamountofthegainisestimable.
ProficiencyQuestions
Question#1(PQ2407)
Ifthegoingconcernassumptionwerenotmet,adherencetothehistoricalcostprinciplewould
continuetobeappropriate.
True
False
Question#2(PQ2408)
Amanagerusesacompanycarforbothbusinessandpersonaluse.Therefore,thecarshouldnot
beincludedamongthefirm'sassets.
True
False
Question#3(PQ2409)
Afirmhasnegativeincomeforaperiod.Hasthefirmexperiencedareturnoncapital?
Yes
No
Question#4(PQ2412)
Underthehistoricalcostprinciple,aremostassetsrecordedatmarketvalueonthepurchase
date?
Yes
No
Question#5(PQ2413)
Aremostassetssubsequentlyadjustedforchangesinmarketvalueunderthehistoricalcost
principle?
Yes
No
Question#6(PQ8496)
Matchingisnotanaccountingassumption.
True
False
Question#7(PQ8497)
Afirmhasincomeofexactlyzeroforayearduringwhichbothspecificandgeneralprices
(inflation)haveincreased.Thefirmmaintaineditscapitalunderthefinancialconceptofcapital
maintenance.
True
False
Question#8(PQ8498)
Theaccountingassumptionofseparateentitysupportstheinclusionofprepaidinsuranceintotal
assets.
True
False
ProficiencyQuestionAnswers
Question#1: False
Question#2: False
Question#3: :False
Question#4: :True
Question#5: :False
Question#6: True
Question#7: True
Question#8: False
ConstraintsandPresentValue
Slides
Studytext
ConstraintsandPresentValue
I. AccountingConstraints
AccountingconstraintsprovideexceptionstothestrictapplicationofGAAP.Theseconstraintsrefertoa
conditionforwhichthenormalmeasurementandrecognitionrulesaremodified.Accountingconstraints
arealsocalledmodifyingconventions.Thetwoaccountingconstraintsarecostmaterialityandcost
effectiveness.
A. MaterialityTransactionsthatarematerialinamountwillbeaccountedforinstrictaccordance
withtheappropriateaccountingprocedures.Thosethatareimmaterialinamountwillbehandled
inthemostexpedientwaypossible.Ineffect,fortransactionsofsmalldollaramount,GAAPmay
besuspended.However,GAAPhasnotspecifiedgeneralquantitativematerialitythresholds(such
as5or10%).Professionaljudgmentisrequired.Materialitydecisionsareaffectedbyboththe
relativedollaramountofanitemanditsnature.
Example:
Afirmmayexpenseimmediatelyanexpenditureofofficecalculators
becauseofthesmallpurchaseprice.StrictadherencetoGAAPwould
requirethatthecostbecapitalizedanddepreciatedbecausethe
calculatorswillbenefitmorethanthecurrentperiod.
However,thereisnomaterialitythresholdforillegalactivitiesandrelatedparty
transactions.Allsuchtransactionsmustbedisclosedproperly.
B. CostEffectivenessThisconstraintonGAAPlimitsrecognitionanddisclosureifthecostof
providingtheinformationexceedsitsbenefit.TheFASBtypicallydiscusseshowitconsideredthe
costandbenefitsofnewaccountingstandardsinits"BasisforConclusions"sectionofaccounting
updates.However,firmsmaynotomitdisclosuresiftheyarematerialandmandatedbyGAAP.
Example:
Afirmwouldnotreportitsentireinventorysubsidiaryledgerinthe
footnotesorfinancialstatements.Thereportingoftotalinventorycostis
sufficient.Reportingmoredetailedinformationisnotworththecostof
doingso.
C. ConservatismConservatismisnolongeraconstraintandisnotaqualitativecharacteristic.
Conservatism(alsocalledprudence)isthereportingoflessoptimisticamounts(lowerincome,net
assets)underconditionsofuncertaintyorwhenGAAPprovidesachoicefromamongrecognitionor
measurementmethods.
1. Conservatismissometimesapreferredreportingstrategytoavoidinflatingexpectationsof
capitalproviders.Somefirmsmayreportconservatively,forexample,toavoidlawsuits.
2. Ifestimatesofanoutcomearenotequallylikely,thepreferredapproachistoreportthe
mostlikelyestimate,ratherthanthemoreconservativeestimate,ifthelatterislesslikely.
3. Conservatismisinconflictwithneutrality,oneoftheingredientsoffaithfulrepresentation.
Example:
1.TheuseofLIFOduringinflationaryperiodsisconsidereda
conservativechoicebecausecostofgoodssoldismaximizedandgross
marginandendinginventoryminimized,relativetootherinventoryvaluation
methods.
2.Choosingshorterusefullivesfordepreciableequipmentisconservativebecause
depreciationwillberecognizedoverashorterperiod,incomewillbesmallerduring
thatperiod,andnetassetsalsowillbesmallerinamount.
II. FinancialStatements,RecognitionCriteria,Elements
A. Afullsetoffinancialstatementsshouldincludethefollowing
1. FinancialPositionatyearend(balancesheet)
2. Earningsfortheyear(incomestatement)
3. ComprehensiveIncomefortheyeartotalnonownerchanges(statementof
comprehensiveincome)
4. CashFlowsduringtheyear(statementofcashflows)
5. InvestmentsbyandDistributionstoOwnersduringtheyear(statementofowner'sequity).
B. RecognitionandmeasurementcriteriaInrelationtomeasurementandrecognitionof
itemsinafinancialreport,thefollowingcriteriamustbemet:
1. DefinitionThedefinitionofafinancialstatementelementismet
2. MeasurabilityThereisanattributetobemeasured,suchashistoricalcost
3. RelevanceTheinformationtobepresentedinthefinancialreportiscapableof
influencingdecisions.Theinformationistimely,haspredictiveability,andprovidesfeedback
value
4. ReliabilityTheinformationisrepresentationallyfaithful,verifiable,andneutral.(Note
thatreliabilityhasbeenreplacedbyfaithfulrepresentation.)
C. ElementsofFinancialStatementsTenelementsthatappearinafinancialreport.
1. AssetsResourcesthathaveprobablefuturebenefitstothefirm,controlledby
management,resultingfrompasttransactions.Notethethreeaspectsofthisdefinition.
2. LiabilitiesProbablefuturesacrificesofeconomicbenefitsarisingfrompresent
obligationsofanentitytotransferassetsorprovideservicestootherentitiesasaresultof
pasttransactionsorevents.
3. EquityResidualinterestinthefirm'sassets,alsoknownasnetassets.Equityis
primarilycomprisedofpastinvestorcontributionsandretainedearnings.
4. InvestmentsbyOwnersIncreasesinnetassetsofanentityfromtransferstoitby
existingownersorpartiesseekingownershipinterest.
5. DistributionstoOwnersDecreasesinnetassetsofanentityfromthetransferof
assets,provisionofservices,orincurrenceofliabilitiesbytheenterprisetoowners.
6. ComprehensiveIncomeAccountingincome(transactionbased)pluscertainholding
gainsandlossesandotheritems.Itincludesallchangesinequityotherthaninvestments
byownersanddistributionstoowners.
7. RevenuesIncreasesinassetsorsettlementsofliabilitiesofanentitybyproviding
goodsorservices.
8. ExpensesDecreasesinassetsorincurrencesofliabilitiesofanentitybyproviding
goodsorservices.Expensesprovideabenefittothefirm.
9. GainsIncreasesinequityornetassetsfromperipheralorincidentaltransactions.
10. LossesDecreasesinequityornetassetsfromperipheralorincidentaltransactions.
Lossesprovidenobenefittothefirm.
III. UsingCashFlowInformationandPresentValueinAccountingMeasurements
Theconceptstatementaddressestheuseofpresentvaluemeasurements.Likeallconceptsstatements,
itdoesnotconstituteGAAPbutisusedinthedevelopmentofGAAP.
A. MeasurementIssues
1. ThisStatementaddressesonlymeasurementissues,notrecognition.Thestatement
appliestoinitialrecognition,freshstartmeasurements,andamortizationtechniquesbased
onfuturecashflows.Afreshstartmeasurementestablishesanewcarryingvalueafteran
initialrecognitionandisunrelatedtopreviousamounts(e.g.,marktomarketaccounting
andrecognitionofassetimpairments).
2. Ifthefairvalueofanassetorliabilityisavailable,thereisnoneedtousepresentvalue
measurement.Ifnot,presentvalueisoftenthebestavailabletechniquetoestimatewhat
fairvaluewouldbeifitexistedinthesituation.
B. PresentValueMeasureWhenapresentvaluemeasureisused:
1. Theresultshouldbeascloseaspossibletofairvalueifsuchavaluecouldbeobtained
2. Theexpectedcashflowapproachispreferred,becausepresentvaluemeasurementsshould
reflecttheuncertaintiesinherentintheestimatedcashflows.
C. CaptureEconomicDifferencesApresentvaluemeasurementthatfullycapturesthe
economicdifferencesbetweenvariousestimatesoffuturecashflowswouldincludethefollowing:
1. Anestimateoffuturecashflows
2. Expectationsaboutvariationsinamountortimingofthosecashflows
3. Timevalueofmoneyasmeasuredbytheriskfreerateofinterest
4. Thepriceforbearingtheuncertaintyinherentintheassetorliability
5. Anyotherrelevantfactors.
D. TwoApproachesThestatementcontraststwoapproachestocomputingpresentvalue:
1. Thetraditionalapproachincorporatesfactors25aboveinthediscountrateandusesa
singlemostlikelycashflowinthecomputation.Thetraditionalapproachusestheinterest
ratetocapturealltheuncertaintiesandrisksinherentinacashflowmeasure.Thisisthe
approachthatcontinuestobeappliedinsomepresentvalueapplicationsinfinancial
accounting.
2. Theexpectedcashflowapproachusesariskfreerateasthediscountrate.Theother4
factorsaboveareusedtodeterminetheriskadjustedexpectedcashflow.
E. ExpectedCashFlowApproachTheexpectedcashflowapproachusesexpectationsaboutall
possiblecashflowsinsteadofasinglemostlikelycashflow.Bothuncertaintyastotimingand
amountcanbeincorporatedintothecalculation.TheBoardbelievesthattheexpectedcashflow
approachislikelytoprovideabetterestimateoffairvaluethanasinglevaluebecauseitdirectly
incorporatestheuncertaintyinestimatedfuturecashflows.
Example:
1.(Exampleofuncertainamount)Theamountofacashflow
mayvaryasfollows:$200,$400,or$600withprobabilitiesof
10%,60%,and30%,respectively.Theexpectedcashflowis$440=
$200(.10)+$400(.60)+$600(.30).Theexpectedcashflowapproach
usesarangeofcashflowswithprobabilitiesattached.Thus,the
uncertaintiesofthecashflowsthemselvesarereflectedinthedistribution
ofcashflows.Presentvaluemaythenbeappliedtotheexpectedcashflow
amount,dependingonthetimingofthecashflow.
2.(Exampleofuncertaintiming)A$100cashflowmightbereceivedin1,
2,or3yearswithprobabilitiesof10%,60%,and30%,respectively.
Assuminganinterestrateof5%,theexpectedpresentvalue=$100(pv1,
.05,1)(.10)+$100(pv1,.05,2)(.60)+$100(pv1,.05,3)(.30).[(pv1,
.05,1)isthesymbolforthepresentvalueofasinglepaymentof$1,due
in1yeardiscountedat5%.]
1. Differentratesofinterestmayalsobeusedineachofthesinglepresentvaluetermsto
reflectdifferentriskforthedifferenttimingofcashflow.
F. TheexpectedcashflowapproachhasbeenincorporatedintoAccountingforAssetRetirement
Obligations.
Flashcards
Flashcard#1(FC6714)
Definecosteffectiveness. ThisconstraintonGenerallyAcceptedAccounting
Principles(GAAP)limitsrecognitionanddisclosureif
thecostofprovidingtheinformationexceedsits
benefit.
Flashcard#2(FC6713)
Whatarethetwoaccountingconstraints? Materialityandcosteffectiveness(orcostbenefit).
Flashcard#3(FC6712)
Towhatconditionsdoaccountingconstraintsrefer? Theseconstraintsrefertoaconditionforwhichthe
normalmeasurementandrecognitionrulesare
modified.
Flashcard#4(FC5362)
WhatisCostEffectiveness? ThisconstraintonGenerallyAcceptedAccounting
Principles(GAAP)limitsrecognitionanddisclosureif
thecostofprovidingtheinformationexceedsits
benefit.
Flashcard#5(FC5361)
WhatisConservatism? Conservatism(alsocalledprudence)isthereportingof
lessoptimisticamounts(lowerincome,netassets)
underconditionsofuncertaintyorwhenGenerally
AcceptedAccountingPrinciples(GAAP)providesa
choicefromamongrecognitionormeasurement
methods.
Flashcard#6(FC5360)
Listtheelementsincludedinafullsetoffinancial
statements.
(1)Balancesheet,(2)Incomestatement,(3)
Statementofcomprehensiveincome,(4)Statement
ofcashflows,(5)Statementofowner'sequity.
Flashcard#7(FC5359)
Whatarethefourcriteriathatmustbemettobe
recognizedandmeasuredinafinancialreport?
1. Definition,
2. Measurability,
3. Relevance,
4. Reliability.
Flashcard#8(FC5357)
Whatdoesafreshstartmeasurementdo? Establishesanewcarryingvalueafteraninitial
recognitionandisunrelatedtopreviousamounts
(e.g.,marktomarketaccountingandrecognitionof
assetimpairments).
Flashcard#9(FC5356)
Listtheelementswhichapresentvaluemeasurement
thatfullycaptureseconomicdifferencesshould
include.
(1)Anestimateoffuturecashflows,(2)Expectations
aboutvariationsinamountortimingofthosecash
flows,(3)Timevalueofmoneyasmeasuredbythe
riskfreerateofinterest,(4)Thepriceforbearingthe
uncertaintyinherentintheassetorliability,(5)Any
otherrelevantfactors.
ProficiencyQuestions
Question#1(PQ2416)
Canallexpensesbedirectlymatchedwithrevenue?
Yes
No
Question#2(PQ2417)
Arethematerialityandcostbenefitconstraintsessentiallythesame?
Yes
No
Question#3(PQ2421)
Afirmhasreporteda20%increaseinearningsforthepastthreeyears.Todampeninvestor
expectations,ithasdecidedtounderstaterevenuesandoverstateexpenses.Isthisan
appropriateapplicationoftheconservatismconstraint?
Yes
No
Question#4(PQ8499)
Inorderforrevenuestoberecognized,thesellermustbesubstantiallyfinishedwithitswork,
andcashcollectionmustbereasonablyassured.
True
False
Question#5(PQ8500)
Forcompleteness,footnotesmustaccompanythefinancialstatements.Thisisanexampleoffull
disclosure.
True
False
Question#6(PQ8501)
AnewAccountingStandardsUpdateisnotadoptedbasedontheviewthat,althoughuserswould
benefitfromtheinformation,reportingfirmswouldbeundulyburdenedbytheproposed
requirement.Thisisanexampleofconservatism.
True
False
Question#7(PQ8502)
Question#7(PQ8502)
Duringperiodsofdeflation,theuseofFIFOratherthanLIFOisanexampleofliberalaccounting.
True
False
Question#8(PQ8503)
Afirmdidnotdisclosearelativelysmallpaymenttoaforeigngovernmentthatisinconflictwith
theForeignCorruptPracticesAct.Thisisaviolationoffulldisclosure.
True
False
Question#9(PQ8504)
GeneralMotorsroundsitsbalancesheetamountstothenearestmilliondollars.Thisisan
exampleofmateriality.
True
False
PastExamQuestions
Question#1(AICPA.951102FARFA)
Accordingtotheconceptualframework,theusefulnessofprovidinginformationinfinancial
statementsissubjecttotheconstraintof:
A.Consistency.
B.Costbenefit.
C.Relevance.
D.Representationalfaithfulness.
ProficiencyQuestionAnswers
Question#1: :False
Question#2: :False
Question#3: :False
Question#4: True
Question#5: True
Question#6: False
Question#7: False
Question#8: True
Question#9: True
PastExamQuestionAnswers
Question#1(AICPA.951102FARFA)
A.Consistencyisnotaconstraintinfinancialreporting.Rather,itisasecondaryqualityofaccounting
information.Consistencyhelpstoincreasetheusefulnessorrelevanceofaccountinginformation.Itdoesnot
constrainusefulness.
B.(Correct!)Costbenefitistheonlyconstraintamongthefouransweralternatives.Whenthecostof
informationexceedsitsbenefit,itshouldnotbereported,evenifitmightbeuseful.
C.Relevanceisnotaconstraint.Rather,itisoneoftheprimarycharacteristicofaccountinginformation.
Althoughthesetwoaresometimestradedoffagainstoneanother,onedoesnotconstraintheother.
D.Representationalfaithfulnessisnotaconstraintinfinancialreporting.Rather,itisoneoftheprimary
characteristicofaccountinginformation.Requiringthatinformationberepresentationallyfaithfuldoesnot
constrainitsusefulness.