2.4: Foundational Principals

Question 1

What are the foundational principles in accounting?

Answer 1

Foundational principles are the concepts that guide the recognition, measurement, and presentation/disclosure of financial elements.

They help ensure consistency and reliability in financial reporting.

Question 2

What are the 10 foundational principles and assumptions in accounting?

Answer 2

Economic entity assumption

Control

Revenue recognition and realization principles

Matching principle

Periodicity assumption

Monetary unit assumption

Going concern assumption

Historical cost principle

Fair value principle and value in use

Full disclosure principle

Question 3

What is recognition in accounting?

Answer 3

Recognition is the process of including an element in the financial statements.

To be recognized, an element must meet the definition, be probable, and be reliably measurable.

Question 4

What is derecognition in accounting?

Answer 4

Derecognition is the act of removing an element from the financial statements.

For assets, this occurs when control is lost.

For liabilities, it happens when the obligation is settled or extinguished.

Question 5

What is the economic entity assumption?

Answer 5

The economic entity assumption identifies economic activity with a particular unit of accountability, such as a company or division.

This ensures that financial transactions are only recognized for that entity, separate from its owners or other entities.

Question 6

What is control in financial reporting under IFRS?

Answer 6

Under IFRS, control is defined by three criteria:

Power over the investee

Exposure to variable returns from involvement with the investee

The ability to use power over the investee to affect returns

Question 7

What is the difference between control under IFRS and ASPE?

Answer 7

While IFRS looks at a broader definition of control, including power over the investee and exposure to risks and rewards,

ASPE focuses more on whether an entity is demonstrably distinct and can be dissolved by the company.

Question 8

What is the revenue recognition principle?

Answer 8

Revenue is recognized when:

Risks and rewards have passed, and the earnings process is substantially complete.

The revenue is measurable.

The revenue is collectible (realized or realizable).

Question 9

What is the five-step approach to revenue recognition under IFRS 15?

Answer 9

Identify the contract with the customer.

Identify the performance obligations.

Determine the transaction price.

Allocate the price to each performance obligation.

Recognize revenue when the performance obligation is satisfied.

Question 10

What is the matching principle?

Answer 10

The matching principle requires that efforts (expenses) be matched with accomplishments (revenues) whenever possible.

This ensures that expenses are recorded in the period they help generate revenue.

Question 11

What are product costs and period costs?

Answer 11

Product costs are directly associated with production, such as materials and labor, and are capitalized as inventory until sold.

Period costs are not directly tied to production, such as administrative expenses, and are expensed as incurred.

Question 12

What is measurement uncertainty?

Answer 12

Measurement uncertainty occurs when an element’s value cannot be objectively identified, requiring the use of estimation techniques.

This affects the faithful representation of the element in financial statements.

Question 13

What are the types of uncertainty in accounting?

Answer 13

Existence uncertainty: Uncertainty about whether an asset or liability exists.

Outcome uncertainty: Uncertainty about the future inflows and outflows from an asset or liability.

Question 14

What are common measurement bases used in accounting?

Answer 14

Fair value

Value in use (for assets) / Fulfillment value (for liabilities)

Current cost

Question 15

What is recognition in financial reporting?

Answer 15

Recognition is the act of including something in the entity’s** statement of financial position or income statement**, such as assets, liabilities, revenues, or expenses.

Question 16

What are the criteria for recognizing an element in financial statements under historical principles?

Answer 16

An element is recognized if it:

Meets the definition of an element (e.g., a liability)

Is probable

Is reliably measurable

Question 17

How does ASPE handle recognition?

Answer 17

ASPE requires an entity to use all information to make a neutral decision on whether an asset or liability exists, whether the definition is met, and if the inflow or outflow of resources is measurable.

Question 18

What does IFRS require for the recognition of elements?

Answer 18

Under IFRS, to be recognized, the element must:

Meet the definition of an element

Provide users with relevant information that faithfully represents the underlying transaction or event

Question 19

What is derecognition in financial reporting?

Answer 19

Derecognition is the act of removing an element from the financial statements, such as when an obligation is extinguished or control is given up.

Question 20

What is the Economic Entity Assumption?

Answer 20

The economic entity assumption allows identification of economic activity with a specific unit of accountability, such as a company, division, or individual, ensuring that events can be accounted for separately.

Question 21

What are the three common forms of business organization?

Answer 21

Proprietorship: Small business owned by one person.

Partnership: Business owned/managed by more than one person.

Corporation: Business incorporated as a separate legal entity.

Question 22

Pros and Cons of Business Structures

Answer 22

What are the pros and cons of a proprietorship?

Pros: Simple to set up, no separate tax return needed.

Cons: Not a separate legal entity, personal assets may be liable for debts.

Question 23

What are the pros and cons of a partnership

Answer 23

Pros: Simple to set up, no separate tax return for tax purposes.

Cons: Not a separate legal entity, personal assets may be liable for debts.

Question 24

What are the pros and cons of a corporation?

Answer 24

Pros: Limited liability, obligations are those of the corporation, not the owners.

Cons: More complex setup, separate tax returns required.

Question 25

IFRS 10 Control Criteria

Answer 25

Power over the investee

Exposure or rights to variable returns from involvement with the investee

Ability to use power to affect the amount of the investor’s returns

Question 26

How does ASPE define control?

Answer 26

Control under ASPE is defined by the continuing power to determine strategic decisions without co-operation from others, focusing on whether an entity can be dissolved unilaterally or has more than a 10% ownership interest.

Question 27

What is the revenue recognition principle?

Answer 27

The revenue recognition principle dictates that revenue should be recognized when:

Risks and rewards have passed, or the earnings process is substantially complete.

Revenue is measurable.

Revenue is collectible (realized or realizable).

Question 28

What are the key differences between ASPE and IFRS in revenue recognition?

Answer 28

ASPE: Focuses more on the earnings process and follows an income statement approach.

IFRS: Follows a 5-step process:

Identify the contract with the customer.

Identify the performance obligations in the contract.

Determine the transaction price.

Allocate the transaction price to each performance obligation.

Recognize revenue when performance obligations are satisfied.

Question 29

What is the difference between realized and realizable revenue?

Answer 29

Realized: When products or services are exchanged for cash.

Realizable: When assets can be readily converted into cash or claims to cash.

Question 30

What is the matching principle?

Answer 30

The matching principle states that efforts (expenditures) should be matched with accomplishments (revenues) whenever it is reasonable and can be done.

This principle illustrates the cause-and-effect relationship between costs incurred and revenue generated.

Question 31

What are the two types of costs under the matching principle?

Answer 31

Product costs: Costs that attach to the product and are carried into future periods as inventory.

Period costs: Costs such as salaries or administrative expenses that are recognized immediately because they do not directly relate to production.

Question 32

What does GAAP require in relation to the matching principle?

Answer 32

GAAP requires that a rational and systematic allocation policy be used to approximate the contribution to the revenue stream, ensuring that costs directly related to revenue generation are properly accounted for.

Question 33

Under what circumstances are revenues and assets recognized?

Answer 33

Revenues and assets are recognized when they meet the definition of an element, are probable, and are reliably measurable.

If costs do not meet the definition of an asset, they are expensed rather than capitalized.

Question 34

What is the purpose of measurement in financial reporting?

Answer 34

Measurement determines whether something meets the definition of an element, and if so, how it should be measured for inclusion in financial statements.

Question 35

What is accrual accounting, and how does it relate to measurement in financial reporting

Answer 35

Accrual accounting requires estimates for certain financial elements.

This makes some financial statement figures “soft” or imprecise because economic events must be converted into measurable numbers.

Question 36

What is measurement uncertainty?

Answer 36

Measurement uncertainty arises when values are difficult to estimate, especially for items like new or developing products.

It affects the faithful representation of financial data and may require tools like discounted cash flow models.

Question 37

What is existence uncertainty?

Answer 37

Existence uncertainty relates to whether something (like an asset or liability) exists and can be recognized in financial statements.

Question 38

What is outcome uncertainty?

Answer 38

Outcome uncertainty deals with the uncertainty surrounding future inflows or outflows for assets and liabilities, often impacting how these items are measured.

Question 39

How do existence and outcome uncertainty contribute to measurement uncertainty?

Answer 39

Both existence and outcome uncertainty can make it difficult to accurately measure financial statement elements, contributing to measurement uncertainty, but they do not always have an effect.

Question 40

What are the three key measurement bases identified by IFRS?

Answer 40

Fair value

Value in use (for assets) and fulfillment value (for liabilities)

Current cost

Question 41

What is the trade-off with using historical costs vs. current values for measurement?

Answer 41

Historical costs are often more readily available, but current values provide more relevant and up-to-date information.

Estimating current values can be subjective and involve a trade-off with uncertainty.

Question 42

What are the key actions for accountants when dealing with uncertainty in financial measurements?

Answer 42

Determine an acceptable level of uncertainty.

Use appropriate measurement tools.

Disclose enough information to signal the uncertainty involved.

Question 43

What is the periodicity assumption in accounting?

Answer 43

The periodicity assumption implies that a company’s activities can be divided into artificial time periods (such as months, quarters, or years) for the purpose of financial reporting.

Question 44

Why is timely reporting important under the periodicity assumption?

Answer 44

Investors, lenders, and other stakeholders need timely information to evaluate and compare firms.

The shorter the reporting period, the greater the chance for estimation errors in accrual accounting.

Question 45

What is the monetary unit assumption?

Answer 45

The monetary unit assumption states that money is the common denominator of economic activity, providing a stable basis for accounting measurement and analysis.

Question 46

How does the monetary unit assumption apply in inflation or deflation?

Answer 46

The assumption is that the unit of measure (e.g., the dollar) remains stable over time, ignoring inflation or deflation unless it becomes extreme.

Question 47

What is the going concern assumption?

Answer 47

The going concern assumption assumes that a business enterprise will continue to operate for the foreseeable future, meaning it is not expected to liquidate or cease operations.

Question 48

When does the going concern assumption not apply

Answer 48

The assumption does not apply when there is intent to liquidate a company’s net assets, cease operations, or when the company has no realistic alternative but to liquidate.

Question 49

What is the historical cost principle?

Answer 49

The historical cost principle dictates that transactions should be recorded at the amount of cash (or equivalent) paid or received at the time of the transaction.

Question 50

What are the three underlying assumptions of the historical cost principle?

Answer 50

It represents value at a point in time.

It results from a reciprocal exchange (two-way exchange).

The exchange includes an outside arm’s-length party.

Question 51

What does initial recognition of non-financial assets include?

Answer 51

Initial recognition includes all costs necessary to get the asset ready for use, such as material, labor, transportation, and overhead allocation.

Question 52

What types of transactions challenge the historical cost principle?

Answer 52

Nonmonetary or barter transactions where no cash is exchanged.

Nonmonetary, non-reciprocal transactions like donations.

Related party transactions where parties are not acting at arm’s length.

Question 53

What is the fair value principle?

Answer 53

The fair value principle is 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.

Question 54

What is the difference between entry price and exit price in fair value measurement?

Answer 54

Entry price: The price paid to purchase an asset (market value).

Exit price: The price that would be received to sell the asset (market value).

Question 55

What is the definition of value in use?

Answer 55

Value in use represents the present value of future cash flows expected to be derived from the use of an asset.

Question 56

What is the full disclosure principle?

Answer 56

The full disclosure principle requires financial statements to provide information that is detailed enough to influence users’ decisions while being condensed enough to remain understandable and cost-effective to prepare.

Question 57

Where can information about a company’s financial position, performance, and cash flows typically be found?

Answer 57

The main body of financial statements.

Notes to the financial statements.

Supplementary information (e.g., Management Discussion and Analysis - MD&A).

Question 58

What is the role of notes to the financial statements?

Answer 58

Notes to financial statements explain or amplify items presented in the main body.

They provide descriptions of accounting policies, explanations of uncertainties, and details that are too voluminous to include in the statements.

Question 59

What are the two guidelines from the IFRS conceptual framework for disclosure in financial statements?

Answer 59

Entity-specific information is most useful.

Duplication of information should be avoided to maintain clarity.

Question 60

What is the purpose of supplementary information?

Answer 60

Supplementary information includes details or amounts not found in financial statements that provide additional insights, such as proven reserves in oil and gas companies or discounted cash flows.

Question 61

What are the six general disclosure principles of the MD&A?

Answer 61

Enable readers to view the entity through management’s eyes.

Supplement and complement the information in the financial statements.

Provide fair, complete, and balanced information material to decision-making.

Outline key trends, risks, and uncertainties.

Explain management’s plans for short- and long-term goals.

Be understandable, relevant, comparable, verifiable, and timely.

Question 62

What are the first level objectives of financial reporting according to the expanded conceptual framework?

Answer 62

Provide useful information in investment and credit decisions.

Provide useful information for assessing resource allocation decisions, including management stewardship.

Question 63

What are the fundamental qualitative characteristics that financial information should have according to the conceptual framework?

Answer 63

Relevance (predictive and feedback value).

Representational faithfulness (complete, neutral, and free from error).

Question 64

What are the enhancing characteristics of financial information?

Answer 64

Comparability (consistency).
Verifiability.
Timeliness.
Understandability.