Basic Theory and Financial Reporting

Question 1

1. What are the Statements of Financial Accounting
   Concepts intended to establish?
   a. Generally accepted accounting principles in financial
   reporting by business enterprises.
   b. The meaning of “Present fairly in accordance with
   generally accepted accounting principles.”
   c. The objectives and concepts for use in developing
   standards of financial accounting and reporting.
   d. The hierarchy of sources of generally accepted
   accounting principles.

Answer 1

1. (c) The Statements of Financial Accounting Concepts
   (SFAC) were issued to establish a framework from which
   financial
   accounting and reporting standards could be
   developed. The SFAC provide the theory behind accounting
   and reporting and provide guidance when no GAAP exists.
   The SFAC are not included
   as GAAP.

Question 2

2. According to the FASB conceptual framework, the
   objectives
   of financial reporting for business enterprises are
   based on
   a. Generally accepted accounting principles.
   b. Reporting for regulators.
   c. The need for conservatism.
   d. The needs of the users of the information.

Answer 2

2. (d) Per SFAC 8, the objectives of financial reporting focus
   on providing present and potential investors and creditors with
   information useful in making investment decisions. Financial
   statement users do not have the authority to prescribe the data
   they desire. Therefore, they must rely on external financial
   reporting to satisfy their information needs, and the objectives
   must be based on the needs of those users.

Question 3

3. According to the FASB conceptual framework, the relevance
   of providing information in financial statements is
   subject to the constraint of
   a. Comparability.
   b. Cost-benefit.
   c. Reliability.
   d. Faithful representation.

Answer 3

3. (b) The FASB conceptual framework has identified the costbenefit
   constraint to the relevance of providing financial reports.
   Information is not disclosed if the costs of disclosure outweigh
   the benefits of providing the information. Comparability
   is an
   enhancing qualitative characteristic. Reliability is no longer part
   of the conceptual framework according to SFAC 8. Faithful
   representation is a fundamental qualitative characteristic.

Question 4

4. The enhancing qualitative characteristics of financial
   reporting
   are
   a. Relevance, reliability, and faithful representation.
   b. Cost-benefit and materiality.
   c. Comparability, verifiability, timeliness, and
   understandability.
   d. Completeness, neutrality, and freedom from error.

Answer 4

4. (c) The enhancing qualitative characteristics
   of financial reporting are comparability (including
   consistency), verifiability, timeliness, and understandability.
   Answer (a) is incorrect because
   relevance and faithful
   representation are fundamental qualitative characteristics
   of financial information. Reliability is no longer listed as
   a fundamental quality. Answer (b) is incorrect because
   cost-benefit is a constraint, and materiality is a threshold
   for reporting useful information. Answer (d) is incorrect
   because completeness, neutrality, and freedom from error
   are characteristics
   of faithful representation, a fundamental
   qualitative characteristic.

Question 5

5. According to Statements of Financial Accounting
Concepts, neutrality is an ingredient of
Faithful representation        Relevance
a. Yes Yes
b. Yes No
c. No Yes
d. No No

Answer 5

5. (b) SFAC 8 defines neutrality as the quality of information
   which requires freedom from bias toward a predetermined
   result. Unbiased information would always be more
   faithfully represented than biased information. Other components
   of faithful representation include information to be
   verifiable
   and free from error. Neutrality is not an ingredient
   of relevance
   because relevance requires information to have
   predictive value and confirmatory value, or both

Question 6

6. According to the FASB conceptual framework, which
   of the following is an enhancing quality that relates to both
   relevance and faithful representation?
   a. Comparability.
   b. Confirmatory value.
   c. Predictive value.
   d. Freedom from error.

Answer 6

6. (a) Per SFAC 8, comparability is an enhancing quality of
   financial reporting which relates to both relevance and faithful
   representation. Confirmatory value and predictive value only
   relate to relevance. Freedom from error only relates to faithful
   representation.

Question 7

7. According to the FASB conceptual framework, the process
   of reporting an item in the financial statements of an entity is
   a. Allocation.
   b. Matching.
   c. Realization.
   d. Recognition.

Answer 7

7. (d) Per SFAC 5, recognition is the process of formally
   recording or incorporating an item into the financial statements
   as an asset, liability, revenue, expense, or the like. According
   to SFAC 6, allocation is the process of assigning or distributing
   an amount according to a plan or formula, matching is the
   simultaneous
   recognition of revenues with expenses that
   are related directly or jointly to the same transactions or
   events, and realization
   is the process of converting noncash
   resources and rights into money.

Question 8

8. Under FASB Statement of Financial Accounting Concepts
   5, which of the following items would cause earnings
   to differ from comprehensive income for an enterprise in an
   industry
   not having specialized accounting principles?
   a. Unrealized loss on investments classified as availablefor-
   sale securities.
   b. Unrealized loss on investments classified as trading
   securities.
   c. Loss on exchange of similar assets.
   d. Loss on exchange of dissimilar assets.

Answer 8

8. (a) Per SFAC 5, earnings and comprehensive income
   have the same broad components—revenues, expenses, gains,
   and losses—but are not the same because certain classes of
   gains and losses are excluded from earnings. Changes in
   market values of investments in marketable equity securities
   classified as available-for-sale securities are included in
   comprehensive income,
   but are excluded from earnings until
   realized. Answers
   (b), (c), and (d) are incorrect because
   they would be included in both earnings and comprehensive
   income. Note that unrealized gains and losses on marketable equity securities classified
   as trading securities are included in
   earnings. This treatment
   is in accordance with SFAS 115.

Question 9

9. Under FASB Statement of Financial Accounting Concepts
   5, comprehensive income excludes changes in equity resulting
   from which of the following?
   a. Loss from discontinued operations.
   b. Prior period error correction.
   c. Dividends paid to stockholders.
   d. Unrealized loss on securities classified as availablefor-
   sale.

Answer 9

9. (c) Per SFAC 6, comprehensive income includes all
   changes in equity during a period except those resulting from
   investments by owners and distributions to owners. Dividends
   paid to stockholders is a change in equity resulting from a
   distribution
   to owners, so it is excluded from comprehensive
   income. Answers (a), (b), and (d) are all included in
   comprehensive income
   because they are changes in equity, but
   are not investments
   by, or distributions to, owners.

Question 10

10. The fundamental qualitative characteristic of faithful
    representation
    has the components of
    a. Predictive value and confirmatory value.
    b. Comparability, consistency, and confirmatory value.
    c. Understandability, predictive value, and reliability.
    d. Completeness, neutrality, and freedom from error

Answer 10

10. (d) The fundamental qualitative characteristic of faithful
    representation has the components of completeness, neutrality,
    and freedom from error. Answer (a) is incorrect because
    predictive
    value and confirmatory value are the components of
    relevance.
    Answer (b) is incorrect because comparability and
    consistency
    are enhancing characteristics, and confirmatory
    value is a component of relevance. Answer (c) is incorrect,
    because understandability
    is an enhancing characteristic,
    predictive value is a component of relevance, and reliability is
    no longer a characteristic
    in the concept statements.

Question 11

11. According to the FASB conceptual framework, which of
    the following statements conforms to the realization concept?
    a. Equipment depreciat was assigned to a production
    department and then to product unit costs.
    b. Depreciated equipment was sold in exchange for a
    note receivable.
    c. Cash was collected on accounts receivable.
    d. Product unit costs were assigned to cost of goods sold
    when the units were sold.

Answer 11

11. (b) According to SFAC 6, realization is the process of
    converting noncash resources and rights into money through
    the sale of assets for cash or claims to cash. When equipment
    is sold for a note receivable, money is realized since a note
    qualifies as a claim to cash. Answers (a) and (d) relate to cost
    allocation. Answer (c) is incorrect because accounts receivable
    represents a claim to cash. Realization occurs at the time of
    sale rather than when cash is collected.

Question 12

12. What is the underlying concept that supports estimating a
fixed asset impairment charge?
a. Substance over form.
b. Consistency.
c. Matching.
d. Faithful representation.

Answer 12

12. (d) An estimate of an impairment charge to a fixed asset
    can only be a faithful representation if the entity has applied
    impairment
    rules properly, disclosed the process of arriving at
    the impairment estimate and disclosed any uncertainties that
    affect the impairment estimate. Assuming the above is true,
    and no other estimate is better than the derived estimate, then
    the estimate
    is comprised of the best available information.
    Therefore, it is a faithful representation.

Question 13

13. What is the concept that supports the issuance of interim
reports?
a. Relevance.
b. Materiality.
c. Consistency.
d. Faithful representation.

Answer 13

13. (a) Relevant financial information is capable of making
    a difference if it has predictive value, confirmatory, value,
    or both. Predictive value requires information to be used to
    predict future outcomes. Confirmatory value requires that
    information either confirm or change prior expectations. An
    interim report provides
    both predictive value and confirmatory
    value because it provides a basis to forecast future earnings
    and it provides feedback
    about prior performance expectations.
    Therefore, interim reporting is relevant.

Question 14

14. FASB’s conceptual framework explains both financial and
    physical capital maintenance concepts. Which capital maintenance
    concept is applied to currently reported net income, and
    which is applied to comprehensive income?
    Currently
    reported net income
    Comprehensive
    income
    a. Financial capital Physical capital
    b. Physical capital Physical capital
    c. Financial capital Financial capital
    d. Physical capital Financial capital

Answer 14

14. (c) Per SFAC 6, the major difference between financial
    and physical capital maintenance is related to the effects of
    price changes on assets held and liabilities owed during a
    period. The financial capital concept is applied in current
    GAAP. Under this concept, the effects of the price changes
    described above are considered “holding gains and losses,” and
    are included in computing
    return on capital. Comprehensive
    income, which is described
    in SFAC 5, is “the change in equity
    of a business enterprise
    during a period from transactions and
    other events and circumstances from nonowner sources.” It
    is also a measure of return on financial capital. The concept
    of physical capital maintenance seeks to measure the effects of price changes that are not currently captured under GAAP
    (e.g., replacement costs of nonmonetary assets). Under this
    concept, holding gains and losses are considered “capital
    maintenance adjustments” which would be included directly in
    equity and excluded from return on capital

Question 15

15. According to the FASB conceptual framework, an entity’s
    revenue may result from
    a. A decrease in an asset from primary operations.
    b. An increase in an asset from incidental transactions.
    c. An increase in a liability from incidental
    transactions.
    d. A decrease in a liability from primary operations.

Answer 15

equity and excluded from return on capital.
15. (d) Per SFAC 6, revenues are inflows of assets or settlements
of liabilities, or both, during a period as a result
of an entity’s
major or primary operations. Two essential
characteristics of revenues are that revenues (1) arise from a
company’s primary earnings activities and (2) are recurring or
continuing in nature. Therefore, answer (d) is correct because
it meets the above criteria.
Answers (b) and (c) are incorrect
because they result from incidental transactions. Answer (a) is
incorrect because a decrease
of an asset is not a revenue.

Question 16

16. According to the FASB conceptual framework, which of
    the following is an essential characteristic of an asset?
    a. The claims to an asset’s benefits are legally
    enforceable.
    b. An asset is tangible.
    c. An asset is obtained at a cost.
    d. An asset provides future benefits.

Answer 16

16. (d) Per SFAC 6, the common quality shared by all
    assets is “service potential” or “future economic benefit.” Per
    SFAC 6, assets commonly have other distinguishing features,
    such as being
    legally enforceable, tangible or acquired at a
    cost. These features,
    however, are not essential characteristics
    of assets.

Question 17

17. According to the FASB conceptual framework, which
    of the following attributes would not be used to measure
    inventory?
    a. Historical cost.
    b. Replacement cost.
    c. Net realizable value.
    d. Present value of future cash flows.

Answer 17

17. (d) Per SFAC 5, five different attributes are used to
    measure assets and liabilities in present practice: historical
    cost, current (replacement) cost, current market value, net
    realizable value, and present value of future cash flows. Three
    of these (historical
    cost, replacement cost, and net realizable
    value) are used in measuring inventory at lower of cost or
    market. Present value of future cash flows is not used to
    measure inventory.

Question 18

18. According to SFAC 7, Using Cash Flow Information and
    Present Value in Accounting Measurements, the most relevant
    measurement of an entity’s liabilities at initial recognition and
    fresh-start measurements should always reflect
    a. The expectations of the entity’s management.
    b. Historical cost.
    c. The credit standing of the entity.
    d. The single most-likely minimum or maximum
    possible amount.

Answer 18

18. (c) The most relevant measure of a liability always
    reflects
    the credit standing of the entity obligated to pay,
    according to SFAC 7. Those who hold the entity’s obligations
    as assets incorporate the entity’s credit standing in determining
    the prices they are willing to pay.

Question 19

19. Which of the following is not covered by SFAC 7, Using
    Cash Flow Information and Present Value in Accounting
    Measurements?
    a. Measurements at initial recognition.
    b. Interest method of amortization.
    c. Expected cash flow approach.
    d. Determining when fresh-start measurements are
    appropriate

Answer 19

19. (d) SFAC 7 provides a framework for using future
    cash flows as the basis for accounting measurements at
    initial recognition
    or fresh-start measurements and for the
    interest method of amortization. FASB limited SFAC 7
    to measurement issues (how to measure) and chose not
    to address recognition questions
    (when to measure).
    SFAC 7 introduces the expected cash flow approach, which
    differs from the traditional approach by focusing on explicit
    assumptions about the range of possible estimated cash flows
    and their respective probabilities

Question 20

20. In calculating present value in a situation with a range of
    possible outcomes all discounted using the same interest rate,
    the expected present value would be
    a. The most-likely outcome.
    b. The maximum outcome.
    c. The minimum outcome.
    d. The sum of probability-weighted present values.

Answer 20

20. (d) The expected cash flow approach uses all expectations
    about possible cash flows in developing a measurement, rather
    than just the single most-likely cash flow. By incorporating a
    range of possible outcomes (with their respective timing differences),
    the expected cash flow approach accommodates the use
    of present value techniques when the timing of cash flows is
    uncertain.
    Thus, the expected cash flow is likely to provide a
    better estimate of fair value than the minimum, most-likely, or
    maximum
    taken alone. According to SFAC 7, expected present
    value refers to the sum of probability-weighted present values
    in a range of estimated cash flows, all discounted using the
    same interest
    rate convention.

Question 21

21. A cash flow of $200,000 may be received by Lydia Nickels,
    Inc. in one year, two years, or three years, with probabilities of
    20%, 50%, and 30%, respectively. The rate of interest on default
    risk-free investments is 5%. The present value factors are
    PV of 1, at 5%, for 1 year is .95238
    PV of 1, at 5%, for 2 years is .90703
    PV of 1, at 5%, for 3 years is .86384
    What is the expected present value of Lydia Nickels’ cash flow
    (in whole dollars)?
    a. $181,406
    b. $180,628
    c. $90,703
    d. $89,925

Answer 21

21. (b) The computation of expected present value using a
single interest rate is as follows:
PV of $200,000 in one year at 5%
Probability
$190,476
20% $38,095
PV of $200,000 in two years at 5%
Probability
$181,406
50% 90,703
PV of $200,000 in three years at
5% Probability
$172,768
30% 51,830
$180,628
According to SFAC 7, expected present value refers to the
sum of probability-weighted present values in a range of
estimated cash flows, all discounted using the same interest
rate convention.

Question 22

22. Which of the following statements regarding interest
    methods
    of allocations is not true?
    a. The term “interest methods of allocation” refers both
    to the convention for periodic reporting and to the
    several approaches to dealing with changes in estimated
    future cash flows.
    b. Interest methods of allocation are reporting conventions
    that use present value techniques in the absence
    of a fresh-start measurement to compute changes in
    the carrying amount of an asset or liability from one
    period to the next.
    c. Interest methods of allocation are grounded in the notion
    of current cost.
    d. Holding gains and losses are generally excluded from
    allocation systems.

Answer 22

22. (c) Like depreciation and amortization conventions,
    interest methods are grounded in notions of historical cost, not
    current cost.

Question 23

23. Which of the following is not an objective of using
    present value in accounting measurements?
    a. To capture the value of an asset or a liability in the
    context
    of a particular entity.
    b. To estimate fair value.
    c. To capture the economic difference between sets of
    future
    cash flows.
    d. To capture the elements that taken together would
    comprise a market price if one existed.

Answer 23

23. (a) According to SFAC 7, the objective of using present
    value in an accounting measurement is to capture, to the
    extent possible, the economic difference between sets of
    future cash flows. The objective of present value, when used
    in accounting measurements at initial recognition and freshstart
    measurements,
    is to estimate fair value. Stated differently,
    present value should attempt to capture the elements that taken
    together would comprise a market price, if one existed, that
    is fair value. Value-in-use and entity-specific measurements
    attempt to capture
    the value of an asset or liability in the
    context of a particular entity. An entity-specific measurement
    substitutes the entity’s assumptions for those that marketplace
    participants would make.

Question 24

24. On December 31, year 1, Brooks Co. decided to end
    operations
    and dispose of its assets within three months.
    At December 31, year 1, the net realizable value of the
    equipment was below historical cost. What is the appropriate
    measurement basis for equipment included in Brooks’
    December 31, year 1 balance sheet?
    a. Historical cost.
    b. Current reproduction cost.
    c. Net realizable value.
    d. Current replacement cost.

Answer 24

24. (c) The Codification provides guidance on the determination
    of gain or loss on disposal of a component of
    a business.
    According to this guidance, such determination
    should be based on estimates of the net realizable value of
    the component. Since Brooks Co. plans to discontinue its
    entire operations, the appropriate measurement basis for its
    equipment is net realizable value. Historical cost and current
    reproduction and replacement costs are not appropriate
    measurement bases for assets once an entity has decided to
    discontinue its operations because these amounts do not reflect
    the entity’s probable future benefit, which is a characteristic of
    assets per SFAC 6.