Chapter 2

Question 1

Fundamental qualities in Financial Reporting

Answer 1

• Relevance

- Faithful representation

Question 2

What does relevance consist of?

Answer 2

• Predictive value
• Confirmatory value
• Materiality

Question 3

What does faithful representation consist of?

Answer 3

• Completeness
• Neutrality
• Free from error

Question 4

What is faithful representation?

Answer 4

Faithful representation means that the numbers and descriptions match what really existed or happened. To be a faithful representation, info must be complete, neutral, and free of material error

Question 5

What is relevance?

Answer 5

To have relevance, accounting information must be capable of making a difference in decision.

Question 6

Predictive value

Answer 6

Info has predictive value if it can help users form expectations about the future.

Question 7

Confirmatory value

Answer 7

The information validates or refutes expectations based on previous evaluations.

Question 8

Materiality

Answer 8

Info is material if omitting or misstating it would influence decisions that users make. In short, it must make a difference or a company need not report it

In evaluating materiality, companies must consider relative size and importance of an item. The general rule of thumb is that anything under 5% of net income is considered immaterial

Question 9

Completeness

Answer 9

Completeness means that all the info necessary for faithful representation is provided

Question 10

Neutrality

Answer 10

Neutrality means that a company must present unbiased information, even if it may be damaging to the company itself

Question 11

Free from error

Answer 11

Free from error doesn’t imply total freedom from error

Question 12

What are the 4 enhancing qualities in financial reporting

Answer 12

• Comparability
• Verifiability
• Timeliness
• Understandability

Question 13

What are the 4 basic assumptions of accounting?

Answer 13

• Economic Entity Assumption
• Going Concern Assumption
• Monetary Unit Assumption
• Periodicity Assumption

Question 14

Economic Entity Assumption

Answer 14

A company keeps its activity separate and distinct from its owners and any other business unit

Question 15

Going Concern Assumption

Answer 15

Company will have a long life and won’t fail any time soon. This assumption is inapplicable if liquidation appears imminent

Question 16

Periodicity Assumption

Answer 16

The assumption that a company can divide its economic activities into artificial time periods (i.e. monthly, quarterly, yearly etc)

Question 17

What are the 4 basic principles of accounting?

Answer 17

• Measurement principle
• Revenue Recognition
• Expense Recognition
• Full disclosure

Question 18

Measurement principles

Answer 18

Either historical cost or fair value

Historical cost - cost of asset or liability at purchase price. Important b/c verifiable

Fair value - price that would be received to sell an asset or paid to transfer a liability between buyer and seller @ measurement date.

FASB considers fair value more relevant than historical cost because it reflects current cash value of financial instruments

Question 19

Revenue Recognition principle

Answer 19

Companies recognize revenue in the period in which the performance obligation was satisfied

Question 20

Expense recognition principle

Answer 20

“Let the expense follow the revenues”

In other words, companies recognize expenses when the service or product contributes to revenue. Ergo, expense recognition is tied with revenue recognition

Question 21

Full disclosure principle

Answer 21

Companies should disclose sufficient information so that users can make informed judgment about the company

Question 22

Comparability

Answer 22

Info measured + reported in similar manner across different companies

Also involves consistency: company uses same accounting treatment to similar events in each period (they can change the treatment if they want to but would have to prove its superiority to the older measurement)

Question 23

Verifiability

Answer 23

Verifiability occurs when independent measurers, using the same methods obtain similar results

Question 24

Timeliness

Answer 24

Timeliness means having recent/up-to-date info available to decision makers before it becomes obsolete and useless in decision making

Question 25

Understandability

Answer 25

Info should be understandable such that someone with reasonable knowledge of business and accounting can understand and interpret the financial statements

Question 26

Monetary Unit Assumption

Answer 26

• Money is the measurement of economic activity
• The monetary unit is assumed to remain relatively stable over the years. In other words, monetary unit assumption disregards inflation/deflation in the economy

Question 27

Cost constraint

Answer 27

The benefits to be derived from providing certain accounting information should exceed the costs of providing that information. The difficulty in cost-benefit analysis is that the costs and especially the benefits are not always evident or measurable.