Chapter 2: Conceptual Framework

Question 1

Assets

Answer 1

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events

Question 2

Objective of Financial Reporting

Answer 2

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

Question 3

Financial Reporting/ Financial Accounting

Answer 3

The identification, measurement and communication of financial information about economic entities to potential users

Question 4

Basic Assumptions of Financial Accounting

Answer 4

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

(set out in SFAC No. 5)

Question 5

Economic Entity Assumption

Answer 5

That economic activity can be identified with a particular unit of accountability.

Activity is kept separate from that of other business units.

Reporting entity does not need to be a specific legal entity (could simply be separate departments)

Question 6

Going Concern Assumption

Answer 6

Assumption that the company will have a long life (continuance)

Not a functional assumption if it’s apparent that liquidation is imminent (Liquidation basis accounting) Depreciation and amortization only make sense if entity is a going concern

Question 7

Monetary Unit Assumption

Answer 7

Assumes money as the common denominator of economic activity, providing a basis for measurement.

Ignores inflation/ deflation (assumes stable dollar)

Question 8

Periodicity Assumption

Answer 8

Assumes that a company can divide its economic activities into artificial time periods (monthly, yearly, quarterly).

Shorter period data, however, tends to be less verifiable and more error prone. Trade off between timeliness and accuracy.

Question 9

Basic Principles of Accounting

Answer 9

Used to record and report transactions

• Measurement
• Revenue Recognition
• Expense Recognition (matching)
• Full disclosure

Question 10

Measurement Principle

Answer 10

Current system permits use of various measurement bases.

• Historical cost principle (acquisition price. highly verifiable)
• Fair value principle (market based)
  - price that would be received for the sale of an asset at the measurement date.
  
  • more useful for certain types of assets
  • measures impairment cost

Question 11

Revenue Recognition Principle

Answer 11

Companies must recognize revenue in the accounting period in which the performance obligation is satisfied.

Steps:

1) Identify the contracts with the customer
2) Identify the separate performance obligations in the contract
3) Determine the transaction price
4) Allocate the transaction price to separate obligations
5) Recognize the revenue when the obligation is satisfied

Question 12

Expense Recognition Principle

Answer 12

"Let the expenses follow the revenues"
Matching efforts (expenses) with revenues (accomplishments) to implement matching principle.

Allocation policy that involves “rational and systemic “ assumptions about benefits the company receives for the cost associated with the benefits.

Product costs vs. Period Costs

Question 13

Full Disclosure Principle

Answer 13

Information that is of sufficient importance to influence the judgement and decisions of an informed user must be disclosed.

• Disclose all important information
• but sufficiently condensed to remain understandable.

Question 14

Cost Constraint

Answer 14

AKA Cost-Benefit Relationship
- weighing the cost of providing the information against the benefits to be derived from using it. Benefit must exceed the cost

Question 15

Qualitative Characteristics of Accounting Information

Answer 15

Fundamental Qualities

• Relevance
  
  • predictive value
  • confirmatory value
  • materiality
• Faithful Representation
  
  • completeness
  • neutrality
  • free from error

Enhancing Qualities

• Comparability
• Verifiability
• Timeliness
• Understandability

Question 16

Relevance

Answer 16

Must be decision-useful
Has predictive value, confirmatory value or both
Also Materiality

Question 17

Predictive value

Answer 17

Helps users predict future profits / cash flows

Question 18

Confirmatory Value

Answer 18

Helps users confirm or correct prior expectations

Question 19

Materiality

Answer 19

Information is material if omitting it or misstating it would influence the decisions that users make.

• nature of transaction (qualitative)
• magnitude of transaction relative to company size

(generally anything under 3% of net income is immaterial but it depends)

Question 20

Faithful Representation

Answer 20

The numbers and descriptions match what really existed or happened

• completeness
• neutrality
• free from error (though some estimates must occur and will not always be accurate)

Question 21

Completeness

Answer 21

All information necessary for faithful representation is provided.

No omissions that changes the view of events

Question 22

Neutrality

Answer 22

A company cannot select information to favor one set of interested parties over another

(No suppressing potentially damaging information)

Question 23

Enhancing Qualities

Answer 23

Qualities that complement fundamental qualities and distinguish more useful information from less useful

• comparability
• verifiability
• timeliness
• understanability

Question 24

Comparability

Answer 24

Enables comparisons between companies

Consistency enables comparability between periods for the same company

Question 25

Verifiability

Answer 25

If an independent measurer uses the same methods on the same information they will achieve similar results Direct verification (ex: counting inventory) Indirect verification (ex: checking inputs and recalculating outputs)

Question 26

Timeliness

Answer 26

Information is available to decision makers before it loses its capacity to influence decisions (relevance)

Question 27

Understandability

Answer 27

Quality of information that lets (reasonably informed) users readily see its significance Assisted by classifying, characterization and clarity Cannot exclude complex information simply because it is complex.

Question 28

Pro-forma measures

Answer 28

Non-GAAP standard measures that companies adjust for unusual or non-recurring items to make them more comparable - practice is subject to misuse Public companies are required to reconcile these numbers to GAAP so users can see how they achieved the results

Question 29

Period costs

Answer 29

No direct relationship between these costs and revenue Expensed as costs are incurred

Question 30

Product Costs

Answer 30

Have a direct relationship to revenue Recognized in period revenue is recognized (Cost of Goods sold - including labor)

Question 31

Fair Value Hierarchy

Answer 31

Least to most subjective Level 1: observable inputs that reflect quoted prices for identical assets/ liabilities in active markets Level 2: inputs other than level 1 inputs, but that are observable for the asset/ liability directly or through corroboration with observable data Level 3: un-observable inputs (assumptions)

Question 32

Fair Value Option

Answer 32

FASB gave companies the option to use fair value as a basis of measurement for financial assets and liabilities companies must disclose not only the fair value measurement but the hierarchy level of the measurement (2007?)

Question 33

How companies (are supposed to) choose an accounting method

Answer 33

Depending on which alternative provides the most useful information for decision making purposes ("decision-usefulness")

Question 34

Overview of FASB Conceptual Framework

Answer 34

1st level - objective of financial reporting 2nd level - qualitative characteristics of accounting information and elements of financial statements 3rd level - establishes how to implement the objective of financial reporting with: assumptions, principles, and constraints

Question 35

Conservatism

Answer 35

aka prudence When in doubt chose the solution that is least likely to overstate assets/ income and/or understate liabilities/ expenses. Somewhat in conflict with neutrality understatement in one period = overstatement in the next

Question 36

Process for a company to switch accounting methods

Answer 36

1) must demonstrate that the new method is preferable (more closely matches reality) 2) must disclose nature and effect of change, and justification for change in financial statements

Question 37

SAFC no. 8

Answer 37

chapter 1: "the objective of general purpose financial reporting" - goals and purposes of accounting chapter 3: "Qualitative characteristics of useful financial information" - what makes accounting information useful chapter 8: "notes to financial statements"

Question 38

SAFC no. 7

Answer 38

"Using cash flow information and present value in accounting measurements" - framework for using expected future cash flows and present value as basis for measurement

Question 39

SAFC no. 6

Answer 39

"Elements of Financial Statements" - definitions of items in financial statements - for profit and not-for-profit orgs

Question 40

SAFC no. 5

Answer 40

"Recognition and measurement in financial statements of business enterprises" Guidance on where and when to incorporate information into financial statments

Question 41

Basic elements of financial statements

Answer 41

Elements that measure performance and financial status Amounts of resources and claims to resources at a moment in time. - assets, liabilities, equity Transaction events and circumstances affecting a company during a period of time - investments by owners - distributions to owners - comprehensive income - revenues - expenses - gains - losses

Question 42

Liabilities

Answer 42

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events

Question 43

Equity

Answer 43

Residual interest in the assets of an entity that remains after deducting its liabilities. in a business enterprise the equity is the ownership interest

Question 44

Investments by owners

Answer 44

Increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise.

Question 45

Distributions to owners

Answer 45

Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services or incurring liabilities oy the enterprise to owners. Distributions to owners decrease ownership interests (equity) in an enterprise

Question 46

Comprehensive Income

Answer 46

Change in equity (net assets) of an entity during a period from transactions and other events and circumstances from non-owner sources. Includes all changes in equity during a period EXCEPT those resulting from investments by owners and distributions to owners.

Question 47

Revenues

Answer 47

Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services or other activities that constitute the entities ongoing major or central operations

Question 48

Expenses

Answer 48

Outflows or other using up of assets or incurrances of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services or carrying out other activities that constitute the entity's major or central operations.

Question 49

Gains

Answer 49

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Question 50

Losses

Answer 50

Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Question 51

Monetary Unit Assumption & Inflation globally

Answer 51

Some countries with persistent inflation use "constant currency" financial reports using a price level index to adjust for inflation

Question 52

Conceptual framework IASB

Answer 52

IASB issued its own conceptual framework which results in some differences from FASB/ GAAP

Question 53

Qualifications for an item to be recognized in financial statments

Answer 53

- Must meet the definition of a basic element - Must be measurable with sufficient certainty - Be reliable - Be relevant

Question 54

FASB

Answer 54

Financial Accounting Standards Board - privately funded board - responsible for the creation and governance of accounting standards

Question 55

SEC

Answer 55

Securities and Exchange Commission - government entity - has the power to mandate guidelines where no accounting principles exist - oversees FASB - oversees Markets