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Conceptual Framework
for Financial Reporting
CHAPTER REVIEW
1. Chapter 2 outlines the development of a conceptual framework for financial reporting. The
conceptual framework is composed of fundamental concepts, assumptions, and measurement,
recognition, and disclosure concepts. Each of these topics is discussed in Chapter 2 and should
enhance your understanding of the topics covered in intermediate accounting.
Conceptual Framework
Basic Objective
4. The basic objective of financial reporting is the foundation of the conceptual framework
and requires that general-purpose financial reporting provide information about the reporting
entity that is useful to present and potential equity investors, lenders, and other creditors in
making investing and credit granting decisions. In order to understand general-purpose financial
reporting, users need reasonable knowledge of business and financial matters.
Note: All asterisked (*) items relate to material contained in the Appendices to the chapter.
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Fundamental Concepts
5. (L.O. 2) Companies must decide what type of information to disclose and how to disclose
it. These choices are determined by which method or alternative provides the most decision-
useful information. The qualitative characteristics of accounting information distinguish better and
more useful information from inferior and less useful information.
Fundamental qualities:
Enhancing qualities:
Basic Elements
Equity. Residual interest in the assets of an entity that remains after deducting its liabilities. In a
business enterprise, the equity is the ownership interest.
Investments by Owners. 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 (or equity) in it. Assets are most commonly received as investments by owners, but
that which is received may include services or satisfaction or conversion of liabilities of the
enterprise.
Distributions to Owners. Decreases in net assets of a particular enterprise that result from
transferring assets, performing services, or incurring liabilities by the enterprise to owners.
Distributions to owners decrease ownership interests (or equity) in an enterprise.
Comprehensive Income. Change in equity (net assets) of an entity during a period from
transactions and other events and circumstances from nonowner sources. It includes all
changes in equity during a period, except those resulting from investments by owners and
distributions to owners.
Revenues. 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, performing
services, or other activities that constitute the entity’s ongoing major or central operations.
Expenses. Outflows or other using up of assets or incurrences of liabilities (or a combination of
both) during a period from delivering or producing goods, performing services, or carrying out
other activities that constitute the entity’s ongoing major or central operations.
Gains. 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.
Losses. Decrease in equity (net assets) from peripheral or incidental transactions of an entity
from all other transactions and other events and circumstances affecting the entity during a
period except those that result from expenses or distributions to owners.
Assumptions
9. (L.O. 3) In the practice of financial accounting, certain basic assumptions are important to
an understanding of the manner in which data are presented. The following four basic
assumptions underlie the financial accounting structure:
Economic Entity Assumption. The economic activities of an entity can be accumulated and
reported in a manner that assumes the entity is separate and distinct from its owners or other
business units.
Going Concern Assumption. In the absence of contrary information, a business entity is
assumed to have a long life. The current relevance of the historical cost principle is
dependent on the going-concern assumption.
Monetary Unit Assumption. Money is the common denominator of economic activity and
provides an appropriate basis for accounting measurement and analysis. The monetary unit is
assumed to remain relatively stable over the years in terms of purchasing power. In essence,
this assumption disregards any inflation or deflation in the economy in which the entity
operates.
Periodicity Assumption. The life of an economic entity can be divided into artificial time periods
for the purpose of providing periodic reports on the economic activities of the entity.
2-4 Student Study Guide for Intermediate Accounting, 17th Edition
As you progress through the remaining chapters in the text, the reasoning behind these
assumptions should become more apparent.
Basic Principles
10. (L.O. 6) Certain basic principles are followed by accountants in recording the
transactions of a business entity. These principles relate basically to how assets, liabilities,
revenues, and expenses are to be identified, measured, and reported. The following is a brief
review of the basic principles considered in Chapter 2 of the text:
Measurement Principle: The historical cost principle requires that companies account for and
report many assets and liabilities on the basis of acquisition price.
Fair Value Information may be more useful for certain types of assets and liabilities and in certain
industries.
Expense Recognition Principle. Using the matching principle accountants attempt to match
expenses incurred while earning revenues with the related revenues. Use of accrual
accounting procedures assists the accountant in allocating revenues and expenses
properly among the fiscal periods that compose the life of a business enterprise.
Full Disclosure Principle. In the preparation of financial statements, the accountant should
include sufficient information to permit the knowledgeable reader to make an informed
judgment about the financial condition of the enterprise in question.
Cost Constraint
11. The Cost Constraint (or cost-benefit relationship) relates to the notion that 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.
*IFRS Insights
*12. (L.O. 5) The existing conceptual frameworks underlying GAAP and IFRS are very similar.
That is, they are organized in a similar manner (objective, elements, qualitative characteristics,
etc.) There is no real need to change many aspects of the existing frameworks other than to
converge different ways of discussing essentially the same concepts. Although both GAAP and
IFRS are increasing the use of fair value to report assets, at this point IFRS has adopted it more
broadly.
Chapter 2: Conceptual Framework for Financial Reporting 2-5
GLOSSARY
CHAPTER OUTLINE
Basic Objective
Qualitative Characteristics
Basic Elements
(L.O. 3) Assumptions
Economic Entity
Going Concern
Monetary Unit
Periodicity
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Cost Constraint
REVIEW QUESTIONS
TRUE-FALSE
Indicate whether each of the following is true (T) or false (F) in the space provided.
_____ 1. (L.O. 1) A conceptual framework is a coherent system of interrelated objectives
and fundamentals that can lead to consistent standards and that prescribes the
nature, function, and limits of financial accounting and financial statements.
_____ 2. (L.O. 1) A conceptual framework underlying financial accounting is necessary
because future accounting practice problems can be solved by reference to the
conceptual framework and a formal standard-setting body will not be necessary.
_____ 3. (L.O. 1) Use of a sound conceptual framework in the development of accounting
principles will make financial statements of all entities comparable because
alternative accounting methods for similar transactions will be eliminated.
_____ 4. (L.O. 1) Accounting theory is developed without consideration of the environment
within which it exists.
_____ 5. (L.O. 1) Relevance and reliability are the two primary qualities that make
accounting information useful for decision making.
_____ 6. (L.O. 1) To be relevant, accounting information must be capable of making a
difference in a decision.
_____ 7. (L.O. 2) Information that has been measured and reported in a similar manner for
different enterprises is considered comparable.
_____ 8. (L.O. 2) Adherence to the concept of consistency requires that the same
accounting principles be applied to similar transactions for a minimum of five years
before any change in principle is adopted.
_____ 9. (L.O. 2) When an amount is determined by the accountant to be immaterial in
relation to other amounts reported in the financial statements, that amount may be
deleted from the financial statements.
_____ 10. (L.O. 2) The basis for determining whether an item is material is based on both
quantitative and qualitative factors.
_____ 11. (L.O. 2) The fact that equity represents an ownership interest and a residual claim
against the net assets of an enterprise means that in the event of liquidation,
creditors have a priority over owners in the distribution of assets.
_____ 12. (L.O. 2) The three elements—assets, liabilities, and equity—describe transactions,
events, and circumstances that affect an enterprise during a period of time.
Chapter 2: Conceptual Framework for Financial Reporting 2-9
_____ 13. (L.O. 3) The economic entity assumption is useful only when the entity referred to
is a profit-seeking business enterprise.
_____ 14. (L.O. 3) The going-concern assumption is generally applicable in most business
situations unless liquidation appears imminent.
_____ 15. (L.O. 3) The monetary unit assumption means that money is the common
denominator of economic activity and provides an appropriate basis for accounting
measurement and analysis.
_____ 16. (L.O. 3) The periodicity assumption is a result of the demands of various financial
statement user groups for timely reporting of financial information.
_____ 17. (L.O. 4) If Company A wishes to acquire an asset owned by Company B, the cost
principle would require Company A to record the asset at the original cost to
Company B.
_____ 18. (L.O. 4) Generally, confirmation of a sale to independent interests is used to
indicate the point at which revenue is recognized.
_____ 19. (L.O. 4) Recognition of revenue when cash is collected is appropriate only when it
is impossible to establish the revenue figure at the time of sale because of the
uncertainty of collection.
_____ 20. (L.O. 4) Under the expense recognition principle, it is possible to have an expense
reported on the income statement in one period and the cash payment for that
expense reported in another period.
_____ 21. (L.O. 4) Period costs such as officer salaries and administrative expenses attach
to the product and are carried into future periods if the revenue from the product is
recognized in subsequent periods.
_____ 22. (L.O. 4) The full disclosure principle states that information should be provided
when it is of sufficient importance to influence the judgment and decisions of an
informed user.
_____ 23. (L.O. 4) The notes to financial statements generally summarize the items
presented in the main body of the statements.
_____ 24. (L.O. 4) The difficulty in applying the cost constraint is that the costs and especially
the benefits are not always evident or measurable.
MULTIPLE CHOICE
_____ 1. (L.O. 1) Which of the following is not a benefit associated with the FASB
Conceptual Framework Project?
A. A conceptual framework should increase financial statement users’
understanding of and confidence in financial reporting.
B. Practical problems should be more quickly solvable by reference to an existing
conceptual framework.
C. A coherent set of accounting standards and rules should result.
D. Business entities will need far less assistance from accountants because the
financial reporting process will be quite easy to apply.
2 - 10 Student Study Guide for Intermediate Accounting, 17th Edition
_____ 2. (L.O. 1) Which of the following violates the concept of faithful representation?
A. The management report refers to new discoveries and inventions made, but
the financial statements never report the results.
B. Financial statements included buildings with a carrying amount estimated by
management.
C. Financial statements were issued one year late.
D. All of the choices violate faithful representation.
_____ 3. (L.O. 2) Which of the following is a characteristic describing the primary quality of
relevance?
A. Materiality.
B. Predictive value.
C. Verifiability.
D. Understandability.
_____ 4. (L.O. 2) Ingredients of faithful representation are
Completeness Neutrality Free from Error
A. Yes Yes Yes
B. Yes No Yes
C. No No No
D. No Yes No
_____ 5. (L.O. 2) If accounting information is complete, free from error, and neutral, it can
be considered:
A. relevant
B. timely.
C. comparable.
D. a faithful representation.
_____ 6. (L.O. 2) The major objective of the quality of comparability is to:
A. provide timely financial information for statement users.
B. promote comparability between financial statements of different accounting
periods.
C. enable users to identify the real similarities and differences in economic events
between companies.
D. be sure the same information is disclosed in each accounting period.
_____ 7. (L.O. 2) Comprehensive income includes all changes in equity during a period
except:
A. sale of assets other than inventory.
B. those resulting from investments by or distribution to owners.
C. sales to a particular entity where ultimate payment by the entity is doubtful.
D. those resulting from revenue generated by a totally owned subsidiary.
_____ 8. (L.O. 2) According to the FASB conceptual framework, equity
A. is the residual interest in the assets of an entity that remains after deducting its
liabilities.
B. is the same thing as comprehensive income.
C. is the net gains less the net loses for a period of time.
D. is the net revenues and expenses for a period of time.
Chapter 2: Conceptual Framework for Financial Reporting 2 - 11
TRUE-FALSE
1. (T)
Chapter 2: Conceptual Framework for Financial Reporting 2 - 13
2. (F) Development of a conceptual framework will not provide a solution to all future
accounting problems, nor will it eliminate the need for a formal standard-setting
body. However, a soundly developed conceptual framework should enable the
FASB to issue more useful and consistent standards resulting in easier solutions to
emerging practical problems.
3. (F) Use of a sound conceptual framework will not eliminate alternative accounting
methods for similar transactions. However, a sound conceptual framework should
allow practitioners to dismiss certain alternatives quickly and focus on a logical and
acceptable treatment.
4. (F) The environment within which any discipline exists plays an integral role in shaping
the theory of that discipline. The purpose of accounting is to serve the business
environment through the issuance of timely and relevant financial information. To
present such information, accounting theory must be developed with consideration
being given to the business environment.
5. (T)
6. (T)
7. (T)
8. (F) Consistency means that a company applies the same methods to similar accounting
transactions from period to period. It does not mean that companies cannot switch
from one method to another. Companies can change to a new method that is
considered preferable to the old method as long as financial statement users are
made aware of the change.
9. (F) Because an item is deemed to be immaterial does not justify its deletion from
financial statements. If an amount is so small that it is quite unimportant when
compared with other items, application of a particular standard may be considered of
less importance.
10. (T)
11. (T)
12. (F) The three elements—assets, liabilities, and equity—describe amounts of resources
and claims to resources at a moment of time.
13. (F) The economic entity assumption holds that the activity of a business entity can be
kept separate and distinct from its owners and any other business unit. This
assumption has nothing to do with the nature of the business organization.
14. (T)
15. (T)
16. (T)
17. (F) The cost principle requires that assets be accounted for on the basis of acquisition
cost. Whatever it costs a particular entity to acquire an asset is that entity’s
acquisition cost.
18. (T)
19. (T)
20. (T)
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21. (F) Product costs such as material, labor, and overhead attach to the product and are
carried into future periods if the revenue from the product is recognized in
subsequent periods. Period costs such as officers’ salaries and other administrative
expenses are charged off immediately, even though benefits associated with these
costs occur in the future, because no direct relationship between cost and revenue
can be determined.
22. (T)
23. (F) The notes to financial statements generally amplify or explain the items presented in
the main body of the statements.
24. (T)
MULTIPLE CHOICE
1. (D) The financial reporting process will always require the expertise of a person trained
in accounting. The development of a conceptual framework will aid the accountant
because new and emerging practical problems should be more quickly solvable by
reference to an existing framework. Alternatives A, B, and C are benefits of the
Conceptual Framework Project.
2. (B) Accounting information is a faithful representation to the extent that it is complete,
neutral, and is reasonably free of error and bias. An estimate of carrying amount of
buildings is deemed unreliable, the buildings should be recorded at their cost at the
date of purchase and subsequent depreciated.
3. (B) For information to be relevant, it should have predictive or confirmatory value.
Answer (A), materiality is a constraint which relates to the magnitude of an omission
or misstatement that in light of the circumstances, may change or influence the
decision of a person relying on the information. Answer (C) is incorrect because
verifiability is an enhancing quality. Answer (D) is incorrect because
understandability is an enhancing quality.
4. (A) Ingredients of faithful representation are completeness, neutrality, and free from
error.
5. (D) To be a faithful representation, accounting information must possess three key
characteristics: completeness, neutrality, and free from error.
6. (B) Comparability between financial statements of different accounting periods
presumes consistent application of GAAP.
7. (B) Comprehensive income includes net income and all other changes in equity,
exclusive of owners’ investments and distributions. Items A, C, and D fit into this
broad definition.
8. (A) Equity is the residual interest in the assets of an entity that remains after deducting
its liabilities.
9. (A) The FASB classifies the elements of financial statements into two distinct groups.
The first group of three elements—assets, liabilities, and equity—describes amounts
of resources and claims to resources at a moment in time. The other seven financial
statement elements describe transactions, events, and circumstances that affect an
enterprise during a period of time. Thus, alternatives B, C, and D are incorrect.
Chapter 2: Conceptual Framework for Financial Reporting 2 - 15
10. (C) The economic entity assumption holds that economic activity can be identified with a
particular unit of accountability. Alternative A represents the essence of the
economic entity assumption not a violation. Alternative B is related to the periodicity
assumption and alternative D is not a basic accounting assumption.
11. (C) The going concern assumption in accounting implies that unless there is evidence to
the contrary, an entity will continue to exist in order to carry out its objectives and
fulfill its commitments. Consistency describes when an entity applies the same
accounting treatment to similar events from period to period.
12. (D) All of the alternatives (A, B, and C) are economic entities for accounting purposes.
13. (A) The monetary unit assumption holds that the unit of measure remains reasonably
stable. Severe inflation would cause this assumption to lose its relevance.
14. (C) The concept of periodicity implies that economic activity can be divided into artificial
time periods—months, quarters, and years for example.
15. (A) Cost is still widely supported for financial reporting because it is an objectively
determinable amount. Answer (B) is incorrect because cost and current value are
generally not the same amount subsequent to the date of acquisition. Answers (C)
and (D) are incorrect because it does not facilitate comparisons between years, nor
does it take into account price-level adjusted information.
16. (A) Revenue is generally recognized when a company satisfies its performance
obligations.
17. (D) The expense recognition principle allows for letting the expense follow the revenue
(expense is recognized when it makes a contribution to income); however,
immediate expensing is appropriate when there’s no apparent association between
an expense and a revenue.
18. (D) The expense recognition principle is the process of relating expenses with revenues
on a cause and effect basis. Answer (A) is incorrect because the expense
recognition principle is not related to the period of existence of current assets and
current liabilities. Answer (B) is incorrect because the the expense recognition
principle is not concerned with the timing of cash flows. Answer (C) is incorrect
because the expense recognition principle is not concerned with a particular
reporting period interval.
19. (C) In deciding what information to report, accountants follow the general practice of
providing information that is of sufficient importance to influence the judgment and
decisions of an informed user. Alternatives A and D are wrong because they do not
assume an informed user. Alternative B would result in disclosing a significant
amount of extraneous information.
20. (A) The cost constraint requires weighing the costs of providing the information with the
benefits derived from using it. Conservatism or prudence reflects a general tendency
toward early recognition of unfavorable events.