Chapter 2
Financial Reporting:
Its Conceptual
Framework
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation
by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under license.
2
Objectives
Explain the FASB conceptual
framework.
2. Understand the relationship among the
objectives of financial reporting.
3. Identify the general objective of financial
reporting.
4. Describe the three specific objectives of
financial reporting.
1.
Continued
3
Objectives
5.
Discuss the types of useful information for
investment and credit decision making.
6.
Explain the qualities of useful accounting
information.
7.
Understand the accounting assumptions and
conventions that influence GAAP.
8.
Define the elements of financial statements.
4
Objectives Oriented Principles
The SEC has recommended that future accounting
standards should not follow a rules-base or
principles based only approach, but should be
objectives-oriented.
Should be built on an improved and consistently
improved conceptual framework
Clearly state the accounting objective
Minimize exceptions
Avoid the use of bright-line (percentage) tests
5
Charges Given to the FASB
To develop a
conceptual
framework of
accounting theory.
6
Charges Given to the FASB
To establish
standards (GAAP)
for financial
accounting
practices.
7
FASB Conceptual Framework- serves as a conceptual underpinning that
provides a unified and consistent structure and direction to financial
accounting and reporting
To guide the FASB in establishing
accounting standards.
To provide a frame of reference for
resolving accounting questions in situations
where a standard does not exist.
To determine the bounds for judgment in
the preparation of financial statements.
To increase users’ understanding of and
confidence in financial reporting.
To enhance comparability.
8
Relationship of Conceptual
Framework and Standard-Setting
Process
9
Conceptual Framework Projects for
Financial Accounting and Reporting
10
Objectives of Financial Reporting—TO
PROVIDE INFORMATION THAT SATISFIES THE
FOLLOWING OBJECTIVES
General Objective
• Useful
Derived External User Objective
– assess their (THE USER) prospective cash receipts
Derived Company Objective
– assess the net cash inflows to the company
Specific Objectives – provide information about a
company’s
– economic resources, obligations, owners’ eq.
– comprehensive income and its components
– cash flows
11
Objectives of Financial
Reporting
General Objective
Provide information that is
useful
to present and potential investors, creditors, and
other users in making their rational investment,
credit, and similar decisions.
12
Objectives of Financial Reporting
Derived External User Objective (relates to external users’
needs) (they made this investment to increase their cash
inflows)
Provide information that is useful to present and potential
investors creditors, and other users in assessing
the amounts, timing, and uncertainty of
prospective cash receipts
from dividends and interest, and the proceeds from the
sale, redemption, or maturity of securities or loans.
(investors need financial information to help set their
expectations of their future cash receipts….they are
interested in not only the return of their investment, but
also, a return on their investment.)
13
Objectives of Financial
Reporting
Derived Company Objective
Provide information to help investors, creditors, and
others in assessing the amounts, timing, and uncertainty
of prospective
net cash inflows to related company.
(In reality, the investor’s cash receipts are affected by
the cash flows of the company)
14
Objectives of Financial
Reporting
Provide information
about a company’s
cash flows.
Provide information about a
company’s economic resources,
obligations, and owners’ equity.
Provide information about a
company’s comprehensive
income and its components.
Specific Objectives---RELATE TO THE TYPES
OF INFORMATION THAT A COMPANY
SHOULD PROVIDE IN ITS FINANCIAL
REPORTS
15
Accrual Accounting
The measurement of comprehensive income
should relate or match the costs or sacrifices
of a com.’s operations to the benefits from
its operations.
Under accrual accounting, the financial
effects of a com.’s transactions having cash
consequences are related to the period in
which they occur instead of to when the
cash receipt or cash payment takes place.
16
Other Issues – the FASB raised these other issues in
its SFAC#1
First, financial reporting
should provide information
about how the management of
a company has discharged its
stewardship responsibilities.
17
Other Issues
Second, financial statements and
other means of financial reporting
should include explanations and
interpretations of management to
help external users understand
the financial information
provided. (KNOWN AS FULL
DISCLOSURE)
18
The FASB first step in developing its
conceptual framework was to
establish the objectives of financial
reporting. These objectives will be
guidelines for providing financial
information for investment and
credit decisions. These guidelines
will help in the efficient operation of
the capital markets and in promoting
the efficient allocation of scarce
resources.
19
Types of Useful Information
 A company’s financial reports should provide information to help
external users asses the amounts, timing, and uncertainty about
its future net cash inflows. The FASB has identified five
types of information as being useful in meeting this
specific objective.
 4.
Return on investment
Risk
Financial flexibility
Liquidity
 5.
Operating capability
 1.
 2.
 3.
20
Return on Investment
Provides a measure of overall company
performance e.g. the comprehensive
income….
21
Risk
The uncertainty or unpredictability of the
future results of a company.
The greater the risk of an investment, the
higher the rate of return expected by
investors or the higher rate of interest
charged by creditors.
22
Financial Flexibility
The ability of a company to use its financial
resources to adapt to change.
Important because it enhances a company
to respond to unexpected needs
and opportunities.
Reduces the risk of failure in the
event of a shortage in net cash flows
from operations.
23
Liquidity
Refers to how quickly a company can convert its assets
into cash to pay its bills.
Liquidity reflects an asset’s nearness to cash.
An indication of a company’s ability to meet its obligations
when they come due.
A more liquid company is likely to have a superior ability
to adapt to unexpected needs and opportunities.
A more liquid company is likely to have a lower risk of
failure.
Liquid assets often offer lower rates of return than
nonliquid assets.
24
Operating Capability
Refers to the ability of a company to maintain a
given physical level of operations.
This level of operating capability may be indicated
by
– The quantity of goods & services produced
– The physical capacity of the fixed assets
Operating capability helps users to understand a
company’s past performance and predict its future
performance.
25
Interrelationship of Final
Reports, Useful Information and
Decision Making
External
Communication Types of Useful Information
Documents
Return on Investment
Risk
Financial
Reports
Financial Flexibility
Liquidity
Operating Capability
Decision
Making
•Buy
•Hold
• Sell
• Extend
Credit
• Continue
Credit
• Deny
Credit
26
Qualitative Characteristics of
Useful Accounting Information
SFAC #2 is to specify the qualitative characteristics or
“ingredients” that accounting information should have.
Hierarchy of qualitative characteristics is bounded by
two constraints
• Benefits > costs
• The dollar amount of the info. Must be material (large enough to
make a difference in decision making)
Hierarchy is not designed to assign priorities among the
qualitative characteristics…accounting info. Must have each of
the qualitative characteristics to a minimum degree
27
Understandability
Accounting information should be
understandable to users who have
• A reasonable knowledge of business and economic
activities
• Are willing to study the information carefully
28
Decision Usefulness
The overall qualitative characteristic to be
used in judging the quality of accounting
information.
Decision Usefulness can be separated into
the primary qualities of
• Relevance
• Reliability
29
Relevance
Accounting information is relevant if it can make a
difference in a decision
Can the accounting information help the users
• Predict the outcome past, present, and future events
• Confirm or correct prior expectations
To be relevant, accounting information should have either
– Predictive value- help forecast
– Feedback value-help to confirm or correct prior expectations
– Be timely- available before it loses its ability to influence
decisions
30
Reliability
Information is free from error and bias, and
faithfully represents what it is intended to
represent
To be reliable, information must be
• Verifiable – measurement results can be duplicated by
different measurers (accountants)
• Neutral- accounting info., is neutral when it is not
biased to attain a predetermined result. In other words,
accounting information is not to be influenced in a
predetermined direction.
• Possess representational faithfulness- there is a
relationship b/w the reported accounting measurements and the
economic resources, obligations, and transactions
31
Consistency and Comparability
Information about a company is more useful if it
can be compared with similar information from
other companies or with similar information from
past periods within the company
• Intercompany comparison
• Intracompany comparison
Consistency- conformity from period to period,
with accounting policies and procedures remaining
unchanged
32
Constraints to the Hierarchy
 Benefits greater than costs –
• Accounting information is a commodity
• Cost are passed onto consumers
• The FASB must have reasonable assurance that the costs of implementing a
standard will not exceed the benefits
Materiality
– A quantitative threshold constraint
– Refers to the magnitude of an omission or misstatement of accounting info.
–would the judgment of a reasonable person relying on the information
have been influenced by the omission or misstatement…..is the amount
large enough to make a difference
– No quantitative guidelines for materiality
• Materiality involves judgment
• Consider the nature of the item (did this item arise from abnormal
circumstances)
• Consider the relative size of the item, rather than the absolute size
– Some co. establish a percentage threshold of 5% of NI and 5% of total assets
33
Hierarchy of Qualitative
Characteristics
Accounting Information
Benefits>Costs
Pervasive
Constraint
Understandability
User- Usefulness
Decision
Specific
Quality
Overall
Relevance Quality
Continued
Reliability
Primary Decision-Specific Qualities
34
Hierarchy of Qualitative
Characteristics
Relevance
Predictive Feedback
Value
Value
Reliability
Timeliness
Verifiability
RepresentaNeutional
trality
faithfulness
Threshold
for
Recognition
Secondary
Comparability
and
Ingredients
of Primary
Qualities
(including
Consistency
Interactive
Qualities
Materiality
35
Hierarchy of Qualitative
Characteristics
Accounting information is
relevant if it can make a
difference in a decision.
36
Hierarchy of Qualitative
Characteristics
Accounting information is
reliable when it is reasonably
free from error and bias, and
faithfully represents what it is
intended to represent.
37
Hierarchy of Qualitative
Characteristics
Comparability of accounting
information enables users to
identify and explain similarities
and differences between two or
more sets of economic facts.
38
Constraints to the Hierarchy
Are
benefits
greater
than
costs?
39
Constraints to the Hierarchy
Materiality
The nature of the item.
The relative size rather
than absolute size of an
item.
40
Assumptions and Conventions
Entity
The entity assumption assumes that a
proprietorship, partnership, or corporation’s
financial activities are distinguished from other
financial organizations in keeping its own
financial records and reports. Each organization is
distinguished from its owners. The personal
transactions are kept separate from those of the
business enterprise.
Assumptions and Conventions
41
Continuity
This assumption assumes that the company will continue
to operate in the near future, unless substantial evidence to
the contrary exists. This assumption is also known as the
going-concern assumption. The continuity assumption is
necessary for many of the accounting procedures used.
Example: If a company is not regarded as a going concern,
it should not depreciate its fixed assets over their expected
useful lives nor should it record its inventory at its cost, b/c
the receipt of future economic benefits from these items is
uncertain. (continued)
42
Continuity (cont)
-does not imply permanence
-implies that a co. will operate long enough
to carry out its existing commitments
-if a co. appears to be going bankrupt, it
must report its financial statements on a
liquidation basis
• All assets and liabilities valued at the amounts
estimated to be collected or paid when they are sold
or liquidated
43
Assumptions and Conventions
Period of Time
In accordance with the period-of-time assumption,
a company prepares financial statements at the end
of each year and includes them its annual report.
The period-of-time assumption is the basis for the
adjusting entry process at period-end. If the co. did
not prepare FS on a certain time basis, there would
be no reason to determine the time frame affected
by particular transactions.
44
Historical Cost
 The exchange price at the time each transaction occurs.
 -a company delays recording gains//losses resulting from value changes
of assets or liabilities until another exchange occurs.
 -historical cost is reliable
 -source documents are available to confirm the recorded amount
 -HC information may not be completely relevant for all decisions, but
it does have reliability
 -in certain situations, the use of valuation methods other than
historical cost to report the fair value of selected items in FS is
required b/c they provide more relevant information for the decision
 -concerns for measurement problems in alternative valuation methods
 -fasb encourages companies to disclose supplemental current value
information in their annual reports
45
Assumptions and Conventions
Historical Cost
Usually, the exchange price is retained in
the accounting records as the value of an
item until it is removed from the records.
Replacement
Market
Cost
Value
Cost
$16,000
$13,000
$13,500
46
Assumptions and Conventions
Historical Cost
Which amount
should be used?
Cost
$16,000
47
Assumptions and Conventions
Monetary Unit
This assumption states that there must be
some basis for measuring exchange of goods
or services. Currently the dollar is considered
to be a stable monetary unit for preparing a
company’s financial statements.
The FASB encourages companies to prepare
supplemental disclosures about the impact of
changing prices.
48
Monetary Unit (cont.)
- used to be gold that was accepted in exchange for
goods & services
-monetary unit is different for almost every nation
-accountants generally adopt the national
currency of the reporting company and the unit of
measure in FS
-the dollar is considered to be a stable monetary
unit for preparing a company’s FS
49
Assumptions and Conventions
Realization and Recognition
Realization is the process of
converting noncash resources and
rights into cash or rights to cash.
Recognition is the process of
formally recording and reporting
an item in the financial statements of
a company.
50
Recognition
-shown in both words and numbers
To be recognized, an item must
• Meet the definition of an element
• Be measurable
• Be relevant
• Be reliable
Revenues should be recognized when
1. realization has taken place
2. they have been earned
51
Realization
-the process of converting noncash
resources and rights Into Cash or rights to
cash
-fasb suggests that revenues are considered
to be earned when a co. has substantially
completed what it must do to be entitled to
the benefits (assets) generated by the
revenues---this is usually the point of sale
52
Recognizing revenue
-at times a co. may not recognize (record) revenue at
the same time as realization
--a co. may recognize revenue
• DURING PRODUCTION
– PERCENTAGE OF COMPLETION METHOD
– PROPORTIONAL PERFORMANCE
• AT THE END OF PRODUCTION
– A FIXED SELLING PRICE AND THERE IS NO LIMIT ON THE
AMOUNT THAT IT CAN SELL
• AFTER THE SALE
– IF THE ULTIMATE COLLECTIBILITY IS UNCERTAIN
» USE THE INSTALLMENT MEHTOD
» USE THE COST RECOVERY METHOD
53
Assumptions and Conventions
Matching and Accrual Accounting
The matching
principle
states
that
to
determine
Accrual accounting is the process of
the income of
a company
for aneffects
accounting
period,
relating
the financial
of
the company
computes
theand
total
expense involved
transactions,
events,
circumstances
in obtaining
of the
and
havingthe
cashrevenues
consequences
to period
the period
in relates
which
they occur
thanrevenues
to when the
these total
expenses
to rather
the total
recorded
receipt
or payment
occurs. THE
in the cash
period.
INTENT
IS TO MATCH
SACRIFICES AGAINST THE BENEFITS, OR THE
EFFORTS AGAINST THE ACCOMPLISHMENTS
54
MATCH EXPENSES AGAINST REVENUES
ON THE BASIS OF THREE PRINCIPLES
1. ASSOCIATION OF CASUE & EFFECT
• Sales commissions
• Product cost included in CGS
2. SYSTEMATIC AND RATIONAL
ALLOCATION
• Depreciation
• amortization
3. IMMEDIATE RECOGNITION
• Period costs
– salaries
55
Assumptions and Conventions
Conservatism
The conservatism convention states that
when alternative accounting valuations are
equally possible, the accountant should
select the one that is least likely to
overstate assets and income in the current
period.
56
Financial Statement
Fasb has identified sources from which
users might obtain information for decision
making
Fasb has identified four specific FS and the
elements of each
Page 52 –Sources of Information Used in
External Decision Making
57
Balance Sheet
It also is called
a statement of
financial
position.
A balance sheet is a
financial statement that
summarizes the financial
position of a company on a
particular date.
58
Balance Sheet
Elements of a balance sheet:
 Assets are the probable future economic benefits
obtained and controlled by a company as a result of
past transactions or events. ECONOMIC
RESOURCES
 Liabilities are the probable future sacrifices of
economic benefits arising from present obligations of a
company to transfer assets or provide services in the
future as a result of past transactions or events.
ECONOMIC OBLIGATIONS
 Equity is the owners’ residual interest in the net assets
of a company.
59
Income Statement
An income statement is a financial
statement that summarizes the results
of a company’s operations. A
company’s operations are called the
earnings process which include its
purchasing, producing, selling,
delivering, servicing, and
administrating activities.
60
Income Statement
The four elements of the income statement are:
 1. Revenues are inflows or other
enhancements of assets of a company or
settlement of its liabilities during a period
from delivering or producing goods,
rendering services, or other activities that
are the company’s ongoing major operation.
Revenues increase the equity of a company.
Continued
61
Income Statement
The elements of the income statement are:
 2. Expenses are outflows or other using
up of assets of a company or incurrences
of liabilities during a period from
delivering or producing goods, rendering
services, or carrying out other activities
that are the company’s ongoing major
operation. Expenses decrease the equity
of a company.
Continued
62
Income Statement
The elements of the income statement are:
 3. Gains are increases in the equity of a
company from peripheral or incidental
transactions and from all other
transactions and other events and
circumstances affecting the company,
except those that result from revenues or
investments by owners. Gains increase
the equity of a company.
Continued
63
Income Statement
The elements of the income statement are:
 4. Losses are decreases in the equity of
a company, from peripheral or incidental
transactions except those that result from
expenses or distribution to owners.
Losses decrease the equity of a company.
64
Income Statement
Expenses decrease
the equity of the
company. May be
thought of as
measures of the
efforts to achieve
the revenues
Revenues increase the equity of
the company. May be thought of
as measures of the
accomplishments of a co. during
its accounting period.
65
Gains/Losses
-gains are similar to revenues
-gains relate to a company’s secondary
activities, not to its primary operations
-losses are similar to expenses
-losses relate to a company’s secondary
activities
66
Statement of Cash Flows
A statement of cash flows is a
financial statement that
summarizes the cash inflows and
outflows of a company for a period.
67
Statement of Cash Flows
The elements of a statement of cash flows are:
 Operating cash flows are the flows of cash
from acquiring, selling, and delivering goods
for sale, as well as providing services.
 Investing cash flows are the flows of cash
from acquiring and selling investments,
property, plant, and equipment, as well as from
lending money and collecting on loans.
 Financing cash flows are the flows of cash to
and from the owners and long-term creditors.
68
Statement of Changes in
Equity
A statement of changes in
equity summarizes the
changes in a company’s
equity for a period.
69
Statement of Changes in
Equity
A statement of changes in equity contains two
elements:
 Investments by owners are increases in equity
resulting from transfers of something valuable to
the company from other entities in order to
obtain or increase ownership interest.
 Distribution to owners are decreases in equity
of a company caused by transferring assets,
rendering services, or incurring liabilities to
owners.
70
Model of Business Reporting—the information that a
company provides to help users with capital allocation
decision about the company…goal of the model is provide a
foundation for future improvement in business reporting—a
recommendation by AICPA
Framework of the Model – 5 categories
1.
Financial and nonfinancial data.
1.
2.
2.
Management’s analysis of the financial and nonfinancial data.
1.
2.
3.
Assessment of opportunities and risks
Management plans
Comparison of actual business performance to plans
Information about management and shareholders.
1.
2.
5.
Reasons for changes
The identity and past effect of key trends
Forward-looking information.
1.
2.
3.
4.
FS and related disclosures
High level operating data and performance measures
Directors, management, compensation, major shareholders
Transactions and relationship among related parties
Background about the company.
1.
2.
3.
Broad objectives and strategies
Scope of business
Industry structure
71
IASB Framework
In 2004, the FASB and the IASB added to
their respective agendas a project to develop
a common conceptual framework.
Promote harmonization of future
accounting standards that are principles
based
72
Question 1
The conceptual framework, which is
intended to provide a theoretical foundation
for consistent accounting standards, has
been essentially completed, with seven
Statements of Financial Accounting
Concepts issued.
SFACs
Statement No. 1 "Objectives of Financial Reporting by
Business Enterprises,"
Statement No. 2 "Qualitative Characteristics of
Accounting Information,"
Statement No. 3 "Elements of Financial Statements of
Business Enterprises," (replaced by Statement No. 6
"Elements of Financial Statements"),
Statement No. 4 "Objectives of Financial Reporting by
Nonbusiness Organizations,"
Statement No. 5 "Recognition and Measurement in
Financial Statements of Business Enterprises,” and
Statement No. 7 “Using Cash Flow Information and
Present Value in Accounting Measurements.”
73
74
Question 2
The most general objective is that financial
reporting should provide useful information for
present and potential investors, creditors, and
other external users in making rational
investment, credit, and similar decisions.
Investors include both equity security holders
(stockholders) and debt security holders
(bondholders), while creditors include suppliers,
customers and employees with claims, individual
lenders, and lending institutions.
75
question 3
The "derived external user objective" is to provide
information that is useful to external users in
assessing the amounts, timing, and uncertainty of
prospective cash receipts. This objective is
important because individuals and institutions
make cash outflows for investing and lending
activities primarily to increase their cash inflows.
Financial information is needed to help establish
expectations about the timing and amount of
prospective cash receipts (e.g., dividends, interest,
proceeds from resale or repayment) and assess the
risk involved.
76
Question 4
The "derived company objective" is to provide
information to help investors, creditors, and
others in assessing the amounts, timing, and
uncertainty of prospective net cash inflows to the
related company. Information about (1) a
company's economic resources, obligations, and
owners' equity; (2) a company's comprehensive
income and its components; and (3) a company's
cash flows should be reported to satisfy the
"derived company objective.“
77
Question 5
 Information about the "economic resources and claims to
those resources" of a company is useful to external users
for four reasons:
 1. To identify the company's financial strengths and
weaknesses and to assess its liquidity;
 2. To provide a basis to evaluate information about the
company's performance during a period;
 3. To provide direct indications of the cash flow
potentials of some resources and the cash needed to satisfy
obligations; and
 4. To indicate the potential cash flows that are the joint
result of combining various resources in the company's
operations.
78
Question 5 cont.
Information about the "comprehensive income
and its components" of a company is useful to
external users in:
1. Evaluating management's performance;
2. Estimating the "earning power" or other
amounts that are representative of its long-term
income producing ability;
3. Predicting future income; and
4. Assessing the risk of investing in or lending to
the company.
79
Question 5 cont.
Information about the cash flows of a
company is useful to external users:
1. To help understand its operations;
2. To evaluate its financing and investing
activities;
3. To assess its liquidity; and
To interpret the comprehensive income
information provided.
80
Question 6

The terms are defined as follows: (a) return
on investment provides a measure of overall
company performance, (b) risk is the uncertainty
or unpredictability of the future results of a
company, (c) financial flexibility is the ability of a
company to use its financial resources to adapt to
change, (d) liquidity refers to how quickly a
company can convert its assets into cash to pay its
bills, and (e) operating capability refers to the
ability of a company to maintain a given physical
level of operations.
81
Question 7
Decision usefulness is the overall qualitative
characteristic of useful accounting
information. The two primary qualities of
decision usefulness are relevance and
reliability.
82
Question 8
 information is relevant if it can make a difference in a
decision by helping users predict the outcomes of past,
present, and future events or confirm or correct prior
expectations. To be relevant, accounting information must
be timely and must have either predictive value or
feedback value, or both. Predictive value is present when
the information helps decision makers forecast the
outcome of past or present events more accurately.
Feedback value is present when the accounting
information enables decision makers to confirm or correct
prior expectations. Timeliness is having information
available to decision makers before it loses its capacity to
influence decisions.
83
Question 9
 Accounting information is reliable if it is reasonably free
from error and bias and faithfully represents what it
purports to represent. To be reliable the information must
be verifiable, neutral, and possess representational
faithfulness. Verifiability is the ability of accountants to
agree that the selected method has been used without error
or bias. Representational faithfulness is the degree of
correspondence between the reported accounting
measurements and the economic resources, obligations,
and the transactions and events causing changes in these
items. Neutrality is present when information is not biased
to influence behavior in a particular direction. Neutrality
also implies a completeness of information.
84
Question 10
The secondary quality of useful accounting
information is comparability. Comparability of
accounting information enables users to identify
and explain similarities and differences between
two (or more) sets of economic phenomena.
Comparability is enhanced by consistency.
Consistency means conformity from period to
period with unchanging accounting policies and
procedures. Without consistency, it would be
difficult to determine whether differences in
results were caused by economic differences or
simply differences in accounting methods.
85
Question 11
Materiality refers to the magnitude of an omission
or misstatement of accounting information that
makes it likely the judgment of a reasonable
person relying on the information would have
been influenced by the omission or misstatement.
Materiality is closely linked to relevance. Both
characteristics are defined in terms of the
influences that affect a decision maker. However,
relevance deals with the need that the users may
have for that information, while materiality occurs
because the amount is large enough to make a
difference.
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Question 12
The continuity assumption (or going-concern
assumption) is the assumption that a company will
continue to operate in the near future, unless
substantial evidence to the contrary exists. This
assumption is important in financial accounting
because it is necessary for many of the accounting
procedures used by the company. For example, its
assets which are depreciated and its method of
recording inventory may be affected if the future
economic benefits from these items are uncertain.
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Question 13
The period-of-time assumption is the assumption
that a company has adopted the year, either
calendar or fiscal, as the reporting period. This
assumption is important to financial accounting
because it is the basis for the adjusting entry
process in accounting. If a company's financial
statements were not prepared on a yearly (or
shorter time) basis, there would be no reason to
determine the time frame affected by particular
transactions.
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Question 14
Historical cost is the exchange price that is
retained in the accounting records as the
value of an economic resource. Reliability
provides the rationale behind the use of
historical cost; it possesses representational
faithfulness, neutrality, and verifiability
(i.e., source documents are usually available
to substantiate the recorded amount).
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Question 15
 Recognition the process of formally recording and
reporting an item in the financial statements of a company.
Realization is the process of converting noncash resources
and rights into cash or rights to cash. Two factors provide
guidance for revenue recognition. Revenues should be
recognized when: (1) realization has taken place, and (2)
the revenues have been earned. Revenues are considered
to be earned when a company has substantially completed
what it must do to be entitled to the benefits generated by
the revenues. Thus, revenue is usually recognized at the
point of sale.
90
Question 16
Accrual accounting is the process of relating the
financial effects of transactions, events, and
circumstances having cash consequences to the
period in which they occur instead of when the
cash receipt or payment occurs. This process is
related to the matching principle, which states that
to determine the income of a company for an
accounting period the company computes the total
expenses involved in obtaining the revenues of the
period and relates these total expenses to (matches
them against) the total revenues recorded in the
period.
91
Question 17
 The three principles for matching
expenses against revenues are:
1. Associating cause and effect;
2. Systematic and rational allocation; and
3. Immediate recognition.
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Question 18
 Conservatism states that when alternative accounting
valuations are equally possible, the accountant should
select the alternative which is least likely to overstate the
company’s assets and income in the current period.
Conservatism, however, can conflict with neutrality.
Conservative financial statements may be unfair to present
stockholders and biased in favor of future stockholders
because the net valuation of the company may not fully
include future expectations. The result may be a relatively
lower current market price of the company's common
stock.
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Question 19
 A balance sheet (or statement of
financial position) is a financial statement
that shows the financial position of a
company on a particular date (usually the
end of the accounting period). There are
three elements of a balance sheet: (a) assets,
(b) liabilities, and (c) equity.
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Question 20
 An income statement is a financial
statement that shows the results of a
company's operations (i.e., net income) for a
period of time (generally a one-year or onequarter accounting period). There are four
elements of an income statement: (a)
revenues, (b) expenses, (c) gains, and (d)
losses.
95
Question 21
 A statement of cash flows is a financial
statement that shows the cash inflows and
outflows of a company for a period of time
(generally one year or one-quarter). There
are three elements of a statement of cash
flows: (a) operating cash flows, (b)
investing cash flows, and (c) financing cash
flows.
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Question 22
statement of changes in equity shows the
changes in a company's equity for a period
of time (generally one year or one-quarter).
There are two elements of a statement of
changes in equity: (a) investments by
owners, and (b) distributions to owners.
question 23
 The IASB Framework states that the objective of financial
statements is to provide information about the financial
position, performance, and changes in financial position of a
company that is useful to a wide range of users in making
economic decisions. The Framework has two underlying
assumptions; that a company is a going concern and uses
accrual accounting. It identifies four qualitative characteristics
of financial statements–understandability, relevance (including
materiality), reliability ( including faithful presentation,
substance over form, neutrality, prudence, and completeness),
and comparability. Three constraints on relevant and reliable
information are identified; they include timeliness, balance
between benefit and cost, and balance between the qualitative
characteristics. The Framework calls for financial statements
that present a true and fair view of the company and a fair
presentation of the company’s activities.
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Chapter 2
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