Chapter 2 ANSWERS TO QUESTIONS
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. A conceptual framework is necessary in financial accounting for the following
reasons:
(1) It will enable the FASB to issue more useful and consistent standards in the future.
(2) New issues will be more quickly solvable by reference to an existing framework of basic theory.
(3) It will increase financial statement users’ understanding of and confidence in financial reporting.
(4) It will enhance comparability among companies’ financial statements.
2. The primary objectives of financial reporting are as follows:
(1) Provide information useful in investment and credit decisions for individuals who have a reasonable
understanding of business.
(2) Provide information useful in assessing future cash flows.
(3) Provide information about enterprise resources, claims to these resources, and changes
in them.
3. “Qualitative characteristics of accounting information” are those characteristics which contribute to the
quality or value of the information. The overriding qualitative characteristic of accounting information is
usefulness for decision making.
4. Relevance and reliability are the two primary qualities of useful accounting information. For informa-tion to
be relevant, it should have predictive value or feedback value, and it must be presented on a timely basis.
Relevant information has a bearing on a decision and is capable of making a difference in the decision.
Relevant information helps users to make predictions about the outcomes of past, present, and future
events, or to confirm or correct prior expectations. Reliable information can be depended upon to
represent the conditions and events that it is intended to represent. Reliability stems from representational
faithfulness, neutrality, and verifiability.
5. In providing information to users of financial statements, the Board relies on general-purpose financial
statements. The intent of such statements is to provide the most useful information possible at minimal
cost to various user groups. Underlying these objectives is the notion that users need reasonable
knowledge of business and financial accounting matters to understand
the information contained in financial statements. This point is important: it means that in the preparation
of financial statements a level of reasonable competence can be assumed; this has an impact on the way
and the extent to which information is reported.
6. Comparability facilitates comparisons between information about two different enterprises at a particular
point in time. Consistency facilitates comparisons between information about the same enterprise at two
different points in time.
7. At present, the accounting literature contains many terms that have peculiar and specific meanings. Some
of these terms have been in use for a long period of time, and their meanings have changed over time.
Since the elements of financial statements are the building blocks with which the statements are
constructed, it is necessary to develop a basic definitional framework for them.
8. Distributions to owners differ from expenses and losses in that they represent transfers to owners, and
they do not arise from activities intended to produce income. Expenses differ from losses in that they arise
from the entity’s ongoing major or central operations. Losses arise from peripheral or incidental
transactions.
Questions Chapter 2 (Continued)
9. Investments by owners differ from revenues and gains in that they represent transfers by owners to the
entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that
they arise from the entity’s ongoing major or central operations. Gains arise from peripheral or incidental
transactions.
10. The four basic assumptions that underlie the financial accounting structure are:
(1) An economic entity assumption.
(2) A going concern assumption.
(3) A monetary unit assumption.
(4) A periodicity assumption.
11. (a) In accounting it is generally agreed that any measures of the success of an enterprise for periods
less than its total life are at best provisional in nature and subject to correction. Measurement of
progress and status for arbitrary time periods is a practical necessity to serve those who must make
decisions. It is not the result of postulating specific time periods as measurable segments of total life.
(b) The practice of periodic measurement has led to many of the most difficult accounting problems such
as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition
tests. The accrual system calls for associating related revenues and expenses. This becomes very
difficult for an arbitrary time period with incomplete transactions in process at both the beginning and
the end of the period. A number of accounting practices such as adjusting entries or the reporting of
corrections of prior periods result directly from efforts to make each period’s calculations as accurate
as possible and yet recognizing that they are only provisional in nature.
12. The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so
that dollars of different years can be added without any adjustment. When the value of the dollar
fluctuates greatly over time, the monetary unit assumption loses its validity.
The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be
used to measure items recognized in financial statements. Only if circumstances change dramatically will
the Board consider a more stable measurement unit.
13. Some of the arguments which might be used are outlined below:
(1) Cost is definite and reliable; other values would have to be determined somewhat arbitrarily and
there would be considerable disagreement as to the amounts to be used.
(2) Amounts determined by other bases would have to be revised frequently.
(3) Comparison with other companies is aided if cost is employed.
(4) The costs of obtaining replacement values could outweigh the benefits derived.
14. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.” Fair value is therefore a
market-based measure.
15. The fair value option gives companies the option to use fair value (referred to as the fair value option as
the basis for measurement of financial assets and financial liabilities.) The Board believes that fair value
measurement for financial instruments provides more relevant and understandable information than
historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent
value of financial instruments. As a result companies now have the option to record fair value in their
accounts for most financial instruments, including such items as receivables, investments, and debt
securities.
Questions Chapter 2 (Continued)
16. The fair value hierarchy provides insight into the priority of valuation techniques that are used to
determine fair value. The fair value hierarchy is divided into three broad levels.
Fair Value Hierarchy
Level 1: Observable inputs that reflect quoted prices for Most Reliable
identical assets or liabilities in active markets.
Level 2: Inputs other than quoted prices included in Level 1 that
are observable for the asset or liability either directly or
through corroboration with observable data.
Level 3: Unobservable inputs (for example, a company’s own
data or assumptions). Least Reliable
As indicated, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in
the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or
liabilities in active markets. At the least-reliable level, Level 3, much judgment
is needed based on the best information available to arrive at a relevant and reliable fair value
measurement.
17. Revenue is generally recognized when (1) realized or realizable, and (2) earned.
The adoption of the sale basis is the accountant’s practical solution to the extremely difficult problem of
measuring revenue under conditions of uncertainty as to the future. The revenue is equal to the amount of
cash that will be received due to the operations of the current accounting period, but this amount will not
be definitely known until such cash is collected. The accountant, under these circumstances, insists on
having “objective evidence,” that is, evidence external to the firm itself, on which to base an estimate of
the amount of cash that will be received. The sale is considered to be the earliest point at which this
evidence is available in the usual case. Until the sale is made, any estimate of the value of inventory is
based entirely on the opinion of the manage-ment of the firm. When the sale is made, however, an
outsider, the buyer, has corroborated the estimate of management and a value can now be assigned
based on this transaction. The sale also leads to a valid claim against the buyer and gives the seller the
full support of the law in enforcing collection. In a highly developed economy where the probability of
collection is high, this gives additional weight to the sale in the determination of the amount to be
collected. Ordinarily there is a transfer of control as well as title at the sales point. This not only serves as
additional objective evidence but necessitates the recognition of a change in the nature of assets. The
sale, then, has been adopted because it provides the accountant with objective evidence as to the amount
of revenue that will be collected, subject of course to the bad debts estimated to determine ultimate
collectibility.
18. Revenues should be recognized when they are realized or realizable and earned. The most common time
at which these two conditions are met is when the product or merchandise is delivered or services are
rendered to customers. Therefore, revenue for Selane Eatery should be recognized at the time the
luncheon is served.
19. Revenues are realized when products (goods or services), merchandise, or other assets are ex-changed
for cash or claims to cash. Revenues are realizable when related assets received or held are readily
convertible to known amounts of cash or claims to cash. Readily convertible assets have (1)
interchangeable (fungible) units and (2) quoted prices available in an active market that can rapidly
absorb the quantity held by the entity without significantly affecting the price.
Questions Chapter 2 (Continued)
20. Each deviation depends on either the existence of earlier objective evidence other than the sale or
insufficient evidence of sale. Objective evidence is the key.
(a) In the case of installment sales the probability of uncollectibility may be great due to the nature of the
collection terms. The sale itself, therefore, does not give an accurate basis on which to estimate the
amount of cash that will be collected. It is necessary to adopt a basis which will give a reasonably
accurate estimate. The installment sales method is a modified cash basis; income is recognized as
cash is collected. A cash basis is preferable when no earlier estimate of revenue is sufficiently
accurate.
(b) The opposite is true in the case of certain agricultural products. Since there is a ready buyer and a
quoted price, a sale is not necessary to establish the amount of revenue to be received. In fact, the
sale is an insignificant part of the whole operation. As soon as it is harvested, the crop can be valued
at its selling price less the cost of transportation to the market and this valuation gives an extremely
accurate measure of the amount of revenue for the period without the need of waiting until the sale
has been made to measure it. In other words, the sale proceeds are readily realizable and earned, so
revenue recognition should occur.
(c) In the case of long-term contracts, the use of the “sales basis” would result in a distortion of the
periodic income figures. A shift to a “percentage of completion basis” is warranted if objec-tive
evidence of the amount of revenue earned in the periods prior to completion is available. The
accountant finds such evidence in the existence of a firm contract, from which the ultimate realization
can be determined, and estimates of total cost which can be compared with cost incurred to estimate
percentage-of-completion for revenue measurement purposes. In general, when estimates of costs to
