CHAPTER 2
Conceptual Framework for
Financial Reporting
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics
Questions
Brief
Exercises
Exercises
Concepts
for Analysis
1.
Conceptual framework–
general.
1
1, 2
1, 2
2.
Objective of financial
reporting.
2, 7
1, 2
3
3.
Qualitative characteristics
of accounting.
3, 4, 5, 6, 8
1, 2, 3, 4, 5
2, 3, 4
4, 9
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives
Questions
Brief
Exercises
Exercises
Concepts for
Analysis
1. Describe the usefulness of a
conceptual framework and the
objective of financial reporting.
1, 2, 7
1, 2
CA2.1
CA2.2, CA2.3
2. Identify the qualitative
3, 4, 5, 6, 8,
1, 2, 3, 4, 5,
2, 3, 4, 5
CA2.4, CA2.9
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of
Difficulty
Time
(minutes)
E2.1
Usefulness, objective of financial reporting.
Simple
15–20
E2.2
Usefulness, objective of financial reporting, qualitative
characteristics.
Simple
15–20
E2.3
Qualitative characteristics.
Moderate
20–30
E2.4
Qualitative characteristics.
Simple
15–20
E2.5
Elements of financial statements.
Simple
15–20
E2.6
Assumptions, principles, and constraint.
Simple
15–20
E2.7
Assumptions, principles, and constraint.
Moderate
20–25
E2.8
Full disclosure principle.
20–25
CA2.1
Conceptual framework–general.
Simple
20–25
CA2.2
Conceptual framework–general.
Simple
25–35
CA2.3
Objective of financial reporting.
Moderate
25–35
CA2.4
Qualitative characteristics.
Moderate
30–35
CA2.5
Revenue recognition principle.
Complex
25–30
CA2.11
Cost Constraint.
Moderate
30–35
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 account-
ing and financial statements. A conceptual framework is necessary in financial accounting for the
2. The primary objective is to provide financial information about the reporting entity that is useful to
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 infor–
4. Relevance and faithful representation are the two primary qualities of useful accounting information.
For information to be relevant, it should be capable of making a difference in a decision by helping
5. The concept of materiality refers to the relative significance of an amount, activity, or item to
informative disclosure, proper presentation of financial position, and the results of operations.
Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size
enter into its evaluation.
An accounting misstatement is said to be material if knowledge of the misstatement could affect
the decisions of the average informed reader of the financial statements. Financial statements are
misleading if they omit a material fact or include so many immaterial matters as to be confusing. In
the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative
risk and disregards immaterial items.
Questions Chapter 2 (Continued)
6. Enhancing qualities are qualitative characteristics that are complementary to the fundamental
qualitative characteristics. These characteristics distinguish more-useful information from less-
7. 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
8. Comparability facilitates comparisons between information about two different enterprises at a
particular point in time. Consistency, a type of comparability, facilitates comparisons between
9. 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 time, and their meanings have changed over time.
10. 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
11. Investments by owners differ from revenues and gains in that they represent transfers by owners
12. The four basic assumptions that underlie the financial accounting structure are:
(1) The economic entity assumption.
Questions Chapter 2 (Continued)
13. (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
14. 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
15. Some of the arguments which might be used are outlined below:
(1) Cost is definite and verifiable; other values would have to be determined somewhat arbitrarily
and there would be considerable disagreement as to the amounts to be used.
16. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a
17. The fair value option gives companies the option to use fair value 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
Questions Chapter 2 (Continued)
18. 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
Least Subjective
identical assets or liabilities in active markets.
19. The revenue recognition principle requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied. In the case of services, revenue is
recognized when the services are performed. In the case of selling a product, the performance
20. A performance obligation is a promise to deliver a product or provide a service to a customer. The
revenue recognition principle requires that companies recognize revenue in the accounting period
21. The five steps in the revenue recognition process are:
Step 1 Identify the contract(s) with the customer. A contract is an agreement between two
parties that creates enforceable rights or obligations.
Questions Chapter 2 (Continued)
Step 5. Recognize revenue when each performance obligation is satisfied. This occurs
when the service is provided or the product is delivered.
23. The president means that the difference between the fair value and the book value should be
recorded in the books as a ‘gain’. This item should not be entered in the accounts, however,
24. The cause and effect relationship can seldom be conclusively demonstrated, but many costs
appear to be related to particular revenues and recognizing them as expenses accompanies
recognition of the revenue. Examples of expenses that are recognized by associating cause and
effect are sales commissions and cost of products sold or services provided.
25. The four characteristics that an item must have before it can be recognized in the financial
statements are:
(1) Definitions—the item meets the definition of an element of financial statements.
(2) Measurability—it has a relevant attribute measurable with sufficient reliability.
26. (a) To be recognized in the main body of financial statements, an item must meet the definition of
an element. In addition, the item must have been measured, recorded in the books, and passed
through the double-entry system of accounting.
Questions Chapter 2 (Continued)
27. The general guide followed with regard to the full disclosure principle is to disclose in the financial
statements any facts of sufficient importance to influence the judgment of an informed reader.
The fact that the amount of outstanding common stock doubled in January of the subsequent
28. Accounting information is subject to the cost constraint. Information is not worth providing unless
29. The costs of providing accounting information include costs of collecting and processing, of
disseminating, of auditing, of potential litigation, of disclosure to competitors, and of analysis and
interpretation. Benefits to preparers may include greater management control and access to
30. In general, conservatism should not be the basis for determining the accounting for transactions
because it is in conflict with the conceptual framework quality of neutrality.
(a) Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can
be estimated accurately, they should be recorded when an obligation exists, usually in the
period of the sale.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 2.1
(a) 5. Comparability
BRIEF EXERCISE 2.2
(a) 5. Faithful representation
BRIEF EXERCISE 2.3
(a) If the company changed its method for inventory valuation, the
consistency, and therefore the comparability, of the financial
statements have been affected by a change in the method of applying
the accounting principles employed. The change would require
BRIEF EXERCISE 2.3 (continued)
(c) If the company reduced the estimated remaining useful life of plant
property because of obsolescence, the comparability of the financial
BRIEF EXERCISE 2.4
(a) Verifiability
BRIEF EXERCISE 2.5
Companies and their auditors, for the most part, have adopted the general
rule of thumb that anything under 5% of net income is considered not material.
Recently, the SEC has indicated that it is okay to use this percentage for
BRIEF EXERCISE 2.5 (continued)
(c) In general, companies that follow an “expense all capital items below
BRIEF EXERCISE 2.6
(a) Equity
(b) Revenues
BRIEF EXERCISE 2.7
(a) Should be debited to the Land account, as it is a cost incurred in acquir-
ing land.
(b) As an asset, preferably to a Land Improvements account. The driveway
will last for many years, and therefore it should be capitalized and
BRIEF EXERCISE 2.7 (continued)
(e) Should be debited to the Building account, as it is a part of the cost of
BRIEF EXERCISE 2.8
(a) Periodicity
BRIEF EXERCISE 2.9
(a) Net realizable value.
(b) Would not be disclosed. Liabilities would be disclosed in the order to
BRIEF EXERCISE 2.10
(a) Revenue recognition
BRIEF EXERCISE 2.11
Investment (1)—Level 3
BRIEF EXERCISE 2.12
(a) Full disclosure
SOLUTIONS TO EXERCISES
EXERCISE 2.1 (15–20 minutes)
(a) True.
(b) False – General-purpose financial reports help users who lack the
ability to demand all the financial information they need from an entity
EXERCISE 2.2 (15–20 minutes)
(a) False – The fundamental qualitative characteristics that make account-
ing information useful are relevance and faithful representation.
EXERCISE 2.3 (20–30 minutes)
(a)
(b)
Confirmatory Value.
Cost.
(g)
(h)
Timeliness.
Relevance.
EXERCISE 2.4 (15–20 minutes)
(d)
Neutrality.
(a)
(b)
Comparability.
Confirmatory Value.
(h)
(i)
Materiality.
Faithful representation.
EXERCISE 2.5 (15–20 minutes)
(a) Gains, losses.
(b) Liabilities.
(c) Investments by owners, comprehensive income.
EXERCISE 2.6 (15–20 minutes)
(a)
7.
Expense recognition principle.
(b)
5.
Measurement principle (historical cost.)
(d)
2.
Going concern assumption.
EXERCISE 2.7 (20–25 minutes)
(a)
Measurement principle
(historical cost.)
(i)
revenue recognition principles.
(c)
Expense recognition principle.
(k)
Periodicity assumption.
Expense recognition and
EXERCISE 2.8 (20–25 minutes)
(a) It is well established in accounting that revenues, expenses, and cost
of goods sold must be disclosed in an income statement. It might be
EXERCISE 2.8 (Continued)
(c) According to GAAP, the basis upon which inventory amounts are
stated (lower of cost or market) and the method used in determining
cost (LIFO, FIFO, average cost, etc.) should also be reported. The
EXERCISE 2.9
(a) This entry violates the economic entity assumption. This assumption
in accounting indicates that economic activity can be identified with a
particular unit of accountability. In this situation, the company erred
by charging this cost to the wrong economic entity.
EXERCISE 2.9 (Continued)
(d) At the present time, accountants do not recognize price-level
adjustments in the accounts. Hence, it is misleading to deviate from
the measurement principle (historical cost) because conjecture or
EXERCISE 2.10 (20–25 minutes)
(a) Depreciation is an allocation of cost, not an attempt to value assets.
As a consequence, even if the value of the building is increasing,
costs related to this building should be matched with revenues on the