Chapter 2 Financial Information Needed Help Establish Expectations About

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CHAPTER 2

FINANCIAL REPORTING: ITS CONCEPTUAL FRAMEWORK

CONTENT ANALYSIS OF CASES

Number

Content

Time Range

(minutes)

C2-1

Qualitative Characteristics. Matching of definitions to the

qualities of useful accounting information.

10-20

C2-5

(AICPA adapted). Cost and Expense Recognition. Rationale

for expense recognition at time of sale, in an accounting

period, or due to systematic and rational allocation.

15-30

C2-6

(CMA adapted). Characteristics of Useful Information. Define

relevance and reliability (and their ingredients), as well as

comparability, consistency, and materiality.

20-30

2-2

Number

Content

Time Range

(minutes)

C2-12

(AICPA adapted). Timing of Revenue Recognition. Discuss

why point-of-sale recognition is usual. Discuss merits of

alternative revenue recognition bases.

20-40

C2-15

Violation of Assumptions and Conventions. For seven situations,

identify what accounting assumption or convention each

procedure or practice violates. Indicate what should be done

to rectify each violation.

15-25

ANSWERS TO QUESTIONS

Q2-1 The “conceptual framework” of the FASB is a theoretical foundation of interrelated

objectives and concepts that provides a logical structure and direction to financial

accounting and reporting. The titles of the “Statements of Concepts” issued by the

Q2-2 The most general objective is that financial reporting should provide useful

information for present and potential investors, creditors, and other external users in

Q2-3 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.

Q2-4 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

Q2-5 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;

Information about the “comprehensive income and its components” of a company is

useful to external users in:

1. Evaluating management’s performance;

Information about the cash flows of a company is useful to external users:

1. To help understand its operations;

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Q2-6 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

Q2-7 Decision usefulness is the overall qualitative characteristic of useful accounting

Q2-8 Accounting 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

Q2-9 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

Q2-10 The secondary quality of useful accounting information is comparability.

Comparability of accounting information enables users to identify and explain

Q2-11 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

Q2-12 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

Q2-13 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

Q2-14 Historical cost is the exchange price that is retained in the accounting records as the

Q2-15 Recognition is the process of formally recording and reporting an item in the financial

statements of a company. Realization is the process of converting noncash

Q2-16 Accrual accounting is the process of relating the financial effects of transactions,

events, and circumstances having cash consequences to the period in which they

Q2-17 The three principles for matching expenses against revenues are:

Q2-18 Conservatism states that when alternative accounting valuations are equally

possible, the accountant should select the alternative which is least likely to overstate

Q2-19 A balance sheet (or statement of financial position) is a financial statement that

Q2-20 An income statement is a financial statement that shows the results of a company’s

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Q2-21 A statement of cash flows is a financial statement that shows the cash inflows and

Q2-22 A statement of changes in equity shows the changes in a company’s equity for a

Q2-23 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

Q2-24 The eight phases of the joint FASB and IASB conceptual framework project include:

(1) objectives and qualitative characteristics, (2) elements and recognition, (3)

Q2-25 The two fundamental qualitative characteristics of useful information identified in the

ANSWERS TO MULTIPLE CHOICE

ANSWERS TO CASES

C2-1

H 1. B 4. E 7. L 10.

C2-2

C2-3

The most general objective of financial reporting states that financial reporting should

provide useful information for present and potential investors, creditors, and other users in

The third objective is the “derived company objective.” It states that financial reporting

should provide information to help external users in assessing the amounts, timing, and

uncertainty of prospective net cash inflows to the related company. Companies, like

external users, invest cash in noncash resources to earn more cash and receive a return on

their investment in addition to a return of their investment. The company’s ability to

generate net cash inflows affects both its ability to pay dividends and interest and the

market prices of its securities, which, in turn, impact on investors’ and creditors’ cash flows.

The second specific objective of financial reporting is to provide information about a

company’s financial performance during a specified period. The primary focus here is

information concerning a company’s comprehensive income and its components. This

information about a company is useful to external users in (a) evaluating management’s

performance, (b) estimating the “earning power” or other amounts that are representative

of its long-term earning ability, (c) predicting future income, and (d) assessing the risk of

investing in or lending to the company.

2-8

C2-4

There are several qualitative characteristics or “ingredients” that accounting information

should possess in order to be most useful. The following characteristics should be

considered when choosing one of several accounting alternatives: (a) understandability,

(b) decision usefulness, (c) relevance, (d) reliability, (e) comparability, and (f) consistency.

Accounting 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 possess

either predictive value or feedback value, or both. Timeliness refers to having information

available to decision makers before it loses its capacity to influence decisions. If

information is not available when needed, it lacks relevance and is of little or no use.

Predictive value refers to accounting information that helps decision makers forecast the

outcome of past or present events more accurately. Feedback value is present in

accounting information that enables decision makers to confirm or correct prior

expectations. Often, information has both predictive value and feedback value because

knowledge about the previous actions of a company will generally improve the decision

makers’ abilities to predict the results of similar future actions.

C2-4 (continued)

differences in accounting methods. However, some sacrifice in consistency must be

C2-5 (AICPA adapted solution)

Note to Instructor: Parts of this case may be slightly advanced for students at this point but

are included to stimulate discussion.

1. Some costs are recognized as expenses on the basis of a presumed direct association with

specific revenue. This presumed direct association has been identified both as

“associating cause and effect” and as the “matching concept.”

Direct cause-and-effect relationships can seldom be conclusively demonstrated, but

2. Some costs are assigned as expenses to the current accounting period because (a) their

incurrence during the period provides no discernible future benefits; (b) they are measures

of assets recorded in previous periods from which no future benefits are expected or can

be discerned; (c) they must be incurred each accounting year, and no build-up of

3. In the absence of a direct basis for associating asset cost with revenue, and if the asset

provides benefits for two or more accounting periods, its cost should be allocated to these

2-10

C2-5 (continued)

3. (continued)

C2-6 (CMA adapted)

1. a. Relevance means relating to the matter at hand. Therefore, relevant accounting

information has the capacity to:

b. Predictive value is that quality of information that improves the decision-maker’s

ability to determine expected outcomes. Feedback value is that quality of

2. a. Reliability is the quality of accounting information that assures that it is reasonably

b. Verifiability is that quality of information that assures that accounting information

would be substantially duplicated by independent measurers using the same

3. a. Comparability is that quality of accounting information that enables users to identify

similarities in and differences between two sets of economic phenomena.

C2-6 (continued)

3. (continued)

c. Materiality in the context of accounting information means being of substance or

C2-7 (CMA adapted)

1. The primary objectives of financial reporting are to provide information that is useful:

• to present and potential investors, creditors, and other users of financial statements in

making rational investment and credit decisions.

2. Although the level of sophistication related to business and financial accounting matters

varies both within and between user groups, users are expected to possess a reasonable

3. One of the results of the corporate form of organization has been the tendency to

separate ownership from management. Thus, the stewardship function has been added

C2-8

By requiring a company that is organized in different operating segments to disclose the

revenues, profits, and assets of each major operating segment, several types of useful