Financial Reporting Theory

CHAPTER 2

Financial Reporting Theory Solutions Questions Q2-1 The conceptual framework sets forth the theory, concepts, and principles that underlie financial reporting standards. A conceptual framework is designed to ensure that a set of accounting standards is coherent and uniform. Thus, standard setters refer to the framework when developing and revising accounting standards. In this way, the individual standards are consistent and supported by the framework. The conceptual framework includes the objective for financial reporting and the qualitative characteristics associated with high quality financial information. It also provides the elements of the financial reporting system and specifies the recognition and measurement criteria to be used in practice.Q2-2 Currently, the FASB and the IASB are working separately on the Conceptual Framework. The two Boards were working together to improve and converge the two frameworks until 2010. To date, they have issued one statement that has converged the Objective and Qualitative Characteristics.Q2-3 A well-developed conceptual framework is needed to ensure that a set of accounting standards is coherent and uniform. Thus, standard setters refer to the framework when developing and revising accounting standards. In this way, the individual standards are consistent and supported by the framework. The conceptual framework includes the objective of financial reporting and the qualitative characteristics associated with high quality financial information. It also provides the elements of the financial reporting system and specifies the recognition and measurement criteria to be used in practice.Q2-4 The standard setters identify “existing and potential investors, lenders, and other creditors” as the primary financial statement user groups. This information is obtained from the FASB’s Statement of Financial Accounting Concepts No. 8, paragraph OB2, and the IASB’s Conceptual Framework for Financial Reporting, paragraph OB2.Financial reporting is aimed at the needs of external financial statements users. The company’s managers are internal and have access to detailed accounting information.Q2-5 Relevance is a fundamental qualitative characteristic of useful financial information. Relevant information is capable of making a difference in decision making because of its predictive value, confirmatory value and materiality.Intermediate Accounting 1st Edition Gordon Solutions Manual Visit TestBankDeal.com to get complete for all chapters

2-2 SOLUTIONS MANUAL FOR INTERMEDIATE ACCOUNTING

© 2016 Pearson Education, Inc.Q2-6. The concept of materiality determines the relevancy of information. Information is material if reporting it inaccurately or omitting it would affect the decisions made by the users of the financial statements. Thus, materiality is an aspect of relevance.Q2-7 Information has predictive value if it can be used as an input into processes that help predict future outcomes. For example, users of the financial statements may use the trend in sales growth reported in current and prior years’ financial statements to predict future revenue. Information has confirmatory value if it provides feedback about prior evaluations. For example, financial statement users will often compare reported net income to prior earnings forecasts.Q2-8 Information is understandable when it is classified, characterized, and presented clearly. This does not mean that an uninformed reader of financial statements should be able to understand all information presented. Some transactions are inherently complex and may not be fully understood by uninformed readers of the financial statements. Therefore, understandability implies that financial information is consumed by reasonably informed users.Q2-9 The elements of financial reporting are the building blocks of the financial statements. U.S. GAAP identifies two main groups of elements. We refer to these groups as point-in-time elements and period-of-time elements. Point–in-time elements represent resources (assets), claims to resources (liabilities), or interests in resources (equity) as of a point in time and appear on the balance sheet. Period-of-time elements describe events and circumstances that affect an entity during a period of time and appear on the income statement, statement of comprehensive income, or statement of shareholders’ equity. The period-of-time elements include investments by owners, distributions to owners, revenues, gains, expenses, losses and comprehensive income.Q2-10 Under U.S. GAAP, an asset is defined as a probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events.Essential characteristics of an asset are also delineated. Under U.S. GAAP, an asset “embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, a particular entity can obtain the benefit and control others' access to it, and the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred.” The future economic benefit from an asset is the cash flows generated from its use. Finally, the asset arises out of an event or transaction that has already occurred.Q2-11 Recognition is the process of reporting an economic event in the financial statements. If an item is recognized, it is included as a line item on the financial statements (i.e., not just in the notes to the statements). An item is not recognized in the financial statements if it is included in the notes to the statements alone.

CHAPTER 2 FINANCIAL REPORTING THEORY 2-3

© 2016 Pearson Education, Inc.Q2-12 The revenue recognition principle is used to guide the timing of revenue recognition. It states that revenue is recognized when it is realized or realizable and earned. An item is considered realized or realizable when a good or service has been exchanged for cash or claims to cash. Revenues are considered earned “when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.” The FASB has developed a new revenue standard. The new revenue standard indicates that the overarching principle of revenue recognition is the notion of the transfer of control of the goods or services.

Q2-13 Expenses are recorded when: (1) they are matched with revenue, (2) in the

period incurred, and (3) they are systematically allocated over the period of use.Q2-14 Under IFRS, expenses are recognized in the income statement when two criteria are met: (1) a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has occurred and (2) the expense can be measured reliably.Q2-15 Accrual-basis accounting records revenues according to the revenue recognition principle and records expenses according to the expense recognition principle, regardless of when cash is received or paid. Accrual-basis accounting records revenues when earned and expenses when incurred. GAAP is based on accrual-basis accounting as opposed to a cash-basis system.Q2-16 Historical cost is the amount of cash (or equivalent) that was paid to acquire the asset. In the case of a liability, historical cost is the amount of cash (or equivalent) that was received when the obligation was incurred. The historical cost may be adjusted for depreciation or amortization over the life of the asset.Q2-17 The going concern concept indicates that accountants will record transactions and prepare financial statements as if the entity will continue to operate for an indefinite period of time, unless there is evidence to the contrary. The going concern concept justifies the use of historical cost by the following rationale. If the business is going to exist for an indefinite period of time, productive assets are not for sale and as a result, market values are not particularly relevant. Of course, if there is evidence that the business will not continue to exist (e.g., bankruptcy) then liquidation values should be used. There are many exceptions in practice. Asset impairments and the increased use of fair value accounting result in many economic resources reported at fair value on the balance sheet.Brief Exercises Solution to BE2-1 The primary users of the financial statements are investors, lenders, and other creditors who are not in a position to demand information from the entity. Those financial statement users who are not in a position to demand information rely on the financial statements to help them assess the amount, timing, and uncertainty of future cash

2-4 SOLUTIONS MANUAL FOR INTERMEDIATE ACCOUNTING

© 2016 Pearson Education, Inc.flows of the reporting entity, so that they can form an opinion about future returns that will accrue to them by holding a stake in the entity.This view applies to both U.S. GAAP and IFRS.Solution to BE2-2 According to the Conceptual Framework, “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit.” This objective is obtained from the FASB’s Statement of Financial Accounting Concepts No. 8, paragraph OB2 and the IASB’s Conceptual Framework for Financial Reporting, paragraph OB2.Solution to BE2-3 The items below are characteristics of information that is relevant (REL) or a faithful

representation (FR):

FR Information that is neutral REL Information has decision-making implications because of its predictive value FR Information that is complete FR Information that is free from error REL Information has decision-making implications because of its confirmatory value Solution to BE2-4 Fundamental characteristics are those basic characteristics that distinguish useful financial information from information that is not useful. Enhancing characteristics distinguish more useful information from less useful information.Solution to BE2-5 Financial reporting information is a faithful representation when it is complete, neutral, and free from error. Complete information includes all information that is necessary for the user to understand the underlying economic event. Neutral means the information is free from bias in both the selection and presentation of financial data. Free from error means the information should not contain errors or omissions in the description of an event.