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Financial Reporting

Overview

Chapter 1 is an overview chapter covering accounting users, financial reporting, GAAP, accounting organizations, the conceptual framework, accounting careers, and ethics. The topics are wide ranging and very heavy on the new terminology side of things. Although it is a good chapter for introductory purposes, the concepts and organizations covered are so extensive that it will make a good chapter to come back to later, or at the end of intermediate accounting, to review. In fact, many parts of the chapter will make more sense and come together in your mind better only after you have dealt with specific details and examples in later chapters. Focus mostly on the terminology at this point in time. Making sense of it all will be easier later on. The final section on accounting careers and ethics may make for some interesting reading, but don’t expect to be tested much on it. The conceptual framework will probably get the bulk of the examination questions, both for this class and for the CPA exam. As such, understanding Exhibit 1-6 in the textbook is very important.

Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered. If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with. The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

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Tips, Hints, and Things to Remember

LO1 – Describe the purpose of financial reporting and identify the primary financial statements. Why? The key difference between financial and managerial accounting is that each benefits different users. Even though financial accounting information (the primary financial statements of balance sheet, income statement, and statement of cash flows) can be beneficial to internal users (management, employees, and the board of directors), the information is created primarily for external users (especially investors, creditors, and the government). Why? The balance sheet is the only financial statement prepared as of a point in time. Why is that? For one, it would be impossible to issue a balance sheet for, say, an entire year since the balances change daily. All of the other financial statements cover a period of time (month, quarter, or year usually). They show totals (total revenue, total cash from investing activities, etc.) for a certain interval. The balance sheet, on the other hand, and as the name of the financial statement implies, doesn’t show totals; instead, the balance sheet shows balances at any stated point in time.

LO2 – Explain the function of accounting standards and describe the role of the FASB in setting those standards in the United States.

LO3 – Recognize the importance of the SEC, AICPA, AAA, and IRS to financial reporting. Why? Do these entities and all of this standard setting (LO2) stuff really matter? The answer, unfortunately for those who prefer to crank through numbers and not worry about politics, is yes. Although these items weren’t frequently tested in the past, don’t be surprised to see definitions and questions related to the topic—especially the newer, “hot” issues like Sarbanes-Oxley and the PCAOB.

LO4 – Realize the growing importance and relevance of international accounting issues to the practice of accounting in the United States and understand the role of the IASB in international accounting standard setting.

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Why? There are still differences between U.S. GAAP and the GAAP of most other countries. However, the IASB and local standard setting bodies are working together to create common GAAP on a worldwide basis. Such changes may happen during your career in the profession.

LO5 – Understand the significance of the FASB’s conceptual framework in outlining the qualities of good accounting information, defining terms such as asset and revenue, and providing guidance about appropriate recognition, measurement, and reporting. How? Gains vs. revenues—At first glance, gains and revenues appear to be synonymous. After all, they both serve to increase net income on the income statement. They result from different kinds of transactions and are, hence, classified as such. Revenues come from selling something related to the primary function of the organization—usually inventory (or services for service businesses). Gains, on the other hand, come from other income-producing transactions—usually the sale of property, plant, and equipment or other non-inventory assets. Why? Gains vs. revenues—By classifying increases to net income as either gains or as revenue, instead of lumping them together, someone analyzing the financial statements can obtain more useful information. Investors and creditors usually are more concerned with revenue than with gains. This is primarily because a business ultimately has to sell its primary product or service (generating revenues—not gains) in order to have success in the long run. In addition, revenues don’t usually fluctuate as much as gains do and are, hence, a better predictor of future income streams. Why? Losses vs. expenses—Losses are to gains what expenses are to revenues. Therefore, losses don’t relate to the sale of inventory or the primary operations of a business. Expenses are the items that are paired up with revenues in the sense that they are going to be more constant and similar in the future (in most instances) and relate to the core of the business activities. Investors and other external parties are, hence, going to be looking more closely at expenses than they are at losses for the reasons given in the above paragraph. Examples of expenses include cost of goods sold, salaries and wages, accounting fees, and marketing costs. Examples of losses include selling a piece of land (that is not considered inventory) for less than the historical cost to the company, buying back and retiring bonds the company previously issued for more than the carrying value of the bonds, and the disposal of a piece of machinery that still has a positive book value (hasn’t been fully depreciated). How? Relevance vs. reliability—The first thing to remember is that these two Rs are the two primary qualities inherent in useful accounting information. That’s the easy part. The difficulty is in distinguishing between the two.

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Let’s start with relevance. An item is only relevant if it is timely. To obtain something unrelated to the topic at hand, years after the fact, is to obtain something that is not relevant. Relevant ends with t, so if you like mnemonic devices to make things easier to remember, break relevance down to relevant and use the t to remind you of the word time. The three words that go along with relevance, then, all deal, to some degree, with time: predictive value, feedback value, and timeliness. Now let’s move on to reliability. An item is only reliable if the data is good. Bad data means unreliable information. The three words that go along with reliability, then, all deal, to some degree, with sound information: verifiability (consensus—more than one person can look at the transactions and come up with the same financial statements), neutrality (all groups kept to the same rules), and representational faithfulness (no mismeasurements).

LO6 – Identify career opportunities related to accounting and financial reporting and understand the importance of personal ethics in the practice of accounting. How? How does one expand their career opportunities within the field of accounting? Perhaps the best method is through the obtaining of professional certification. The most common certification for accountants in the United States is that of CPA. Although the P in CPA stands for public, becoming a CPA can increase a person’s credentials within both private and government institutions as well. The most common questions related to LO6 on quizzes and exams tend to revolve around obtaining certification. How does one do so? It depends on the state. The state boards of accountancy are actually the issuers of CPA licenses—not the federal government or the AICPA. Each state has different requirements, but most states have an education and experience requirement. All states require the passing of the CPA exam. The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely rereading a chapter, that is only a secondary objective in presenting this information in this format.

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The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC1-1 (LO1) The financial statement that is NOT for an interval of time is the a. balance sheet. b. income statement. c. statement of cash flows. d. statement of changes in owners’ equity. MC1-2 (LO1) Independent auditors express an opinion on the a. tax return of a company. b. quality of a company’s management. c. soundness of a company’s future. d. fairness of financial statements. MC1-3 (LO3) The SEC issues which of the following? a. Exposure Drafts b. Financial Reporting Releases c. International Financial Reporting Standards d. Financial Accounting Standards MC1-4 (LO3) GAAP sources do NOT include a. IRS. b. AICPA. c. SEC. d. FASB. MC1-5 (LO3) Form 10-K is submitted to the a. IRS. b. AICPA. c. SEC. d. FASB.

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MC1-6 (LO4) Which of the following is TRUE about international accounting standards? a. The IASB board members are all from Europe. b. Few differences exist between U.S. GAAP and GAAP of other countries. c. Significant differences exist between U.S. GAAP and GAAP of other

countries. d. It is unlikely that the differences between U.S. GAAP and GAAP of other

countries will diminish over time. MC1-7 (LO5) The overall objective of financial reporting is to provide information a. that allows owners to assess management’s performance. b. about a company’s assets, liabilities, and owners’ equity. c. about a company’s financial performance during a period. d. that is useful for decision making. MC1-8 (LO5) FASB’s conceptual framework’s primary qualitative characteristics of accounting information include a. full disclosure. b. historical cost. c. recognition. d. reliability. MC1-9 (LO5) FASB’s conceptual framework’s primary qualitative characteristic of relevance includes a. verifiability. b. feedback value. c. neutrality. d. representational faithfulness. MC1-10 (LO5) Elements of financial statements do NOT include a. gains. b. comprehensive income. c. stable monetary units. d. distributions to owners. MC1-11 (LO5) Secondary qualitative characteristics of accounting information include a. relevance (including reliability). b. comparability (including consistency). c. reliability (including comparability). d. predictive value (including feedback).

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MC1-12 (LO5) Land was acquired many years ago at a cost of $50,000. The assessed valuation for tax purposes is $55,000; an appraiser placed its value at $98,000; and a recent firm offer for the land was for a cash payment of $91,000. The land should be reported in the financial statements at a. $50,000. b. $55,000. c. $91,000. d. $98,000. MC1-13 (LO6) CPAs are licensed by a. the federal government. b. the SEC. c. the AICPA. d. state governments.

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Matching

Matching 1-1 (LO1) Listed below are the terms and associated definitions from the chapter for LO1. Match the correct definition letter with each term number. ___ 1. accounting ___ 2. stakeholder ___ 3. internal user ___ 4. external user ___ 5. management

accounting ___ 6. financial

accounting ___ 7. creditors ___ 8. investors ___ 9. general-

purpose financial statements

___ 10. balance sheet ___ 11. income

statement ___ 12. statement of

cash flows ___ 13. notes to the

financial statements

___ 14. auditors ___ 15. auditor’s

opinion

a. a person within a company who uses accounting information to make operating decisions

b. outside parties who are owed money by a company c. a balance sheet, income statement, and statement of

cash flows d. reports a company’s profit for a certain period of time e. the activity associated with the development and

communication of financial information for external users f. quantitative information, primarily financial in nature,

about economic entities that is intended to be useful in making economic decisions

g. separated into operating, investing, and financing activities

h. a report about the fairness of a company’s financial statements

i. supplemental information that outlines the accounting assumptions and estimates

j. external public accountants hired by a company to independently examine the company’s financial records

k. the activity associated with financial reporting for internal users

l. a user of a company’s financial statements who is outside the company

m. reports, as of a given point in time, the assets, liabilities, and owners’ equity of a business

n. owners and potential owners of a company o. a party, inside or outside of a company, that is interested

in the performance of a company

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Matching 1-2 (LO2, LO3, LO4) Ready for some acronyms? Listed below are the terms and associated definitions from the chapter for LO2 through LO4. Match the correct definition letter with each term number. ___ 1. SEC ___ 2. GAAP ___ 3. FASB ___ 4. APB ___ 5. FAF ___ 6. GASB ___ 7. SFAS or FAS ___ 8. SFAC ___ 9. Exposure Draft ___ 10. EITF ___ 11. FRR ___ 12. SAB ___ 13. AICPA ___ 14. CPA ___ 15. AAA ___ 16. IRS ___ 17. IASB ___ 18. PCAOB

a. an SEC statement dealing with reporting and disclosure requirements in documents filed with the SEC

b. responsible for studying accounting issues and establishing accounting standards to govern financial reporting in the United States

c. an organization primarily for accounting professors d. a set of guidelines established by the FASB to provide a

conceptual framework for establishing and administering accounting standards

e. the U.S. government agency created to regulate the issuance and trading of securities in the United States

f. the independent private organization responsible for establishing standards in state and local governmental areas

g. a preliminary statement of a standard that includes specific recommendations made by the FASB

h. accounting interpretations made by the staff of the SEC i. the organization responsible for selecting members of the

FASB, GASB, and their advisory councils j. the government agency responsible for administering

U.S. income tax rules k. the private-sector organization created by the Sarbanes-

Oxley Act of 2002 l. an accountant who has met specified professional

requirements established by the AICPA m. representatives from the accounting profession and

industry created by the FASB to take timely action on emerging issues of financial reporting

n. official statements of the FASB that govern external financial reporting

o. accounting standards recognized by the accounting profession as required in the preparation of financial statements for external users

p. the board of the AICPA that issued Opinions establishing accounting standards during the period 1959–1973

q. develops accounting standards that can serve as the basis for harmonizing conflicting national standards

r. the professional organization that publishes a monthly journal, the Journal of Accountancy

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Matching 1-3 (LO5) Listed below are the terms and associated definitions from the chapter for LO5. Match the correct definition letter with each term number. ___ 1. conceptual

framework ___ 2. asset ___ 3. comparability ___ 4. comprehensive

income ___ 5. conservatism ___ 6. consistency ___ 7. current market

value ___ 8. current

replacement cost

___ 9. disclosure ___ 10. economic entity ___ 11. equity ___ 12. expenses ___ 13. feedback value ___ 14. full disclosure

principle ___ 15. gain ___ 16. going concern ___ 17. historical cost

a. all changes in owners’ equity except investments by and distributions to owners

b. theoretical foundation underlying accounting standards and practice

c. the same accounting methods should be followed from one period to the next

d. basic accounting concept that requires that all relevant information be presented in an unbiased, understandable, and timely manner

e. residual interest in the assets of an entity that remains after deducting its liabilities; sometimes referred to as net assets

f. outflows or other “using up” of assets of an entity or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations

g. resource of an entity h. the amount by which the proceeds from disposing of an

asset (other than inventory) exceed the book value of the asset

i. the cash equivalent price that would be paid now to purchase or replace goods or services

j. a key ingredient of relevant accounting information; helps to confirm or change a decision maker’s beliefs based on whether the information matches what was expected

k. the premise that information is more useful when it can be related to a benchmark or standard

l. the cash equivalent price of goods or services at the date of acquisition

m. a specific reporting unit, separate and distinct from its owners or other entities

n. the notion that when doubt exists concerning two or more reporting alternatives, users should select the alternative with the least favorable impact on reported income, assets, and liabilities

o. reporting the details of a transaction in the notes to the financial statements

p. the cash equivalent price that could be obtained now by selling an asset in an orderly liquidation

q. an entity that is expected to continue in existence for the foreseeable future

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Matching 1-4 (LO5) Listed below are the terms and associated definitions from the chapter for LO5. Match the correct definition letter with each term number. ___ 1. materiality ___ 2. net realizable

value ___ 3. neutrality ___ 4. predictive value ___ 5. recognition ___ 6. relevance ___ 7. reliability ___ 8. representational

faithfulness ___ 9. revenues ___ 10. stable monetary

units ___ 11. timeliness ___ 12. verifiability ___ 13. liabilities ___ 14. loss ___ 15. matching

a. the amount of cash expected to be received from the conversion of assets in the normal course of business

b. the process of formally recording an item in the accounting records

c. one of two primary qualities inherent in useful accounting information; includes the key ingredients of verifiability, neutrality, and representational faithfulness

d. important constraint underlying the reporting of accounting information; it relates to how large an item is in terms of dollar amount or relative to the size of the company

e. expenses for a period are determined by associating them with specific revenues over a particular time period

f. U.S. financial statements have traditionally reported items in nominal dollars without adjustment for changes in purchasing power

g. probable future sacrifices of economic benefits arising from present obligations

h. helps a decision maker predict future consequences based on information about past transactions and events

i. information provided soon after period end or on a timely basis

j. the amount by which the proceeds from disposing of an asset (except inventory) are less than the book value of the asset

k. a key ingredient of reliable accounting information; reported information should be based on objectively determined facts that can be duplicated by other accountants using the same measurement methods

l. one of two primary qualities inherent in useful accounting information; includes the key ingredients of feedback value, predictive value, and timeliness

m. inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations

n. amounts and descriptions reported in the financial statements reflect the actual results of economic transactions and events

o. a key ingredient of reliable accounting information requiring that information be presented in an unbiased manner

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Problems

Problem 1-1 (LO5) For each of the following situations, discuss the qualitative characteristic, constraint, ingredient, component, assumption, recognition, measurement, or reporting item that best fits (or is violated by) the description. a. Three different CPAs independently agree on the amount and method of reporting a

transaction. b. Foster Corporation has started placing its quarterly financial statements on its Web

site, thereby reducing by two weeks the time it previously took to get information to investors and creditors.

c. Graven Incorporated recognizes all losses but doesn’t recognize any gains on their books until they’ve actually sold the item for more than its book value.

d. Villarreal’s Pet Store’s balance sheet listed cash at $1,000 even though the owner has cash of $10,000 in his personal checking account and another $5,000 in the checking account of the owner’s other business.

e. Gigantic Company, with revenues for the prior year and assets at the end of the prior year at well over a billion dollars each, expensed $50 worth of batteries that were purchased during the year and expected to last several years in handheld devices.

f. Long Term Corporation has accounts receivable of $1 million, prepaid rent of $30,000, and unearned revenue of $50,000 for services to be performed in future years.

g. Nepotism Incorporated does 50 percent of its business with the CEO’s wife’s company at prices higher than it does with other customers and vendors.

Solutions, Approaches, and Explanations

MC1-1 Answer: a Approach and explanation: The balance sheet is the only financial statement that is as of a particular date. For instance, the cash on the balance sheet is the amount of cash on hand as of the date stated. It is not the amount of cash that came in during the period. The cash balance during the year may have fluctuated widely, but one cannot tell from a balance sheet. All of the other financial statements are for a period of time (like a month, quarter, or year). In the case of the income statement, one can see how much income was earned during an interval of time. If it was dated December 31, 2011, one wouldn’t know whether it was dealing with income for that day, month, quarter, or year. The same can be said for the statement of cash flows and statement of changes in owners’ equity. All three financial statements show changes or cumulative happenings during a period, or interval, of time.

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MC1-2 Answer: d Approach and explanation: Even though this isn’t an auditing course, and you’ll cover this information in much more detail when you do take an auditing course, it is a good idea to understand what an audit is and what is included in an audit report/opinion. Your professor will likely refer to auditing at times during the course, so having some basic knowledge may help. Read through an actual audit opinion or two to get a flavor for what is included. The language is usually boilerplate, so it doesn’t really matter whose opinion you read. They all usually say basically the same thing. You can find audit reports in annual reports, on company Web sites, or at http://www.sec.gov. To find them on a company Web site, look for a link like “about the company” or “investor relations.” On http://www.sec.gov, click on “Search for Company Filings,” then click on “Company or fund name, ticker symbol, CIK (Central Index Key), file number, state, county, or SIC (Standard Industrial Classification),” enter the company name or ticker symbol (for instance Intel or INTC), and finally click on the 10-K in html format. (You may need to click another link [usually the first] on the 10-K index page to get to the actual 10-K.) The audit opinion tends to be near the end. Now on to the choices… a. When people think of auditors, the first thing that comes to mind is taxes and the

IRS. Don’t let the first choice distract you. An audit opinion has nothing to do with taxes or the company’s tax return.

b. You’ll notice from reading an actual opinion that nothing is said about a company’s management other than the fact that the financial statements are their responsibility.

c. Finally, if you look at multiple audit opinions, you’ll notice that they are usually the same. Auditors don’t recommend companies or comment on their financial statements, other than to say that they are in accordance with GAAP or not. A company can have really lousy financial statements and still get the same clean opinion. It is up to the reader of the financial statements to decide if the company’s future appears sound. Analysts on Wall Street comment on the soundness of a company—not auditors.

d. The fairness of the financial statements is what auditors disclose in their opinion. An unqualified opinion states that the financial statements are fairly presented in conformity with GAAP.

MC1-3 Answer: b Approach and explanation: Before looking at the choices, list the issuances of the SEC. They include FRRs and SABs. Then scan the list for one of those items.

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If you don’t know what the SEC issues but do know what FASB issues, then list the FASB items and cross them off the list to narrow your choices. FASB issues preliminary views, exposure drafts, staff positions, SFAS (FAS), and SFACs. Therefore, you can cross out a and d and be left with b and c to choose from. Now ask yourself what the SEC’s purpose and responsibilities are. Are they an international body? No. The SEC is a U.S. agency. Therefore, they wouldn’t be issuing IFRSs, so the only choice left is FRRs, which is the correct choice. MC1-4 Answer: a Approach and explanation: First, make sure that you note the not in the question. Circle it, underline it, highlight it, do whatever it takes to not forget that you are looking for the not answer. Otherwise you may select the first GAAP source you see and leave it at that. Always, always look at all the answer choices before making your final choice. That way if you miss the not but find two or three GAAP sources, you’ll realize that you misread the question since two or three answers can’t be correct. Think about who the major players are in the creation of GAAP. The authority ranking in Exhibit 1-5 is a good source to think back to. The major players have been FASB and FASB’s predecessors. FASB’s predecessors were largely run by the AICPA. If you know that, then you can easily eliminate the AICPA and FASB. For publicly traded companies, the SEC becomes a major player. Although, historically, the SEC hasn’t wielded much of its GAAP formation powers, the SEC can and has been a contributor. With Sarbanes-Oxley and growth in the SEC, the SEC promises to become an even greater force in the establishment and changes to GAAP in the future. MC1-5 Answer: c Approach and explanation: As mentioned in the explanation to MC1-2, it is a good idea to look at actual 10-Ks to get a feeling for what they are. That way if you missed from the chapter which body 10-Ks are submitted to, you’d probably still have seen that across the top of every 10-K “United States and Securities and Exchange Commission” is very prominently listed. Tax returns are filed with the IRS. Companies don’t usually submit anything to the FASB or the AICPA.

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MC1-6 Answer: c Approach and explanation: This is actually a very easy question to answer correctly even if you have no understanding of international accounting standards. The first thing to note is that you are looking for the true statement. Therefore, three of the statements are false. When you encounter such a question, look for answers that are opposites. If you find two opposite answers, then you have a pretty good idea that one of them is the correct one. In this case, choices b and c are opposites. One of them must be true, and one of them must be false. That also means that choices a and d are likely to be false. See if one of them is similar to choices b and c. In this case, they are not. But if they were, you would then know that the one that is similar to a false one is also false and the other would be the correct answer. In this case, we have determined that choice d is false, but it can still provide clues about the true answer. It indicates, in part, that there are differences between U.S. GAAP and GAAP for other countries. That is the true part. The false part is that the differences probably will diminish over time. The true part of d indicates that c is a better choice than b (were you to be making an educated guess). Note: Merely making educated guesses isn’t the best way to perform well on a test; nor is learning how to make educated guesses your best method for preparing for an exam. Studying the material itself is more worthwhile and time better spent. However, for questions that you don’t know an answer to or are somewhat unsure, then making an educated guess is better than making a random guess or leaving a question blank. Over 5 percent of students sometimes leave answers blank when they don’t know the correct answer. This is not a good strategy! Unless your instructor tells you that you will be docked more points for an incorrect answer than a blank answer, don’t ever leave an answer blank. Make an educated guess first, and if one is not possible given the question and choices, then make a random one as a last resort. MC1-7 Answer: d Approach and explanation: The key word in the question is “overall.” Think of the big picture. The wrong choices probably only deal with a piece of the entire picture. Also remember that financial reporting is primarily for external decision makers, which include owners, potential investors, and creditors. That being the case, let’s now turn to the choices. Information for owners in choice a is a good choice but it doesn’t include potential investors or creditors. Hence, it is incomplete when we are talking about an overall objective. Choice b refers to the balance sheet, which, again, is only a part of financial reporting. Choice c refers to the income statement, which is important but, again, only a part of financial reporting. Choice d is the only choice that is broad enough to be an overall objective of financial reporting.

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MC1-8 Answer: d Approach and explanation: As mentioned previously, understanding Exhibit 1-6 in the textbook is very important for exams in this course and for the CPA exam. You need to understand the exhibit on several levels.

1. Know what each of the words mean including examples. 2. Understand how they fit together. 3. Be familiar with their relationships to the words in the column on the left.

With that understanding already in place, you would know that the two primary qualitative characteristics are reliability and relevance. Think of this, or better yet write the words reliability and relevance down, after reading the question but before looking at the possible choices. That way you don’t get thrown off by the two words beginning with an r and start to second-guess yourself, wondering if it is recognition or reliability because you can no longer remember what the two r words are. What if you didn’t know that the two r words were the primary qualitative characteristics, but you did know what the two r words are and that they are related? Then you may be able to back into the answer, making a quasi-guess. Here is the thought process: I know relevance and reliability go together for something. Why do these choices not include both? Probably because if it included both, there would be two correct answers. So the author of the question had to drop one. In its place, they threw in another r word to try and distract the student who didn’t know the answer well. Therefore, since I know the two r words are relevance and reliability and relevance has been dropped for recognition, reliability must be the correct answer. Full disclosure, historical cost, and recognition are actually all components of “Recognition, Measurement, and Reporting”—not qualitative characteristics. MC1-9 Answer: b Approach and explanation: The first thing to note is that if this question were asked on the same exam as the prior question, it could give you some serious clues about the answer to the prior question. Since relevance is mentioned in the question as a primary qualitative characteristic, it may help trigger your memory that the other one is reliability. Don’t be shy about using other questions to possibly assist you on a given question. Questions, and the choices provided, can sometimes assist your recollection of material. There is no need to read each question in complete isolation from the rest of them.

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This question is testing your knowledge of point 2 explained in the prior question, understanding how Exhibit 1-6 fits together. Recall from the “How? Relevance vs. reliability” section on pages 1-3 and 1-4 that relevance deals with time-related issues and reliability deals with data being sound. The three ingredients of relevance are, therefore, prediction, feedback, and timeliness, so b must be correct. The other three all relate to the soundness of the data. But what if you couldn’t remember which (of relevance and reliability) dealt with time and which dealt with data quality? Then you should play the “which-of-these-is-not-like-the-other” game. Choices a, c, and d are more similar to each other than they are to feedback value because they all deal with information for which users can have confidence in. Feedback value, on the other hand, is on a different wavelength and deals with comparability over time. MC1-10 Answer: c Approach and explanation: First, and foremost, make sure that you note the not in the question. Circle it, underline it, highlight it, do whatever it takes to not forget that you are looking for the not answer. Otherwise, you may quickly select gains since you learned about it being a part of income statements in your introductory course. The other items are probably new and seem different at first glance. Next, while covering up the choices with a piece of scratch paper, list what the elements to the financial statements include. Assets, liabilities, equity, revenue, and expenses are the easy ones. Gains and losses are a bit more difficult to come up with, but you know they show up on an income statement too. Are there any other financial statements besides the balance sheet and income statement? What is on the statement of changes in owners’ equity (stockholders’ equity for corporations)? That one may be new to you so be sure to study the box in Exhibit 1-7 whose first section is “Investment by Owners” carefully. That statement includes investments by and distributions to owners. Most companies also include comprehensive income on that statement. So if you came up with all 10, then you would certainly get the answer correct. But what if you didn’t? Again, it would be time to play the which-of-these-is-not-like-the-other game. Choices a, b, and d are all things you could reasonably expect to see somewhere on one of a company’s financial statements. Choice c, on the other hand, is a concept, or more accurately stated—an assumption. You wouldn’t expect to see it as an element on a financial statement (even though financial statements are expressed in a currency).

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MC1-11 Answer: b Approach and explanation: Can you tell that Exhibit 1-6 is important yet? Remember that the two Rs go together and that the two Cs do as well. That will rule out choice c. Choice d can be eliminated as well because predictive and feedback value are ingredients, or components, of the primary qualities of accounting information and not secondary qualitative characteristics at all. That leaves just choices a and b. Hopefully, you already knew that the two Rs are the primary characteristics (or you learned that they are from reading other questions like MC1-11) and then you can back into choice b even if you didn’t know the answer. MC1-12 Answer: a Approach and explanation: This is a good example of the historical cost measurement principle. Since $50,000 was the original acquisition cost, it is the reported amount on the financial statements. Market value, replacement cost, and realizable value do not come into play when it comes to reported amounts for land unless the property has been sold. Although you’ll cover this topic of measurement in more detail (for specific items) in later chapters, it is a good idea to know the basic ones that are provided as examples in LO5. MC1-13 Answer: d Approach and explanation: This one is a little trickier than it looks on the surface. If you don’t know the answer, you should probably start by crossing off choices a and b since those are basically the same thing. Many students quickly jump to choice c since the word AICPA has CPA in it, and the AICPA administers the CPA exam. Technically, however, it is the state boards of accountancy that license CPAs. To find out the requirements in your state (as all states differ) see http://www.nasba.org.

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Matching 1-1 1. f 2. o 3. a 4. l 5. k 6. e 7. b 8. n 9. c 10. m 11. d 12. g 13. i 14. j 15. h Remember that accounting is the “language of business.” Terminology can account for anywhere from 10 to 40 percent of many quizzes and exams. For this chapter, the figure is probably even higher at around 30 to 70 percent. Sometimes answering problems, that aren’t directly testing terminology knowledge, correctly can also be dependent on an accurate understanding of the terms used in the problem. New vocabulary is essential to master when first encountered since the same words will appear (without definitions provided again) in subsequent chapters. Complete these terminology matching exercises without looking back to the textbook or on to the glossary. After all, you probably won’t have those as a reference at test time. Learning through trial and error causes the item to be learned better and to stick in your memory longer than if you just look to the textbook, glossary, or a dictionary and “cook book” the answers. Sure you may get the answer correct on your first attempt, but missing something is sometimes best for retention. Don’t be afraid of failure while studying and practicing.

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Matching 1-2 1. e 2. o 3. b 4. p 5. i 6. f 7. n 8. d 9. g 10. m 11. a 12. h 13. r 14. l 15. c 16. j 17. q 18. k Acronyms are never easy or fun to learn, but these are actually quite important ones to know. They are used quite frequently in the literature, the rest of the textbook, and the profession. The good news is that there are relatively few acronyms in the book after this first chapter—and these two LOs in particular.

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Matching 1-3 1. b 2. g 3. k 4. a 5. n 6. c 7. p 8. i 9. o 10. m 11. e 12. f 13. j 14. d 15. h 16. q 17. l Approaching matching problems is intuitive, and you probably have already figured it out. However, here are some steps to go through, especially if you get stuck. Step 1: Start with the terms that you are sure of. Cross them (and the match) out as you fill in the matching definitions to reduce the number of choices you will have for the ones that are more difficult. Step 2: Look for solutions that are a better fit. For instance, “the same accounting methods should be followed from one period to the next” sounds like a possible fit for “comparability,” but a better fit for “comparability” is “the premise that information is more useful when it can be related to a benchmark or standard.” That reduces your choices for “the same accounting methods should be followed from one period to the next” and should help steer your match of it to “consistency.” Step 3: Synonyms can be a give away, so scan the remaining list for them. Examples in this exercise include “now,” which mean basically the same thing as “current” and “cost,” which means the same as “price.”

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Matching 1-4 1. d 2. a 3. o 4. h 5. b 6. l 7. c 8. n 9. m 10. f 11. i 12. k 13. g 14. j 15. e Problem 1-1 Approach, solution, and explanation: Before reading the situations, you should list out all of the characteristics, assumptions, etc. that you can so that you’ll have a laundry list to choose from. Don’t limit yourself to the first answer that looks good or pops into your head. Consider all the relevant alternatives you can possibly come up with, and then narrow down your answer to the one or two that look the best. a. Your first thought may be comparability or consistency. After all, the three CPAs

could compare notes and see that they all consistently agree. However, comparability, in the conceptual framework, has to do with comparing a company’s results against its own past (or future) results or against the financial statements or accounting information for other companies in the same industry. It does not imply comparisons between accountants. Nor does consistency imply, in the conceptual framework, consistent agreement between parties. Consistency means that we don’t usually change our treatment of accounting period to period.

Consensus (yet another c word!) is what is taking place here. And consensus, in the conceptual framework, means the same as verifiability. Therefore, verifiability is the best answer. Another acceptable answer would be reliability since verifiability is an ingredient, or component, of reliability.

By listing both verifiability and reliability as your answer and explaining that verifiability is a part of reliability on your exam, you are sure to score bonus points with your professor or CPA exam grader. They will know that you really know what you are talking about.

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b. This one has timeliness written all over it. But do you know which primary qualitative characteristic goes along with timeliness? If you list your answer out as “timeliness which is an ingredient of relevance,” then you have done even better than your fellow students who just wrote timeliness and left it at that.

c. Conservatism is the best answer. Another possible answer that you may wish to

discuss (but certainly not in place of conservatism) would be recognition. In this situation, recognition is not happening for assets that have appreciated in value until sold. Recognition (a write-down of the asset on the balance sheet and a loss on the income statement) is happening for assets that have dropped in value.

d. Economic entity is the concept that an organization’s activities should be separated

from those of the owner(s) and the owners’ other businesses. e. Materiality is the best answer. Another possible answer is “benefits greater than

cost.” The benefit of adjusting the financial statements slightly to reflect the use of the batteries isn’t worth the cost of doing so.

f. Going concern is the assumption that a company will continue to function in the

future. Because of this assumption, financial statements are prepared on an accrual basis with future cash flows reflected in some balance sheet accounts. Financial statements are not prepared with the assumption that the company has gone bankrupt and is liquidating.

g. The best answer is arm’s-length transactions assumption. The suggestion here is

that these transactions are not at arm’s length since they are with a related party and for amounts different than normal. A secondary answer (which you would not be expected to know at this point) is that related party transactions need to be disclosed. Hence, the full disclosure principle also comes into play with related party transactions.

Glossary

Note that Appendix C in the rear portion of the textbook contains a comprehensive glossary for all of the terms used in the textbook. That is the place to turn to if you need to look up a word but don’t know which chapter(s) it appeared in. The glossary below is identical with one major exception: It contains only those terms used in Chapter 1. This abbreviated glossary can prove quite useful when reviewing a chapter, when studying for a quiz for a particular chapter, or when studying for an exam which covers only a few chapters including this one. Use it in those instances instead of wading through the 19 pages of comprehensive glossary in the textbook trying to pick out just those words that were used in this chapter.

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accounting A service activity whose “function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions—in making reasoned choices among alternative courses of action” (Statement of the Accounting Principles Board No. 4, par. 40).

accounting periods The time intervals used for financial reporting; due to the need for timely information, the life of a business or other entity is divided into specific accounting periods for external reporting purposes. One year is the normal reporting period, although most large U.S. companies also provide quarterly statements.

Accounting Principles Board (APB) A board of the AICPA that issued Opinions establishing accounting standards during the period 1959–1973.

American Accounting Association (AAA) An organization primarily for accounting professors. The AAA’s role in establishing accounting standards includes research projects to help the FASB and a forum for representing different points of view on various issues.

American Institute of Certified Public Accountants (AICPA) A professional organization for CPAs in which membership is voluntary. It publishes a monthly journal, the Journal of Accountancy.

arm’s-length transactions Exchanges between parties who are independent of each other. A traditional assumption in accounting is that recorded transactions and events are executed between independent parties, each of whom is acting in its own best interest.

asset A resource of an entity.

auditor An external public accountant hired by a company to independently examine the company’s financial records and issue an opinion about the fairness of the financial statements.

auditor’s opinion  Report about the fairness of a company’s financial statements issued by an independent auditor after reviewing the company’s financial records.

balance sheet  A statement that reports, as of a given point in time, the assets, liabilities, and owners’ equity of a business.

certified public accountant (CPA) An accountant who has met specified professional requirements established by the AICPA and local and state societies. A CPA often does not work for a single business but provides a variety of professional services for many different individual and business clients. A key service provided by CPAs is the performance of independent audits of financial statements.

comparability A quality of useful accounting information based on the premise that information is more useful when it can be related to a benchmark or standard, such as data for other firms within the same industry.

comprehensive income A concept of income measurement and reporting that includes all changes in owners’ equity except investments by and distributions to owners.

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conceptual framework A theoretical foundation underlying accounting standards and practice. The framework established by the FASB encompasses the objectives, fundamental concepts, and implementation guidelines described in FASB Concepts Statement Nos. 1–7.

conservatism The notion that when doubt exists concerning two or more reporting alternatives, users should select the alternative with the least favorable impact on reported income, assets, and liabilities.

consistency A quality of useful accounting information requiring that accounting methods be followed consistently from one period to the next.

creditors Outside parties who are owed money by a company.

current market value The cash equivalent price that could be obtained currently by selling an asset in an orderly liquidation.

current replacement cost  The cash equivalent price that would be paid currently to purchase or replace goods or services.

disclosure  Reporting the details of a transaction in the notes to the financial statements. Disclosure is sometimes used in place of recognition; that is, instead of including the results of a transaction in the financial statements themselves, it is disclosed in the notes.

economic entity A specific reporting unit, separate and distinct from its owners or other entities.

Emerging Issues Task Force (EITF) A task force of representatives from the accounting profession and industry created by the FASB to take timely action on emerging issues of financial reporting. The EITF identifies significant emerging issues and develops consensus positions when possible.

equity The residual interest in the assets of an entity that remains after deducting its liabilities; sometimes referred to as net assets.

expenses Outflows or other “using up” of assets of an entity or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

exposure draft A preliminary statement of a standard that includes specific recommendations made by the FASB. Reaction to the Exposure Draft is requested from the accounting and business communities, and the comments received are carefully considered before a final Statement of Financial Accounting Standards is issued.

external users  Users of a company’s financial statements who are outside the company.

feedback value A key ingredient of relevant accounting information; helps to confirm or change a decision maker’s beliefs based on whether the information matches what was expected.

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financial accounting The activity associated with the development and communication of financial information for external users.

Financial Accounting Foundation (FAF) An organization responsible for selecting members of the FASB, GASB, and their advisory councils.

Financial Accounting Standards Board (FASB) Responsible for studying accounting issues and establishing accounting standards to govern financial reporting in the United States.

financial income Income reported on the financial statements as opposed to taxable income that is reported to taxing authorities in accordance with tax regulations.

Financial Reporting Release (FRR) SEC statement dealing with reporting and disclosure requiremen s in documents filed with the SEC. t

full disclosure principle  A basic accounting concept that requires that all relevant information be presented in an unbiased, understandable, and timely manner.

gain Amount by which the proceeds from disposing of an asset exceed the book value of the asset.

generally accepted accounting principles (GAAP) Accounting standards recognized by the accounting profession as required in the preparation of financial statements for external users. Currently, the FASB is the principal issuer of generally accepted accounting principles.

general-purpose financial statements A balance sheet, income statement, and statement of cash flows.

going concern An entity that is expected to continue in existence for the foreseeable future.

Governmental Accounting Standards Board (GASB)  An independent private organization responsible for establishing standards in state and local governmental areas.

historical cost  The cash equivalent price of goods or services at the date of acquisition.

income statement A statement that reports a company’s net income for a certain period.

Internal Revenue Service (IRS) U.S. government agency responsible for administering U.S. income tax rules.

internal users Parties within a company who use accounting information to make operating decisions.

International Accounting Standards Board (IASB) International group, based in London, representing accounting bodies in over 100 countries formed to develop accounting standards that can serve as the basis for harmonizing conflicting national standards.

investors Owners and potential owners of a company.

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liabilities The claims of creditors against an entity’s resources; technically defined by the FASB as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

loss  Amount by which the proceeds from disposing of an asset are less than the book value of the asset.

management accounting The activity associated with financial reporting for internal users.

matching A basic accounting concept that is applied to determine when expenses are recognized (recorded). Under this principle, expenses for a period are determined by associating or “matching” them with specific revenues over a particular time period.

materiality  An important constraint underlying the reporting of accounting information; it relates to how large an item is in terms of dollar amount. Accounting standards do not need to be applied to items that are considered to be immaterial.

net realizable value The amount of cash expected to be received from the conversion of assets in the normal course of business; net realizable value equals selling price less normal selling costs for inventory and equals gross receivables less the allowance for bad debts for accounts receivable.

neutrality A key ingredient of reliable accounting information requiring that information be presented in an unbiased manner; neutrality relates to the concept of fairness to users.

notes to the financial statements  Supplemental information that outlines the accounting assumptions and estimates.

off-balance-sheet financing Procedures used by companies to avoid disclosing all of their debt on the balance sheet to make their financial position look stronger.

other comprehensive income The summary typically provided by companies as part of their statement of stockholders’ equity showing changes in owners’ equity exclusive of net income and contributions by and distributions to owners; required by the FASB beginning in 1998.

predictive value Helps a decision maker predict future consequences based on information about past transactions and events.

preliminary views A document issued by the FASB that identifies the principal issues involved with financial accounting and reporting topics. It includes a discussion of the various points of view as to the resolution of issues but does not reach a specific conclusion.

Public Company Accounting Oversight Board (PCAOB) A private-sector organization created by the Sarbanes-Oxley Act of 2002. The SEC has Congressional authority to oversee the PCAOB’s activities.

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recognition The process of formally recording an item in the accounting records and eventually reporting it in the financial statements; includes both the initial recording of an item and any subsequent changes related to that item.

relevance One of two primary qualities inherent in useful accounting information; essentially, information is relevant if it will affect a decision. The key ingredients of relevance are feedback value, predictive value, and timeliness.

reliability One of two primary qualities inherent in useful accounting information; to be reliable, information must contain the key ingredients of verifiability, neutrality, and representational faithfulness.

representational faithfulness A key ingredient of reliable accounting information requiring that the amounts and descriptions reported in the financial statements reflect the actual results of economic transactions and events.

revenues  Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Securities and Exchange Commission (SEC) A U.S. government agency created to regulate the issuance and trading of securities in the United States. As part of this function, the SEC is vitally interested in financial accounting and reporting standards. The SEC has the legal authority to establish accounting standards, but it has historically relied heavily on the private sector to perform this function.

stable monetary units An accounting assumption that the measuring unit maintains constant purchasing power; based on this assumption, U.S. financial statements have traditionally reported items in nominal dollars without adjustment for changes in purchasing power.

Staff Accounting Bulletin (SAB) Accounting interpretations made by the staff of the SEC. SABs do not necessarily represent official positions of the SEC.

stakeholders All parties interested in the performance of a company.

statement of cash flows One of the three primary financial statements. The cash flow statement provides information about the cash receipts (inflows) and cash payments (outflows) of a company during a period of time. The statement is separated into cash flows from operating, investing, and financing activities.

statement of changes in owners’ equity A report that shows the total changes in all owners’ equity accounts during a period of time; provides a reconciliation of the beginning and ending owners’ equity amounts.

statement of changes in stockholders’ equity A report that summarizes the reasons for the changes in all equity accounts during a period of time.

Statements of Financial Accounting Concepts (SFAC) A set of guidelines established by the FASB to provide a conceptual framework for establishing and administering accounting standards.

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Statements of Financial Accounting Standards (SFAS or FAS)  The official statements of the FASB that govern external financial reporting.

timeliness  Quality of information that is provided on a timely basis.

verifiability A key ingredient of reliable accounting information; reported information should be based on objectively determined facts that can be verified by other accountants using the same measurement methods.