Financial Accounting Chapter 1
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Questions and Answers

Which of the following is NOT considered an element of financial statements?

  • Expenses
  • Inflation (correct)
  • Assets
  • Revenues

    • What does the going concern assumption imply about a business entity?

  • It will be liquidated in the near future.
  • It will operate indefinitely. (correct)
  • It has no debts.
  • It will merge with another entity.

    • Which assumption allows the life of a company to be divided into artificial time periods?

  • Periodicity assumption (correct)
  • Economic entity assumption
  • Going concern assumption
  • Monetary unit assumption

    • Which of the following is a component of liabilities?

    <p>Accounts payable</p> Signup and view all the answers

    What is encompassed by the term 'comprehensive income'?

    <p>Net income along with other comprehensive income</p> Signup and view all the answers

    What characteristic does the economic entity assumption provide?

    <p>Economic events can be specifically identified with an economic entity.</p> Signup and view all the answers

    Which of the following elements indicates the residual interest in the assets of a business?

    <p>Equity</p> Signup and view all the answers

    Which of the following best describes 'gains' in financial statements?

    <p>Increases in equity from peripheral or incidental transactions.</p> Signup and view all the answers

    What amount is recognized as rent expense each year under accrual basis accounting for Carter Company?

    <p>$20,000</p> Signup and view all the answers

    What is the total revenue reported by Carter Company over the three years?

    <p>$300,000</p> Signup and view all the answers

    Which of the following expenses is not consistently reported each year in the income statement for Carter Company?

    <p>Utilities</p> Signup and view all the answers

    What is the total amount of net income for Carter Company over the three years?

    <p>$20,000</p> Signup and view all the answers

    How much did Carter Company pay for rent at the beginning of year 1?

    <p>$60,000</p> Signup and view all the answers

    What is the total amount for salaries expense reported over the three years?

    <p>$150,000</p> Signup and view all the answers

    In which year does Carter Company recognize the total utility expense of $30,000?

    <p>Years 2 and 3</p> Signup and view all the answers

    What is the total expenses amount reported for Carter Company in year 1?

    <p>$80,000</p> Signup and view all the answers

    What is true about Level 1 inputs in the fair value hierarchy?

    <p>They are the least subjective.</p> Signup and view all the answers

    Which level of the fair value hierarchy is based on the entity's own assumptions?

    <p>Level 3</p> Signup and view all the answers

    In ARO valuation situations, which level of fair value inputs is typically used?

    <p>Level 3</p> Signup and view all the answers

    Which of the following statements about the fair value hierarchy is not true?

    <p>Level 3 inputs are based on observable market prices.</p> Signup and view all the answers

    What do Level 2 inputs rely on in the fair value hierarchy?

    <p>Prices from similar assets in active markets.</p> Signup and view all the answers

    Which statement describes the preference of input levels in the fair value hierarchy?

    <p>Level 1 is the most preferred among the levels.</p> Signup and view all the answers

    Which level in the fair value hierarchy is characterized by the most subjectivity?

    <p>Level 3</p> Signup and view all the answers

    Fair value determined using Level 3 inputs often includes which of the following?

    <p>Assumptions about future market conditions.</p> Signup and view all the answers

    What is the primary focus of the revenue/expense approach in accounting?

    <p>Highlighting principles for recognizing revenues and expenses.</p> Signup and view all the answers

    Which of the following best describes the asset/liability approach?

    <p>Measuring existing assets and liabilities at a balance sheet date.</p> Signup and view all the answers

    According to the proposals from the FASB, how are assets and liabilities defined?

    <p>As present rights to receive or provide economic benefits.</p> Signup and view all the answers

    What change has been proposed regarding revenues and expenses by the FASB?

    <p>They no longer need to come from ongoing major operations.</p> Signup and view all the answers

    How are gains and losses now defined according to the FASB proposals?

    <p>As algebraically defined increases and decreases.</p> Signup and view all the answers

    What aspect of financial statement elements is the FASB focusing on revising?

    <p>The definitions of assets and liabilities.</p> Signup and view all the answers

    In the evolving GAAP, what is a significant change regarding the measurement of elements?

    <p>Emphasis on present rights or obligations rather than probable benefits.</p> Signup and view all the answers

    What characterizes the current conceptual framework development by the FASB?

    <p>A move towards consistency with international standards.</p> Signup and view all the answers

    What type of inputs characterizes Level 1 of the Fair Value Hierarchy?

    <p>Quoted market prices in active markets for identical assets or liabilities.</p> Signup and view all the answers

    What is the primary purpose of financial reporting?

    <p>To provide financial information to external users</p> Signup and view all the answers

    For Level 2 Fair Value Hierarchy, which of the following is considered an acceptable input?

    <p>Quoted prices for similar assets in either active or inactive markets.</p> Signup and view all the answers

    Which of the following is NOT typically considered a financial statement?

    <p>Statement of operational performance</p> Signup and view all the answers

    What is a valid example of fair value measurement for a building acquisition?

    <p>Valuation relies on quoted market prices for similar recently sold buildings.</p> Signup and view all the answers

    What type of entities are generally responsible for providing financial information?

    <p>Both profit-oriented and not-for-profit entities</p> Signup and view all the answers

    In what scenario would the use of Level 2 inputs be necessary?

    <p>When active market prices for identical assets are unavailable.</p> Signup and view all the answers

    When deriving fair value using observable market data, which approach is commonly used for Level 2 assets?

    <p>Using a price per square foot derived from relevant transactions.</p> Signup and view all the answers

    Who among the following is considered an external user of financial information?

    <p>Government regulatory agencies</p> Signup and view all the answers

    What type of transaction may require consideration of fair value for noncash elements?

    <p>An exchange where multiple assets are traded.</p> Signup and view all the answers

    Which financial statement provides insight into a company’s cash inflows and outflows?

    <p>Statement of cash flows</p> Signup and view all the answers

    Which group is primarily interested in a company's profitability and ability to pay debts?

    <p>Investors</p> Signup and view all the answers

    Which characteristics define the inputs of Level 1 in the Fair Value Hierarchy?

    <p>Inputs are quoted market prices in active markets.</p> Signup and view all the answers

    Which of the following is NOT true about Level 2 Fair Value inputs?

    <p>They solely depend on one unique input for valuation.</p> Signup and view all the answers

    Which of the following user groups would most likely utilize financial statements for credit assessments?

    <p>Creditors</p> Signup and view all the answers

    Which financial statement reflects the owner’s equity in the firm?

    <p>Statement of shareholders' equity</p> Signup and view all the answers

    What kind of organization might fall under not-for-profit entities?

    <p>Charitable organizations</p> Signup and view all the answers

    Which of the following is a key component of the income statement?

    <p>Revenue</p> Signup and view all the answers

    Study Notes

    Chapter 1: Environment and Theoretical Structure of Financial Accounting

    • Financial accounting provides useful information about economic activity to help make good decisions and foster a prosperous society.
    • The primary focus of financial accounting is providing financial information to external users such as investors, creditors, and other external users.
    • Financial information is conveyed through financial statements and related disclosure notes.
    • Financial statements include the balance sheet, income statement, statement of cash flows, and statement of shareholders' equity.
    • Financial reporting refers to the process of providing financial information to external users.
    • Financial information providers include profit-oriented companies, not-for-profit entities (e.g., government entities, schools), and households.
    • Users of financial information include investors, creditors, employees, labor unions, customers, suppliers, government agencies, and financial intermediaries.
    • Capital markets help the economy efficiently allocate resources.
    • Corporations acquire capital from investors (ownership) and creditors (borrowing).
    • Investors and creditors want a fair return on their resources.

    The Investment-Credit Decision—A Cash Flow Perspective

    • Investors and creditors provide capital to earn a fair return on their resources.
    • Shareholders receive cash from the sale of stock and periodic dividends.
    • Key variables in investment decisions include rate of return and uncertainty or risk. (Example calculation of rate of return is provided in the text.)

    Concept Check: Rate of Return

    • Creecher purchased $200,000 worth of stock, received $4,000 in dividends, and sold the shares for $206,000.
    • Creecher's rate of return was 5%.

    Example of Uncertainty

    • Investors may choose between a 5% savings account and a higher-return, but riskier, profit-oriented company.
    • Most investors prefer the profit-oriented company if the potential return is high enough to compensate for the risk.

    Objective of Financial Accounting

    • Provided information should be useful for decision-making.
    • Information should help investors and creditors evaluate the enterprise's future cash receipts and disbursements concerning amounts, timing, and uncertainty.

    Cash versus Accrual Accounting

    • Cash Basis Accounting: Measures cash receipts and cash payments from transactions related to providing goods and services. The difference is net operating cash flow.
    • Accrual Basis Accounting: Measures revenues and expenses regardless of when cash is received or paid. The difference is net income or net loss.

    Cash Basis Example

    • Carter Company paid $60,000 for three years' rent at the start of year 1.
    • Under cash basis accounting, the rent payment is shown when paid. (Cash flow data for Carter Co. is provided for year 1-3).

    Accrual Basis Example

    • Under accrual basis accounting, rent is recognized as an expense throughout the three years, even though the payment happened at the beginning. (Income statement data for Carter Co. is presented showing a $20,000 annual expense).

    Concept Check: Accrual Accounting

    • Cash-basis accounting focuses on cash inflows and outflows, whereas accrual accounting highlights the impact of transactions and expenses over time.

    The Development of Financial Accounting and Reporting Standards

    • Generally Accepted Accounting Principles (GAAP) is a dynamic set of guidelines for measurement and reporting.
    • GAAP facilitates decision-making by allowing comparability among companies' financial data.

    Accounting Standard Setting

    • A hierarchical structure exists governing the setting of accounting standards in the United States. Federal, SEC oversight bodies, and private sector organizations play different roles and have overlapping authorities.

    Historical Perspective and Standards

    • The Securities and Exchange Commission (SEC) was created after the 1929 stock market crash to restore investor confidence.
    • The 1933 Securities Act and 1934 Securities Exchange Act mandate reporting requirements for companies whose securities are traded.

    Early U.S. Standard Setting

    • The Committee on Accounting Procedure (CAP) was the first private-sector standard-setting body. The American Institute of Accountants (AICPA) was its predecessor.
    • The Accounting Principles Board (APB) issued accounting principles.

    Financial Accounting Standards Board (FASB)

    • The FASB was established in 1973 to set US accounting standards, supported by the Financial Accounting Foundation.
    • The Emerging Issues Task Force (EITF) resolves financial reporting issues.

    Concept Check: Accounting Standard Setting

    • The FASB, since 1973, is the main body setting accounting standards.

    Codification

    • The FASB Accounting Standards Codification is the single source of authoritative nongovernmental U.S. GAAP.
    • Topics are organized into approximately 90 accounting topics, and includes SEC accounting guidance.
    • New standards are issued by FASB in updates.

    International Accounting Standards Committee (IASC)

    • The International Accounting Standards Committee (IASC) was formed in 1973 to develop global accounting standards.
    • The International Accounting Standards Board (IASB) was established in 2001 to develop a single set of global accounting standards.

    Comparison of Organizations of U.S. and International Standard Setters

    • Organizational structures and responsibilities for standard-setting differ between US GAAP and IFRS.

    International Financial Reporting Standards (IFRS)

    • The IASB has revised many International Accounting Standards (IASs) and issued new International Financial Reporting Standards (IFRSs).
    • Many jurisdictions require or permit the use of IFRS.

    Efforts to Converge U.S. and International Standards

    • The FASB and IASB have been working to converge US GAAP and IFRS standards, but complete convergence in the foreseeable future seems unlikely.

    The FASB's Standard-Setting Process

    • The process for setting US accounting standards involves numerous steps, including identifying issues, analyzing them, soliciting public input, resolving issues, drafting updates, and disseminating issued standards.

    Politics in Standard Setting

    • Political considerations often influence accounting standards, including those for employee stock options and fair value accounting standards.

    Encouraging High-Quality Financial Reporting

    • Auditors provide credibility to financial statements by expressing an opinion on the compliance of statements with GAAP.
    • Certified public accountants (CPAs) are licensed by states to provide audit services.

    Financial Reporting Reform

    • Accounting scandals prompted reforms such as Sarbanes-Oxley to strengthen the financial reporting process.

    A Move Away from Rules-Based Standards?

    • Principles-based accounting stresses professional judgment.

    Ethics and Professionalism

    • Ethics deals with distinguishing right from wrong.
    • Codes of ethics are provided by professional organizations like the American Institute of CPAs (AICPA).

    Analytical Model for Ethical Decisions

    • An analytical process helps evaluate and make decisions in ethical situations with clear steps.

    Concept Check: High-Quality Financial Reporting

    • Several methods encourage high-quality financial reporting, including standards comparability and auditor assessments.

    The Conceptual Framework

    • The conceptual framework provides a foundation and structure for United States accounting standards.
    • The framework outlines objectives, qualitative characteristics, constraints, elements, and recognition and measurement concepts.

    The Conceptual Framework (concluded)

    • The framework provides direction for financial reporting.

    International Financial Reporting Standards: Role of the Conceptual Framework

    • Conceptual frameworks are similar in US GAAP and IFRS, converging more with ongoing efforts from the FASB and IASB.
    • Helps standardize standards for the United States.

    Qualitative Characteristics of Financial Reporting Information

    • Qualitative characteristics are essential to decision usefulness. These factors are described in a hierarchy.

    Hierarchy of Qualitative Characteristics of Financial Information

    • Understandability, relevance, faithful representation (e.g. complete, neutral, free from error), and comparability and consistency are essential factors.

    Concept Check: FASB Conceptual Framework-Relevance

    • Free from error is a component of faithful representation, not relevance.

    Concept Check: FASB Conceptual Framework-Faithful Representation

    • Understandability is an enhancing characteristic of decision usefulness, not a component of faithful representation.

    Elements of Financial Statements

    • Elements include assets, liabilities, equity, investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains, and losses.

    Underlying Assumptions

    • Assumptions that underlie GAAP include the economic entity, going concern, periodicity, and monetary unit assumptions.

    Recognition, Measurement, and Disclosure Concepts

    • Recognition refers to admitting information into financial statements; measurement to associating numerical amounts with elements; disclosure to include additional information in statements and accompanying notes.

    Revenue Recognition

    • Revenue results from providing a product or service to a customer and the realization principle is used to guide recognition: complete or virtually complete earnings process and reasonable certainty of collectability.

    Expense Recognition

    • Matching revenues and expenses arising from the same transactions are emphasized. Expense recognition follows four principal approaches, including cause and effect, associating expenses with specific recognized revenues, rational allocation to specific periods, or combination of approaches.

    Measurement

    • GAAP uses a "mixed attribute" measurement model, utilizing five attributes: historical cost, net realizable value, current cost, present value, and fair value.

    Historical Cost

    • Historical cost measures transactions based on the amounts exchanged.

    Net Realization Value, Current Cost, and Present Value

    • Net realizable value estimates the selling price less costs of completion, disposal, and transportation; current cost is the cost to purchase or replace an asset today, and present value values future cash flows.

    Fair Value

    • Fair value is the price received in an orderly market transaction for the sale of assets or liabilities . It's determined via market, income, or cost approaches.

    Concept Check: FASB Conceptual Framework-Measurement Attributes

    • List price is not a measurement attribute within the FASB conceptual framework.

    Fair Value Hierarchy

    • Level 1 inputs utilize quoted market prices; level 2 inputs are observable, while level 3 inputs are unobservable.

    Fair Value Option

    • The fair value option allows some financial assets and liabilities to be reported at fair value, aiming to reduce volatility while supporting consistent international accounting standards.

    Disclosure

    • Full disclosure is a fundamental principle, demanding any information affecting external user decisions to be included in financial reports. This is achieved through formal disclosure notes, parenthetical statements, or supplementary schedules and tables.

    Summary of Recognition, Measurement, and Disclosure Concepts

    • Overview of the details and criteria to be considered in recognizing measurements, and disclosures into each financial statement.

    Evolving GAAP

    • GAAP continues to evolve emphasizing principles for revenue/expense recognition; with an emphasis on the asset/liability approach, financial statements reflect the assets and liabilities as of a specific date; with revenues, expenses, gains and losses related to the changes in these assets and liabilities.

    Accounting Concepts Development: GAAP vs. IFRS

    • GAAP and IFRS differences in the development of concepts are detailed regarding assets, liabilities, revenues, and expenses.

    End of Chapter 1

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    Chapter 1: Environment and Theoretical Structure of Financial Accounting PDF

    Description

    Explore the foundational concepts of financial accounting in Chapter 1. Understand how financial information is utilized by external users and the various financial statements that help in decision-making. This chapter sets the stage for the crucial roles of financial reporting in diverse entities.

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