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Chapter 1

ENVIRONMENT AND

THEORETICAL STRUCTURE OF

FINANCIAL ACCOUNTING

Questions For Review of Key Topics

Q 1–1 What is the function and primary focus of financial accounting?

Q 1–2 What is meant by the phrase efficient allocation of resources? What mechanism fosters the efficient allocation of

resources in the United States?

Q 1–3 Identify two important variables to be considered when making an investment decision.

Q 1–4 What must a company do in the long run to be able to provide a return to investors and creditors?

Q 1–5 What is the primary objective of financial accounting?

Q 1–6 Define net operating cash flows. Briefly explain why periodic net operating cash flows may not be a good

indicator of future operating cash flows.

Q 1–7 What is meant by GAAP? Why should all companies follow GAAP in reporting to external users?

Q 1–8 Explain the roles of the SEC and the FASB in the setting of accounting standards.

Q 1–9 Explain the role of the auditor in the financial reporting process.

Q 1–10 List three key provisions of the Sarbanes-Oxley Act of 2002. Order your list from most important to least

important in terms of the likely long-term impact on the accounting profession and financial reporting.

Q 1–11 Explain what is meant by adverse economic consequences of new or changed accounting standards.

Q 1–12 Why does the FASB undertake a series of elaborate information-gathering steps before issuing a substantive

accounting standard?

Q 1–13 What is the purpose of the FASB’s conceptual framework project?

Q 1–14 Discuss the terms relevance and faithful representation as they relate to financial accounting information.

Q 1–15 What are the components of relevant information? What are the components of faithful representation?

Q 1–16 Explain what is meant by: The benefits of accounting information must exceed the costs.

Q 1–17 What is meant by the term materiality in financial reporting?

Questions For Review of Key Topics

CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 37

Q 1–18 Briefly define the financial accounting elements: (1) assets, (2) liabilities, (3) equity, (4) investments by owners,

(5) distributions to owners, (6) revenues, (7) expenses, (8) gains, (9) losses, and (10) comprehensive income.

Q 1–19 What are the four basic assumptions underlying GAAP?

Q 1–20 What is the going concern assumption?

Q 1–21 Explain the periodicity assumption.

Q 1–22 What are four key accounting practices that often are referred to as principles in current GAAP?

Q 1–23 What are two important reasons to base the valuation of assets and liabilities on their historical cost?

Q 1–24 Describe the two criteria that must be satisfied before revenue can be recognized.

Q 1–25 What are the four different approaches to implementing the matching principle? Give an example of an expense

that is recognized under each approach.

Q 1–26 In addition to the financial statement elements arrayed in the basic financial statements, what are some other

ways to disclose financial information to external users?

Q 1–27 Briefly describe the inputs that companies should use when determining fair value. Organize your answer

according to preference levels, from highest to lowest priority.

Q 1–28 What measurement attributes are commonly used in financial reporting?

Q 1–29 Distinguish between the revenue/expense and the asset/liability approaches to setting financial reporting

standards.

Q 1–30 What are the functions of the conceptual framework under IFRS?

Q 1–31 What is the standard-setting body responsible for determining IFRS? How does it obtain its funding?

Q 1–32 In late 2011, what further information did the SEC provide about its plans with respect to future convergence

between U.S. GAAP and IFRS?

Brief Exercises

Cash flows during the first year of operations for the Harman-Kardon Consulting Company were as follows:

Cash collected from customers, $340,000; Cash paid for rent, $40,000; Cash paid to employees for services

rendered during the year, $120,000; Cash paid for utilities, $50,000.

In addition, you determine that customers owed the company $60,000 at the end of the year and no bad

debts were anticipated. Also, the company owed the gas and electric company $2,000 at year-end, and the rent

payment was for a two-year period. Calculate accrual net income for the year.

For each of the following items, identify the appropriate financial statement element or elements: (1) probable

future sacrifices of economic benefits; (2) probable future economic benefits owned by the company; (3) inflows

of assets from ongoing, major activities; (4) decrease in equity from peripheral or incidental transactions.

Listed below are several statements that relate to financial accounting and reporting. Identify the basic assumption,

broad accounting principle, or pervasive constraint that applies to each statement.

  1. Sirius Satellite Radio Inc. files its annual and quarterly financial statements with the SEC.
  2. The president of Applebee’s International, Inc. , travels on the corporate jet for business purposes only and

does not use the jet for personal use.

  1. Jackson Manufacturing does not recognize revenue for unshipped merchandise even though the merchandise

has been manufactured according to customer specifications.

  1. Lady Jane Cosmetics depreciates the cost of equipment over their useful lives.

Identify the basic assumption or broad accounting principle that was violated in each of the following

situations.

  1. Astro Turf Company recognizes an expense, cost of goods sold, in the period the product is manufactured.
  2. McCloud Drug Company owns a patent that it purchased three years ago for $2 million. The controller

recently revalued the patent to its approximate market value of $8 million.

  1. Philips Company pays the monthly mortgage on the home of its president, Larry Crosswhite, and charges the

expenditure to miscellaneous expense.

For each of the following situations, (1) indicate whether you agree or disagree with the financial reporting practice

employed and (2) state the basic assumption, pervasive constraint, or accounting principle that is applied

(if you agree), or violated (if you disagree).

  1. Winderl Corporation did not disclose that it was the defendant in a material lawsuit because the trial was still

in progress.

  1. Alliant Semiconductor Corporation files quarterly and annual financial statements with the SEC.
  2. Reliant Pharmaceutical paid rent on its office building for the next two years and charged the entire expenditure

to rent expense.

  1. Rockville Engineering records revenue only after products have been shipped, even though customers pay

Rockville 50% of the sales price in advance.

Indicate the organization related to IFRS that performs each of the following functions:

  1. Obtains funding for the IFRS standard-setting process.
  2. Determines IFRS.
  3. Encourages cooperation among securities regulators to promote effective and efficient capital markets.
  4. Provides input about the standard-setting agenda.
  5. Provides implementation guidance about relatively narrow issues.

Exercises

An alternate exercise and problem set is available on the text website: www.mhhe.com/spiceland7e

Listed below are several transactions that took place during the first two years of operations for the law firm of

Pete, Pete, and Roy.

Year 1 Year 2

Amounts billed to customers for services rendered ………………………………. $170,000 $220,000

Cash collected from customers …………………………………………………………… 160,000 190,000

Cash disbursements: …………………………………………………………………………..

Salaries paid to employees for services rendered during the year ………. 90,000 100,000

Utilities …………………………………………………………………………………………. 30,000 40,000

Purchase of insurance policy …………………………………………………………… 60,000 –0–

In addition, you learn that the company incurred utility costs of $35,000 in year 1, that there were no liabilities

at the end of year 2, no anticipated bad debts on receivables, and that the insurance policy covers a threeyear

period.

Required:

  1. Calculate the net operating cash flow for years 1 and 2.
  2. Prepare an income statement for each year similar to Illustration 1–3 on page xxx according to the accrual

accounting model.

  1. Determine the amount of receivables from customers that the company would show in its year 1 and year 2

balance sheets prepared according to the accrual accounting model.

Listed below are several transactions that took place during the second two years of operations for RPG Consulting.

Year 2 Year 3

Amounts billed to customers for services rendered $350,000 $450,000

Cash collected from credit customers 260,000 400,000

Cash disbursements:

Payment of rent 80,000 –0–

Salaries paid to employees for services rendered during the year 140,000 160,000

Travel and entertainment 30,000 40,000

Advertising 15,000 35,000

In addition, you learn that the company incurred advertising costs of $25,000 in year 2, owed the advertising

agency $5,000 at the end of year 1, and there were no liabilities at the end of year 3. Also, there were no anticipated

bad debts on receivables, and the rent payment was for a two-year period, year 2 and year 3.

Required:

  1. Calculate accrual net income for both years.
  2. Determine the amount due the advertising agency that would be shown as a liability on the RPG’s balance

sheet at the end of year 2.

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally

accepted accounting principles.

Required:

  1. Obtain the relevant authoritative literature on fair value measurements using the FASB’s Codification Research

System at the FASB website ( www.fasb.org ). Identify the Codification topic number that provides guidance

on fair value measurements.

Exercises

CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 39

  1. What is the specific citation that lists the disclosures required in the notes to the financial statements for each

major category of assets and liabilities measured at fair value?

  1. List the disclosure requirements.

Access the FASB’s Codification Research System at the FASB website ( www.fasb.org ). Determine the specific

citation for each of the following items:

  1. The topic number for business combinations.
  2. The topic number for related party disclosures.
  3. The topic, subtopic, and section number for the initial measurement of internal-use software.
  4. The topic, subtopic, and section number for the subsequent measurement of asset retirement obligations.
  5. The topic, subtopic, and section number for the recognition of stock compensation.

Three groups that participate in the process of establishing GAAP are users, preparers, and auditors. These groups

are represented by various organizations. For each organization listed below, indicate which of these groups it

primarily represents.

  1. Securities and Exchange Commission
  2. Financial Executives International
  3. American Institute of Certified Public Accountants
  4. Institute of Management Accountants
  5. Association of Investment Management and Research

For each of the items listed below, identify the appropriate financial statement element or elements.

  1. Obligation to transfer cash or other resources as a result of a past transaction.
  2. Dividends paid by a corporation to its shareholders.
  3. Inflow of an asset from providing a good or service.
  4. The financial position of a company.
  5. Increase in equity during a period from nonowner transactions.
  6. Increase in equity from peripheral or incidental transaction.
  7. Sale of an asset used in the operations of a business for less than the asset’s book value.
  8. The owners’ residual interest in the assets of a company.
  9. An item owned by the company representing probable future benefits.
  10. Revenues plus gains less expenses and losses.
  11. An owner’s contribution of cash to a corporation in exchange for ownership shares of stock.
  12. Outflow of an asset related to the production of revenue.

Listed below are several terms and phrases associated with the FASB’s conceptual framework. Pair each item

from List A (by letter) with the item from List B that is most appropriately associated with it.

List A List B

  1. Predictive value a. Decreases in equity resulting from transfers to owners.
  2. Relevance b. Requires consideration of the costs and value of information.
  3. Timeliness c. Important for making interfirm comparisons.
  4. Distribution to owners d. Applying the same accounting practices over time.
  5. Confirmatory value e. Users understand the information in the context of the decision

being made.

  1. Understandability f. Agreement between a measure and the phenomenon it purports

to represent.

  1. Gain g. Information is available prior to the decision.
  2. Faithful representation h. Pertinent to the decision at hand.
  3. Comprehensive income i. Implies consensus among different measurers.
  4. Materiality j. Information confirms expectations.
  5. Comparability k. The change in equity from nonowner transactions.
  6. Neutrality l. The process of admitting information into financial statements.
  7. Recognition m. The absence of bias.
  8. Consistency n. Results if an asset is sold for more than its book value.
  9. Cost effectiveness o. Information is useful in predicting the future.
  10. Verifiability p. Concerns the relative size of an item and its effect on decisions.

40 SECTION 1 The Role of Accounting as an Information System

Phase A of the joint FASB and IASB conceptual framework project stipulates the desired fundamental and

enhancing qualitative characteristics of accounting information. Several constraints impede achieving these

desired characteristics. Answer each of the following questions related to these characteristics and constraints.

  1. Which component would allow a company to record the purchase of a $120 printer as an expense rather than

capitalizing the printer as an asset?

  1. Donald Kirk, former chairman of the FASB, once noted that “ . . . there must be public confidence that the

standard-setting system is credible, that selection of board members is based on merit and not the influence of

special interests . . .” Which characteristic is implicit in Mr. Kirk’s statement?

  1. Allied Appliances, Inc., changed its revenue recognition policies. Which characteristic is jeopardized by this

change?

  1. National Bancorp, a publicly traded company, files quarterly and annual financial statements with the SEC.

Which characteristic is relevant to the timing of these periodic filings?

  1. In general, relevant information possesses which qualities?
  2. When there is agreement between a measure or description and the phenomenon it purports to represent,

information possesses which characteristic?

  1. Jeff Brown is evaluating two companies for future investment potential. Jeff’s task is made easier because

both companies use the same accounting methods when preparing their financial statements. Which characteristic

does the information Jeff will be using possess?

  1. A company should disclose information only if the perceived benefits of the disclosure exceed the costs of

providing the information. Which constraint does this statement describe?

Listed below are several terms and phrases associated with basic assumptions, broad accounting principles, and

constraints. Pair each item from List A (by letter) with the item from List B that is most appropriately associated

with it.

List A List B

  1. Matching principle a. The enterprise is separate from its owners and other entities.
  2. Periodicity b. A common denominator is the dollar.
  3. Historical cost principle c. The entity will continue indefinitely.
  4. Materiality d. Record expenses in the period the related revenue is recognized.
  5. Realization principle e. The original transaction value upon acquisition.
  6. Going concern assumption f. All information that could affect decisions should be reported.
  7. Monetary unit assumption g. The life of an enterprise can be divided into artificial time periods.
  8. Economic entity assumption h. Criteria usually satisfied at point of sale.
  9. Full-disclosure principle i. Concerns the relative size of an item and its effect on decisions.

Listed below are several statements that relate to financial accounting and reporting. Identify the basic assumption,

broad accounting principle, or component that applies to each statement.

  1. Jim Marley is the sole owner of Marley’s Appliances. Jim borrowed $100,000 to buy a new home to be used

as his personal residence. This liability was not recorded in the records of Marley’s Appliances.

  1. Apple Inc. distributes an annual report to its shareholders.
  2. Hewlett-Packard Corporation depreciates machinery and equipment over their useful lives.
  3. Crosby Company lists land on its balance sheet at $120,000, its original purchase price, even though the land

has a current fair value of $200,000.

  1. Honeywell Corporation records revenue when products are delivered to customers, even though the cash

has not yet been received.

  1. Liquidation values are not normally reported in financial statements even though many companies do go out

of business.

  1. IBM Corporation , a multibillion dollar company, purchased some small tools at a cost of $800. Even though

the tools will be used for a number of years, the company recorded the purchase as an expense.

Identify the basic assumption or broad accounting principle that was violated in each of the following situations.

  1. Pastel Paint Company purchased land two years ago at a price of $250,000. Because the value of the land has

appreciated to $400,000, the company has valued the land at $400,000 in its most recent balance sheet.

  1. Atwell Corporation has not prepared financial statements for external users for over three years.
  2. The Klingon Company sells farm machinery. Revenue from a large order of machinery from a new buyer

was recorded the day the order was received.

  1. Don Smith is the sole owner of a company called Hardware City. The company recently paid a $150 utility

bill for Smith’s personal residence and recorded a $150 expense.

CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 41

  1. Golden Book Company purchased a large printing machine for $1,000,000 (a material amount) and recorded

the purchase as an expense.

  1. Ace Appliance Company is involved in a major lawsuit involving injuries sustained by some of its employees

in the manufacturing plant. The company is being sued for $2,000,000, a material amount, and is not insured.

The suit was not disclosed in the most recent financial statements because no settlement had been reached.

For each of the following situations, indicate whether you agree or disagree with the financial reporting practice

employed and state the basic assumption, component, or accounting principle that is applied (if you agree) or

violated (if you disagree).

  1. Wagner Corporation adjusted the valuation of all assets and liabilities to reflect changes in the purchasing

power of the dollar.

  1. Spooner Oil Company changed its method of accounting for oil and gas exploration costs from successful

efforts to full cost. No mention of the change was included in the financial statements. The change had a

material effect on Spooner’s financial statements.

  1. Cypress Manufacturing Company purchased machinery having a five-year life. The cost of the machinery is

being expensed over the life of the machinery.

  1. Rudeen Corporation purchased equipment for $180,000 at a liquidation sale of a competitor. Because the

equipment was worth $230,000, Rudeen valued the equipment in its subsequent balance sheet at $230,000.

  1. Davis Bicycle Company received a large order for the sale of 1,000 bicycles at $100 each. The customer paid

Davis the entire amount of $100,000 on March 15. However, Davis did not record any revenue until April 17,

the date the bicycles were delivered to the customer.

  1. Gigantic Corporation purchased two small calculators at a cost of $32.00. The cost of the calculators was

expensed even though they had a three-year estimated useful life.

  1. Esquire Company provides financial statements to external users every three years.

For each of the following situations, state whether you agree or disagree with the financial reporting practice

employed, and briefly explain the reason for your answer.

  1. The controller of the Dumars Corporation increased the carrying value of land from its original cost of $2

million to its recently appraised value of $3.5 million.

  1. The president of Vosburgh Industries asked the company controller to charge miscellaneous expense for the

purchase of an automobile to be used solely for personal use.

  1. At the end of its 2013 fiscal year, Dower, Inc., received an order from a customer for $45,350. The merchandise

will ship early in 2014. Because the sale was made to a long-time customer, the controller recorded the

sale in 2013.

  1. At the beginning of its 2013 fiscal year, Rossi Imports paid $48,000 for a two-year lease on warehouse space.

Rossi recorded the expenditure as an asset to be expensed equally over the two-year period of the lease.

  1. The Reliable Tire Company included a note in its financial statements that described a pending lawsuit

against the company.

  1. The Hughes Corporation, a company whose securities are publicly traded, prepares monthly, quarterly,

and annual financial statements for internal use but disseminates to external users only the annual financial

statements.

Listed below are the basic assumptions, broad accounting principles, and constraints discussed in this chapter.

  1. Economic entity assumption g. Matching principle
  2. Going concern assumption h. Full-disclosure principle
  3. Periodicity assumption i. Cost effectiveness
  4. Monetary unit assumption j. Materiality
  5. Historical cost principle k. Conservatism
  6. Realization principle

Identify by letter the assumption, principle, or constraint that relates to each statement or phrase below.

  1. Revenue is recognized only after certain criteria are satisfied.
  2. Information that could affect decision making should be reported.
  3. Cause-and-effect relationship between revenues and expenses.
  4. The basis for measurement of many assets and liabilities.
  5. Relates to the qualitative characteristic of timeliness.
  6. All economic events can be identified with a particular entity.
  7. The benefits of providing accounting information should exceed the cost of doing so.

42 SECTION 1 The Role of Accounting as an Information System

  1. A consequence is that GAAP need not be followed in all situations.
  2. Not a qualitative characteristic, but a practical justification for some accounting choices.
  3. Assumes the entity will continue indefinitely.
  4. Inflation causes a violation of this assumption.

Determine the response that best completes the following statements or questions.

  1. The primary objective of financial reporting is to provide information
  2. About a firm’s management team.
  3. Useful to capital providers.
  4. Concerning the changes in financial position resulting from the income-producing efforts of the entity.
  5. About a firm’s financing and investing activities.
  6. Statements of Financial Accounting Concepts issued by the FASB
  7. Represent GAAP.
  8. Have been superseded by SFAS s.
  9. Are subject to approval of the SEC.
  10. Identify the conceptual framework within which accounting standards are developed.
  11. In general, revenue is recognized as earned when the earning process is virtually complete and
  12. The sales price has been collected.
  13. A purchase order has been received.
  14. There is reasonable certainty as to the collectibility of the asset to be received.
  15. A contract has been signed.
  16. In depreciating the cost of an asset, accountants are most concerned with
  17. Conservatism.
  18. The realization principle.
  19. Full disclosure.
  20. The matching principle.
  21. The primary objective of the matching principle is to
  22. Provide full disclosure.
  23. Record expenses in the period that related revenues are recognized.
  24. Provide timely information to decision makers.
  25. Promote comparability between financial statements of different periods.
  26. The separate entity assumption states that, in the absence of contrary evidence, all entities will survive indefinitely.
  27. True
  28. False

 

CPA and CMA Exam Questions

 

The following questions are adapted from a variety of sources including questions developed by the AICPA

Board of Examiners and those used in the Kaplan CPA Review Course to study the environment and theoretical

structure of financial accounting while preparing for the CPA examination. Determine the response that best

completes the statements or questions.

  1. Which of the following is not a qualitative characteristic of accounting information according to the FASB’s

conceptual framework?

  1. Auditor independence.
  2. Neutrality.
  3. Timeliness.
  4. Predictive value.
  5. According to the conceptual framework, neutrality is a characteristic of
  6. Understandability.
  7. Faithful representation.
  8. Relevance.
  9. Both relevance and faithful representation.
  10. The Financial Accounting Standards Board (FASB)
  11. Is a division of the Securities and Exchange Commission (SEC).
  12. Is a private body that helps set accounting standards in the United States.

CPA Exam

Questions

  • LO1–7
  • LO1–7
  • LO1–3

CPA and CMA Exam Questions

CHAPTER 1 Environment and Theoretical Structure of Financial Accounting 43

  1. Is responsible for setting auditing standards that all auditors must follow.
  2. Consists entirely of members of the American Institute of Certified Public Accountants.
  3. Confirmatory value is an ingredient of the primary quality of

Relevance

Faithful

Representation

  1. Yes No
  2. No Yes
  3. Yes Yes
  4. No No
  5. Predictive value is an ingredient of

Faithful

Representation Relevance

  1. Yes No
  2. No No
  3. Yes Yes
  4. No Yes
  5. Completeness is an ingredient of the primary quality of
  6. Verifiability.
  7. Faithful representation.
  8. Relevance.
  9. Understandability.
  10. The objective of financial reporting for business enterprises is based on