1

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 1-5 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.
1-2 Chapter 1

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.

Why? Understanding the function of accounting standards and the role of FASB in
setting those standards is necessary in understanding the history of accounting in the
United States. In addition, it’s important to understand how new accounting standards
are created and how existing standards are modified.

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 FASB ASC 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
Chapter 1 1-3

setting.

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
1-4 Chapter 1

the two primary qualities inherent in useful accounting information. That’s the easy part.
The difficulty is in distinguishing between the two.

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.
Chapter 1 1-5

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) What is the official source of U.S. GAAP?

a. Exposure Drafts
b. FASB ASC
c. International Financial Reporting Standards
d. Accounting Standards Updates

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.
1-6 Chapter 1

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).
Chapter 1 1-7

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.
1-8 Chapter 1

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 a. a person within a company who uses accounting

___ 2. stakeholder information to make operating decisions
___ 3. internal user b. outside parties who are owed money by a company
___ 4. external user c. a balance sheet, income statement, and statement of
___ 5. management cash flows
accounting d. reports a company’s profit for a certain period of time
___ 6. financial e. the activity associated with the development and
accounting communication of financial information for external users
___ 7. creditors f. quantitative information, primarily financial in nature,
___ 8. investors about economic entities that is intended to be useful in
___ 9. general- making economic decisions
purpose g. separated into operating, investing, and financing
financial activities
statements h. a report about the fairness of a company’s financial
___ 10. balance sheet statements
___ 11. income i. supplemental information that outlines the accounting
statement assumptions and estimates
___ 12. statement of j. external public accountants hired by a company to
cash flows independently examine the company’s financial records
___ 13. notes to the k. the activity associated with financial reporting for internal
financial users
statements l. a user of a company’s financial statements who is
___ 14. auditors outside the company
___ 15. auditor’s m. reports, as of a given point in time, the assets, liabilities,
opinion 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
Chapter 1 1-9

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 a. official source of U.S. GAAP

___ 2. GAAP b. responsible for studying accounting issues and
___ 3. FASB establishing accounting standards to govern financial
___ 4. APB reporting in the United States
___ 5. FAF c. an organization primarily for accounting professors
___ 6. GASB d. a set of guidelines established by the FASB to provide a
___ 7. Accounting conceptual framework for establishing and administering
Standards accounting standards
Updates e. the U.S. government agency created to regulate the
___ 8. Statements of issuance and trading of securities in the United States
Financial f. the independent private organization responsible for
Accounting establishing standards in state and local governmental
Concepts areas
___ 9. Exposure Draft g. a preliminary statement of a standard that includes
___ 10. EITF specific recommendations made by the FASB
___ 11. FASB ASC h. source of formal SEC rules
___ 12. CFR i. the organization responsible for selecting members of the
___ 13. AICPA FASB, GASB, and their advisory councils
___ 14. CPA j. the government agency responsible for administering
___ 15. AAA U.S. income tax rules
___ 16. IRS k. the private-sector organization created by the Sarbanes-
___ 17. IASB Oxley Act of 2002
___ 18. PCAOB 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
1-10 Chapter 1

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

framework distributions to owners
___ 2. asset b. theoretical foundation underlying accounting standards
___ 3. comparability and practice
___ 4. comprehensive c. the same accounting methods should be followed from
income one period to the next
___ 5. conservatism d. basic accounting concept that requires that all relevant
___ 6. consistency information be presented in an unbiased,
___ 7. current market understandable, and timely manner
value e. residual interest in the assets of an entity that remains
___ 8. current after deducting its liabilities; sometimes referred to as net
replacement assets
cost f. outflows or other “using up” of assets of an entity or
___ 9. disclosure incurrences of liabilities (or a combination of both) from
___ 10. economic entity delivering or producing goods, rendering services, or
___ 11. equity carrying out other activities that constitute the entity’s
___ 12. expenses ongoing major or central operations
___ 13. feedback value g. resource of an entity
___ 14. full disclosure h. the amount by which the proceeds from disposing of an
principle asset (other than inventory) exceed the book value of the
___ 15. gain asset
___ 16. going concern i. the cash equivalent price that would be paid now to
___ 17. historical cost 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
Chapter 1 1-11

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 a. the amount of cash expected to be received from the

___ 2. net realizable conversion of assets in the normal course of business
value b. the process of formally recording an item in the
___ 3. neutrality accounting records
___ 4. predictive value c. one of two primary qualities inherent in useful accounting
___ 5. recognition information; includes the key ingredients of verifiability,
___ 6. relevance neutrality, and representational faithfulness
___ 7. reliability d. important constraint underlying the reporting of
___ 8. representational accounting information; it relates to how large an item is
faithfulness in terms of dollar amount or relative to the size of the
___ 9. revenues company
___ 10. stable monetary e. expenses for a period are determined by associating
units them with specific revenues over a particular time period
___ 11. timeliness f. U.S. financial statements have traditionally reported
___ 12. verifiability items in nominal dollars without adjustment for changes
___ 13. liabilities in purchasing power
___ 14. loss g. probable future sacrifices of economic benefits arising
___ 15. matching 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
1-12 Chapter 1

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, 2013, 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.
Chapter 1 1-13

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: First, look at the choices and decide if any of the choices are
not associated with U.S. GAAP. The International Financial Reporting Standards can
automatically be crossed off the list. This is not a source of GAAP.

Next, list review the remaining items. Exposure drafts are published before GAAP is
1-14 Chapter 1

ever created. Therefore, you can cross out a also. Now to choose between b and d.
Accounting Standards Updates serve as notification that GAAP has been updated.
Therefore, the only choice left is FASB ASC, 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 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.
Chapter 1 1-15

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.
1-16 Chapter 1

MC1-8
Answer: d
Approach and explanation: As mentioned previously, understanding Exhibit 1-5 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.
Chapter 1 1-17

This question is testing your knowledge of point 2 explained in the prior question,
understanding how Exhibit 1-5 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 1-6 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).
1-18 Chapter 1

MC1-11
Answer: b
Approach and explanation: Can you tell that Exhibit 1-5 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.
Chapter 1 1-19

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.
1-20 Chapter 1

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.
Chapter 1 1-21

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.”
1-22 Chapter 1

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.
Chapter 1 1-23

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.
1-24 Chapter 1

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.
Accounting Standards Update The official statements of the FASB that govern
external financial reporting.
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.
certified public accountants (CPAs) 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.
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.
Chapter 1 1-25

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 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.
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 Accounting Standards Update is issued.
fair value The cash equivalent price that could be obtained by selling an asset in an
orderly transaction.
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.
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.
full disclosure principle A basic accounting concept that requires that all relevant
information be presented in an unbiased, understandable, and timely manner.
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.
1-26 Chapter 1

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.
Internal Revenue Service (IRS) U.S. government agency responsible for
administering U.S. income tax rules.
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.
management accounting The activity associated with financial reporting for internal
users.
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.
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.
predictive value Helps a decision maker predict future consequences based on
information about past transactions and events.

Present (or discounted) value Amount of net future cash inflows or outflow

discounted to their present value of an appropriate rate of interest.
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.
Chapter 1 1-27

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.
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.
stakeholders All parties interested in the performance of a company.
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.
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.
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.