NINJA BOOK

Financial Accounting & Repor ting 2020

Conceptual Framework
 Copyright & Disclaimer
This book contains material copyrighted © 1953 through 2020 by the American Institute of Certified Public
Accountants, Inc., and is used or adapted with permission.

Material from the Uniform CPA Examination Questions and Unofficial Answers, copyright © 1976 through 2020,
American Institute of Certified Public Accountants, Inc., is used or adapted with permission.

This book is written to provide accurate and authoritative information concerning the covered topics for the
Uniform CPA Examination and is to be used solely for studying for the Uniform CPA Examination and for no
other purpose.

© 2020 NINJA CPA Review, LLC. All Rights Reserved.

2
 Conceptual Framework
Accounting

Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, to
be useful in making decisions.

• Financial Accounting reports and statements purport to present, in a condensed form, the economic
events of an entity during a specific period of time and the cumulative effect of such events. The most
important criterion to meet in financial statement presentation is that the information provided be useful for
decision making.

• Managerial Accounting also provides information useful for decision making, normally just for use by
managers within the organization. Besides the difference in primary user, external for financial versus
internal for managerial, financial accounting must follow GAAP whereas managerial accounting does not.

Underlying Environmental Assumptions

Accounting operates in a varied environment. To provide a basis for comparison, it has been necessary to have
certain underlying environmental assumptions on which financial accounting theory is based. The most
important of these assumptions are as follows:

• Economic Entity is a distinction is also made between a business concern and its owners.

• Going Concern means an entity has the resources to continue operating indefinitely. Substantial doubt
about an entity’s ability to continue as a going concern exists when it is probable the entity will be unable to
meet obligations as they become due within one year after the date of the financial statements being issued.
This information must be disclosed by management.

If a substantial doubt is raised by management and that doubt has been alleviated (management has a plan
to alleviate the threat), then disclosures are required by management about the events that led to the doubt,
as well as management’s overall evaluation and plan to alleviate.

If a substantial doubt is raised and the doubt has not been alleviated because management’s plan is limited
projected success, then a statement by management is required, as well as disclosures.

• Unit-of-Measure are used for accounting measurement and reporting economic activity. Costs incurred at
different points in time are intermingled in the accounts and, thus, it is assumed that the purchasing power
of the dollar remains constant over time. Inflation makes this assumption questionable. Entities are
encouraged to issue voluntary supplementary reports based on current costs and dollars of constant
purchasing power.

• Periodicity recognizes the necessity of providing financial accounting information on a periodic, timely basis,
so that it is useful in decision making.

Basic Accounting Principles

Based upon the underlying environmental assumptions, basic accounting principles evolved.

• Measurement Most assets acquired, and liabilities incurred, are recorded at historical cost. Cost is gen-
erally defined as the cash equivalent amount that would be paid in an arms-length transaction. When costs
benefit more than one period, they are apportioned among the periods benefited through depreciation or
amortization. Historical cost is known to be reliable, however, fair value information may be more useful for
certain types of assets and liabilities.

• Revenue is generally recognized in five steps:

Step 1: Identify the contract(s) with a customer.

Step 2: Identify the performance obligations in the contract.

3
 Step 3: Determine the transaction price (i.e., Amount).
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

• Matching For income to be stated fairly, all expenses incurred in generating the revenues for a period must
be recognized in that same period.

• Objectivity Accounting data should be both objectively determined and verifiable. While this does not
preclude the use of estimates, they must be verifiable in the sense that an independent, knowledgeable
person would find such estimates reasonable.

• Materiality The relative importance of data, the cost-benefit relationship of additional accuracy, and the
possible confusion resulting from the use of too much detail are considerations that must be weighed in
determining the materiality of accounting information. When an item is immaterial, good accounting theory
can be abandoned.

• Consistency The usefulness of accounting information is enhanced when the information is presented in a
manner consistent with that used in prior periods. This provides for interperiod comparability and the
identification of trends. Consistency in the application of accounting principles also prevents income manip-
ulation by management.

• Full Disclosure Financial statements should be presented in a manner that will reasonably assure com-
plete and understandable communication of all relevant accounting information useful for decision making.
When the nature of relevant information is such that it cannot appear in the accounts, this principle dictates
that such relevant information be included in the accompanying Notes to the Financial Statements.

• Conservatism Where use of the most appropriate accounting treatment is uncertain, when making esti-
mates or when data conflicts, the favored accounting treatment should be that which understates rather than
overstates income or net assets.

Application } 1

What is the basic accounting principle that supports the immediate recognition of a contingent loss?
a. Substance over form
b. Consistency
c. Matching
d. Conservatism
(d) A contingency is a situation that involves uncertainty as to the final outcome. Loss contingencies should be
recognized on a consistent basis, but it is the principle of conservatism, because the loss has not actually
occurred, that requires immediate recognition of the loss contingency and supersedes substance over form.
Matching may not be possible when a contingent loss arises.

Generally Accepted Accounting Principles

The meaning of the GAAP has varied over time.

• Background Originally, GAAP referred to accounting policies and procedures that were widely used in
practice. For many years public companies led the manner in which to report accounting data as a means to
attract investors. As standard-setting bodies became more involved, the term came to refer to the pro-
nouncements issued by particular accounting bodies. Historically, no single source of GAAP has existed.
Instead, GAAP has been derived from many sources.

4
 Securities act 1934
Standard-Setting Bodies SEC Before FAF We had CAP
Securities and Exchange Commission

Passage of the Securities Act of 1934 chartered the Securities and Exchange Commission (SEC), and gave the
SEC the power to oversee US accounting and auditing methods. The SEC has statutory authority to establish
GAAP for publicly-held entities, but has relied on the accounting profession for self-regulation.

During the entire time period of the accounting profession’s development of accounting principles, the SEC has
often taken an active role, including issuing its own pronouncements, where it feels the public’s interest
demands action. The SEC issues public company standards in the form of Regulations S-X and SK, Financial
Reporting Releases (FRR)/ Accounting Series Releases (ASR), Interpretive Releases (IR), Staff Accounting
Bulletins (SAB), and EITF Topic D and SEC Staff Observer Comments. All companies that issue securities in
the US are subject to SEC rules and regulations.

Financial Accounting Standards Board

In 1972 a new body, the Financial Accounting Foundation (FAF), was created to serve as the nation’s account-
ing standard-setting authority. Previously, US accounting standards were issued by the Committee on Accounting
Procedures (CAP) with Accounting Research Bulletins (ARBs) from 1939 to 1959, and then the Accounting
Principles Board (APB) with pronouncements known as Opinions. Through the FAF, the Financial Accounting
Standards Board (FASB) replaced the APB in 1973 to became the designated organization for setting standards
that govern the preparation of corporate financial reports along with that of not-for-profit organizations.

• FASB Standards The first promulgations issued by the FASB had the same authority as the prior APB
Opinions and were known as Statements of Financial Accounting Standards (SFASs). A new statement was
issued only after a majority vote by the members of the FASB. In addition, the FASB also issued FASB
Interpretations, FASB Staff Positions, FASB Technical Bulletins, and Emerging Issues Task Force (EITF)
Consensuses. The FASB did a major restructuring of accounting and reporting standards into the FASB
Accounting Standards Codification.

• FASB Accounting Standards Codification In 2009, the FASB Accounting Standards Codification became
the single official source of authoritative, nongovernmental US GAAP, superseding existing FASB, AICPA,
EITF, and related literature. The Codification presents US GAAP in an organized and easily accessible
structure.

With the Codification, only two levels of US GAAP exist:

(1) Authoritative, represented by the Codification, and

(2) Non-Authoritative, represented by all other literature.

• Standards-Setting Process The nature and extent of the Boards’ specific research and outreach activities
will vary from project to project, depending on the nature and scope of the reporting issues involved. An
overview of the standards-setting process, as established by the Rules of Procedure, is as follows:

o The Board identifies financial reporting issues based on recommendations from stakeholders or through
other means.

o The FASB Chairman decides whether to add a project to the technical agenda.

o The Board deliberates at one or more public meetings.

o The Board issues an Exposure Draft to solicit broad stakeholder input. (In some projects, the Board may
issue a Discussion Paper to obtain input in the early stages.)

o The Board holds a public roundtable meeting on the Exposure Draft, if necessary.

o The staff analyzes comment letters, public roundtable discussion, and any other information obtained
through due process activities.

5
 o The Board redeliberates the proposed provisions, carefully considering the input received, at one or
more public meetings.

o The Board issues an Accounting Standards Update (ASU) describing amendments to the Accounting
Standards Codification.

• Accounting Standards Updates The results of the ongoing standard-setting activity are an Accounting
Standards Update (ASU). The title of the combined set is “Accounting Standards Update YYYY-XX,” where
YYYY is the year issued and XX is the sequential number for each Update that year. The FASB does not
consider new ASUs as authoritative in their own right. Instead, the ASUs serve only to provide background
information about the issue, update the Codification, and provide the basis for conclusions on changes in
the Codification.

International Accounting Standards Board

The International Accounting Standards Board (IASB) was formed in 2001 to replace the International Accounting
Standards Committee. The IASB is an independent, private-sector body that develops and approves International
Financial Reporting Standards (IFRS). The IASB follows a thorough, open, and transparent due process of
which the publication of consultative documents, such as discussion papers and exposure drafts, for public com-
ment is an important component.

Governmental Accounting Standards Board

The Governmental Accounting Standards Board (GASB) is the private, nonpartisan, nonprofit organization that
works to create and improve the rules US state and local governments follow when accounting for their finances
and reporting them to the public. The GASB is subject to oversight by the Financial Accounting Foundation (FAF).

• Mission The GASB has a broad mission to develop standards that will not only result in useful information
for users of financial reports, but also educate the public, including issuers, auditors, and users about gov-
ernmental financial issues.

• GASB Codification The GASB incorporated the governmental GAAP hierarchy into the GASB Codification in
March 2009. In 2010, the Board also added guidance applicable to governmental accounting and reporting
from FASB and AICPA literature to the GASB codification which simplified the search for the appropriate
guidance. Governmental entities now have one primary source for accounting and reporting standards, the
GASB Codification.

Nonauthoritative Guidance

If the guidance for a transaction or event is not specified within a specific source of authoritative GAAP, an entity
shall first consider accounting principles for similar transactions within another source of GAAP. Then the entity
may consider nonauthoritative guidance from other sources such as: practices that are widely recognized and
prevalent either generally or in the industry; FASB Concepts Statements; AICPA Issues Papers; and pronounce-
ments of professional associations or regulatory agencies.

6
Statements of Financial Accounting Concepts (SFAC)
Purpose

The FASB has issued pronouncements called Statements of Financial Accounting Concepts (SFAC) to serve the
public interest by setting the objectives, qualitative characteristics, and other concepts that guide selection of
economic phenomena to be recognized and measured for financial reporting. The Concepts Statements guide
the FASB in developing sound accounting principles. SFACs do not establish GAAP; therefore, SFACs are not
considered authoritative pronouncements.

Objectives of Financial Reporting by Nonbusiness Organizations (SFAC 4)

SFAC 4 established the objectives of general purpose external financial reporting by nonbusiness organizations.
Those objectives, together with the objectives set forth in FASB Concepts Statement No. 8 (which supersedes
SFAC No. 1), serve as the foundation of the conceptual framework the FASB developed for financial accounting
and reporting. This Statement focuses on organizations that have predominantly nonbusiness characteristics
that heavily influence the operations of the organization.

• Objectives stem from the common interests of those who provide resources to nonbusiness organizations.
The objectives apply to general purpose external financial reporting by nonbusiness organizations. The
objectives of financial reporting are affected by the economic, legal, political, and social environment in
which financial reporting takes place. The objectives also are affected by the characteristics and limitations
of the kind of information that financial reporting can provide.

• Nonbusiness Characteristics The major distinguishing characteristics of nonbusiness organizations

include:

o Receipts of significant amounts of resources from resource providers who do not expect to receive
either repayment or economic benefits proportionate to resources provided.

o Operating purposes that are primarily other than to provide goods or services at a profit or profit
equivalent.

o Absence of defined ownership interests that can be sold, transferred, or redeemed, or that convey
entitlement to a share of a residual distribution of resources in the event of liquidation of the organiza-
tion.

• Transactions These characteristics result in types of transactions that are infrequent in business enter-
prises, such as contributions and grants, and in the absence of transactions with owners.

• Inclusions Examples of organizations that clearly fall within the focus of this Statement include most
human service organizations, churches, foundations, and some other organizations, such as those private
nonprofit hospitals and nonprofit schools, that receive a significant portion of their financial resources from
sources other than the sale of goods and services.

• Exclusions Examples of organizations that clearly fall outside the focus of this Statement include all
investor-owned enterprises and other types of organizations, such as mutual insurance companies and
other mutual cooperative entities that provide dividends, lower costs, or other economic benefits directly and
proportionately to their owners, members, or participants.

7
Recognition and Measurement in Financial Statements of Business Enterprises (SFAC 5)

Some information is provided better by financial statements, and some is provided better or can only be dis-
closed in notes to financial statements or by supplementary information or other means of financial reporting.
The Statement sets forth recognition criteria and guidance on what information should be incorporated into finan-
cial statements and when.

• Completeness A full set of financial statements includes information showing the financial position at the
end of the period, earnings (net income) for the period, comprehensive income (total nonowner changes in
equity) for the period, cash flows during the period, and investments by and distributions to owners during
the period.

• Capital Maintenance Concepts The full set of financial statements is based on the concept of financial
capital maintenance. Under the financial capital concept, if the effects of price changes are recognized, they
are reported as holding gains or losses, (i.e., included in income). Under the physical capital concept, such
changes are considered adjustments to equity.

o Financial Concept Under the financial concept, a return on financial capital results only if the financial
amount of an enterprise’s net assets at the end of a period exceeds the corresponding amount at the
beginning of the period, after excluding the effects of transactions with owners. The financial capital
concept is the traditional view and is the capital maintenance concept in present financial statements
and comprehensive income.

o Physical Concept Under the physical concept, a return on physical capital results only if the physical
productive capacity of the enterprise at the end of the period exceeds its capacity at the beginning.
Thus, the physical capital concept can be implemented only if the enterprise’s productive assets, inven-
tory, etc., are measured by their current cost.

• Recognition The process of formally recording or incorporating an item into the financial statements of an
entity as an asset, liability, revenue, expense, or the like. An item and information about it must meet four
fundamental recognition criteria to be recognized, subject to cost-benefit and materiality considerations.

o The item meets the definition of an element of financial statements.

o The item has a relevant attribute measurable with sufficient reliability.

o The information may make a difference in user decisions.

o The information is representationally faithful, verifiable, and neutral.

• Revenues and Gains are recognized when they are both realized and earned.

o Revenues and gains generally are not recognized until realized or realizable.

o Revenues are not recognized until the performance obligation is satisfied.

• Expenses and Losses are recognized based on the following:

o Consumption of economic benefits may be recognized either directly or by relating them to revenues
recognized during the period.

o Expenses or losses are recognized if it becomes evident that previously recognized future economic
benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased,
without associated economic benefits.

8
Elements of Financial Statements

Elements of financial statements are the building blocks with which financial statements are constructed—the
classes of items that financial statements comprise.

Elements SFAC 6 identifies ten interrelated elements of financial statements that are directly related to
measuring performance and status of an entity.

Seven elements of financial statements of both business enterprises and not-for-profit organizations:

1. Assets

2. Liabilities

3. Equity or Net Assets

4. Revenues

5. Expenses

6. Gains

7. Losses

Three elements of business enterprises only:

1. Investment by owners

2. Distributions to owners

3. Comprehensive income

• Accrual Accounting attempts to record the financial effects on an entity of transactions and other events and
circumstances that have cash consequences for the entity in the periods in which those transactions, events,
and circumstances occur, rather than only in the periods in which cash is received or paid by the entity.

Accrual accounting is characterized by the use of accruals, deferrals, allocations, and amortizations.

o Accrual is the accounting process of recognizing assets or liabilities and the related liabilities,
assets, revenues, expenses, gains, or losses for amounts expected to be received or paid, usually
in cash, in the future.

o Deferral is the accounting process of recognizing a liability resulting from a current cash receipt or
an asset resulting from a current cash payment with deferred recognition of revenues, expenses,
gains, or losses.

o Allocation is the accounting process of assigning or distributing an amount according to a plan or

a formula.

o Amortization is the accounting process of reducing an amount by periodic payments or write-

downs. It is an allocation process for accounting for prepayments and deferrals by reducing a
liability or an asset and recognizing a revenue or an expense.

• Realization and Recognition

o Realization is the process of converting noncash resources and rights into money. This term is most
precisely used in accounting and financial reporting to refer to sales of assets for cash or claims to
cash. The related terms realized and unrealized, therefore, identify revenues or gains or losses on
assets sold and unsold, respectively.

o Recognition is the process of formally recording or incorporating an item in the financial

statements of an entity. Thus, an asset, liability, revenue, expense, gain, or loss may be recognized
(recorded) or unrecognized (unrecorded).

9
 • Matching is the combined or simultaneous recognition of the revenues and expenses that result directly
and jointly from the same transactions and other events.

o Period costs cannot be directly related to particular revenues, yet result in benefits that are
exhausted in the same period in which the cost was incurred. These costs are usually recognized
as expenses in the period in which incurred. Examples: administrative salaries, store utilities, etc.

o Other costs yield their benefits over two or more periods of time. These costs are usually allocated
to the periods benefited through a systematic and rational cost allocation method (e.g.,
depreciation and amortization).

Using Cash Flow Information and Present Value in Accounting Measurements (SFAC 7)

• Present Value Measurement of Assets and Liabilities Most accounting measurements use an observ-
able marketplace-determined amount, such as cash exchanged, current cost, or current market value.

However, in other instances, estimates of future cash flows must be used as the basis for measuring an
asset or a liability.

• Present Value as Surrogate for Market Value In order to provide more relevant information (a primary
qualitative characteristic of financial reporting), present value must represent some observable measure-
ment attribute of assets or liabilities. In the absence of observed transaction prices, accounting measure-
ments at initial recognition and fresh-start measurements should attempt to capture the elements that taken
together would comprise a market price if one existed (fair value).

While the expectations of management are often useful and informative, ultimately, it is the market that
dictates market price when exchanges occur. However, for certain assets or liabilities, management’s
estimates may be the only information available on which to value the asset or liability.

In that case, the use of present value can be seen as a surrogate for market value.

• Uncertainties An accounting measurement that uses present value should reflect the uncertainties inherent
in the estimated cash flows. This means that risk should be specifically incorporated into the computation.

• Projection of Future Cash Flows Expected cash flows are used in the projection of future cash flows, which
incorporates uncertainty, use of ranges, and probabilistic computations.

• Credit Risk can affect a variety of components in the present value computation and should be
incorporated in the present value computation. Additionally, in measuring liabilities, the entity’s credit stand-
ing should always be incorporated into that measurement.

Conceptual Framework for Financial Reporting (SFAC 8)

• Objectives of Financial Reporting

o Usefulness Users need to assess the amount, timing, and uncertainty of future net cash inflows to the
entity in order to form opinions about the returns that they expect from an investment. Since most
external users cannot require entities to provide information directly to them, they must rely upon
general purpose financial statements.

o Limitations General purpose financial statements are not intended to show the value of a reporting
entity. They do not and cannot provide all the information that existing and potential users need. Users
should also consider relevant and useful information from other sources, such as: general economic
conditions and expectations; political events and climate; and industry and company outlooks.

o Economic Resources A reporting entity’s financial strengths and weaknesses can be identified through
information about the nature and amount of a reporting entity’s economic resources available for use in
a reporting entity’s operations. Users need to know not only the nature and amount of resources
available for use in an entity’s operations, but they also need to know the different types of resources.

10
 o Changes in Resources and Claims Changes in resources and claims result from the entity’s financial
performance and other transactions, such as issuing debt or equity instruments. Users need to be able
to distinguish between both of these changes in order to properly assess the prospects of future cash
flows from the entity.

o Evaluation Financial performance information helps users to evaluate the return that the entity has
produced. This information also helps users assess how well management has discharged its respon-
sibilities to make efficient and effective use of the entity’s resources; in assessing the uncertainty of
future cash flows; and in predicting the entity’s future returns on its economic resources.

• Qualitative Characteristics of Useful Financial Information The qualitative characteristics of useful

financial information apply to financial information provided in financial statements and in other ways. The
constraint of cost applies similarly. Useful financial information must be both relevant and faithfully
representational. The usefulness is further enhanced if it is also comparable, verifiable, timely, and
understandable.

o Fundamental Qualitative Characteristics

ü Relevance Information is relevant if it is capable of making a difference in a decision by helping

users to form predictions about the outcomes of past, present, and future events or to confirm or
correct prior expectations.

Predictive, and/or confirmatory, value are the traits that allows financial information to make a
difference. Information has predictive value if it can be useful in predicting future outcomes by
users. Confirmatory value provides feedback (confirms or changes) about previous assessments.

Information is material if omitting it or misstating it could influence decisions that users make on the
basis of the financial information of a specific reporting entity. Materiality is different for each entity,
and as such is an entity-specific aspect of relevance.

ü Faithful Representation A perfectly faithful representation would have three characteristics. It

would be complete, neutral, and free from error.

Complete information includes all the information necessary for a user to understand the economic
phenomena being reported, including all necessary descriptions and explanations.

Neutral information is without bias in the selection or presentation of financial information.

Free of error means there are no errors or omissions in the description or preparation of the
information reporting on the phenomenon.

o Enhancing Qualitative Characteristics These characteristics enhance the usefulness of information

that is relevant and faithfully represented. They can also help in determining which of two ways should
be used to depict a phenomenon if both are considered equally relevant and faithfully represented.

ü Comparability Information is more useful if it helps users to choose between alternative decisions
(i.e., buy or sell an investment) by comparing similar information about other entities. It aids users in
identifying and understanding similarities and differences among items. Consistency is related to
comparability, and refers to the use of the same method for making comparisons across entities or
periods of time. Consistency helps to achieve comparability.

ü Verifiability When a large number of independent observers derive similar results using the same
measurement methods, information is verifiable. It can be direct or indirect. If information cannot be
verified (i.e., projections), it would be helpful to disclose the underlying assumptions, methods of
compiling the information, and other factors and circumstances that support the information.

ü Timeliness Information is timely if it is available to a decision maker before it loses its capacity to
influence decisions. Older information is generally less useful than newer information, but older
information can aid in identifying and assessing trends.

ü Understandability Classifying, characterizing, and presenting information clearly and concisely

makes it understandable. Complex information should not be omitted in an attempt to make

11
 financial statements easy to understand. Users of financial statements are assumed to possess a
reasonable knowledge of business activities.

o Cost (Pervasive Constraint) on Useful Financial Reporting Cost is a pervasive constraint, and must
be balanced with the benefits of providing that information. Different assessments of costs and benefits
may be reasonable given the different sizes of entities, ways of raising capital (publicly or privately),
different users’ needs, or other factors.

Application } 2
Which of the following characteristics of accounting information primarily allows users of financial statements
to generate predictions about an organization?
a. Reliability
b. Timeliness
b. Neutrality
d. Relevance
(d) Information is relevant if it is capable of making a difference in a decision by helping users to form pre-
dictions about the outcomes of past, present, and future events or to confirm or correct prior expectations.
Predictive, and/or confirmatory, value are the traits of the relevance characteristic that allows financial infor-
mation to make a difference.

“Reliability” is not a characteristic of useful financial information per the standards. While it may seem like a
possible correct option, it is intended to trick you.

Timeliness is a characteristic that enhances the usefulness of information that is relevant and faithfully
represented. Information is timely if it is available to a decision maker before it loses its capacity to influence
decisions.

Neutrality is a characteristic of faithful representation. A perfectly faithful representation would have three
characteristics. It would be complete, neutral, and free from error. Complete information includes all the infor-
mation necessary for a user to understand the economic phenomena being reported, including all necessary
descriptions and explanations. Neutral information is without bias in the selection or presentation of financial
information.

Financial Reporting
Accounting Model

Accounting principles and assumptions are implemented through the use of the basic accounting model, upon
which the accounting for most profit-oriented entities is based. This model is composed of three main sub-
models, each focusing on a different aspect of the economic activities of an enterprise.

• Financial Position

Assets = Liabilities + Owners’ Equity.

The financial position sub-model purports to present the economic resources, the economic obligations, and
the resulting residual interest in the assets of the entity to its owners. This information is reported by means
of a Statement of Financial Position or balance sheet.

• Results of Operations

Revenues – Expenses = Net Income.

The purpose of the results of operations sub-model is to report on the relative success of the profit-directed
activities of an entity. Revenues obtained through the sale of goods and services are compared to the
expenses incurred in providing those goods and services. The resulting difference is the operating income or

12
 loss for the period. The information is formally represented by the Income Statement (or Statement of Profit
and Loss) and also the statement of changes in comprehensive income.

• Statement of Cash Flows

Cash flows from operating activities

+(–) Cash flows from investing activities

+(–) Cash flows from financing activities

= Change in cash.

The objective of this sub-model is to provide information about the cash receipts and cash payments of an
entity during the period. The Statement of Cash Flows reports the net cash provided or used by operating,
investing, and financing activities, and the aggregate effect of those flows on cash during the period.

Accounting Policies

The disclosure of accounting policies is considered an integral part of the financial statements. No specific dis-
closure format is required. A separate note, or a summary preceding the notes titled Summary of Significant
Accounting Policies is preferred. The accounting policy disclosures should identify and describe the principles
and methods that materially affect the financial position and operations. Prospective financial statements should
not only include a summary of significant policies, but they should also include a summary of significant assump-
tions.

• Policy Choices Disclosure should include policies involving a choice of alternative acceptable policies,
policies peculiar to the industry, and unusual applications of acceptable principles.

• Examples Disclosure requirements include: criteria determining which investments are treated as cash
equivalent; basis of accounting for loans and trade receivables; method of recognizing interest income on
loan and trade receivables; depreciation methods; inventory pricing methods; methods of recognizing profit
on long-term construction contracts; and basis of consolidation.

• No Duplication of Information Financial statement disclosure of accounting policies should not duplicate
details presented elsewhere as part of the financial statements, such as a description of current year equity
transactions, composition of inventories or plant assets, depreciation expense, and maturity dates of long-
term debt.

Application } 3
Which of the following disclosures should prospective financial statements include?
Summary of significant accounting policies Summary of significant assumptions
a. Yes Yes
b. Yes No
c. No Yes
d. No No
(a) Disclosures for prospective financial statements should include summaries of both significant accounting
policies and significant assumptions.

13
Statement of Financial Position—Balance Sheet
Description

The balance sheet presents the assets, liabilities, and owners’ equity of an entity at a specific point in time,
measured in conformity with GAAP.

Format

The formats most commonly used are the account format and the report format.

Exhibit 1 } Balance Sheet Formats (assumed amounts)

Account Format Report Format
Assets Liabilities Assets $50,000
$50,000 $35,000
Liabilities $35,000
Owners’ equity
$15,000 Owners’ equity $15,000

• Assets Probable future economic benefits obtained or controlled by an entity as a result of past transac-
tions or events. Assets are classified in their order of liquidity and intended use.

o Current assets are assets or resources that are reasonably expected to be converted into cash, sold, or
consumed during the normal operating cycle of the business or one year, whichever is longer. An
operating cycle is the average time between the acquisition of materials or services and the final cash
realization.

o Investments are assets held for control, appreciation, regular income, or a combination of these. Exam-
ples include stocks, bonds, subsidiaries, land held as a future plant site, and the cash surrender value of
life insurance. Also included are special purpose funds.

o Operational assets are assets directly used by the enterprise in generating revenues.

o Valuation accounts are reductions or increases in an asset account to reflect adjustments beyond the
historical cost or carrying amount of the asset. Valuation accounts are part of the related asset; they are
neither assets nor liabilities in their own right.

• Liabilities Probable future sacrifices of economic benefits arising from present obligations to transfer
assets or provide services to other entities in the future as a result of past transactions or events. Liabilities
are classified according to their due date as either current or long-term.

o Current liabilities are obligations whose liquidation is expected to require the use of existing current
assets or the creation of other current liabilities.

o Long-term liabilities are obligations not requiring the use of existing current assets or the creation of
current liabilities for their extinguishment.

o Valuation accounts may increase or decrease the carrying amount of a liability. Examples include the
premium or discount on outstanding bonds payable. Valuation accounts are part of the related liability;
they are neither assets nor liabilities in their own right.

• Owners’ Equity The residual interest in the assets of an entity that remains after deducting its liabilities. An
equity interest derives its value from being a potential source of distribution of cash or other assets to its
owner. In a liquidation, all liabilities must be satisfied first. Equity is originally created by the initial investment
of owners. Subsequent investments by owners or the admission of new owners increases equity, while
distributions to owners decreases it. Equity is also changed as a result of the operating activities of the entity
and other certain events and circumstances affecting it. This combined effect constitutes comprehensive
income.

14
Valuation

• Assets
o Historical cost is the acquisition cost less depreciation or amortization to date. While this method of
valuation is both verifiable and systematic, it often fails to reflect either the current value of the asset or
changes due to the purchasing power of the dollar.

o Market value is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.

o Replacement cost attempts to value assets on the basis of their current replacement cost. Current
replacement cost is defined as the price of a new, similar item after allowance for use and depreciation.
It is the amount of cash or its equivalent that would have to be paid if the same or equivalent assets
were acquired currently. This method is used in the primary financial statements only in cases where the
utility of inventory items has diminished.

o Price-level adjusted historical cost adjusts value to reflect changes in the general purchasing power of
the dollar.

o Discounted cash flows value assets in terms of the present value of the future benefits associated with
the ownership of the asset. Notes receivable and bond investments are valued at present value upon
acquisition.

• Liabilities are valued at their current debt equivalent. For long-term liabilities this implies discounting to their
present value the future sums required to satisfy the liability. Due to materiality considerations, short-term
liabilities are usually presented at their face amount.

• Owners’ Equity The valuation of owners’ equity depends on the amounts presented for assets and liabili-
ties.

• Off-Balance-Sheet Risk is the risk of accounting loss from a financial instrument that exceeds the amount
recognized for the instrument in the balance sheet. Examples include standby loan commitments written,
options, letters of credit, and noncancelable operating leases with future minimum lease commitments.
Where not directly reflected on the balance sheet, there are increased disclosure (note) requirements.
Companies must also provide off-balance-sheet related information in their management discussion and
analysis sections.

Fair Value Measurements

• Background Historical cost has been the primary basis for recording assets and liabilities for many years.
Its advantage over other measurement methods was objectivity. Recent standards have been developed
that require periodic assessment of value when evidence indicates that an item’s current cost might be less
than its historical cost.

• Definition Fair value is a market-based (not an entity-based) measurement. The objective is to estimate the
price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date (that is, an exit price from the perspective of a market partici-
pant that holds the asset or owes the liability).

o The term “orderly transaction” assumes that the item has been exposed to the marketplace prior to the
measurement date for a reasonable period of time (not a forced transaction).

o The principal market, or else otherwise most advantageous market, is determined from the standpoint of
the entity that holds the asset or liability, and requires the entity to consider the market in which it
conducts its highest volume or level of activity.

• Initial Measurement When as asset is acquired or a liability assumed, the transaction price is the price paid
to acquire the asset or received to assume the liability (an entry price). The fair value of the asset or liability
is the price that would be received to sell the asset or paid to transfer the liability (an exit price). In many
cases, the transaction price will equal the fair value.

15
• Exchange Transaction It is assumed that the asset or liability is exchanged in an orderly transaction
between market participants under current market conditions. Additionally, it is assumed that the transaction
takes place in either the principal market or in the most advantageous market if a principal market does not
exist.

In the absence of evidence to the contrary, the market in which the entity would normally enter into for all
transactions is deemed to be the principal market. The price in that market is the fair value measurement of
the asset or liability.

• Market Participants When measuring the fair value of an asset or liability, an entity must use the same
assumptions that other market participants would use.

• Highest and Best Use A fair value measurement of a nonfinancial asset only considers the ability to
generate economic benefits by using the asset in its highest and best use; the use of the asset that is
physically possible, legally permissible, and financially feasible at the measurement date.

Current use is assumed to be the highest and best use unless market or other factors suggest that a
different use by market participants would maximize the value of the asset. (The concepts of highest and
best use and valuation premise concepts are not relevant when measuring the fair value of financial assets
or financial liabilities.)

• Valuation Techniques The technique(s) used shall be the most appropriate in the circumstance and for
which sufficient data are available to measure fair value, maximize the use of relevant observable inputs
and minimize the use of unobservable inputs. Revisions resulting from a change in the valuation technique
shall be accounted for as a change in accounting estimate.

o Inputs The highest and best use of a nonfinancial asset establishes the valuation premise used to
measure fair value of an asset, as follows:

ü Valuation techniques shall maximize the use of relevant observable inputs and minimize the use of
unobservable inputs. Markets with observable inputs include: exchange markets, dealer markets,
brokered markets, and principal-to-principal markets. If there is a quoted price in an active market
(i.e., a Level 1 input) for an asset or liability, an entity shall use that quoted price without adjustment
when measuring fair value.

ü If an asset or liability has a bid price and an ask price, the price within the bid-ask spread that is
most representative of fair value shall be used to measure fair value regardless of where the input is
categorized within the fair value hierarchy. This does not preclude the use of mid-market pricing or
other pricing conventions as a practical expedient for fair value measurement in a bid-ask spread.

o Valuation Technique Approaches

ü Market Approach uses prices and other relevant information generated by market transactions
involving identical or comparable assets or liabilities.

ü Income Approach uses valuation techniques to convert future amounts to a single present amount.
The measurement is based on the value indicated by current market expectations about those
future amounts. Valuation techniques include: present value; option-pricing models (such as Black-
Scholes-Merton); and the multiperiod excess earnings method.

ü Cost Approach is based on the amount that currently would be required to replace the service
capacity of an asset, often referred to as the current replacement cost. From the perspective of a
market seller, the price that would be received for the asset is based on the cost to a market buyer
to acquire or construct a substitute asset of comparable use, adjusted for obsolescence.
Oftentimes, the current replacement cost method is used to estimate fair value.

o Fair Value Hierarchy are categorized into three levels. Highest priority is given to quoted prices
(unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to
unobservable inputs (Level 3 inputs).

ü Level 1 Inputs Are quoted prices (unadjusted) in active markets for identical assets or liabilities
that can be accessed on the measurement date by the reporting entity. A quoted active market price

16
 provides the most reliable evidence of fair value and shall be used without adjustment, except for
certain circumstances.

ü Level 2 Inputs Are inputs other than quoted prices included within Level 1 that are observable for
the asset or liability, either directly or indirectly. Level 2 inputs include: quoted prices for similar (not
identical) assets or liabilities in active markets; quoted prices for identical or similar assets or
liabilities in nonactive markets; interest rates and yield curves observable at commonly quoted
intervals; implied volatilities; and credit spreads.

Adjustments to Level 2 inputs depend on the condition and location of the asset; the extent to which
inputs relate to items that are comparable to the asset or liability; and the volume or level of activity
in the market within which the inputs are observed.

ü Level 3 Inputs Are unobservable inputs for the asset or liability. These are most often used where
there is little, if any, market activity for the asset or liability at the measurement date. An entity
needs to develop unobservable inputs using the best information available, which might include
using the entity’s own data.

That data should be adjusted if other market participants would use different data or if there is
something unique in the entities’ data not available to other market participants. An entity is required
to disclose quantitative information about the unobserved inputs used in the measurements.

• Disclosures Reporting entities are required to expand the disclosures for fair value to provide information
related to which assets and/or liabilities are measured at fair value, the methods and assumptions used in
measuring fair values, and the effect of fair value measurements on reported income. A reporting entity shall
disclose information that helps users of its financial statements to assess assets and liabilities that are
measured at fair value on a recurring or nonrecurring basis, the valuation techniques, and the inputs used to
develop those measurements.

Application } 4
In the FASB’s fair value hierarchy, which category of inputs are unadjusted quoted prices in active markets for
identical assets or liabilities that can be accessed on the measurement date?
a. Level 1
b. Level 2
c. Level 3
d. Level 4
(a) Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. A quoted
active market price provides the most reliable evidence of fair value and shall be used without adjustment,
except for certain circumstances.

Level 2 inputs are other than quoted prices included within Level 1 that are observable for the asset or liability.

Level 2 inputs include: quoted prices for similar (not identical) assets or liabilities in active markets; quoted
prices for identical or similar assets or liabilities in nonactive markets; interest rates and yield curves
observable at commonly quoted intervals; implied volatilities; and credit spreads. Level 3 inputs are
unobservable inputs for the asset or liability.

These are most often used where there is little, if any, market activity for the asset or liability at the
measurement date. An entity needs to develop unobservable inputs using the best information available,
which might include using the entity’s own data. That data should be adjusted if other market participants
would use different data or if there is something unique in the entities’ data not available to other market
participants. An entity is required to disclose quantitative information about the unobserved inputs used in the
measurements.

There is no such category as Level 4 inputs in the fair value hierarchy.

17
Fair Value Option

Entities are permitted to measure many financial instruments and certain other assets and liabilities at fair value
on an instrument-by-instrument basis under a fair value option.

• Eligible Items In addition to certain commonly recognized financial assets and financial liabilities, such as
loans receivable and payable, the following qualify for the Fair Value Option (FVO):

o A firm commitment that would otherwise not be recognized at inception and only involves financial
instruments; or a written loan commitment.

o The rights and obligations under an insurance contract or warranty that is not a financial instrument but
permits the insurer or warrantor to settle by paying a third party to provide goods or services.

o A host financial instrument resulting from the separation of an embedded nonfinancial instrument from a
nonfinancial hybrid instrument.

• Financial Instruments Not Eligible No entity may elect the fair value option for the following financial
assets and financial liabilities:

o An investment in a subsidiary or an interest in a variable interest entity that the entity is required to
consolidate.

o Obligations for pension benefits, other postretirement benefits, postemployment benefits, employee
stock option and purchase plans, and other forms of deferred compensation.

o Financial instruments recognized under leases.

o Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions,
and other similar depository institutions.

o Financial instruments classified by the issuer as a component of shareholder’s equity.

• Method of Electing FVO

• Election Dates An entity may choose to elect the fair value option only on the date that one of the following
occurs:

o The entity first recognizes the eligible item; or enters into an eligible firm commitment.

o Financial assets that, because of specialized accounting principles, have been reported at fair value with
unrealized gains and losses included in earnings cease to qualify for fair value measurement.

o The accounting treatment for an investment in another entity changes because the investment becomes
subject to the equity method of accounting; or the investor ceases to consolidate a subsidiary or vari-
able interest entity but retains an interest.

o An event that requires an eligible item to be measured at fair value at the time of the event but does not
require fair value measurement at each reporting date after that.

5. Reporting and Presentation

6. Disclosures should facilitate comparisons between entities that choose different measurement attributes
for similar assets and liabilities and also facilitate comparisons between assets and liabilities in the financial
statements of an entity that selects different measurement methods for similar assets and liabilities.

18
Reporting of Operations—Income Statement
Description

The Income Statement for a period presents the revenues, expenses, gains, losses, and net income (net loss)
recognized during the period and thereby presents an indication, in conformity with GAAP, of the results of the
enterprise’s profit-directed activities during the period. Information in the Income Statement helps users evaluate
the past performance the company and provides a basis for predicting the future performance of the company.

Format

Two basic formats are used to present the Income Statement.

• Single-Step Format Focuses on two classifications of items: revenues and expenses. All revenues are
added together to arrive at a total revenue figure. The sum of all expenses is subtracted from this figure.
The resultant amount is “Income from Continuing Operation.”

• Multiple-Step Format Focuses on multiple classifications of revenue and expense items. This format is
characterized by several intermediate subtotals, such as gross margin and operating income, which together
produce “Income from Continuing Operation.”

Exhibit 2 } Income Statement Formats (assumed amounts)

Single-Step Format Multiple-Step Format
Revenues: Net sales $500,000
Sales revenue $500,000 Less COGS 350,000
Other revenues, gains 20,000 Gross margin $150,000
Total revenues $520,000 Less operating exp.
Expenses: Selling 80,000
COGS 350,000 Administrative 30,000
Selling 80,000 Total operating exp. 110,000
Administrative 30,000 Operating income 40,000
Other expenses, losses 10,000 Other revenues, gain 20,000
Income taxes 5,000 Other exp., losses 10,000 10,000
Total expenses 475,000 Income from continuing
Income from operations before taxes 50,000
continuing operations 45,000 Income taxes 5,000
Income from Income from
Discontinued Operations 0 continuing operations 45,000
Net income $ 45,000 Income from Discontinued
Operations 0
Net income $ 45,000

Elements
• Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a
combination of both) during a period from delivering or producing goods, rendering services, or other
activities. that constitute the entity’s ongoing major or central operations. Revenues represent actual or
expected cash inflows (or equivalents). Revenues are usually recognized when performance obligations
have been satisfied.

• Expenses are outflows or other use of assets or incurrence of liabilities (or a combination of both) from
delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s
ongoing major or central operations during a period. Expenses represent actual or expected cash outflows
(or equivalents). Expenses generally are recognized in accordance with one of three principles.

o Some costs are presumed to be directly related to specific revenues. Examples are cost of goods sold
and sales commissions.

19
 o If a direct association is not apparent, costs must be allocated on a systematic and rational basis among
the periods benefited. Depreciation of fixed assets, amortization of intangible assets, and allocation of
prepaid rent and insurance are applications of this principle.

o Costs that are deemed to provide no discernible future benefits are expensed in the current period.
Likewise, costs recorded as assets in prior periods that no longer have discernible benefits are
expensed in the current period.

• Gains and Losses Gains and losses are defined as increases (or decreases) in equity—i.e., net assets—
from peripheral or incidental transactions of an entity and from all other transactions and other events and
circumstances affecting the entity during a period, except those that result from revenues (expenses) or
investments (withdrawals) by owners.

o Gains and losses related to the business enterprise’s central operations (e.g., write-down of inventory to
lower of cost or market) are classified as operating.

o Gains and losses not attributable to operations are classified as nonoperating.

Statement of Changes in Equity

Often referred to as Statement of Retained Earnings in US GAAP, this Statement helps users identify factors
that cause a change in owners’ equity over an accounting period by presenting the movement in reserves com-
prising the shareholders’ equity.

A retained earnings statement is required by US GAAP whenever comparative balance sheets and Income
Statements are presented. It uses information from the Income Statement and provides information to the
balance sheet. It is often presented as a supplement to the Income Statement, serving as a link between
beginning and ending retained earnings.

Exhibit 3 } Statement of Retained Earnings

Beginning balance, as reported $ XXX
+/– Prior period adjustments, net of $______ tax XXX
Beginning balance, as adjusted XXX
+ Net income (– Net loss) XXX
– Dividends (XXX)
Ending balance $ XXX

Statement of Comprehensive Income

Description

Comprehensive income is the change in equity of a business enterprise during a period from transactions and
other events and circumstances from nonowner sources. Comprehensive income is to be displayed prominently
within a financial statement in a full set of general-purpose financial statements. It must be shown on the face of
a statement, not just in the notes to the statements.

• Comprehensive income includes all changes in equity during a period except those resulting from invest-
ments by owners and distributions to owners.

• Over the life of the business, comprehensive income equals the net difference between cash receipts and
outlays, excluding cash investments by owners and cash distributions to owners, regardless of whether cash
or accrual accounting is used.

• Comprehensive income is divided into the components of net income and Other Comprehensive Income.

• Other Comprehensive Income (OCI) refers to revenues, expenses, gains, and losses that are included in
comprehensive income, but excluded from net income.

20
Format

There are two acceptable means of reporting comprehensive income: a Statement of Income and Comprehen-
sive Income, or a Statement of Income and a separate Statement of Comprehensive Income.

• Classification Comprehensive income is comprised of two components, net income and Other
Comprehensive Income. An entity must classify items of Other Comprehensive Income by their nature:
foreign currency items, pension adjustments, unrealized gains and losses on certain investments in debt
securities, and certain gains and losses on hedging activities.

• Accumulated Balance of OCI An entity must also display the accumulated balance of Other
Comprehensive Income separately from retained earnings and additional paid-in capital in the equity section
of a Statement of Financial Position. An entity must disclose accumulated balances for each classification in
that separate component of equity on the face of the Statement of Financial Position, in the Statement of
Changes in Equity, or in the Notes to the Financial Statements.

Exhibit 4 } Comprehensive Income Reporting (Separate Statement)

Net Income $ XXX
Foreign currency adjustments, net of tax of $XXX $XXX
Unrealized holding gain/loss arising during period, net of tax of $XX $XX
Reclassification adjustment, net of tax of $XX, for gain/loss included in net
income XX
Unrealized Gain/Loss on Marketable Securities XXX
Pension adjustment, net of tax of $XX XXX
Other Comprehensive Income XXX
Comprehensive Income $ XXX

Statement of Cash Flows

Description

A Statement of Cash Flows must be issued whenever a balance sheet and an Income Statement are issued.
This financial statement provides relevant information about the cash receipts and cash payments of an
enterprise during a period.

• Classification The Statement of Cash Flows classifies cash receipts and cash payments resulting from
operating, investing, and financing activities.

• Noncash Investing and Financing Transactions Noncash investing and financing transactions are not
reported in the Statement of Cash Flows because the statement reports only the effects of operating, invest-
ing, and financing activities that directly affect cash flows. If significant, noncash investing and financing
transactions are reported in related disclosures.

Format

Net cash from operating activities can be determined under either the direct or indirect method.

Under the direct approach, operating cash payments are deducted from operating cash receipts, effectively
resulting in a cash basis Income Statement.

The indirect approach converts net income to net cash flow from operating activities by adding back noncash
charges in the Income Statement to net income and subtracting noncash credits from net income.

21