Chapter 3

Conceptual Framework and Theoretical Structure of Financial Accounting and Reporting, Part II

Answer to Questions

1. Liquidity refers to how quickly an asset of a company can be converted into cash or a liability paid.
Financial flexibility refers to the ability of a company to use its financial resources to adapt to change.
Operating capability refers to the ability of a company to maintain a given physical level of operations.
2. Financial capital is the monetary value of the net assets contributed by stockholders and the value of the
increase in net assets resulting from earnings retained by the corporation (cumulative income in excess of
cumulative dividends). Capital maintenance refers to maintaining the stockholders’ equity of the
corporation in order to provide a return of investment. Information about the maintenance of a
corporation’s capital is important in assessing the adequacy of a corporation’s profitability and its ability to
provide a return on investment.
3.
 Assets are probable future economic benefits obtained or controlled by a particular entity as a result of
past transactions or events.
 Liabilities are probable future sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other entities in the future as a result of past
transactions.
 Equity is the residual interest in the assets of any entity that remains after deducting its liabilities.
 Investments by owners are increases in equity resulting from transfers of resources, usually cash, to a
company in exchange for ownership interest.
 Distributions to owners are decreases in equity resulting from transfers to owners.
 Revenues are inflows of assets or settlements of liabilities from delivering or producing goods, rendering
services, or other activities that constitute the entity’s ongoing major or central operations.
 Expenses are outflows or other using up of assets or incurrences of liabilities during a period from
delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing
major or central operations.
 Gains are defined as increases in equity from peripheral or incidental transactions of an entity.
 Losses represent decreases in equity arising from peripheral or incidental transactions of an entity.
 Comprehensive income is defined as the change in equity of an entity during a period from nonowner
transactions.
4. At present, the accounting literature contains many terms that have peculiar and specific meanings. Some of
these terms have been in use for a long period of time, and their meanings have changed over time. Since the
elements of financial statements are the building blocks with which the statements are constructed, it is
necessary to develop a basic definitional framework for them.

Answers to Multiple Choice

1. D 11. C 21. D
2. C 12. D 22. B
3. C 13. D 23. A
4. D 14. D 24. D
5. B 15. B 25. D
6. B 16. B 26. A
7. A 17. B 27. C
8. D 18. B 28. C
9. A 19. C
10. D 20. A