ACCOUNNTING THEORY, CONCEPTUAL ISSUES IN A POLITICAL AND ECONOMIC ENVIRONMENT 8TH EDITION BY HARRY W by QuentinAxel

TEST BANK

ACCOUNNTING THEORY, CONCEPTUAL ISSUES IN A POLITICAL AND ECONOMIC ENVIRONMENT 8TH EDITION BY HARRY WOLK, JAMES DODD, JOHN ROZYCKI TEST BANK Chapter 1—AN INTRODUCTION TO ACCOUNTING THEORY

TRUE/FALSE QUESTIONS 1. Financial accounting refers to accounting information that is used by management for decisionmaking purposes. ANSWER: False 2. Accounting theory includes the basic rules, definitions, and principles that underlie the drafting of accounting standards and how they are derived. ANSWER: True 3. Accounting theory includes conceptual frameworks, accounting legislation, valuation models, and hypotheses and theories. ANSWER: True 4. Hypotheses and theories are based on an informal method of investigation. ANSWER: False 5. Replacement cost as a measure of asset value is generally more reliable than historical cost. ANSWER: False 6. Accounting theory is developed and refined by the process of accounting research. ANSWER: True 7. Indirect measures are usually preferable to direct measures because they are less costly to obtain. ANSWER: False 8. Assessment measures are concerned with particular attributes of objects and are always direct measurements. ANSWER: False 9. When a direct assessment measure is used, there is always only one correct measure. ANSWER: False 10. The simplest type of measuring system is the nominal scale. ANSWER: True 11. A chart of accounts is an example of an ordinal classification. Accounting Theory: 8th edition

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ANSWER: False

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12. Numerals assigned in ordinal rankings indicate an order of preference where the degree of preference among ranks is the same. ANSWER: False 13. In a ratio scale, the zero point implies "nothingness," or the absence of the quality being measured. ANSWER: True 14. Using ratio scale measurement is possible in accounting. ANSWER: True 15. Objectivity may be defined as the degree of consensus among measurers. ANSWER: True 16. Assessment measures are not concerned with particular attributes of objects. ANSWER: False 17. Prediction measures are concerned with factors that may be indicative of future conditions. ANSWER: True 18. Timeliness and cost are pertinent to assessment measures but are not pertinent to prediction measures. ANSWER: False 19. All accounting measurements are of either the assessment or the prediction variety. ANSWER: True 20. The need for information on a timely basis may conflict with cost constraints in some situations. ANSWER: True 21. The terms calculation and measurement both refer to the valuation of a real phenomena or attribute. ANSWER: False 22. Calculations attempt to simulate or come as close as possible to the measurement of real phenomena or attributes. ANSWER: False

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23. FIFO and LIFO measures of cost of goods sold and inventories are examples of calculations rather than measurements. ANSWER: True 24. There are often trade-offs between objectivity and the usefulness of numbers generated by the measurement process. ANSWER: True 25. Measurement is an integral part of accounting theory. ANSWER: True 26. Throughout the financial history of the United States, current value has been the accepted valuation system for published financial statements. ANSWER: False 27. The discounted cash flow approach can be used to determine an objective measurement for most assets and liabilities. ANSWER: False 28. A general price-level adjustment refers to the purchasing power of the monetary unitary unit relative to all goods and services in the economy. ANSWER: True 29. Both exit value and replacement cost are valuation systems that fall into the current value category. ANSWER: True 30. The principal argument used to justify the replacement cost system over exit values is that if the great majority of the firm's assets were not already owned, it would be economically justifiable to acquire them. ANSWER: True MULTIPLE CHOICE QUESTIONS 1. Which of the following methods of valuing an asset is based on the amount that a firm could acquire by selling the asset? a. Replacement cost b. Entry value c. Exit value d. Both a and b ANSWER:

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2. Which of the following methods of valuing an asset is based on the amount that would be paid for it in markets where the asset would ordinarily be acquired? a. Replacement cost b. Entry value c. Exit value d. Both a and b ANSWER:

3. Which of the following would be considered a political factor relative to the financial accounting policy function? a. Auditors b. Inflation c. Taxes d. Price changes ANSWER:

4. Which of the following groups carry out most accounting research? a. Public accounting firms b. Private industry c. Accounting professors d. Chartered Financial Analysts ANSWER:

5. If a number assigned to an object is an actual measurement of a property of the object, it is referred to as a(n): a. Direct measurement. b. Biased measurement. c. Indirect measurement. d. Prediction measurement. ANSWER:

6. Which of the following factors is not listed in your text as affecting a direct assessment measure? a. The measurer b. The attribute being measured c. Instruments available for the measuring task d. The individual who will use the measure ANSWER:

7. The simplest type of measuring system is the: a. Interval scale. b. Ratio scale. c. Nominal scale. d. Ordinal scale. ANSWER:

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8. Which measurement scale indicates an order of preference but not the degree of preference among ranks? a. Interval scale b. Ratio scale c. Nominal scale d. Ordinal scale ANSWER:

9. The use of which of the following types of measurement scales in accounting allows meaningful comparisons among similar accounting measurements for different firms? a. Interval scale b. Ratio scale c. Nominal scale d. Ordinal scale ANSWER:

10. For which measurement scale must the change in the attribute measured among assigned numbers be equal? a. Interval scale b. Ratio scale c. Ordinal scale d. Both a and b ANSWER:

11. For which measurement scale must the change in the attribute measured among assigned numbers be equal and the zero point imply the absence of the attribute measured? a. Interval scale b. Ratio scale c. Ordinal scale d. Both a and b ANSWER: B 12. Which of the following is an example of a measurement rather than a calculation? a. FIFO inventory valuation b. Replacement cost of ending inventory c. LIFO cost of goods sold d. Historical cost depreciation ANSWER:

13. In an accounting context, which of the following represents the degree of consensus among measurers in situations where a given group of measurers having similar instruments and constraints group measures the same attribute of a given object? a. Bias b. Equality c. Objectivity d. Impartiality ANSWER:

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14. In attempting to analyze the worth of an accounting measure, which of the following qualities is not mentioned in the text as an important consideration? a. Objectivity b. Timeliness c. Cost d. Complexity ANSWER:

15. Which of the following is not a major input into the accounting standard-setting process? a. Accounting theory b. Political factors c. Geographical constraints d. Economic conditions ANSWER:

16. Which of the following specifically refers to the process of arriving at a pronouncement issued by the FASB or SEC? a. Standard setting b. Accounting research c. Policy determination d. Accounting valuation measurement

ANSWER:

17. Which of the following is not true regarding accounting theory? a. It includes concepts, valuation models, and hypotheses. b. It is developed and refined by the process of accounting research. c. It is concerned with improving financial accounting and statement presentation. d. It is concerned with insuring that managers and investors are in agreement on how to improve financial statements. ANSWER:

18. Which of the following refers to accounting information that is used by investors, creditors, and other outside parties for analyzing management performance and decision-making? a. Managerial accounting b. Financial accounting c. Income tax accounting d. Institutional accounting ANSWER:

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19. Computations and comparisons of accounting ratios is possible because: a. The zero point in accounting implies "nothingness" in terms of dollar amount. b. Accounting measures are on an interval scale. c. Assets and liabilities are listed in the order of liquidity in the balance sheet. d. Accounting is a basic classification system. ANSWER:

20. Which of the following is a measure of predictive ability? a. Objectivity b. Bias c. Timeliness d. Productivity ANSWER:

21. Which of the following has/have been the accepted valuation system for published financial statements throughout the financial history of the United States? a. Historical cost b. Income tax valuation c. Discounted cash flows d. General price level ANSWER:

22. Which of the following valuation approaches has/have been defended as more suitable as a means for distributing income because it is not based on hypothetical opportunity cost figures? a. Income tax valuation b. Discounted cash flows c. Historical cost d. Current value ANSWER:

23. Which of the following valuation approaches converts historical cost dollars by an index such as the Consumer Price Index? a. Current value b. Discounted cash flows c. Replacement cost d. General price-level adjustment ANSWER:

24. Which of the following valuation methods is frequently referred to as a process of orderly liquidation? a. Exit valuation b. Entry value c. Replacement cost d. Historical cost ANSWER:

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25. Of the valuation systems discussed in your text, which one is purely theoretical, with virtually no operable practicability on a statement-wide basis? a. Current value b. Discounted cash flows c. General price-level adjustment d. Historical cost ANSWER:

ESSAY QUESTIONS 1. What is the policy function performed by bodies such as the FASB and the SEC? List and discuss the three sources of inputs to the policy-making function. ANSWER: The policy function performed by the FASB and the SEC is called standard setting (or rule making) and specifically refers to the process of arriving at pronouncements issued by these bodies. The three sources of inputs to the policy-making function are economic conditions, political factors, and accounting theory. The steep inflation of the 1970s, which led the FASB to require the disclosure of information concerning price changes, is an example of an economic condition that affected policy making. Auditors, preparers of financial statements, investors, management of major firms, industry trade associations, and the public itself, who might be represented by Congress or government agencies, are all political factors influencing the policymaking process. Accounting theory is developed and refined by the process of accounting research. This research is primarily performed by accounting professors, but many individuals from policy-making organization, public accounting firms, and private industry also play an important part in the research process.

2. Discuss the difference between direct measurement and indirect measurement. Give examples of each in an accounting context. ANSWER: A direct measurement of a property is an actual measurement of the property. An indirect measurement is one that must be made by roundabout means. Direct measurements are generally preferable to indirect measures. A direct measurement of replacement cost for an item of ending inventory would be the current wholesale price (the actual price for which it could be currently purchased). An example of an indirect measurement would be an estimate of the replacement cost based on a combination of factors such as original cost, condition, estimated current selling price, and normal markup.

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3. List the four types of measurement scales in order of measurement rigor. Describe and give examples of each type of scale. ANSWER: The four types of measurement scales listed in order of measurement rigor are: nominal, ordinal, interval, and ratio. A nominal scale is a basic classification system, or a system of names. A chart of accounts is an example of nominal classification in accounting. An ordinal scale indicates (ranks) degree of preference, but degrees of preference between ranks are not necessarily equal. Listing current assets and current liabilities in order of liquidity is an example of ordinal ranking. Interval scales also allow ranking of attributes, but the change in the attribute measured among assigned numbers must be equal. The Fahrenheit temperature scale is an example of an interval scale. The ratio scale also assigns equal value to the intervals between assigned numbers. However, unlike the interval scale, the zero point on a ratio scale indicates absence of the property measured. Because zero indicates "nothingness" in terms of dollar amounts, accounting numbers are based on a ratio scale.

4. Give at least three examples of how accounting numbers may affect social reality. ANSWER: Some examples of how accounting numbers affect social reality are as follows: (1)

In a period of rising prices, LIFO inventory valuation generally results in lower income and, therefore, lower income taxes.

(2)

Income numbers can be instrumental in evaluating the performance of management, which can affect salaries and bonuses.

(3)

Income numbers and various balance sheet ratios can affect dividend payment and security prices.

(4)

Income numbers and balance sheet ratios can affect the firm's credit standing and therefore the cost of capital.

5. Identify four qualities that are pertinent to accounting measures. ANSWER: Four qualities that should be considered in analyzing the worth of a measure are: (1)

Objectivity (verifiability) — the degree of consensus among measurers.

(2)

Bias (usefulness) — a measure of predictive ability.

(3)

Timeliness — measurements (financial statements) should be up-to-date.

(4)

Cost constraints — data are costly to produce.

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6. Explain how a firm might use a special purpose entity (SPE) to subvert the standard-setting process. ANSWER: SPEs are arrangements whereby the firm and an outside equity investor jointly own an entity which may largely be a shell enterprise. SPEs allow firms to “park” liabilities on the SPE’s balance sheet if the outside equity investor owns as little as 3% of the SPE. Leaving the liability off its own balance sheet improves the firm’s debt-equity ratio. 7. List arguments for and arguments against the use of historical cost, general price-level adjustment, exit value (net realizable value) and replacement cost (entry value). Explain why the discounted cash flow method is virtually impossible to apply in a real situation. ANSWER: Historical cost For: Historical cost is more objectively determinable and better understood than are other valuation systems. Historical costs have also been defended as more suitable as a means of distributing income among capital providers, officers and employees, and taxation agencies because it is not based on hypothetical opportunity cost figures. Against: Opportunity cost valuations are more indicative of economic valuation than are historical costs. In a period of rising prices, attributes measured by historical costing methods generally have limited relevance to economic reality. There is also a serious additivity problem under historical costing because dollars of different purchasing power are added to or subtracted from each other. General price-level adjustment For: Price-level adjustments restore the additivity of amounts on the financial statements. Against: Every item on the financial statements, except for monetary assets and liabilities, must be adjusted for price levels and restated in terms of the general purchasing power of the dollar during the current year. Exit value (net realizable value) For: The balance sheet reflects the net liquidity available to the enterprise in the ordinary course of operations, thus portraying the firm's ability to shift its presently existing resource into new opportunities. Also, all the measurements are additive since valuations are at the same time point and measure the same attribute. Exit valuation can be combined with general price-level adjustment to provide a more complete analysis of inflationary effects upon the firm. Against: The relevance of net realizable value measurements for fixed assets is questionable when the firm intends to keep and utilize the great bulk of them for revenue production purposes in the foreseeable future. Also, exit value measurements are often unavailable for unique fixed assets such as land, buildings, and custom made equipment. Replacement cost (entry value) For: If the great majority of the firm’s assets were not already owned, it would be economically justifiable to acquire them. Replacement cost can also be combined with general price-level adjustment to provide a more complete analysis of inflationary effects upon the firm.

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Against: Market values are often unavailable for such unique fixed assets as land, buildings, and heavy equipment specially designed for a particular firm. Discounted cash flows would be virtually impossible to apply because many assets contribute jointly to the production of cash flows, so individual asset valuation could not be determined. Also, the future orientation of asset valuation and income determination leads to very formidable estimation problems, which would reduce objectivity in terms of the degree of consensus among measurers.

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TRUE/FALSE 1. The use of research in accounting results in the field being referred to as an academic discipline. ANSWER: True 2. The scientific method refers to the formal procedures used to derive the laws and principles that govern scientific disciplines, such as physics and chemistry, and is therefore not used in the published research on accounting. ANSWER: False 3. An important segment of accounting theory is derived from the research process. ANSWER: True 4. Deductive reasoning analyzes empirical data to make inferences about a population. ANSWER: False 5. Hypotheses are conclusions derived from the research process. ANSWER: False 6. General deductive reasoning is extremely important in accounting theory and policy making. ANSWER: True 7. Analytical/deductive research methods are commonly used in accounting research. ANSWER: False 8. Positive accounting research attempts to explain behavioral relationships in accounting. ANSWER: True 9. Positive accounting research attempts to describe "what is" and determine how things should be. ANSWER: False 10. Positive accounting research attempts to be value-free, while normative accounting research is value judgment oriented. ANSWER: True 11. Only a few examples of inductively derived theories are present in accounting literature. ANSWER: False

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12. Normative theories contain at least one premise stating how things should be. ANSWER: True 13. A premise stating that accounting reports should be based on historical costs would indicate a normative approach. ANSWER: True 14. Inductive approaches to accounting theory usually attempt to be descriptive. ANSWER: True 15. An important difference between deductive and inductive research is that inductive research is sometimes global in content, whereas deductive research is usually particularistic. ANSWER: False 16. One of the purposes of positive research is to satisfy information demand by managers, auditors, creditors, and standard setters. ANSWER: True 17. Because deductive research is grounded in real-world phenomena, it can realistically focus on only a small part of the relevant environment. ANSWER: False 18. Deductive and inductive research are competing approaches and may not be used together. ANSWER: False 19. Inductive research in accounting can help to shed light on relationships and phenomena existing in the business environment. ANSWER: True 20. Inductive research can be useful in the accounting policy-making process in which deductive reasoning helps to determine rules that are to be prescribed. ANSWER: True 21. To be useful, inductive research must be kept value-free. ANSWER: False 22. The decision-model approach to accounting research is normative. ANSWER: True

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23. Accounting research of two generations ago was purely normative. ANSWER: True 24. The decision-model approach to accounting research seeks to determine what information users of accounting information want. ANSWER: False 25. The normative nature of the decision-model approach has led to criticism that this method is nonscientific. ANSWER: True 26. Empirical research shows that prices of publicly traded securities react slowly and in an erratic manner to new information. ANSWER: False 27. The efficient-markets hypothesis states that the return of a security is based on its risk. ANSWER: True 28. Because of the efficient-markets hypothesis, the impetus for increased disclosure with less concern for choice among accounting alternatives has grown stronger. ANSWER: True 29. Much of the accounting research in the behavioral area uses laboratory subjects in carefully controlled experimental situations. ANSWER: True 30. An argument against using students as subjects in behavioral research experiments is that they are not representative of the broad population of accounting information users. ANSWER: True 31. Agency theory studies are always inductive. ANSWER: False 32. One hypothesis of agency theory is that management attempts to maximize its own welfare by minimizing the various agency costs arising from monitoring and contracting. ANSWER: True 33. Agency theory holds that management always tries to maximize the value of the firm. ANSWER: False

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34. Information economics research is usually inductive in nature. ANSWER: False 35. Information economics has relatively recently included agency theory assumptions in its analysis. ANSWER: True 36. Critical accounting discourages active social roles for accountants. ANSWER: False 37. Critical accounting research assumes a sharp separation between the researcher and his or her field of investigation. ANSWER: False 38. Of the research methods discussed in the text, the critical accounting approach is the closest to the standard-setting function. ANSWER: False 39. Currently accepted alternative depreciation methods illustrate that accounting is closer to an art than a science. ANSWER: True 40. Because accounting is not very much concerned with the human element, we can expect it to be more precise in its measurement and predictions than are the natural sciences. ANSWER: False MULTIPLE CHOICE 1. Which of the following examines or tests data, usually from a sample of a population, to make inferences about the population? a. Deductive reasoning b. Inductive reasoning c. Subjective reasoning d. Objective reasoning ANSWER: B

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2. When the premises of a theory are constructed so that they can be tested by statistical inference, they are usually called: a. Postulates. b. Inferences. c. Hypotheses. d. Assumptions. ANSWER: C 3. Judging a theory by observing evidence rather than simply by its internal logic is called: a. Subjective reasoning. b. Inductive reasoning. c. Deductive reasoning. d. Objective reasoning. ANSWER: B 4. Which of the following is not a characteristic of good inductive accounting theory research? a. It must carefully specify the problem that is being examined. b. It must be based on a hypothesis that is capable of being tested. c. It must test the entire population under investigation. d. It must employ the requisite tools of statistical inference. ANSWER: C 5. Which of the following types of research can realistically examine only rather narrowly defined questions and problems? a. Inductive research b. Normative research c. Deductive research d. Nonempirical research ANSWER: A 6. The basic set of premises in a theory are also sometimes called all of the following except: a. Hypotheses. b. Assumptions. c. Postulates. d. Positions. ANSWER: D 7. Empirical research that attempts to determine why particular accounting alternatives are selected by management is an example of: a. Normative research. b. Deductive research. c. Positive accounting research. d. Analytical research. ANSWER: C

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8. Which of the following statements is not true? a. Inductive and deductive methods can be used together. b. It is impossible to keep inductive research completely value-free. c. Inductive approaches to accounting theory usually attempt to be descriptive. d. Deductive research makes inferences about a population based on tests of data. ANSWER: D 9. Which of the following characteristics does not apply to the decision-model approach to research? a. It asks what information is needed for making decisions. b. It asks what information users want. c. It concentrates on what information is useful for particular decisions. d. It has a normative and deductive orientation. ANSWER: B 10. Which one of the following statements is true regarding the decision-model approach to research? a. A premise underlying this research approach is that decision makers may need to be taught how to use information they are unfamiliar with. b. This approach has become more important with the rise of empirical research in accounting. c. Some advocates of newer approaches have declared that this approach is too scientific. d. The decision-model approach does not parallel those of standard-setters because standardsetters must cope with the politics of the regulatory process. ANSWER: A 11. Which of the following statements is not true regarding the efficient-markets hypothesis? a. It stems primarily from the discipline of finance. b. It assumes that market prices of publicly traded securities reflect fully all publicly available information. c. As a result of this proposition, the impetus for less disclosure with more concern for choice among accounting alternatives has grown stronger. d. It states that the return of a security is based on its risk. ANSWER: C 12. Which of the following statements regarding behavioral research is true? a. It is a normative approach. b. The main concern of this type of research is how users of accounting information make decisions and what information they need. c. Many studies have shown that there are no discrepancies between normative decision models and the actual decision process of users. d. Since behavioral research is positive in approach, it is impossible to reach a conclusion regarding whether or not the usage of accounting data for decision-making purposes could be improved upon. ANSWER: B

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13. Which of the following statements regarding behavioral research in accounting is not true? a. Much of this research uses laboratory subjects in carefully controlled experimental situations. b. This approach seeks to understand what accounting information is selected for use and how it is processed. c. This research has found that published financial statements are not often used for managerial decision-making purposes. d. The question of how representative student subjects are to the broad population is a problem that pervades virtually all behavioral research that uses student subjects. ANSWER: C 14. The roots of behavioral research lie in the field(s) of: a. Economics. b. Finance. c. Psychology and sociology. d. Accounting. ANSWER: C 15. Agency theory studies are a special case of: a. Capital markets research. b. The decision-model approach. c. Critical accounting. d. Behavioral research. ANSWER: D 16. Which of the following is not true regarding agency theory? a. It is also called contracting theory. b. Its underlying assumption is that individuals act in their own best self-interest. c. Few agency relationships between parties may be defined or governed by accounting numbers. d. It is concerned with the various costs of monitoring and enforcing relations among management, owners, creditors, and government. ANSWER: C 17. The objective of information theory analysis is: a. To determine how optimal contractual arrangement incentives and risk sharing can be negotiated. b. To determine appropriate alternatives to accrual accounting. c. To use inductive research techniques to test hypotheses regarding information usefulness. d. To find alternatives to agency theory assumptions. ANSWER: A

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18. Critical accounting: a. Developed from two other areas of accounting, behavioral accounting and agency theory. b. Is concerned with the economic rather than social role of accountants. c. Presumes a sharp separation between the researcher and his or her field of investigation. d. Views accounting as having a pivotal role in adjudicating conflicts between the corporation and constituencies such as labor, consumers, and the general public. ANSWER: D 19. Which of the following statements is not true regarding critical accounting? a. Critical accountants believe that accounting should more strongly emphasize the attempt to solve broad societal problems. b. Critical accounting researchers believe that in viewing and investigating reality, they also help to shape that reality. c. It is the intention of critical accounting researchers to move the field into the mainstream of accounting research by adopting a conflict-based perspective. d. In critical accounting, there is less emphasis upon historical models and more upon mathematical and statistical models. ANSWER: D 20. Which of the following statements is true? a. A paradigm is a shared problem-solving view among members of a science or discipline. b. In accounting, the shared paradigm has been current valuation. c. Criticism of historical cost has increased since inflation lessened during the 1980s. d. It appears that a scientific revolution has occurred in accounting because historical cost is no longer the dominant paradigm. ANSWER: A 21. In which of the following research areas do researchers believe that there is not a sharp separation between the researcher and his or her field of investigation? a. Information economics b. Critical accounting c. Capital markets research d. Agency theory ANSWER: B 22. Which of the following research areas hypothesizes that management attempts to maximize its own welfare by minimizing costs of monitoring and contracting? a. Information economics b. Critical accounting c. Capital markets research d. Agency theory ANSWER: D

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23. Which of the following accounting research areas is based on the efficient-markets hypothesis? a. The decision-model approach b. Behavioral research c. Critical accounting d. Capital markets research ANSWER: D 24. Empirical research is: a. Inductive. b. Deductive. c. Analytical. d. None of the above ANSWER: A 25. In a scientific approach to accounting: a. A great deal of latitude is allowed in measurements. b. There is a low degree of objectivity. c. The intention is to provide information useful for either predictive or assessment purposes. d. The straight-line method of depreciation would always be used. ANSWER: C 26. Which of the following accounting research approaches arose as a result of the perceived separation of interests in the modern corporation between management and ownership interests? a. Capital markets research b. Behavioral research c. Agency theory d. Information economics ANSWER: C ESSAY 1. Discuss the differences between each of the following: • • •

Normative vs. descriptive theories Inductive vs. deductive reasoning Global vs. particularistic theories

Also identify how these types of approaches relate to one another. (For example: is deductive research normative or descriptive; is it global or particularistic?) ANSWER: Normative theories contain at least one value judgment, or premise, saying how things should be. Descriptive theories try to find relationships that actually exist and attempt to be value-free. Inductive reasoning examines or tests data, usually a sample from a population, and makes inferences about the population. Deductive reasoning uses logic to derive one or more conclusions from a set of premises. Global theories are all-encompassing in nature, while particularistic theories focus on only a small part of the relevant environment, examining rather

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narrowly defined questions and problems. Deductive research tends to be normative and global. Inductive approaches are usually descriptive and particularistic. 2. A study by Watts and Zimmerman that explored the question of how corporate management responds to new standards proposed by the FASB was discussed in the text. Answer the following questions related to that study. a. b. c. d.

What was the hypothesis of the study? Describe the study and discuss its findings. Was the study inductive or deductive? Explain. Discuss the criticisms that have been directed at the study and the implications of those criticisms.

ANSWER: a. Watts and Zimmerman hypothesized that management has more incentive to favor standards that lower reported net income when the firm is subject to political pressures, such as antitrust action or regulation because of their dominant market position. b.

Watts and Zimmerman examined responses to the FASB's exposure draft requiring general price-level adjusted income calculations in corporate annual reports. They found that the proposal was supported by larger firms that would have lower income as a result of general price-level adjustment. Larger firms that would have higher income using general price-level adjustment tended to be against the proposal. These findings supported their hypothesis.

The study was inductive because it tested actual data (responses to the exposure draft) from a sample of firms and made inferences about the relevant population.

Solomons stated that Watts and Zimmerman's evidence is rather flimsy because it involves a relatively small number of firms, a single accounting issue, and a single point in time. He also noted that many of the firms that lobbied in favor of general price-level-adjustments were not using already available techniques, such as accelerated depreciation and LIFO, which would have reduced reported income. Also, several large firms that would have had lower general price-level-adjusted income relative to historical cost income lobbied against the proposed standard. This implies that the premise of the study, that large firms would be in favor of standards that decrease income, would be applicable only to a very small handful of very large firms. These criticisms show that empirical research in an area involving human behavior is subject to many interpretations and must be used carefully if inferences relative to the standard-setting process are to be drawn from the research.

3. Are inductive and deductive research mutually exclusive methods? Give examples to support your answer. ANSWER: Inductive and deductive research techniques are not mutually exclusive and are often used together. For example, the inductive method may be used to assess the appropriateness of a set of originally selected premises in a primarily deductive system. Researchers often work backward from the conclusions of other studies by developing new hypotheses that appear to fit the data. They then attempt to test the new hypotheses. Inductive research in accounting can shed light on

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relationships and phenomena existing in the business environment. This research, in turn, can be useful in the policy-making process in which deductive reasoning helps to determine rules that are to be prescribed. 4. Describe the decision-model approach to accounting research and identify the two major decisions embraced by this approach. ANSWER: The decision-model approach to research asks what information is needed by decision makers. It does not address what information users want but rather concentrates on what information is useful for a particular decision. Its orientation is normative and deductive. The two major decisions embraced by this approach are: (1) enabling the user to better predict future cash flows; and (2) analyzing the efficiency and effectiveness of management (stewardship) as well as subcategories of both these major types of decisions. 5. Answer the following related to behavioral research: a. b. c.

What is the main concern of behavioral research? How does behavioral research differ from the decision-model approach? What are some of the findings of this research?

ANSWER: a. The main concern of behavioral research is how users of accounting information make decisions and what information they need. b.

This approach is descriptive, whereas the decision-model approach is normative. Also, much of behavioral research uses laboratory subjects in carefully controlled experimental situations.

Many behavioral studies have shown discrepancies between normative decision models and the actual decision processes of users. Also, revision of probabilities by decision-makers occurs less than Bayesian decision models indicate is appropriate. Other research has found that there may be a tendency to use published financial statements for managerial decision-making purposes.

6. Answer the following questions regarding agency theory: a. b. c.

What are the assumptions, focus, and hypothesis of agency theory? How does opportunistic behavior, or moral hazard apply to agency theory? How does an audit of financial statements pertain to agency theory?

ANSWER: a. The underlying assumption of agency theory is that individuals act in their own best self-interest. Another assumption is that the enterprise is the intersection point for many contractual-type relationships that exist among management, owners, creditors, and government. As a result, agency theory is concerned with the various costs of monitoring and enforcing relations among these various groups. One hypothesis of agency theory is that management attempts to maximize its own welfare by minimizing the various agency costs arising from monitoring and contracting. b.

According to agency theory, management will try to maximize its compensation, but

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must do so within the framework of increasing net income, return on investment, or similar accounting measures. While the main management drive will usually be toward improving performance, management may also attempt to choose accounting rules that maximize income immediately rather than over time in order to maximize its own compensation. In this case, management actions may not always be in the best interest of stockholders. This is called opportunistic behavior or moral hazard. c.

The audit minimizes agency costs, and is an example of efficient contracting. It attempts to give assurances to outsiders, such as owners and creditors, about the governance of the enterprise by management.

7. What is critical accounting, and in what way does it differ from all of the other research areas discussed in the text? ANSWER: Critical accounting views accounting as having a pivotal role in adjudicating conflicts between the corporation and social constituencies such as labor, consumers, and the general public. It is thus directly concerned with the active social role of accountants. All of the other research areas discussed in the text presume a sharp separation between the researcher and his or her field of investigation. Critical accounting researchers believe that in observing and investigating reality, they also help shape that reality.

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TRUE/FALSE 1. The accounting profession has been regulated by Congress since the 1880s when it became clear that accounting was an important instrument in America for conducting business. ANSWER: False 2. The SEC was created by Congress to replace the AICPA's standard-setting group. ANSWER: False 3. The SEC is legally empowered to regulate accounting principles. ANSWER: True 4. Most of the responsibility for establishing accounting principles has remained with the private sector rather than the SEC. ANSWER: True 5. The Securities Act of 1933 and the Securities and Exchange Act of 1934 were the first national securities legislations in the United States. ANSWER: True 6. The Journal of Accountancy was founded by the American Association of Public Accountants in 1905. ANSWER: True 7. The American Accounting Association was originally called the American Society of Certified Public Accountants. ANSWER: False 8. The Committee on Accounting Procedures (CAP) used a formalized deductive approach to develop a comprehensive accounting theory. ANSWER: False 9. The Committee on Accounting Procedures (CAP) represented the profession's first sustained attempt to develop workable financial accounting rules. ANSWER: True 10. APB Opinions were originally expected to be based on in-depth research studies. ANSWER: True

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11. The Trueblood Study Group formed the FASB and called for significant changes in the establishment of financial accounting standards. ANSWER: False 12. The responsibility of the Financial Accounting Foundation is to elect the board of trustees, which selects FASB members, funds the board's activities, and performs the oversight role. ANSWER: True 13. The FASB has made more extensive use of research than did its predecessors. ANSWER: True 14. FASB statements have resulted in a more conservative balance sheet and immediate recognition of events on the income statement. ANSWER: True 15. The Accounting Standards Executive Committee of the AICPA (ASEC) and the Emerging Issues Task Force (EITF) were established to solve the problems of particular industries as well as narrow technical issues. ANSWER: True 16. A normal four-to-three majority vote is required for passing new accounting standards. ANSWER: True 17. The Federal Litigation Reform Act of 1995 replaced the previous proportionate liability requirement with joint and several liability for damages suffered by third parties who rely on the financial statement of firms attested to by CPAs. ANSWER: False 18. The AICPA has exclusive authority in the private sector for promulgating auditing rules. ANSWER: False 19. Congress has recently been concerned with the laxity of auditors in detecting and disclosing fraud. ANSWER: True 20. An important role of the AICPA is to curb "shopping for accounting principles." ANSWER: True

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21. An annual report to stockholders prepared using FASB accounting standards generally has more disclosure of nonfinancial statement information than does the typical annual report filed with the SEC. ANSWER: False 22. The Litigation Reform Act of 1995 requires that an audit include procedures designed to guarantee that illegal acts that would materially affect financial statements will be detected. ANSWER: False 23. The importance of the auditing function relative to the management consulting function is declining in major auditing firms. ANSWER: True 24. A problem with the increased importance of the management consulting function in auditing firms is the possible erosion of the integrity of the auditing function. ANSWER: True 25. The AICPA has developed an electronic filing of financial data called EDGAR. ANSWER: False 26. FASB lost a significant amount of independence from the SEC due to Sarbanes-Oxley’s passage. ANSWER: True 27. The International Accounting Standards Board’s role in establishing standards has decreased significantly since 2002. ANSWER: False MULTIPLE CHOICE 1. Which of the following characteristics does not apply to accounting practices and procedures in the U.S. prior to 1930? a. They were applied uniformly among companies. b. They were considered confidential by the companies applying them. c. They met the needs of creditors to a greater extent than they met the needs of shareholders. d. They emphasized the disclosure of cash and near-cash resources. ANSWER: A

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2. Which of the following was an accomplishment of the American Association of Public Accountants? a. The passage of a law in 1896 that created the professional designation of "Certified Public Accountant" b. The founding of The Journal of Accountancy in 1905 c. The development of a list of terms and definitions in 1915 d. All of the above ANSWER: D 3. In 1918, the American Institute of Accountants (AIA) worked with which of the following organizations to publish minimum standards for conducting a balance sheet audit? a. The Federal Trade Commission (FTC) b. The Securities and Exchange Commission (SEC) c. The American Society of Certified Public Accountants d. The New York Stock Exchange (NYSE) ANSWER: A 4. Which state passed the law that first created the designation "Certified Public Accountant"? a. Massachusetts b. California c. Ohio d. New York e. Iowa ANSWER: D 5. Which of the following factors led to significant changes in accounting practices? a. The Great Depression of 1929 b. The election of Franklin D. Roosevelt to the presidency in 1932 c. The enactment of the New Deal legislation d. All of the above ANSWER: D 6. Which of the following is not true regarding Accounting Series Release No. 4? a. It stated that financial statements filed with the SEC and prepared in accordance with accounting principles for which there is no substantial authoritative support would be presumed to be misleading. b. It implied that the SEC might in the future determine acceptable accounting practices and mandate methods to be used in reports filed with it. c. It established an authoritative body for the development of accounting standards. d. It indicated that the SEC was growing impatient with the accounting profession. ANSWER: C

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7. Which of the following is true regarding the Committee on Accounting Procedures (CAP)? a. It developed a comprehensive statement of accounting principles. b. It adopted a policy of attacking specific problems and recommending preferred methods of accounting when possible. c. It was formed by the SEC in 1936. d. It eliminated the use of alternative accounting practices by establishing an underlying accounting theory. ANSWER: B 8. The Committee on Accounting Procedures (CAP) was immediately succeeded by: a. The Financial Accounting Standards Board (FASB). b. The Accounting Principles Board (APB). c. The Accounting Research Board (ARB). d. The Financial Accounting Foundation (FAF). ANSWER: B 9. Which of the following was a controversial issue faced by the Accounting Principles Board (APB)? a. The investment tax credit b. Income tax allocation c. Business combinations and goodwill d. All of the above ANSWER: D 10. What was the purpose of APB Statement 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises? a. To provide a foundation for evaluating existing accounting practices b. To assist in solving accounting problems and to guide the future development of financial accounting c. To enhance understanding of the purposes of financial accounting d. All of the above ANSWER: D 11. Criticism of the standard-setting process under the APB included: a. Exposure for tentative opinions was too limited and occurred too late in the process. b. The standard-setting process was too long and subject to too many outside pressures. c. Both a and b d. None of the above ANSWER: C

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12. In which of the following ways did the charge to the Financial Accounting Standards Board (FASB) differ from that given to the Accounting Principles Board (APB)? a. The FASB was to establish standards of financial accounting and reporting in the most efficient and complete manner possible. b. The FASB was to work toward standard setting with a two-pronged approach. c. The FASB was expected to stipulate principles of accounting as an underlying framework. d. The accounting standards established by the FASB were to be advisory rather than mandatory. ANSWER: A 13. Which of the following are true regarding the Financial Accounting Standards Board (FASB)? a. The FASB includes ten members, each serving a term of three years. b. Each member of the FASB must be a Certified Public Accountant. c. There must be no conflict between the FASB members' private interest and the public interest. d. All of the above are true. ANSWER: C 14. The establishment of which of the following groups has resulted in a challenge to the FASB's standard-setting powers? a. The Governmental Accounting Standards Board (GASB) b. The Emerging Issues Task Force (EITF) c. The Accounting Standards Executive Committee (AcSEC) d. All of the above ANSWER: D 15. The liability concept that restricts liability to each defendant's share of the damages based upon the judge or jury's assessment of their share of the damages is called: a. Proportionate liability. b. Compensatory liability. c. Joint and several liability. d. Disproportionate liability. ANSWER: A 16. The liability concept that can result in one party having to pay for more than its proportionate share of damages is called: a. Proportionate liability. b. Compensatory liability. c. Joint and several liability. d. Punitive liability. ANSWER: C

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17. Post-SOX, the accounting/auditing standards setting function has been relegated to a. The FASB alone b. The FASB and the PCAOB c. The AICPA d. The IASB ANSWER: B 18.Which of the following professional associations has an interest in the accounting standard-setting process? a. The AICPA b. The Financial Executives Institute (FEI) c. The American Accounting Association (AAA) d. All of the above ANSWER: D 19. Which of the following events resulted in shareholders’ beginning to question whether accounting and reporting practices were adequate to assess investments? a. The stock market crash of 1929 b. The federal government's lump-sum payments for the retirement of Liberty Bonds c. The creation of the SEC in 1934 d. None of the above ANSWER: A 20. In 1930 the AICPA began working with which of the following organizations to prepare "five broad accounting principles," one of the most important documents in the development of accounting rule making? a. The SEC b. The NYSE c. The AAA d. The FTC ANSWER: B 21. Which of the following represented the first formal attempt to develop "generally accepted accounting principles"? a. "Approved Methods for the Preparation of Balance Sheet Statements" in 1918 b. "Five broad accounting principles" in 1932 c. Accounting Research Bulletin (ARB) 43 d. The FASB's conceptual framework project ANSWER: B

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22. Which of the following is a true statement? a. The SEC initially required the accounting profession to consult with it before setting any specific accounting principles. b. The SEC was created by Congress to oversee the accounting profession. c. The SEC was given authority to prescribe the form and content of financial information filed with the SEC. d. The SEC formed the Committee on Accounting Procedure to develop a comprehensive set of accounting principles. ANSWER: C 23. Which of the following is true regarding the Emerging Issues Task Force (EITF)? a. It has formal authority to establish GAAP. b. Members of this group consist of CEOs of six major corporations and the chief accountant of the SEC. c. It is concerned with highly technical issues, such as financial instruments, which may affect firms in virtually every industry. d. All of the above ANSWER: C 24. Major complaints aimed at the FASB's standard setting process include: a. The cost of preparing standards is too high. b. Some standards are very difficult to understand. c. Both a and b d. None of the above ANSWER: C 25. Which of the following bodies was created to deal with municipal accounting issues? a. GASB b. FASB c. FAF d. EITF ANSWER: A 26. In which of the following ways has the Financial Executives Institute (FEI) become involved in the accounting standard-setting process? a. By funding research projects in accounting and related areas b. By reviewing FASB discussion memorandums and exposure drafts and communicating an official position to FASB. c. By participating in FASB public hearings d. All of the above ANSWER: D

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27. Which of the following are characteristics of the FASB? a. It is part of the AICPA. b. Members are part-time employees of the FASB. c. A member must be a CPA. d. It makes more extensive use of research than its predecessors. ANSWER: D 28. The accounting standard-setting process begins with which of the following steps? a. A problem is identified. b. A task force is formed. c. Public hearings are held. d. An exposure draft is issued. ANSWER: A 29. Which of the following is NOT true regarding the PCAOB? a. The PCAOB is a governmental sector regulatory body. b. The PCAOB is overseen by the SEC. c. The PCAOB was established by the Sarbanes-Oxley Act. d. The PCAOB has authority to set auditing standards. ANSWER: A 30. Which former Special Prosecutor attempted to have the Sarbanes-Oxley Act of 2002 ruled to be unconstitutional? a. John G. Roberts b. Ruth Bader Ginsberg c. James Patterson d. Kenneth W. Starr ANSWER: D 31. Which of the following is NOT true regarding the passage of the Sarbanes-Oxley (SOX) Act? a. SOX more clearly defined auditor independence. b. SOX was intended to erode public confidence in the accounting profession due to recent scandals. c. SOX replaced peer review with inspection by the PCAOB d. SOX implementation became the immediate focus of public companies and CPA firms. ANSWER: B

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ESSAY 1. Why did accounting and reporting practices in the U.S. prior to 1930 not meet the needs of shareholder investors? ANSWER: In the U.S. prior to 1930, accounting was unregulated and accounting practices and procedures were considered confidential. This resulted in a lack of uniformity in accounting practices among companies, both from year to year and within the same industry. Also, the American public did not invest large sums in private corporations until the 1920s, when private corporations were expanding, and both they and government leaders encouraged the public to invest in stock. Before that time, banks and other creditors were the primary users of financial information, resulting in an emphasis on a company's debt-paying ability. When individuals began investing in corporate stock, financial reporting lagged behind and continued to be prepared primarily for the needs of creditors. It wasn't until the stock market crash of 1929 that shareholders began to question whether accounting and reporting practices were adequate to assess investments. 2. Compare and contrast the characteristics of the CAP, APB, and FASB. ANSWER: The FASB is separate from the AICPA, while the CAP and the APB were part of the AICPA. FASB members are more independent since they are full-time employees of the FASB. CAP and APB members were also employed elsewhere, usually by a CPA firm. FASB members need not be a CPA. CAP and APB members were required to be CPAs. The FASB allows for a more extensive due process. The CAP engaged in little if any due process and the APB engaged in only very limited due process. The FASB succeeded in developing a conceptual framework, something the CAP did not attempt and the APB failed to accomplish. FASB also makes more extensive use of research than did its predecessors and has been more productive. 3. Discuss the steps in the accounting standard-setting process and explain why it may not be capable of dealing with the complex environment of the 2000s and beyond. ANSWER: The standard-setting procedure starts with the identification of a problem. A task force then explores all aspects of the problem and circulates a discussion memorandum that identifies the issues and possible solutions. The FASB then convenes a public hearing where interested parties may make their views known to the board. An exposure draft of the final standard is then issued and written comments requested. After consideration of written comments, either a revised exposure draft is issued or a final vote is taken by the board. Five votes are needed for the issuance of a final standard. The FASB process developed in the 1970s may not be capable of dealing with the more complex environment of the 1990s and beyond. Financial markets are now globalized, communication is almost instantaneous, institutions are more competitive, and information technology makes it possible to better determine current valuations of both assets and liabilities. Secondly, some nonfinancial measures may correlate more closely with security prices than financial measures such as income that are addressed in the typical financial statements generated under GAAP. An additional issue involves how the conceptual framework might need to be amended and extended to adapt to newly emerging types of business.

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4. How has the Government Accounting Standards Board (GASB) challenged the FASB's standard setting powers? ANSWER: The GASB establishes another jurisdiction. It was created by the FAF in 1984 to deal with municipal accounting issues. However, its responsibilities overlap with those of the FASB. Separately issued general-purpose financial statements of such entities as hospitals, colleges and universities, and pension plans are supposed to utilize FASB standards except where the GASB has issued a particular standard covering a specific type of entity or a precise economic practice or activity. As a result of this overlap, GASB standards tend to "muscle out" particular FASB standards for governmental entities.

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5. Discuss what is meant by "the liability crisis in public accounting." How did the Federal Litigation Reform Act of 1995 address this issue? ANSWER: There has been tremendous pressure to turn the audit into a fraud detection mechanism with the auditor to report to the SEC, in the case of publicly traded companies, if management and the board of directors do not take corrective action. Though auditors share some of the blame when fraud is undetected, there have been some inherent problems in the legal system combined with the fact that auditors are seen to have very "deep pockets." Prior to the Federal Litigation Reform Act of 1995, auditors in both federal and state cases were subject to joint and several liability for damages suffered by third parties who relied on the financial statements of firms attested to by CPAs. Auditors could be stuck with more than their proportional share of judgments. Under the 1995 Act, joint and several liability is not applicable in federal court unless the defendant knowingly violates security laws. The Act replaced joint and several liability with proportionate liability which restricts liability to each defendant's proportionate share of the damages based upon the judge’s or jury's assessment of their share of the damages. 6. Describe the controversy surrounding the issuance of APB Opinion No. 2, which addressed the investment tax credit? How did the APB resolve this controversy and what was the resulting effect on the board's authority? ANSWER: The accounting profession was divided on how to account for the investment tax credit. Two alternatives existed: (1) recognize the tax benefit in the year received (the flow-through method), or (2) recognize the tax benefit over the life of the related asset (the deferral method). The APB did not commission a research study on the subject and issued Opinion No. 2, which opted for the deferral method. Three large CPA firms made it known that they would not require their clients to follow the opinion and the SEC continued to allow its registrants to use either method. As a result of this challenge to its authority, the APB issued Opinion No. 4, which permitted the use of either method. This successful challenge caused the binding authority of APB opinions to be questioned in the press for several years. 7. Explain how Sarbanes-Oxley of 2002 significantly changes how the FASB will operate in the future. ANSWER: The FASB’s funding originally came from accounting firm contributions and publication sales. Sarbanes-Oxley now requires that FASB be funded through an assessment of annual fees on public companies and accountants. This change increases FASB’s independence from the constituents it serves, but increases its dependence on the SEC. Now the SEC potentially controls FASB’s funding by its recognition. If not recognized by the SEC, FASB cannot assess fees required for operations. Laws are now in place to make movement to 100% government regulation relatively simple should the FASB fail to restore the public's confidence in the accounting profession.

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How and why did the AICPA’s role change under Sarbanes-Oxley? ANSWER: The AICPA no longer has exclusive authority in the private sector for promulgating auditing standards. The Auditing Standards Board advises the PCAOB before it sets auditing, attestation, and quality control standards. Audit firms became more advocates for clients than protectors of the public interest and the AICPA campaigned for a broader certification that deemphasized the CPA’s auditing responsibilities, leading to the lose of its role as police officer for self-regulation.

9. How might the AICPA regain some of the power it has lost over the years? Are there any disadvantages to these proposals? ANSWER: The AICPA might regain some power by becoming the standard-setting body for smaller firms – referred to as baby GAAP. There has been some question whether this differentiation should be small firms versus large firms or public versus privately owned firms. The FASB has joined with the AICPA in proposing that the AICPA participate in a separate standards-setting process for private companies. Disadvantages of this proposal are that this would add complexity to the standards-setting process, and make the AICPA the representative of the privately owned firms. Another important role for the AICPA is to curb opinion shopping, where clients try to find an auditing firm who will either “lowball” its bid to secure a client or will go along with a questionable accounting method that the client desires to employ. The AICPA had been attempting to strengthen professional standards and rules of performance and behavior. Also, the AICPA has formed the AICPA Special Committee on Financial Reporting, which was given the charge of recommending what additional information management should provide for users and the extent to which auditors should report on the information.

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TRUE/FALSE 1. Financial reporting for publicly-listed companies in the United States was first regulated in the 1950s. ANSWER: False 2. Congress empowered the Securities and Exchange Commission (SEC) to regulate financial reporting in the 1930s. ANSWER: True 3. The SEC has allowed accounting policy-making power to remain in the private sector. ANSWER: True 4. Arguments supporting unregulated markets are largely inductive in nature. ANSWER: False 5. All of the arguments supporting the case for unregulated markets relate to the incentives for a firm to report information about itself to owners and to the capital market in general. ANSWER: True 6. Empirical tests of the free market position are impossible since we live in a regulated environment. ANSWER: True 7. Agency theory explains that firms have an incentive to report voluntarily to the capital market because they are competing for risk capital. ANSWER: False 8. The major agency relationship is between the management of a firm and the firm's creditors. ANSWER: False 9. Good financial reporting will lower a firm's cost of capital. ANSWER: True 10. Only firms that perform well have incentives to report their operating results. ANSWER: False 11. According to signalling theory, firms have an economic incentive to report bad news. ANSWER: True

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12. The value of a company can be increased when the firm voluntarily reports private information about itself if the information reduces uncertainty about the firm's future prospects. ANSWER: True 13. There is usually information symmetry between the firm and outsiders. ANSWER: False 14. Early adoption of new financial accounting standards generally indicates "bad news" whereas late adoption generally indicates "good news." ANSWER: False 15. The stock market shows that people are willing to contract privately for information about a firm. ANSWER: True 16. An argument in favor of unregulated markets is that because of private opportunities to contract for information, market intervention in the form of mandatory disclosure rules is both unnecessary and undesirable. ANSWER: True 17. An argument supporting accounting regulation is that it is better to force mandatory reporting than to have individuals competing to buy information privately. ANSWER: True 18. An argument supporting accounting regulation is that the production costs of mandatory reporting requirements may be small since most of the basic information is produced as a byproduct of internal accounting systems. ANSWER: True 19. Risk in investment can be eliminated by improved accounting and auditing procedures. ANSWER: False 20. Accounting regulation prevents fraud. ANSWER: False 21. Public goods are commodities that, once consumed, reduce the opportunity for consumption by others. ANSWER: False

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22. True market demand for public goods may be determined by the number of consumers who pay for the goods. ANSWER: False 23. An argument supporting regulated markets is that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from frauds and failures. ANSWER: True 24. An argument supporting regulation is that the only way to increase production of public goods to meet the real demand of the public is through regulatory intervention. ANSWER: True 25. Accounting information is a public good. ANSWER: True 26. Information symmetry exists when potential investors do not all have equal access to the same information. ANSWER: False 27. Proregulation arguments as well as arguments for unregulated markets are largely deductively reasoned rather than empirically researched. ANSWER: True 28. There is a tendency for overproduction in unregulated markets. ANSWER: False 29. The Impossibility Theorem implies that once the free market pricing system is abandoned, there is no way of determining aggregate social preferences. ANSWER: True 30. Overproduction of accounting information, or the problem of standards overload, has the greatest effect on large, publicly traded companies. ANSWER: False 31. The present financial disclosure system imposes costs on users rather than the companies themselves. ANSWER: False

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32. In setting policy, due process means that a regulatory agency seeks to involve all affected parties in its deliberations. ANSWER: True 33. Sarbanes-Oxley has brought about a separation between auditing and management consulting. ANSWER: True MULTIPLE CHOICE 1. Which of the following is not an argument supporting unregulated markets? a. Agency theory b. Private contracting opportunities c. Signalling theory d. Social goals ANSWER: D 2. Which of the following concepts provides a framework for analyzing financial reporting incentives between managers and owner? a. Signalling theory b. Agency theory c. Information symmetry d. Private contracting ANSWER: B 3. Which of the following concepts explains why firms have an incentive to report voluntarily to the market even if there were no mandatory reporting requirements? a. Signalling theory b. Life-cycle theory c. Information overload d. Capture theory ANSWER: A 4. Which of the following concepts holds that anyone who genuinely desires information about a firm is able to obtain it? a. Signalling theory b. Agency theory c. Information symmetry d. Private contracting ANSWER: D

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5. Which of the following concepts holds that voluntary disclosure is necessary in order for a firm to compete successfully in the market for risk capital? a. Signalling theory b. Agency theory c. Information symmetry d. Private contracting ANSWER: A 6. Which of the following is not a possible justification for regulated markets? a. Possible market failure b. Natural monopolies c. The possibility that free markets are contrary to social goals d. Private contracting opportunities ANSWER: D 7. Which of the following has been cited as a reason for the alleged low quality of financial reporting, even under regulation? a. Not enough management flexibility in the choice of accounting policies b. Poor accounting and auditing standards c. Laxity by securities analysts d. All of the above ANSWER: B 8. Goods that possess hard property rights so that nonpurchasers are excluded from consuming them are called: a. Public goods. b. Regulated goods. c. Private goods. d. Underproduced goods. ANSWER: C 9. An externality exists if: a. A producer of a good is unable to impose production costs on all users of the good. b. True market demand for a good is revealed in the market place. c. Production of a good equals true market demand. d. The production of a good is regulated. ANSWER: A 10. The effect of an externality is that: a. Production of a public good equals market demand. b. Production of a private good equals market demand. c. True market demand for public goods may be determined by the number of consumers that pay for the goods. d. The producer of a public good has a limited incentive to produce it because all consumers cannot be charged for the good. ANSWER: D Accounting Theory: 8th edition

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11. Which of the following is considered a social goal related justification for imposing financial reporting regulation? a. Information symmetry b. Comparability c. A competitive capital market d. All of the above ANSWER: D 12. Which of the following does not apply to a codificational system such as accounting standards? a. It is pragmatic because maximizing the standards is impossible. b. Outputs are evaluated on the basis of whether they work correctly. c. Outputs are evaluated on the basis of whether they provide information to users at a reasonable cost. d. Outputs are correct in terms of deductive logic. ANSWER: D 13. Mandatory public reporting of financial information: a. Enhances the perceived fairness of the capital market. b. Increases the total cost to society of obtaining the information. c. Results in costs greater than benefits. d. Requires companies to generate a lot of information that would not otherwise be produced by its accounting system. ANSWER: A 14. The focus of accounting regulation is on: a. Mandatory reporting. b. Improving the quality of reported information. c. Standards overload. d. Underproduction of accounting information. ANSWER: B 15. Which of the following is not a negative consequence of regulating accounting? a. A wealth transfer from nonusers to users of accounting information. b. The imposition of disclosure costs on the users of financial information. c. A potential overallocation of social resources to the production of free, publicly available accounting information. d. Benefits are received by the users of free accounting information while nonusers implicitly incur the production costs. ANSWER: B

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16. Which of the following is not a reason cited in the text for the failure of the CAP and the APB as regulatory bodies? a. The SEC did not officially endorse private-sector standard setting until 1973. b. The CAP and the APB lacked the necessary political structure to ensure their survival. c. Policy making was exposed to outside influence. d. There appeared to be no due process in the determination of accounting and disclosure rules. ANSWER: C 17. Which of the following theories argues that the group being regulated eventually comes to use the regulatory process to promote its own self-interest? a. Life-cycle theory b. Agency theory c. Signalling theory d. Contracting theory ANSWER: A 18. Life-cycle theory argues that: a. Regulation eventually becomes an instrument for protecting the information users. b. The regulatory body often protects the regulated group from competition. c. Regulation goes through several phases, but is never in the public interest. d. Both b and c. ANSWER: B 19. Prior to the FASB, accounting regulation was done primarily by: a. The SEC. b. The FTC. c. AICPA subcommittees. d. Large accounting firms. ANSWER: C 20. Which of the following groups is not listed in your text as being affected by accounting regulation? a. The FASB b. Companies c. Auditors d. Free riders ANSWER: A, however, the SEC does have approval of FASB’s annual budget.

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21. Which of the following is a reason that the FASB should closely watch the lobbying behavior of free riders? a. Responding to the interests of free riders could lead to an underproduction of accounting information. b. Free riders claim to be acting in the public interest but actually make the market less competitive. c. Free riders are not affected by accounting regulation. d. Free riders do not have the direct economic interests in information production that others have. ANSWER: D 22. Which of the following is not true about the FASB? a. It considers the economic consequences of proposed accounting policies. b. It has seriously considered the question of the desirability of corporate social responsibility accounting. c. It is sensitive to whether there are sufficient benefits to external users to warrant the imposition of new accounting standards. d. The FASB has commissioned studies to aid in assessing the effects of proposed standards on firms. ANSWER: B 23. When the FASB considers the effects of an accounting standard: a. The only costs it considers are auditing costs. b. It considers benefits primarily in terms of the information needs of the stock market. c. It is not concerned with producer costs. d. It is primarily concerned with the effects of the standard on small or nonpublicly listed firms. ANSWER: B 24. Democratic paralysis refers to: a. The tendency of decision making under due process to be extremely slow. b. The inability to achieve a consensus in the regulatory process. c. The argument that regulation is not a democratic policy. d. The inability of previous standard setting bodies to develop a conceptual framework. ANSWER: A 25. Which of the following statements is true? a. The problems of the FASB stem from its limited use of due process. b. The FASB has not been as successful as its predecessors were. c. Many studies have found that large accounting firms tend to dominate policy at the FASB. d. With the implementation of the FASB, the capture theory argument lost much of its validity. ANSWER: D

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ESSAY 1. What are the arguments favoring regulation of financial reporting? ANSWER: One argument supporting regulation is that it is in the public interest. Without regulation, there is the possibility of failure in the free market system because the firm is a monopoly supplier of information about itself. This situation creates the opportunity for restricted production of information and monopolistic pricing if the market is unregulated. Mandatory disclosure would result in more information and a lower cost to society. It is argued that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from fraud and failures. Another argument in favor of regulation is that accounting information is a public good, and public goods are underproduced in a free market. Underproduction of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met. It is also possible that free markets are contrary to social goals because they may not communicate enough information to the security markets, resulting in insiders having information that is not available to shareholders. In addition, the information that would be available in unregulated markets might not provide enough comparability among firms. A philosophical justification of the standard-setting process—called codification—is based on evolutionary improvement of accounting standards in an open and democratic society. The goal of the standard-setting process should be to provide the best standards from the societal point of view. 2. What are the arguments against regulation of financial reporting? ANSWER: The arguments supporting unregulated markets for accounting information are based on agency theory, signalling theory, and private contracting opportunities. Agency theory predicts a conflict between owners and managers. Owners are interested in maximizing return on investment and security prices, while managers desire to maximize their total compensation. Because of this potential conflict, owners incur costs monitoring agency contracts with management, and these costs reduce managers' compensation. Financial reporting is a way to mitigate this conflict to some extent, and allow owners to monitor employment contracts with their managers. Minimizing agency costs is an economic incentive for managers to report accounting results reliably to owners. Good reporting will enhance the reputation of a manager; and a good reputation should result in higher compensation because agency monitoring costs are minimized if owners perceive that accounting reports are reliable. Signalling theory explains why firms have an incentive to report voluntarily to the capital market: voluntary disclosure is necessary in order for firms to compete successfully in the market for risk capital. Insiders know more about a company and its future prospects than investors do; therefore, investors will protect themselves by offering a lower price for the company. However, the value of the company can be increased if the firm voluntarily reports (signals) private information about itself that is credible and reduces outsider uncertainty. Accounting Theory: 8th edition

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Another argument against regulation is the presumption that anyone who genuinely desired information about a firm would be able to obtain it by privately contracting for information with the firm itself, with the firm's owners, or indirectly with information intermediaries, such as stock analysts. If information were desired beyond that which is publicly available and free of charge, private individuals would be able to buy the desired information. In this way, market forces should result in the optimal allocation of resources to the production of information. 3. Discuss the regulation question in terms of determining and meeting the demand for accounting information. Who pays for and who benefits from accounting information? ANSWER: An argument in favor of regulation is that accounting information is a public good, and public goods are underproduced in a free market. Underproduction of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The people who consume public goods without paying for them are called free riders. True market demand for public goods is not revealed in the market place because free riders are able to use the goods at no cost. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met. There is another argument that regulated markets result in a tendency for overproduction. This overproduction can be avoided only if a pricing system can be imposed on public goods, creating nonpurchasers who are effectively excluded from consuming the good. If accounting information had to be purchased, such as through the SEC's EDGAR system, there would be incentives for users not to pass on the information to free riders. In this way, real economic demand for information could be determined, and production costs could be recovered from the real users of accounting information. By contrast, the present disclosure system imposes costs on companies rather than on users. One of the negative consequences of regulating accounting is that it results in a wealth transfer from nonusers to users of accounting information. A wealth transfer occurs because users receive the benefits of free accounting information while nonusers implicitly incur the production costs. 4. What is meant by "the paradox of regulation"? ANSWER: Arguments favoring regulation are that intervention in the form of mandatory reporting requirements are necessary to ensure that the real demand for accounting information is met and to provide the best standards from the societal point of view. However, economists have concluded that it is impossible to derive regulatory policies that will knowingly maximize the social welfare. Once the free market pricing system is abandoned, there is no way of determining aggregate social preferences. If the pricing system is working, aggregate social preferences are revealed through supply-demand equilibrium, and resources are allocated according to market prices. There is no comparable rule in a regulated market, so it is impossible to know if accounting regulation is producing the optimal quantity and quality of financial reporting.

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5. What is due process, and how has the political nature of regulation affected the CAP, the APB and the FASB? ANSWER: Due process means that a regulatory agency seeks to involve all affected parties in its deliberations. Due process is important in maintaining the legitimacy of the regulatory process. The CAP and APB failed as regulatory bodies for at least two reasons: (1)

They had only a weak mandate to regulate financial reporting. Until the issue of ASR 150 in 1973, the SEC did not officially endorse private-sector standard setting.

(2)

Their apparent lack of due process sometimes led to a low level of acceptance by affected parties.

From a regulatory viewpoint, the FASB is functioning much more successfully than did the CAP and the APB. Its standards were endorsed by the SEC in ASR 150 and due process has been adopted as standard procedure in debating and developing accounting policy. 6. What are the capture theory and the life-cycle theory of regulation, and how do they apply to the regulation of accounting? ANSWER: Capture theory and the life-cycle theory of regulation both argue that the group being regulated eventually comes to use the regulatory process to promote its own self-interest. When this occurs, the regulatory process is considered captured. The life-cycle theory of regulation argues that a regulatory agency starts out in the public interest, but later becomes an instrument for protecting the regulated group. From 1976 to 1978, the United States Congress investigated the allegation that accounting regulation had been captured by the Big Eight group of accounting firms, who were the predominant auditors of publicly listed corporations. Prior to the FASB, accounting regulation was done primarily by AICPA subcommittees, which were undoubtedly heavily influenced by the Big Eight accounting firms. However, with the implementation of the independent FASB, the capture theory argument lost much of its validity. Current practices of accounting regulation survived the scrutiny of Congress partly because capture theory and the life-cycle theory are less applicable to financial reporting. The number of parties directly affected by accounting regulation is much larger and more diverse than in traditional regulated industries. Auditors and other parties affected by accounting regulation, companies that must comply with regulations, and free riders who use the costless information for investment analyses have a divergence of interests, which place the accounting regulator in a more naturally neutral posture than is possible in other regulated industries.

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7. Describe Ronen's solution to the auditor behavior problem that involves the capture of auditors by auditees. ANSWER: Ronen suggests the creation of financial statement insurance which would be paid by the auditee to an outside insurance company. This insurance would cover both insurance payments to shareholders as a result of misrepresentation in financial statements and also auditor fees. In turn, the insurance carrier would select and pay the auditor. The amount of coverage and premium would be published, so those firms having higher coverage and relatively lower premiums would look best. The principal-agent relation is changed from firm and auditor to insurance carrier and auditor. If the insurance carrier selects a “low ball” auditor, it increases the risk of having to pay shareholders for sub-par audits. 8.

Discuss Ronen’s solution to the problem of companies “capturing” auditors as a result of management consulting contracts between auditor and auditee. ANSWER: Ronen suggests the creation of financial statement insurance which would be paid by the auditee to an outside insurance company. This insurance would cover both insurance payments to the shareholders as a result of misrepresentation in financial statements and also auditor fees. In turn, the insurance carrier would select and pay the auditor. The amount of coverage and premium would be published with those firms having higher coverage and relatively lower premiums looking best. If the insurance carrier selects a low ball auditor, it increases the risk of having to pay shareholders for sub-par audits.

What do Healy and Palepu propose as a remedy for the auditing process being reduced to a “complex checklist”? ANSWER: Healy and Palepu argue the auditing process has become a complex “checklist” which insulates the auditor from legal responsibilities for errors in the financial statements. They recommend that auditing firms make a professional judgment regarding the transparency of the financial statements, similarly to what is done by bond rating agencies. The stock exchanges would be involved to oversee the process. This should improve the quality of the information provided, though would likely also increase the cost of audits.

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Chapter 5—POSTULATES, PRINCIPLES, AND CONCEPTS

TRUE/FALSE 1. The APB was the first to successfully derive an underlying framework of postulates and principles. ANSWER: FALSE 2. ARS 1 and ARS 4 represent a milestone in the attempt to provide a unified theoretical underpinning for financial accounting rules by the APB. ANSWER: TRUE 3. One reason ARS 1 and ARS 3 fell short of the goal of obtaining a framework for APB accounting opinions is that the accounting profession refused to abandon historical cost. ANSWER: TRUE 4. Postulates are generally defined as basic assumptions that cannot be verified. ANSWER: TRUE 5. A principle contains elements observable by empirical techniques. ANSWER: FALSE 6. The key group in Moonitz's set of postulates consists of postulates stemming from accounting itself. ANSWER: FALSE 7. The key imperative postulate in ARS 1 appears to be stability of the monetary unit. ANSWER: TRUE 8. There are eight broad principles in ARS 3. ANSWER: TRUE 9. Accounting concepts have largely evolved from practical operating necessities, including income tax laws. ANSWER: TRUE 10. Principles are basic assumptions concerning the business environment. ANSWER: FALSE 11. Output-oriented principles are broad rules that guide the accounting function. ANSWER: FALSE

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Chapter 5—POSTULATES, PRINCIPLES, AND CONCEPTS

12. The going-concern postulate states that unless there is evidence to the contrary, it is assumed that the firm will continue indefinitely. ANSWER: TRUE 13. The time period idea is somewhat artificial because it creates definite segments out of what is a continuing process. ANSWER: TRUE 14. When the business is viewed in the context of accounting as well as in its legal form, it is clear that the entity is identical to its owners. ANSWER: FALSE 15. "Matching" refers to the fact that all expenses can be directly identified with either specific revenues or specific time periods. ANSWER: FALSE 16. Conservatism, materiality, and disclosure are examples of constraining principles. ANSWER: TRUE 17. The lower-of-cost or market valuation of inventories is an example of the disclosure principle. ANSWER: FALSE 18. Conservatism has been called the dominant principle of accounting. ANSWER: TRUE 19. Some capital markets research has indicated that “bad news” relative to reported earnings has a greater impact upon security prices than “good news.” ANSWER: TRUE 20. Disclosure will become less important in the future because of market efficiency. ANSWER: FALSE 21. Consistency refers to the degree of reliability users should find in financial statements when evaluating financial condition or the results of operations on an interfirm basis or predicting income or cash flows. ANSWER: FALSE 22. Proprietary theory assumes that the owners and the firm are virtually identical. ANSWER: TRUE

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Chapter 5—POSTULATES, PRINCIPLES, AND CONCEPTS

23. The balance sheet equation for entity theory is "Total Assets - Total Liabilities = Owners' Equities.” ANSWER: FALSE 24. The proprietary theory approach largely coincides with the components of income measurement as it is presently construed in historical cost-based systems. ANSWER: TRUE 25. Under entity theory, creditors are considered equity holders. ANSWER: TRUE 26. Preferred stockholders are residual equity holders. ANSWER: FALSE MULTIPLE CHOICE 1. Which of the following is not a reason why ARS 1 and ARS 3 fell short of the goal of obtaining a framework for APB accounting opinions? a. The authors refused to abandon historical cost. b. The postulates were not complete and therefore could not exclude all value systems other than the one prescribed in the principles. c. At least one of the principles was not derived from any of the postulates. d. The question of whether valuations of various assets were additive became an issue. ANSWER: A 2. Which of the following is a true statement? a. A principle contains elements observable by empirical techniques. b. The APB's Special Committee on Research Program defined both postulates and broad principles. c. A principle is an analytical statement whose truth or falsity is self-contained by its internal logic. d. Postulates are generally defined as basic assumptions that cannot be verified. ANSWER: D 3. Which of the following is not a true statement? a. A principle is a statement of a true and generalized nature containing referents to the real world. b. If a principle could be empirically tested and proven true, it would be capable of becoming a law. c. The truth of a law or principle means that is should not be replaced by a newer system. d. Principles are general statements that influence the way we view phenomena and the way we think about problems. ANSWER: C

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Chapter 5—POSTULATES, PRINCIPLES, AND CONCEPTS

4. Which of the following is a true statement regarding Moonitz's approach to ARS 1? a. He initially rejected an inductive type of approach. b. He used symbolic terminology and formal methods. c. He rejected a deductive approach rooted in reasoning alone. d. He was unconcerned about the experiential and empirical aspects of accounting. ANSWER: C 5. Which of the following is the key group in Moonitz's set of postulates? a. The Environmental group b. The Imperatives c. The Economic group d. Postulates stemming from accounting itself ANSWER: B 6. Which of the following is not a criticism that has been aimed at ARS 1? a. Some postulates appear to stem from one of the other postulate categories. b. Self-evident postulates may not be sufficiently substantive to lead to a unique and meaningful set of accounting principles. c. The postulates are necessary but not sufficient to lead to a viable outcome. d. Postulates should have played a less passive role. ANSWER: D 7. Which of the following is not true regarding the imperatives of ARS 1? a. They are normative in nature. b. They have developed within the context of accounting practice. c. They are objectives that should be striven for. d. The key imperative postulate appears to be consistency. ANSWER: D 8. Which of the following is not a possible outcome of postulate C-4, stability of the monetary unit? a. If purchasing power of the monetary unit is not stable, some form of inflation accounting is appropriate. b. If purchasing power of the monetary unit is not stable, historical cost is still justified. c. If purchasing power of the monetary unit is stable, a system of current values is justified. d. If purchasing power of the monetary unit is stable, retention of historical cost is justified. ANSWER: B 9. Which of the following statements is true regarding ARS 3? a. One of its principles states that revenue is earned by the entire process of operations of the firm rather than at the point of sale. b. All of its principles were derived from the postulates of ARS 1. c. The asset valuation measures prescribed are additive. d. One of the main criticisms aimed at ARS 3 relates to its advocating the exit-value approach to asset valuation. ANSWER: A

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10. Which of the following is not a true statement regarding ARS 1 and ARS 3? a. The authors were commissioned to find postulates and principles that would lead to a measure of true income. b. The postulates were not complete and could not exclude all value systems other than the one prescribed in the principles. c. The authors were able to identify a single concept of income that was superior to others. d. Nothing is said about the users of accounting information and what their needs and abilities might be. ANSWER: C 11. Which of the following is an accurate overall label for the terms postulates and principles? a. Constraints b. Concepts c. Axioms d. Conventions ANSWER: B 12. Which of the following are defined in the text as the result of the process of identifying, classifying, and interpreting various phenomena or precepts? a. Concepts b. Principles c. Postulates d. Axioms ANSWER: A 13. Which of the following are defined in the text as basic assumptions concerning the business environment? a. Concepts b. Principles c. Postulates d. Axioms ANSWER: C 14. Which of the following are defined in the text as general approaches utilized in the recognition and measurement of accounting events? a. Concepts b. Principles c. Postulates d. Axioms ANSWER: B 15. Which of the following are defined in the text as broad rules that guide the accounting function? a. Input-oriented principles b. Output-oriented principles c. Basic principles d. Axioms ANSWER: A

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Chapter 5—POSTULATES, PRINCIPLES, AND CONCEPTS

16. Which of the following are the basic postulates underlying historical costing? a. Going Concern, Time Period, Market Prices, Monetary Unit b. Objectivity, Time Period, Accounting Entity, Monetary Unit c. Going Concern, Time Period, Accounting Entity, Monetary Unit d. Going Concern, Time Period, Financial Statements, Monetary Unit ANSWER: C 17. Which of the following postulates states that unless there is evidence to the contrary, it is assumed that the firm will continue indefinitely? a. Entities b. Time period c. Consistency d. Going concern ANSWER: D 18. Which of the following postulates is violated when liquidation values for assets and equities are reported under ordinary circumstances? a. Entities b. Time period c. Consistency d. Going concern ANSWER: D 19. Which of the following is not true regarding the time period postulate? a. It results in an artificial segmentation of a continuing process. b. It has led to accrual accounting. c. It allows different accounting methods to be followed in interim periods. d. It allows interim reports to include estimates of annual amounts. ANSWER: C 20. When we view the business entity in the context of accounting, as well as in its legal form, it is clear that: a. The entity is separate from its owners. b. The entity is identical to its owners. c. The pooling method should be used for business combinations. d. Entities should be considered as one unit as a result of one controlling the other(s). ANSWER: A 21. Who are residual equity holders? a. Preferred stockholders b. Managers c. Bondholders d. Common stockholders ANSWER: D

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22. Under which of the following theories would the accounting equation be Total Assets = Total Equities (including liabilities)? a. Residual equity theory b. Proprietary theory c. Entity theory d. Commander theory ANSWER: C 23. Under which of the following theories would the accounting equation be Total Assets - Total Liabilities = Owners' Equities? a. Residual equity theory b. Proprietary theory c. Entity theory d. Commander theory ANSWER: B 24. Which of the following theories assumes that the owners and the firm are virtually identical? a. Residual equity theory b. Proprietary theory c. Entity theory d. Commander theory ANSWER: B 25. Which of the following theories assumes that the firm and its owners are separate beings? a. Residual equity theory b. Proprietary theory c. Entity theory d. Commander theory ANSWER: C 26. Which type of accounting principle is concerned with the comparability of financial statements of different firms? a. Input-oriented principles b. Output-oriented principles c. Constraining principles d. Both a and c ANSWER: B 27. Which type of accounting principle is concerned with general approaches or rules for preparing financial statements and their content? a. Input-oriented principles b. Output-oriented principles c. Constraining principles d. Both a and c ANSWER: D

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28. Recognition and Matching are examples of: a. Input-oriented principles b. Output-oriented principles c. Constraining principles d. Both a and c ANSWER: A 29. Which of the following concepts applies to users of financial statements? a. Comparability b. Consistency c. Uniformity d. Both b and c ANSWER: A 30. Which of the following concepts focuses on preparers of financial information? a. Comparability b. Consistency c. Uniformity d. Both b and c ANSWER: D 31.

refers to the importance of an item to financial statement users in terms of its relevance to decision making. a. Comparability b. Materiality c. Consistency d. Objectivity ANSWER: B

32. a. b. c. d.

refers to a firm’s use of the same accounting methods over consecutive time periods. Comparability Materiality Consistency Objectivity

ANSWER: C ESSAY 1. Distinguish between a postulate and a principle as they are used in ARS 1 and ARS 3. Identify the major categories of each that are included in these two studies. ANSWER: Postulates are basic assumptions concerning the business environment. They cannot be verified, but serve as a basis for inference and a foundation for deducing propositions. ARS 1 identified and defined the basic postulates of accounting. These postulates were of two different types. Groups A and B were made up of general, descriptive postulates that were derived from the economic and political environments. The second category is value judgments. Accounting Theory: 8th edition

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The postulates themselves are in three groups: the environmental group, those stemming from accounting itself, and the imperatives, with the imperatives being the key group. The imperatives correspond to objectives that should be striven for. The key imperative postulate appears to be stability of the monetary unit. Principles are general approaches utilized in the recognition and measurement of accounting events. Most of the principles listed in ARS 3 were reasoned from the postulates of ARS 1. These principles are divided into two main types: input-oriented principles and output-oriented principles. Input-oriented principles are broad rules that guide the accounting function and include general underlying rules of operation and constraining principles. Output-oriented principles involve certain qualities or characteristics that financial statements should possess if the input-oriented principles are appropriately executed. 2. What were the reasons for the failure of ARS 1 and ARS 3? ANSWER: ARS 1 and ARS 3 failed for several reasons including the following: (1)

The accounting profession would not abandon historical cost.

(2)

The postulates and principles were not complete and therefore could not exclude all value systems other than the one prescribed in the principles.

(3)

At least one principle (related to profit recognition) was not derived from any of the postulates.

(4)

The question of whether valuations of various assets were additive became an issue.

(5)

The authors were commissioned to find those postulates and principles that would lead to "true income." It has since become evident that no income measurement can be deemed to have such an advantage over competing concepts.

(6)

They occurred at a time when little formal attention was given to opportunities to react to potential accounting rules for those who will be subject to them.

3. What is the going-concern postulate of ARS 1, and how has it been criticized? ANSWER: The going-concern postulate states that unless there is evidence to the contrary, it is assumed that the firm will continue indefinitely. Under ordinary circumstances, reporting liquidation values for assets and equities is a violation of this postulate. This principle is too broad to lead to any kind of a choice among valuation systems, including historical cost. The postulate was also criticized because the time period of continuity is presumed to be long enough to conclude the firm's present contractual arrangements. However, by the time these affairs are concluded, they will have been replaced by new arrangements. Hence, the implication is one of indefinite life. However, over the long run, many firms do conclude their activities. Therefore, continuity is more in the nature of a predication than an underlying assumption.

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4. Distinguish between input-oriented principles and output-oriented principles and list at least three principles in each category. ANSWER: Input-oriented principles are concerned with general approaches or rules for preparing financial statements and their content, including any necessary supplementary disclosures. Output-oriented principles are concerned with the comparability of financial statements of different firms. Inputoriented principles include recognition, matching, conservatism, disclosure, materiality, and objectivity. Out-oriented principles include comparability, consistency, and uniformity. 5. Discuss the revenue recognition principle and how the terms "critical event," "earned," "realized," and "realizable" apply to revenue recognition. ANSWER: The most prevalent revenue recognition point is at the point of sale. Other possibilities may arise, however, such as the firm's "critical event." The critical event is the operation function that is the most crucial in terms of the earning process. However, ARS 3 states that revenue is earned by the entire process of operations of the firm rather than at one point only. The conceptual framework of the FASB states that revenue recognition occurs in accordance with two criteria: (1) the assets to be received from the performance of the revenue function are realized or realizable; and (2) performance of the revenue function is "substantially accomplished" (earned). Realized means that the firm's product or service has been converted to cash or claims to cash, while realizable has been defined as the ability to convert assets already received or held into known amounts of cash or claims to cash. 6. Discuss the matching principle and how it applies to recognizing expenses. Why is the matching principle currently under attack? ANSWER: Expenses are costs that expire as a result of generating revenues. Some expenses can be directly identified with either specific revenue or specific time periods. However, many important expenses cannot be so identified. The process of recognizing cost expiration for categories such as depreciation, cost of good sold, interest, and deferred charges is called matching. Matching implies that expenses are being recognized on a fair and equitable basis relative to the recognition of revenues. Matching is currently under attack because the historical cost approach often tends to substantially understate expense measurements relative to the value of expired-asset services. Also the systematic and rational methods employed under GAAP tend to be extremely arbitrary. 7. How is conservatism defined from a preparer’s orientation? Which conservatism goal should take precedence when conservatism criteria conflict? ANSWER: Conservative, from a preparer’s point of view, is the attempt to select generally accepted accounting methods that result in any of the following: (1) slower revenue recognition, (2) faster expense recognition, (3) lower asset valuation, (4) higher liability valuation. If these criteria conflict, lower income considerations should take precedence.

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Distinguish between proprietary theory and entity theory. Include descriptions of the balance sheet equation used by each and how income is computed. ANSWER: Proprietary theory assumes that the owners and the firm are virtually identical. This theory is descriptive of economies made up largely of the small owner-operated firms that existed prior the Industrial Revolution. More recently, it has been applied to large oligopolistic firms in an attempt to bring the absentee owner to center stage when viewing the business enterprise. These absentee ownership claims were legitimized by measuring profit available for distribution to owners rather than the notion that earnings—and capital—belong to the corporation itself. Under proprietary theory, the assets belong to the firm's owners, the liabilities are their obligations, and ownership equities accrue to the owners. The balance sheet equation is "Total assets - Total liabilities = Owners' Equities." Income represents the owners' increase in both net assets and owners' equities arising from operations during the period. Entity theory assumes the firm and its owners are separate beings. The assets belong to the firm itself; both liability and equity holders are investors in those assets with different rights and claims against them. The balance sheet equation is "Total Assets = Total Equities (including liabilities)." Under orthodox entity theory, stockholders have rights relative to receiving dividends when declared, voting at the annual corporate meeting, and sharing in net assets after all other claims have been met. Owners' equity accounts do not represent their interest as owners but simply their claims as equity holders. Similarly, net income does not belong to the owners although the amount is credited to the claims of equity holders after all other claims have been satisfied. Income does not belong to capital providers until dividends are declared or interest becomes due. In measuring income, both interest and dividends represent distribution of income to providers of capital. Hence, both are treated the same and neither is a deduction from income. If the entity theory were taken to its logical conclusion, the owners' equity accounts would belong unequivocally to the firm, despite the presence of stockholder claims. Also, income would belong to the firm itself and, in turn, interest and dividends would both be deductions in calculating it.

9. Discuss the residual equity theory and its assumptions. Include a description of the accounting equation used and how income would be computed. ANSWER: The residual equity theory is a variant of both proprietary and entity theory. The residual equity holders are that group of equity claimants whose rights are superseded by all other claimants, the common stockholders. Common stockholders are the ultimate risk takers within an enterprise. Their interest in the firm serves as a buffer or protector for all groups with prior claims on the firm, such as preferred stockholders and bond owners. The underlying assumption of the residual equity theory is that information appropriate for decision-making purposes, such as that helpful in predicting cash flows, must be supplied to the residual equity holders. The balance sheet equation under this approach would be "Total Assets - Total Specific Equities (including liabilities and preferred stock) = Residual Equity." Although the assets are still owned by the firm, they are held in a trust type of arrangement and management's objective is maximization of the value of the residual equity. Income accrues to the residual equity holders after all other claims have been met. Interest and preferred dividends (but not common dividends) would be deductions in arriving at income.

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Chapter 6—THE SEARCH FOR OBJECTIVES

TRUE/FALSE 1. The postulates and principles approach was concerned with user objectives. ANSWER: FALSE 2. Several important committee reports gave rise to objectives and standards in place of the postulates and principles approach. ANSWER: TRUE 3. "A Statement of Basic Accounting Theory" (ASOBAT) assumed that the evaluative framework of standards and guidelines was dependent upon the objectives of accounting. ANSWER: FALSE 4. The purpose of ASOBAT was to refine the objectives of financial statements as a part of a metatheoretical structure. ANSWER: FALSE 5. Moonitz felt that APB Statement 4 should have been issued as an opinion rather than as a statement because departures from GAAP made in a statement did not have to be disclosed. ANSWER: TRUE 6. APB Statement No. 4 acknowledges a conflict between the relevance and reliability objectives. ANSWER: TRUE 7. Relevance is considered the most important of the qualitative objectives of APB Statement 4. ANSWER: FALSE 8. APB Statement 4 adopted a very strong emphasis on the diversity of users. ANSWER: TRUE 9. APB Statement 4 was in agreement with ASOBAT that financial statements should be oriented toward a limited group of users. ANSWER: FALSE 10. According to APB Statement 4, basic accounting terminology is defined by whatever is being done in practice. ANSWER: TRUE

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11. Large parts of APB Statement 4 are restatements of the conventional wisdom of the time. ANSWER: TRUE 12. The Trueblood report noted that, during the short run, cash flows are a better predictor of cashgenerating power than are earnings. ANSWER: FALSE 13. In the Trueblood Committee Report, the meaning of the word accountability is limited to the functions of safekeeping of assets and ensuring that they are used in accordance with investors' purposes. ANSWER: FALSE 14. According to the Trueblood Committee Report, current values should be reported when they differ significantly from historical costs. ANSWER: TRUE 15. The purpose of SATTA was to provide a survey of the current financial accounting literature and a statement of where the profession stood relative to accounting theory. ANSWER: TRUE 16. The decision-usefulness approach is one of the classical approaches to accounting theory mentioned in SATTA. ANSWER: FALSE 17. The overriding message of SATTA is that current-cost should be accepted as the dominate valuation system. ANSWER: FALSE 18. A problem brought up by SATTA is the diversity of users in terms of their decisions and their possible different information needs. ANSWER: TRUE 19. Accounting information is determined by supply and demand. ANSWER: FALSE 20. Empirical research has proven that user needs are heterogeneous. ANSWER: FALSE

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21. Accountability refers to the responsibility of management to report on achieving goals for the effective and efficient utilization of enterprise resources. ANSWER: TRUE 22. Measurements based on the accountability objective would include earnings per share but not return on investment. ANSWER: FALSE 23. The main problem standing in the way of newer information approaches is the perceived competitive disadvantage of making public matters that management would prefer to keep secret. ANSWER: TRUE 24. The first statement to address the issue of user objectives extensively was ASOBAT. ANSWER: FALSE 25. SATTA expressed the opinion that choice among accounting theories could not be made at the time because of the diversity of users and their presumably different objectives and information needs. ANSWER: TRUE 26. The Chartered Financial Analysts’ business reporting model for equity investors shows a preference for relevance over reliability. ANSWER: TRUE MULTIPLE CHOICE 1. Which of the following bodies did not publish one of the important committee reports and documents that lead to accounting objectives and standards? a. AAA b. AICPA c. APB d. CAP ANSWER: D 2. Which of the following organizations published "Objectives of Financial Statements" (Trueblood Committee Report)? a. AAA b. AICPA c. APB d. CAP ANSWER: B

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3. Which of the following organizations published "A Statement of Basic Accounting Theory" (ASOBAT)? a. AAA b. AICPA c. APB d. CAP ANSWER: A 4. Which of the following documents stated fundamental concepts of financial reporting that would serve as a foundation for the opinions of the APB? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: B 5. Which of the following documents contained a definition of accounting that fortified the perception of the accountant as a learned professional whose presentation must be accepted by those who do not have his qualifications and credentials? a. "Statement of Accounting Theory and Theory Acceptance" (SATTA) b. "A Statement of Basic Accounting Theory" (ASOBAT) c. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) d. "Accounting Terminology Bulletin No. 1" ANSWER: D 6. Which of the following documents defined accounting as a service activity whose function is "to provide quantitative information... that is intended to be useful in making economic decisions"? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: B 7. Which of the following documents first stated that users of financial statements should be knowledgeable and should understand the characteristics and limitations of financial statements? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: B

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8. ASOBAT emphasized which of the following in its definition of accounting? a. The creative ability of the accountant b. The work and skill of the accountant c. The needs of the users of accounting information d. Recording transactions ANSWER: C 9. Which of the following was not a goal of ASOBAT? a. To identify the field of accounting so that useful generalizations about it could be made and a theory developed b. To establish standards by which accounting information might be judged c. To point out possible improvements in accounting practice d. To emphasize the creative skill and ability of the accountant, whose presentation should be accepted by those who do not have his or her qualifications and credentials ANSWER: D 10. Which of the following is not one of the four objectives of accounting given by ASOBAT? a. To make decisions concerning the use of limited resources (including the identification of crucial decision areas) and to determine objectives and goals b. To direct and control an organization's human and material resources effectively c. To relate the evaluative framework of standards and guidelines to the objectives themselves d. To facilitate social functions and controls ANSWER: C 11. Which of the following set of standards is at the heart ASOBAT? a. Relevance, Verifiability, Objectivity, Usefulness b. Relevance, Verifiability, Freedom from Bias, Quantifiability c. Reliability, Verifiability, Freedom from Bias, Quantifiability d. Relevance, Usefulness, Freedom from Bias, Objectivity ANSWER: B 12. Which of the following is not a problem of APB Statement 4 mentioned in the text? a. It is questionable whether the objectives can be implemented by means of the various principles derived from the existing body of accounting. b. It contains a loosely worded set of definitions. c. It attempts to be all things to all people. d. It does not state important evolutionary changes that had begun to occur. ANSWER: D 13. Which of the following standards is related to measurement theory? a. Quantifiability b. Freedom from bias c. Usefulness d. Objectivity ANSWER: A

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14. Which of the following standards is related to the qualitative characteristic of neutrality? a. Quantifiability b. Freedom from bias c. Usefulness d. Objectivity ANSWER: B 15. Which of the following statements is not true regarding the Trueblood Committee? a. It was formed at a time when the APB was under heavy criticism. b. It was formed when very little progress was being made in terms of reformulating the structure of accounting theory. c. It was charged with using APB Statement 4 as a vehicle for refining the objective of financial statements. d. It enumerated a total of twelve objectives of financial accounting. ANSWER: B 16. According to Sorter and Gans, which of the following describes the intent of the Trueblood Committee Report's second financial statement objective? a. Financial statements should serve those with limited ability. b. Financial statements should serve special needs of specific users. c. Financial statements should serve the general needs of users. d. Financial statement should serve only those users who are very knowledgeable about financial statements and information. ANSWER: C 17. According to the text, "limited ability" in the Trueblood Committee Report's second financial statement objective may refer to: a. Full disclosure. b. Financial statements designed to meet the special needs of specific users. c. Serving users with specific limitations. d. Both a and b ANSWER: A 18. Which of the following statements is true regarding the Trueblood Committee Report? a. It expresses the belief that different valuation bases are appropriate for different assets and liabilities. b. It is concerned with guaranteeing additivity of asset and liability amounts. c. It expresses the belief that the same valuation base should be used for all assets and all liabilities. d. Both b and c ANSWER: A

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19. Which of the following statements is not true regarding the Trueblood Committee Report? a. It emphasizes the importance of cash flows to users. b. It emphasizes the relation of earning-power measurements to the generation of future cash flows. c. Its earning-power orientation to income is grounded in the notion that in computing economic income, future cash flows should not be discounted to present value. d. Its objectives represented an important step taken toward establishing a meaningful conceptual framework of objectives. ANSWER: C 20. Which of the following is not true regarding SATTA? a. It attempted to develop metatheoretical guidelines for the evaluation of accounting information and valuation systems. b. It took into account the many valuation systems of accounting as well as other theoretical considerations. c. It enumerated the reasons why it was impossible to develop criteria that would enable the profession to unequivocally accept a single valuation system for accounting. d. It was commissioned by the AAA. ANSWER: A 21. What was the purpose of SATTA? a. To develop standards for accounting b. To determine an appropriate valuation system for financial statements c. To provide a survey of the current financial accounting literature and a statement of where the profession stood relative to accounting theory d. To develop metatheoretical guidelines for the evaluation of accounting information and valuation systems ANSWER: C 22. For which of the following areas is broad information applicable to many user groups? a. Predictive ability b. Accountability c. Both a and b d. None of the above ANSWER: C 23. Which of the following is true regarding the predictive ability of accounting data? a. The predictive ability objective is validated by market efficiency. b. Previous studies have indicated that historical cost income is not as good a predictor of itself as general price-level-adjusted income or current value income. c. Studies have found that income measurement methods that have the greatest predictive ability are also best in terms of most other objectives. d. Predictive ability is the same as the quantifiability standard of ASOBAT. ANSWER: A

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24. Which of the following statements is true regarding accountability? a. Accountability refers to a narrower concept than does stewardship. b. Measurements based on the accountability objective include earnings per share but not return on investment. c. The question of which valuation system provides the best input for accountability-oriented measurement is unimportant. d. Accountability refers to the responsibility of management to report on achieving goals for the effective and efficient utilization of enterprise resources. ANSWER: D 25. What is the most common thread running through various documents, reports, and monographs discussed in the text? a. The historical cost method of income measurement is as good a predictor of itself as other methods. b. Financial statements should be relevant to users for decision-making purposes. c. Earning-power measurements are essential to the prediction of future cash flows. d. The same valuation base should be used for all assets and all liabilities. ANSWER: B 26. Which of the following documents was the first to be based on an orientation toward user relevance? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: C 27. Which of the following documents was the first to address the issue of user objectives extensively? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: A 28. Which of the following documents expressed the opinion that a choice among accounting valuation systems could not be made because of the diversity of users? a. "Objectives of Financial Statements" (Trueblood Committee Report) b. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises" (APB Statement 4) c. "A Statement of Basic Accounting Theory" (ASOBAT) d. "Statement of Accounting Theory and Theory Acceptance" (SATTA) ANSWER: D

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29. The major objectives of financial statements are: a. Capital maintenance measurement and adaptability. b. Accountability and adaptability. c. Predictive ability and accountability. d. Capital maintenance and predictive ability. ANSWER: C 30. The secondary objectives of financial statements are: a. Capital maintenance measurement and adaptability. b. Accountability and adaptability. c. Predictive ability and accountability. d. Capital maintenance and predictive ability. ANSWER: A ESSAY 1. How did the definition of accounting change from the period before ASOBAT to the issuance of SATTA in 1977? ANSWER: Prior to ASOBAT, the most widely disseminated definition of accounting was used in 1953 in Accounting Terminology Bulletin No. 1, which emphasized the work and skill of the accountant. This definition fortified the perception of the accountant as a learned professional whose presentation must be accepted by those who do not have his qualifications and credentials. Virtually no mention was made of the user of accounting information. ASOBAT's definition of accounting represented a fundamental departure from the past by addressing the users of accounting information and their needs. It defined accounting as "... the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information." APB Statement 4 started by defining accounting along the newer, user-oriented track that ASOBAT took. APB 4 then went further than ASOBAT by stating that users of financial statements should be knowledgeable and should understand the characteristics and limitations of financial statements. Both ASOBAT and APB Statement 4 recognized the fact that many user groups require information for decision-making purposes. One of ASOBAT's reactions to this problem was to call for multiple measures. The Trueblood Report, on the other hand, established the premise that while there are different user groups, they make similar decisions and have similar information needs. SATTA was more pessimistic than the Trueblood Report and concluded that while there is a large degree of user homogeneity among high users, there is much less homogeneity among other users.

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2. List and define the four standards for evaluating accounting that are at the heart of ASOBAT. ANSWER: The four standards at the heart of ASOBAT are: (1) (2) (3) (4)

Relevance pertains to usefulness in making the decision at hand. Verifiability is synonymous with objectivity and refers to the degree of statistical consensus among measurers. Freedom from bias refers to neutrality in the preparation of financial statements. Quantifiability refers to the ability to be measured.

3. Identify the major contributions of APB Statement 4. ANSWER: The major contributions of APB Statement 4 are: (1)

It defined accounting along the user-oriented track taken by ASOBAT.

(2)

It adopted ASOBAT's very strong emphasis on the diversity of users, but went further by stating the users of financial statements should be knowledgeable and should understand the characteristics and limitations of financial statements.

(3)

It viewed financial statements as being general purpose in nature as opposed to oriented toward a limited group of users.

(4)

It noted that accounting is a measurement discipline.

(5)

The qualitative objectives identified consist of relevance, understandability, verifiability, neutrality, timeliness, comparability, and completeness. These would later appear as qualitative characteristics in the conceptual framework. The statement concurs with ASOBAT on possible conflict among objectives.

(6)

It concentrated on developing the user-oriented approach.

(7)

The pervasive principles and modifying conventions in the section on generally accepted accounting principles consist of those concepts that constitute the heart of the system of historical costing.

4. Respond to the following: a. b. c.

What is the decision-usefulness approach to accounting theory? What are the characteristics and limitations of the decision-model approach? What are the characteristics of the decision-maker approach?

ANSWER: a. The decision-usefulness approach is a contemporary approach to accounting theory that has concentrated on users of accounting reports, their decisions, information needs, and information-processing abilities. This approach has been further dichotomized into decision models and decision-makers. b.

The characteristics of the decision-model approach are:

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(1) (2) (3)

They are normative and deductive. Some form of relevance for particular decisions by a particular user group or groups is stressed. The relevance criterion is instrumental in measuring the selected attributes of assets, liabilities, and income transactions.

Since decision-model approaches are deemed appropriate for communicating extremely relevant information for decision making, an argument can be made that users must be educated to understand the method. c.

The decision-maker approach is descriptive and inductive. It attempts to find out what information is actually used or desired, the assumption being that the information that is desired should be supplied.

5. Identify and explain the two primary objectives of financial statements and the two secondary objectives of financial statements. ANSWER: The two primary objectives of financial statements are predictive ability and accountability. Predictive ability refers to the usefulness of accounting data as an aid to predicting future variables. Accountability refers to the responsibility of management to report on achieving goals for the effective and efficient utilization of enterprise resources. The two secondary objectives of financial statements are capital maintenance and adaptability. A measure of capital maintenance gives information about the amount of dividends that can be paid during a period without returning capital to the stockholders. Adaptability is concerned with measuring total liquidity available to the firm. This is determined by measuring the exit value of the firm's assets minus its liabilities. 6. Respond to the following: a. b.

List some of the possible groups of financial statement users. What is meant by "user diversity," and does user diversity create a potential problem?

ANSWER: Possible user groups include: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Shareholders (actual and potential) Creditors Financial analysts and advisers Employees Labor unions Customers Suppliers Industry trade associations. Governmental agencies Public-interest groups Researchers and standard setters

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User diversity refers to the fact that different users have different types of objectives. For example, actual shareholders probably desire information that would maximize security values, whereas potential shareholders would prefer information that would minimize security values. This creates a potential problem because it is not clear whether the information needs of the various types of objectives can be satisfied by general-purpose financial statements. However, despite the heterogeneity of groups of users as well as within groups, empirical research has not proven that the groups have strongly differentiated information needs.

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TRUE/FALSE 1. The conceptual framework is an attempt to provide a metatheoretical structure for financial accounting. ANSWER: TRUE 2. The most important new issue brought up in the discussion memorandum that preceded the conceptual framework was predictive ability. ANSWER: FALSE 3. The discussion memorandum that preceded the conceptual framework was perhaps the most extensive ever published by the FASB. ANSWER: TRUE 4. The eight (8) statements making up the conceptual framework establish generally accepted accounting principles. ANSWER: FALSE 5. SFAC No. 1 maintains that financial statements should be geared toward specific needs of particular user groups. ANSWER: FALSE 6. The conceptual framework maintains that accounting reports should become the only relevant source of information about enterprises. ANSWER: FALSE 7. SFAC No. 1 takes the position that users of financial statements must be assumed to be knowledgeable about financial information and reporting. ANSWER: TRUE 8. With regard to users, SFAC No. 1 established that financial statements should be aimed at a common core of similar information users. ANSWER: TRUE 9. The quality of understandability is a characteristic influenced by both users and preparers of accounting information. ANSWER: TRUE 10. The benefits of accounting information pertain to how useful the accounting information is relative to the capital maintenance and accountability objectives. ANSWER: FALSE

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11. Competitive disadvantage is an indirect cost of published information. ANSWER: TRUE 12. The indirect costs of information pertain to gathering, preparation, and dissemination of information. ANSWER: FALSE 13. There is a conflict between timeliness and the other aspects of relevance. ANSWER: TRUE 14. According to SFAC No. 4, "earnings" is the indicator of a nonbusiness organization's performance that is comparable to "income" in the profit sector. ANSWER: FALSE 15. SFAC No. 5 makes clear that the concepts discussed in the conceptual framework apply to other means of disclosure in addition to financial statements. ANSWER: FALSE 16. SFAC No. 5 appears to deny one of the main tenets of the efficient-markets hypothesis. ANSWER: TRUE 17. The definitions of SFAC No. 6 are virtually identical to those in SFAC No. 3 except that they are extended to nonbusiness organizations. ANSWER: TRUE 18. Comprehensive income as defined by SFAC No. 6 includes all changes in equity during a period. ANSWER: FALSE 19. Relevance and reliability are the primary characteristics that standard setters should be concerned with. ANSWER: TRUE 20. Timeliness and predictive value are the two main aspect of relevance. ANSWER: FALSE 21. "Economic consequences" is not part of the conceptual framework. ANSWER: TRUE 22. SFAC No. 8 included the true and fair view in the qualitative characteristics of accounting. ANSWER: FALSE

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23. Timeliness is an enhancing qualitative characteristic of information about economic phenomenon. ANSWER: TRUE 24. Codification is a justification of the standard-setting process itself rather than of the individual standards that result from that process. ANSWER: TRUE 25. The jurisprudential view of the FASB is concerned with the theory embodied in the conceptual framework. ANSWER: FALSE 26. Opinion is virtually unanimous that SFAC No. 5 on recognition and measurement is the low point of the conceptual framework. ANSWER: TRUE MULTIPLE CHOICE 1. Which of the following is not true regarding the FASB's conceptual framework? a. It is supposed to embody a system of interrelated objectives. b. It is an attempt to provide a metatheoretical structure for financial accounting. c. It establishes generally accepted accounting principles. d. It includes seven statements of financial accounting concepts. ANSWER: C 2. Which of the following is not true regarding the discussion memorandum that preceded the conceptual framework? a. It represented the end product of the FASB's deliberations related to the conceptual framework project. b. The most important new issue brought up in the document was capital maintenance. c. It brought up three views of financial accounting and financial statements. d. It presented various definitions for basic accounting terms. ANSWER: A 3. Which statement in the conceptual framework deals with qualitative characteristics of accounting information? Note that SFAC No. 8 replaces this older SFAC. a. SFAC No. 1 b. SFAC No. 2 c. SFAC No. 3 d. SFAC No. 5 ANSWER: B

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4. Which statement in the conceptual framework is concerned with the objectives of business financial reporting? Note that SFAC 8 replaces this SFAC. a. SFAC No. 1 b. SFAC No. 2 c. SFAC No. 3 d. SFAC No. 5 ANSWER: A 5. The qualitative characteristics of accounting information detailed in the conceptual framework proceeded directly from which of the following documents? a. The Trueblood Report b. SATTA c. APB Statement 4 d. ASOBAT ANSWER: D 6. The objectives of business financial reporting detailed in the conceptual framework proceeded directly from which of the following documents? a. The Trueblood Report b. SATTA c. APB Statement 4 d. ASOBAT ANSWER: A 7. Which of the following is a value judgment found in SFAC No. 1? a. Accounting reports should become the only relevant source of information about enterprises. b. Cash basis accounting is extremely useful in assessing and predicting earning power and cash flows of an enterprise. c. Information is not costless to provide, so benefits of usage should exceed costs of production. d. Users of accounting information have limited ability regarding financial information and reporting. ANSWER: C 8. The qualitative characteristics of accounting on which the conceptual framework is centered come under the general heading of: a. Relevance. b. Materiality. c. Representational faithfulness. d. Decision usefulness. ANSWER: D

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9. Which of the following is a pervasive constraint under the “original” qualitative characteristics of accounting, pre-SFAC No. 8? It is an entity-specific constraint post SFAC No. 8. a. Decision usefulness b. Understandability c. Materiality d. Neutrality ANSWER: C 10. Under SFAC No. 8, which of the following are aspects of relevance? a. Comparability and understandability b. Timeliness and comparability c. Representational faithfulness and decision usefulness d. Predictive value and confirmatory value ANSWER: D 11. Which component of the conceptual framework is perhaps the most difficult to apply in practice? a. Confirmatory value b. Understandability c. Benefits greater than costs d. Faithful representation ANSWER: C 12. The quality of being 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 expectations" is referred to in the conceptual framework as: a. Reliability. b. Relevance. c. Representational faithfulness. d. Understandability. ANSWER: B 13. The degree of consensus among measurers is referred to in the conceptual framework as: a. Reliability. b. Relevance. c. Representational faithfulness. d. Understandability. ANSWER: A 14. The idea that a measurement should correspond with the phenomenon it is attempting to measure is referred to in the conceptual framework as: a. Reliability. b. Relevance. c. Faithful representation. d. Understandability. ANSWER: C

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15. Which of the following is a true statement regarding feedback value? a. It concerns confirming or correcting decision makers' earlier expectations. b. It refers to assessing where the firm presently stands. c. It is closely related to accountability. d. All of the above ANSWER: D 16. Pre-SFAC No. 8, the three components of reliability are: a. Predictive value, feedback value, timeliness. b. Verifiability, neutrality, representational faithfulness. c. Verifiability, predictive value, feedback value. d. Relevance, comparability, materiality. ANSWER: B 17. Which qualitative characteristic pertains wholly to the attitude of board members as opposed to being more directly concerned with specific aspects of information contained in the financial statements? a. Representational faithfulness b. Verifiability c. Consistency d. Neutrality ANSWER: D 18. Which of the following is not part of the conceptual framework? a. Conservatism b. Economic consequences c. Consistency d. None of the above are in the conceptual framework ANSWER: B 19. SFAC designated which of the following as the term to indicate the comprehensive or total change in net assets occurring during the period as a result of operations? a. Income b. Earnings c. Revenue d. Profits ANSWER: A

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20. Which of the following is a true statement? a. SFAC No. 5 makes clear that the concepts discussed in the conceptual framework apply to other means of disclosure in addition to financial statements. b. SFAC No. 5 appears to deny one of the main tenets of the efficient-markets hypothesis, that disclosure outside of the body of financial statements is as effective as disclosure within statements themselves. c. SFAC No. 5 made a clear attempt to resolve the issues of recognition and measurement. d. SFAC No. 5 was successful because it addressed measurement prior to discussing recognition. ANSWER: B 21. Which of the following is a true statement? a. The eight SFACs that comprise the conceptual framework were not evolutionary because they were derived from previous documents such as the Trueblood Report and ASOBAT. b. The definitions of SFAC No. 6 were basically a restatement of the definitions of APB Statement 4. c. The Achilles' heel of the document is SFAC No. 5, which reaffirmed historical cost as the basic measurement system. d. The key document in the series of SFACs that comprise the conceptual framework is SFAC No. 1. ANSWER: C 22. Which of the following concepts was referred to as a convention in SFAC No. 2? a. Consistency b. Materiality c. Comparability d. Conservatism ANSWER: D 23. Which of the following is not a true statement? a. SFAC No. 3 defines 10 elements of financial statements. b. SFAC No. 3 is a resolution of the definitions presented in the discussion memorandum for the conceptual framework project. c. SFAC No. 3 was amended by SFAC No. 6. d. SFAC No. 3 discusses in detail the three views of financial accounting mentioned in the discussion memorandum. ANSWER: D 24. Which of the following is a true statement? a. Predictive value refers to usefulness of inputs for predictions rather than being an actual prediction itself. b. Timeliness complements rather than conflicts with the other aspects of relevance because information is more complete and accurate if it is timely. c. The conceptual framework stressed predictive value rather than the importance of decision making by outside users. d. Timeliness and predictive value are the two main aspects of relevance. ANSWER: A

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25. Which of the following is not true regarding SFAC No. 7 a. SFAC No. 7 requires that estimated future cash flows be used for asset measurement in certain circumstances. b. SFAC No. 7 concerns specific measurement issues rather than conceptual-type issues. c. SFAC No. 7 applies only to initial recognition and not subsequent revaluations. d. SFAC No. 7 is divided into two parts: asset measurement and income measurement. ANSWER: D 26. SFAC No. 8 replaces a. SFAC No. 1 b. SFAC No. 2 c. SFAC No. 3 d. SFAC No. 1 and 2. ANSWER: D 27. Effective with SFAC No. 8, the two primary decision-specific qualities include relevance and a. Reliability. b. Faithful representation c. Timeliness d. Predictive value. ANSWER: B

ESSAY 1. Do the SFACs that constitute the conceptual framework establish generally accepted accounting principles? What are the benefits and limitations of this approach? ANSWER: The SFACs that constitute the conceptual framework do not establish generally accepted accounting principles. They are not part of the FASB Financial Statement Codification. This avoids the possibility of a crisis arising from a failure to comply with the statements. Also, the process of arriving at a workable and utilitarian metatheoretical-type structure must be acknowledged as a slow, evolutionary process. The tentative nature of the statements may make it easier to change components as the need arises. On the other hand, the possibility also exists that the statements will have a purely cosmetic effect. 2. Why might SFAC No. 5 be considered a "failure"? ANSWER: SFAC No. 5 did not deal extensively with the issues of recognition and measurement. It backed away from considering possible criteria for change, which suggests a continued use of present measurement attributes and reliance on evolutionary approach. It dealt with recognition ahead of measurement, but the issue of when to recognize an element cannot be discussed until we know the measurement characteristics that are to be recognized. In addition, the move toward the assetliability viewpoint in the first three SFACs was a shift toward current valuation and away from matching. The "counterreformation” of SFAC No. 5, particularly its statement to the effect that change should occur in a gradual and evolutionary manner, effectively stymied this reform.

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3. Respond to the following: a. b.

How is net income different from earnings in SFAC No. 5? What is comprehensive income?

ANSWER: a. One of the principal concerns of SFAC No. 5 was the format and presentation of changes in owners' equity that do not arise from transactions with owners. "Earnings" would replace net income and would differ from the latter by excluding the cumulative effect on prior years of a change in accounting principle. Earnings would thus be a better indicator of current operating performance than net income. b.

Comprehensive income includes all changes in owner's equity during the period except for transactions with owners. A cumulative effect of a change in accounting principle would be included in comprehensive income as would such items as the income effect of recognized gains and losses of marketable securities that are not classified as current assets, foreign currency translation adjustments, and prior period adjustments.

4. Explain the hierarchy of accounting qualities identified in SFAC No. 2. ANSWER: Decision makers are at the top of the hierarchy. The specific qualitative characteristics of accounting come under the general heading of decision usefulness, continuing the emphasis on decision makers and their needs. The two primary, decision-specific qualities are relevance and reliability. Comparability is a secondary qualitative characteristic. Relevance is defined as being 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 expectations. Relevance has two main aspects—predictive value and feedback value—and one minor one, timeliness. Predictive value refers to usefulness of inputs for predictions while feedback value concerns confirming or correcting the expectations of decision-makers. Timeliness is really a constraint on both of the other aspects of relevance. To be relevant, information must be timely, which means that it must be "available to decision makers before it loses its capacity to influence decisions." Reliability is composed of three components: verifiability, representational faithfulness, and neutrality. Verifiability refers to the degree of consensus among measurers. Representational faithfulness refers to the idea that the measurement itself should correspond with the phenomenon it is attempting to measure. Neutrality refers to the belief that the policy-setting process should be primarily concerned with relevance and reliability rather than the effect a standard or rule might have on a specific user group or the enterprise itself. These qualities are applied within the constraints of benefits greater than cost and materiality. Materiality addresses whether an item is large enough to influence users' decisions. 5. Define the elements of financial statements identified in SFAC No. 3 and SFAC No. 6. ANSWER: Assets are probable future economic benefits obtained or controlled by a particular entity as result of past transactions or events.

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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 or events. Equity (or net assets) is the residual interest in the assets of an entity that remains after deducting its liabilities. Investments by owners are increases in equity resulting from transfers to it from other entities of something valuable to obtain or increase ownership interests (equity) in it. Distributions to owners are decreases in equity resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Comprehensive income is the change in equity during a period from transactions and other events and circumstance from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Revenues are inflows or other enhancements of assets or settlements of its 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 depletion of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Gains are increases in equity from peripheral or incidental transactions of an entity and form all other transactions and other event and circumstance affecting the entity except those that result from revenues or investment by owners. Losses are decreases in equity from peripheral or incidental transactions of an entity and from all other transaction and other events and circumstance affecting the entity except those that result from expenses or distribution to owners. 6. Discuss the criticisms that of SFAC No. 6? ANSWER: The definitions of the elements of financial statements have been criticized on the grounds that the various criteria for each of the categories is necessary but not sufficient to determine whether a general type of accounting event falls into a particular definitional category. However, it would be impossible to completely specify all characteristics of elements. The lack of completeness must be complemented by the professional judgment capabilities of the accountant and auditor. It has also been argued that the FASB definition of assets that emphasized future economic benefits is grounded in future revenue and income measurement. Consequently, the matching concept is the primary focus of the definition. It has been argued that the asset definition should concentrate on property rights that are concerned with wealth, which provides a true balance sheet orientation. This would result in certain deferred charges being expensed immediately even though their incurrence may bring about future economic benefits. Another argument related to the definitions of SFAC No. 6 concerns how broadly the term "past transactions" can be interpreted under the asset and liability definitions.

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7. Explain the main key points regarding asset and liability measurement made in SFAC No. 7. ANSWER: The most important point about asset measurement is that present value measurements are intended to simulate fair value rather than the particular present value of the asset to the firm itself. If a firm does not know the specific market value of a particular asset, it should strive for that discount rate which would lead as closely as possible to estimated fair value. Discount rates should also include risk and uncertainty which would reflect the assessment of the market toward the asset’s value. If a particular asset has several possible cash flows within specific years, the expected cash flows should be determined (the individual cash flows should be multiplied by their expected probabilities) rather than using the single most likely cash flow. The key point about liability measurement is that the discount rate must be tied to the credit standing of the firm. This means that if the firm’s credit standing worsens, the valuation of the liability decreases (because a poorer credit standing means that the applicable interest (discount) rate would rise). Hence any firm acquiring the liability from the original creditor would pay less to acquire the liability due to the debtor’s worsening credit standing.

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Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS

TRUE/FALSE 1. The FASB has implicitly adopted the cash flow valuation model. ANSWER: TRUE 2. The FASB maintains that accrual accounting systems are more useful for predicting net cash flows than are simpler cash-based systems. ANSWER: TRUE 3. The value to investors of the information in financial reporting lies in its role as an historical record. ANSWER: FALSE 4. Residual income refers to income in excess of a charge for the capital that is employed to generate that income. ANSWER: TRUE 5. Economic profit is equal to net operating profit less taxes paid minus a charge on invested capital. ANSWER: TRUE 6. Economic profit is sometimes referred to as abnormal earnings. ANSWER: FALSE

7. According to the clean surplus accounting, ending book value of equity equals beginning book value plus earnings. ANSWER: FALSE 8. The underlying premise of the clean surplus accounting is that all profit and loss elements go through income. ANSWER: TRUE 9. Residual income can be used as a company and intra-company performance measurement tool. ANSWER: TRUE 10. The calculation of residual income recognizes that equity, but not debt, has a cost. ANSWER: FALSE 11. Economic income is equal to residual income. ANSWER: FALSE

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12. Unlike stock price, which is forward looking, residual income focuses on historical performance. ANSWER: TRUE 13. The efficient-markets hypothesis refers to the speed with which financial analysts are able to predict a firm's cash flows. ANSWER: FALSE 14. Most testing of the efficient-markets hypothesis has dealt only with past information reflected in security prices. ANSWER: FALSE 15. The theoretical foundation of capital market or security price research comes from the efficientmarkets hypothesis. ANSWER: TRUE 16. According to portfolio theory, systematic risk can be reduced by holding a portfolio of investments. ANSWER: FALSE 17. The expected portfolio return decreases as risk increases. ANSWER: FALSE 18. In portfolio theory, systematic risk is defined as the variance of expected investment returns. ANSWER: TRUE 19. The assumption of the capital asset pricing model is that individual securities are priced solely on unsystematic risk. ANSWER: FALSE 20. In the capital asset pricing model, beta is used to represent systematic risk of individual securities and to predict the risk-based price of securities. ANSWER: TRUE 21. The relationship between risk and return for diversified portfolios is modeled by the Security Market Line (SML). ANSWER: FALSE

22. The strongest evidence from capital market research concerns the information content of annual accounting earnings numbers. ANSWER: TRUE

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23. Capital market research has shown that investors do not appear to adjust accounting income to compensate for artificial bookkeeping differences. ANSWER: FALSE 24. Research studies have predominantly supported the naive-investor hypothesis. ANSWER: FALSE 25. When accounting numbers are used to monitor agency contracts, there can be indirect consequences from changes in accounting policies. ANSWER: TRUE 26. The study by Lev that examined earnings numbers and stock returns found a high explanatory relationship between earnings and stock returns. ANSWER: FALSE 27. The study by Ou and Penman, which used traditional accounting measures to predict whether a company's income would increase or decrease, indicated that markets are not as efficient as previously thought, and that fundamental analysis is important for investment purposes. ANSWER: TRUE 28. Post-earnings-announcement drift refers to the fact that it takes up to 90 days for security prices to react significantly to earnings announcements. ANSWER: FALSE 29. Because post-earnings-announcement drift shows that there is at least some amount of efficiency in the market, it is even more important to attempt to improve the quality of accounting standards. ANSWER: TRUE 30. The usefulness of accounting information may be determined by directly asking investors how they use annual reports. ANSWER: TRUE 31. Surveys of individual investors have generally indicated a high readership of accounting information. ANSWER: FALSE 32. It may be assumed that accounting information has no usefulness to investors because many individual stockholders do not read annual reports. ANSWER: FALSE

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33. Accounting information ranks at the top on surveys that ask investors to weigh the importance of different types of investment information. ANSWER: FALSE 34. Accounting-based ratios have not been very useful in discriminating between firms that subsequently went bankrupt and those that did not. ANSWER: FALSE 35. The relationship between earnings and stock prices has diminished over the years, but the ability of earnings to forecast futures cash flows has not. ANSWER: TRUE

MULTIPLE CHOICE 1. Which of the following is not a true statement? a. There is empirical evidence that future cash flows are better forecasted with accrual data than with cash flow data. b. Accrual accounting numbers incorporate the attribute that determines firm valuation-net cash flow data. c. Changes in reported accounting earnings affect firm valuation through changes in stock prices. d. The value to investors of the information in financial reporting lies in its role as an historical record. ANSWER: D

1. Which of the following is not true regarding earnings and dividends? a. Managers adjust dividends primarily to reflect the change in current earnings. b. Stock price may be modeled as the present value of future expected dividends. c. Investors regard cash dividends as credible signals of future performance. d. Current income has a value in predicting future dividends. ANSWER: A 2. Which of the following is true regarding the term residual income? a. Residual income is the income over and above the amount needed to cover current expenses. b. Residual income is the income in excess of a charge for the capital that is employed to generate that income. c. Residual income is equal to economic income. d. Residual income is called abnormal earnings when applied to the enterprise’s operating income and invested capital. ANSWER: B

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Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS

3. Excess income over and above the expected amount of after-tax operating income is called: a. Extraordinary Profit b. Remaining Profit c. Economic Profit d. Monetary Profit ANSWER: C 4. Which of the following would be an argument in favor of using residual income models in performance measurement? a. All forms of residual income are consistent with discounted net cash flows for any method of depreciation. b. Residual income focuses on historical performance. c. The determination of residual income is dependent on an accurate estimate of the cost of capital. d. Residual income recognizes that all capital, debt as well as equity, has a cost. ANSWER: D 5. Which of the following applies to the clean surplus theory? a. It is a theory that is applied to security valuation, but is not very attuned to accounting concepts and numbers. b. The theory values a firm's equity based on the beginning of the period book value plus the present value of expected future abnormal earnings. c. The theory considers a firm's abnormal earnings amount to be equal to its beginning of the period book value multiplied by the cost of equity capital. d. This theory does not tie in well with the FASB's concept of comprehensive income. ANSWER: B 6. Which of the following would give rise to abnormal earnings? a. Accelerated depreciation b. LIFO costing for inventories and cost of goods sold c. Immediate write-off of research and development d. All of the above ANSWER: D 7. Which of the following are possible sources of abnormal earnings? a. Recognizing the positive excess present value above the cost of a project on the balance sheet b. The use of current values in reporting marketable securities c. Conservative matching and recognition procedures under historical costing d. All of the above ANSWER: C 8. The three forms of the efficient-markets hypothesis are: a. Weak, semistrong, strong. b. Slow, quick, instantaneous. c. Past, current, future. d. Private, semipublic, public. ANSWER: A

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Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS

9. Which of the following statements does not apply to portfolio theory? a. It is the foundation for the capital asset pricing model. b. It is the foundation for capital market or security price research. c. It holds that risk can be eliminated by holding a portfolio of investments. d. It is a theory of rational investment choice and utility maximization. ANSWER: C 10. Which of the following statements applies to the capital asset pricing model? a. It assumes that individual securities are priced solely on unsystematic risk. b. It uses beta to represent unsystematic risk of individual securities. c. It assumes that if the rate of return on an individual security is greater than the market average, systematic risk of the security must be smaller. d. It assumes that if beta equals 1, the systematic risk of an individual security is equal to the average risk of the market as a whole. ANSWER: D 11. Which of the following statements does not apply to the market model? a. It is a simpler approach than the standard version of the capital asset pricing model. b. This approach is seldom used in accounting research. c. In this model, the risk-free return is dropped from the equation. d. Abnormal returns are captured in the error term of the model. ANSWER: B 12. Which of the following is a finding of previous capital market research studies? a. The market is not fooled by arbitrary accounting numbers. b. The direction of change in reported accounting earning is inversely correlated with security price movements. c. The market is affected by alternative accounting income numbers that do not affect cash flow, such as those related to a change from deferral to recognition of unrealized holding gains on marketable securities. d. Security prices are affected by a change from the deferral to flow-through method of accounting for the investment credit. ANSWER: A 13. In security-price research, which of the following is an indirect consequence of an accounting policy change? a. The value of the firm is affected through an effect on cash flow. b. The value of the firm is affected through an effect on net income. c. The value of the firm is affected through an effect on owners. d. The value of the firm is not affected. ANSWER: C

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14. Which of the following findings would support the naive-investor hypothesis? a. A finding that security prices respond to income levels that differ solely because of alternative accounting methods with no cash flow consequences b. A finding that security prices do not respond to artificial book-income differences c. A finding that security prices do not respond to the adoption of LIFO for accounting for inventories and cost of goods sold d. A finding that security prices do not respond to a change in reported accounting earnings from the prior year ANSWER: A 15. Which of the following is a possible reason why security prices were found to respond to changes from pooling to purchase accounting for combinations? a. A change from pooling to purchase accounting does not affect cash flow b. Differences between purchase and pooling accounting affect only book income c. The change could have affected dividend distribution because of debt covenants d. Income would normally be higher under purchase accounting than pooling ANSWER: C 16. Which of the following is an assumption of fundamental analysis? a. Securities markets are efficient. b. Prices of securities rapidly reflect all publicly available information. c. The strong form of the efficient-markets hypothesis is true. d. Under-priced shares can be found in the securities market by means of financial statement analysis. ANSWER: D 17. Which of the following is not a finding or conclusion of the research study by Ou and Penman that used traditional accounting measures to predict whether a company's income would increase or decrease? a. The researchers were unable to describe the following year earnings changes correctly in most cases. b. Markets are not as efficient as efficient-market advocates would like to believe. c. Better accounting standards might improve the predictive ability of accounting information. d. Fundamental analysis is still important for investment purposes. ANSWER: A 18. Which of the following statements does not apply to the study by Lev that examined earnings numbers and stock returns? a. According to Lev, over time, the correlation between earnings numbers and stock returns has been low. b. Lev believed that earnings have very little explanatory power relative to changes in stock prices. c. Lev believed that one of the primary reasons for the level of correlation between earning and stock returns lies with the low quality of reported income numbers. d. The study's results contradicted those of the Ou and Penman study. ANSWER: D

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Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS

19. Which of the following statements is true regarding post-earnings-announcement drift? a. Security prices do not react significantly at the time of earnings announcements. b. At least part of the blame for this effect has been laid at the feet of financial analysts. c. This effect is more important for larger firms than for smaller firms. d. Security prices never fully reflect the effects of earnings announcements. ANSWER: B 20. Which of the following is not a possible cause of post-earnings-announcement drift? a. Financial analysts overreact to fundamental signals stemming from securities. b. Shareholders do not distinguish well between the cash flow portions and the accrual portions of earnings. c. Financial analysts' forecast errors lead to incomplete security price adjustments. d. Transaction costs are too high relative to the potential gain that can be earned from the mispricing of the securities. ANSWER: A 21. Which of the following is not true regarding capital market research? a. Studies have found a low correlation between the variability of accounting earnings and beta. b. Studies have found a strong association between accounting-based ratios and the market measure of risk. c. Studies have found that supplemental segment (line of business) disclosures resulted in a revision of systematic risk, indicating that such information is useful for risk assessments. d. At least one study has found that pension information is not useful for risk assessments. ANSWER: A 22. Which of the following statements is not supported by empirical evidence from capital market research? a. Accounting earnings appear to have information content and to affect security prices. b. Alternative accounting policies with no apparent direct or indirect cash flow consequences to the firm do not seem to affect security prices. c. There are no incentives to choose certain alternative accounting policies over others because there are never cash consequences. d. Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment. ANSWER: C 23. Early advocates of security-price research now recognize there are limitations to this research for use in choosing the best accounting policies and evaluating the economic consequences of alternative accounting policies on security prices. Which of the following is not a reason for these limitations? a. The public-good nature of accounting information b. The existence of free riders c. The resultant market failure in terms of optimal resource allocation d. The use of historical costing distorts financial statement amounts ANSWER: D

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24. Which of the following ranks below annual reports on surveys that ask investors to weigh the importance of different types of investment information? a. Information from company reports b. Information about general economic conditions c. Company announcements on products and markets d. None of the above rank below annual reports ANSWER: D 25. The research approach that examines the association between accounting data reported in annual financial statements and the levels of stock prices is called: a. Cross-sectional valuation b. Investor survey analysis c. Accounting information usefulness research d. Time series analysis ANSWER: A 26. Which one of the following statements is not part of the incomplete revelation hypothesis (IRH)? a. Some accounting numbers or relationships may not be fully revealed in security prices. b. Footnote disclosure is all that is needed for information to fully impact security prices. c. Some individuals' trading habits do not respond in a rational way to new information. d. Some individuals respond to information is such a way as to impede the market from acting in a fully efficient manner. ANSWER: B ESSAY 1. What is the underlying premise of clean surplus theory and how is it applied in determining the valuation of a firm's equity? ANSWER: The underlying premise of clean surplus theory is that all profit and loss elements go through income. The valuation of a firm's equity is based on the beginning of the period book value of equity plus the present value of expected future abnormal earnings, which are defined as earnings in excess of expected normal earnings. 2. Respond to the following: a. b. c.

What is meant by market efficiency? What does the efficient-markets hypothesis imply about the value of accounting information? Describe the three forms of the efficient-markets hypothesis.

ANSWER: a. Market efficiency means that (1) the market fully reflects available information, and (2) by implication, market prices react instantaneously to new information. b.

If the efficient-markets hypothesis is correct, an item of information has value (information content) to investors only if there is evidence of a price response to the new information.

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Chapter 8—USEFULNESS OF ACCOUNTING INFORMATION TO INVESTORS AND CREDITORS

The three forms of the efficient-markets hypothesis are the weak, the semistrong, and the strong form. The weak form says that security prices reflect information contained in the sequence of historical prices; the semistrong form says that prices reflect all past and current information that is publicly available; and the strong form says that prices reflect all information (both public and private).

3. Respond to the following: a. b.

Describe the capital asset pricing model. What is the market model?

ANSWER: a. The capital asset pricing model has been developed for the theoretical pricing of individual stocks. Its first step is to relate the risk of an individual security relative to the market as a whole. The market is assumed to be a diversified portfolio. A correlation is made between the returns on individual stocks and market returns over a period of time. Regression analysis is used to fit a line to a scattergram of these correlations. The slope of this line is called beta and represents a market-based measure of the systematic risk of an individual security relative to the average risk in the market as a whole. If beta equals 1, the returns are perfectly associated and the risks are equal. If beta exceeds 1, the returns on the individual stock are greater than the market. The assumption of the capital asset pricing model is that individual securities are priced solely on systematic risk. Beta is used to predict the risk-based price of securities. A standard version of the capital asset pricing model defines the predicted rate of return for an individual security as a function of the risk-free rate of return, beta, and the expected return on the market portfolio. b.

Empirical studies in accounting use a simpler approach to the capital asset pricing model, the market model, in which the risk-free return is dropped and unexpected (or abnormal) returns for any time period are captured in an error term.

4. What are the weaknesses of capital market research? ANSWER: Determining cause and effect between information and security prices is difficult because new information is continuously causing price movements. Since the set of information affecting security prices is large, it is extremely difficult to isolate the effects of one piece of information. In addition, only a relatively small group of investors, those at the margin who influence stock prices, are examined. The methodology is not always capable of detecting information content, so stronger evidence from efficient-markets research exists where there is information content rather than where there is none. Another weakness of capital market research is that it is a joint test of both market efficiency and information content. The absence of price responses is usually interpreted to mean the information tested has no information content; however, this interpretation is correct only if the market is efficient. If the market is inefficient, there is no way of determining what the absence of a price response means.

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Finally, market-based research necessarily considers only the aggregate effect of individual investor decision making. The role of accounting information is modeled as a black box: an event, the reporting of accounting information, occurs, and the effect of this event is then inferred from whether there was a market reaction. 5. Discuss whether alternative accounting policies have a systematic effect on security prices and what this implies about the information content of accounting policy changes. Include a discussion of previous research in this area. ANSWER: If security prices do not respond to artificial book-income differences, then there is evidence that investors are sophisticated and are able to see through superficial bookkeeping differences. If security prices do respond to income levels that differ solely because of alternative accounting methods, with no cash flow consequences, then there is support for the naive-investor hypothesis. Most of the initial research in this area supported rejecting the naive investor hypothesis. Research studies have examined security-price responses to a reported change in accounting policy by a company, and they have compared companies using different accounting methods. The evidence from this research supports the claim that there is no information content in accounting policy changes, at least where there are no apparent underlying changes in cash flows. This finding has also been interpreted as a rejection of the naive-investor hypothesis. Investors appear to adjust accounting income to compensate for artificial bookkeeping differences with no real substance. One type of change in accounting policy that does produce a security-price response is a change from FIFO to LIFO inventory accounting. Changes to LIFO have been associated with a positive security-price movement. The suggested reason for the price response is that a change to LIFO does generate real cash flow consequences by lowering taxable income, and thus income taxes. Other studies, however, contradict these findings, showing no evidence of price response or a negative price response. If these studies are correct, there may be some support for the naiveinvestor hypothesis. A negative price response could be interpreted as a mechanistic response to a lower accounting number, ignoring the real positive cash flow consequence due to lower taxes. However, another reason for the negative price reactions could be that investors are considering the potentially high adoption costs relative to LIFO such as accounting system changes and higher probability of violating debt contract provisions, possible diluting presumed future tax savings. Research studies have also investigated the effect on security prices of indirect cash flow consequences, such as a reduction of dividend paying ability because of restrictive debt covenants. Studies in this area have found negative security-price responses in the case of such indirect consequences. 6. What is post-earnings-announcement drift, and what are possible causes for this phenomenon? ANSWER: Post-earnings-announcement drift refers to the fact that while markets do react significantly at the time of earnings announcements, it takes up to 60 days for the full effect to be reflected in security prices. One possible reason for post-earnings-announcement drift is that financial analysts underreact to very fundamental signals. This leads to forecast errors which, in turn, lead to incomplete security price adjustments. It is also possible that shareholders do not distinguish well between cash flow portions of earnings and the accrual portion. The cash flow portion persists longer into the future and is less subject to manipulation than the accrual part of earnings.

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Another possibility is that transaction costs are too high relative to the potential gain that can be earned from the mispricing of the securities. Securities markets may not be as efficient as we once believed. 7. What is cross-sectional valuation and how has this approach been used in research studies? ANSWER: Cross-sectional valuation examines the association between accounting data reported in annual financial statements and the levels of stock prices. This approach has been used to investigate how specific components of the financial statements are associated with the market valuation of the firm. If an item is considered an asset/revenue, it should normally have a positive relation to market value, whereas if the item is considered a liability/expense, it should normally have a negative relation with market value. Several studies have used this framework to determine that a firm's pension plan assets and liabilities, as reported in footnote disclosures, are consistent with their being viewed as real (onbalance sheet) assets and liabilities. Another study determined that components of pension expense are not weighted equally in terms of their association with market valuation. The transitional asset amortization component of pension expense was implicitly valued at zero, which is consistent with the fact that there are no cash flows associated with the item. Another study examined the association of research and development expenditures with firm value. On average, each dollar of R&D was associated with a five-dollar increase in market value. This shows that the market interprets R&D as an asset rather than an expense, contrary to the required accounting treatment. Studies have also examined supplemental disclosures of nonperforming loans and interest rate risk in banks and thrifts. Nonperforming loans were negatively associated with firm value and interest rate risk was negatively associated with firm value only for banks. Another study reported that banks' supplemental disclosures of the "fair market value" of investment securities is associated with market value over and above that explained by historical costs alone, a finding that gives credence to the SEC's and FASB's recent push for market-to-market accounting. 8. Discuss the results of the study by Loh and Mian as they relate to the importance of earnings forecasting. ANSWER:

The residual income model provides a central role for future earnings forecasts in determining the intrinsic value of a stock. Loh and Mian provided evidence that better earnings forecasts make for wealthier investors. They examined the usefulness of accurate earnings forecasts from security analysts. Each firm-year, they sorted analysts based on the accuracy of their forecasts of annual earnings. They found that analysts with the best earnings forecasts provided the best returns, suggesting that their stock-picking ability was real, and showing support for fundamental analysis of accounting data.

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Chapter 9—UNIFORMITY AND DISCLOSURE: SOME POLICY MAKING DIRECTIONS

TRUE/FALSE 1. Events are economic occurrences that require accounting entries. ANSWER: TRUE 2. The concept of uniformity appears to overlap with consistency. ANSWER: FALSE 3. Transactions are economic or financial events that are recorded in the firm's accounts. ANSWER: TRUE 4. An event, as defined in SFAC No. 6 is, "a happening of consequence to an entity." ANSWER: TRUE 5. Because events that are internal to the firm are not considered "transactions," they do not require entries in the firm's accounts. ANSWER: FALSE 6. Relevant circumstances are an important aspect of the uniformity issue. ANSWER: TRUE 7. Future contingencies that are allocations do not have real information content for financial statement users. ANSWER: FALSE 8. Minimizing reported income would not be a motive guiding the selection of accounting methods. ANSWER: FALSE 9. Environmental conditions are elements beyond managerial control. ANSWER: TRUE 10. Rigid uniformity has been formulated as an alternative to finite uniformity. ANSWER: TRUE 11. In accounting, we presume that if rigid uniformity can be attained, it is superior to finite uniformity. ANSWER: FALSE

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12. Improving comparability may lessen relevance or reliability. ANSWER: TRUE 13. Rigid uniformity considers relevant circumstances. ANSWER: FALSE 14. Flexibility is an approach to the uniformity problem. ANSWER: TRUE 15. Flexibility applies to situations in which there are relevant circumstances and more than one possible accounting method exists. ANSWER: FALSE 16. Flexibility is not often used in generally accepted accounting principles. ANSWER: FALSE 17. Whenever possible, flexibility should be used in formulating accounting policy. ANSWER: FALSE 18. Finite uniformity should always be used in accounting for complex events. ANSWER: FALSE 19. Since the 1970s, the SEC appears to have shifted its emphasis toward informative disclosure rather than protective disclosure. ANSWER: TRUE 20. Lev advocated restricting disclosures to "good news" items only. ANSWER: FALSE 21. An organized disclosure policy that includes "bad news" is beneficial to all parties because uncertainty about the firm is reduced. ANSWER: TRUE 22. The SEC requires disclose of both retrospective and prospective information in the Management's Discussion and Analysis section of the annual report. ANSWER: TRUE 23. Signalling theory appears to be inconsistent with the advocacy of greater disclosure. ANSWER: FALSE

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24. Management disclosures in the face of a major earnings surprise may take the form of conference calls with analyst or public announcements via news services. ANSWER: TRUE MULTIPLE CHOICE 1. Which of the following is not listed by Fields, Lys, and Vincent as a possible reason underlying management choice? a. Minimizing agency cost b. Comparability c. Signaling d. Influencing outside parties ANSWER: B 2. Which of the following is not a true statement? a. Comparability refers to accounting for similar transactions similarly and different circumstances differently. b. Comparability refers to comparing alternatives in order to make a decision. c. Comparability is an inherent quality of accounting numbers in the same sense that relevance and reliability are. d. Uniformity influences comparability. ANSWER: C 3. Which of the following is a true statement? a. Transactions are events that may be either external or internal to an enterprise. b. Events that are internal to the firm do not require entries in the firm's accounts. c. Transactions are economic or financial events that may or may not be recorded in the firm's accounts. d. "Simple events" do not have any significant economic variables that lead to essentially different recording. ANSWER: D 4. The term "present magnitudes" refers to: a. Conditions known at the time of an event. b. Conditions known only at a later date. c. Events that will significantly affect the financial statements. d. None of the above ANSWER: A 5. Which of the following terms represents the two general types of relevant circumstances? a. Present circumstances and future contingencies b. Present conditions and future contingencies c. Present magnitudes and future conditions d. Present magnitudes and future contingencies ANSWER: D

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6. Circumstantial variables are environmental conditions that possess which of the following qualities? a. Excessive measurement costs b. A high degree of verifiability relative to other accounting methods c. Both a and b d. None of the above ANSWER: A 7. Prescribing one method for generally similar transactions even though relevant circumstances may be present is referred to as: a. Finite uniformity. b. Rigid uniformity. c. Inflexible uniformity. d. Measurable uniformity. ANSWER: B 8. Which of the following is a true statement? a. Finite uniformity should be more representationally faithful than rigid uniformity. b. Finite uniformity should be more verifiable than rigid uniformity. c. Rigid uniformity is more relevant than finite uniformity. d. Rigid uniformity can be obtained only at a greater cost that finite uniformity. ANSWER: A 9. Where rigid uniformity is in effect, the underlying reasons may be attributable to all but which one of the following factors? a. A desire for conservatism b. An inability of the standard-setting organization to determine meaningful relevant circumstances c. An attempt to increase representational faithfulness of the measurement d. Recognition of the fact that an allocation is involved ANSWER: C 10. Flexibility applies to which of the following situations? a. Situations in which there are relevant circumstances and more than one possible accounting method exists b. Situations in which there are relevant circumstances but only one possible accounting method exists c. Situations in which there are no observable relevant circumstances and more than one possible accounting method exists d. All of the above ANSWER: C 11. Which of the following is not true of accounting allocations? a. Examples include depreciation and cost of good sold b. They are arbitrary c. No method can be proved superior to another method d. They are not useful in providing financial information ANSWER: D

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12. The requirement by SFAS No. 2 that research and development costs be immediately expensed is an example of: a. Elastic uniformity. b. Finite uniformity. c. Flexible uniformity. d. Rigid uniformity. ANSWER: D 13. The determination of whether a lease is a capital or operating lease is an example of: a. Elastic uniformity. b. Finite uniformity. c. Flexible uniformity. d. Rigid uniformity. ANSWER: B 14. The treatment of loss contingencies required in SFAS No. 5 is an example of: a. Elastic uniformity. b. Conservatism. c. Flexible uniformity. d. Rigid uniformity. ANSWER: B 15. Accounting for inventory and cost of goods sold and for depreciation is an example of: a. Elastic uniformity. b. Finite uniformity. c. Flexibility. d. Rigid uniformity. ANSWER: C 16. Under which of the following circumstances should rigid uniformity be used? a. If the event is a not a simple event b. If the event is a complex event in which finite uniformity cannot be instituted in a costeffective manner c. Both a and b d. None of the above; rigid uniformity should never by used ANSWER: B 17. Under which of the following circumstances should finite uniformity be used? a. If the event is a simple event b. If the event is a complex event in which relevant circumstances cannot be measured and implemented in a cost-effective manner c. If the event is a complex event in which relevant circumstances can be measured and implemented in a cost-effective manner d. Both a and b ANSWER: C

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18. Which of the following is a true statement? a. Disclosure is concerned with information in the financial statements as well as information in the footnotes, management's discussion and analysis, financial and operating forecasts, and other supplementary communications. b. Disclosure is concerned with information in the financial statements only. c. Disclosure is concerned with information in the footnotes only. d. Disclosure is concerned with information in the financial statements and all supplementary communications except financial and operating forecasts. ANSWER: A 19. SFAC No. 5 defines disclosure as: a. Presentation of information in the financial statements. b. Presentation of information by means other than recognition in the financial statements. c. Recognition of information in the financial statements or footnotes. d. Presentation of information in any source available. ANSWER: B 20. Protective disclosure and informative disclosure are two types of disclosures as interpreted by the: a. FTC. b. FASB. c. AICPA. d. SEC. ANSWER: D 21. The system of disclosure largely in effect today is called: a. Selective disclosure. b. Conventional disclosure. c. Differential disclosure. d. Standard disclosure. ANSWER: C 22. The 10-K report filed annually with the SEC is basically aimed toward which of the following groups? a. Shareholders b. Professional financial analysts c. Management d. All of the above ANSWER: B

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23. Which of the following describes information overload? a. The inability of preparers to process and adequately report all the information that should be provided in financial reports b. The inability of auditors to process and adequately attest to all the information that should be provided in financial reports c. The inability of users to process and intelligently use all the information provided in financial reports d. The inability of preparers, auditors, and users to process and adequately utilize all the information provided in financial reports ANSWER: C

24. Which of the following represents the principal theoretical issue underlying quarterly data? a. Whether an interim period should be viewed as a separate period standing on its own b. Whether an interim period report should include balance sheet and cash flow statements c. Whether quarterly earnings should be disaggregated by segments in terms of revenues, profit or loss, and segment assets d. Whether interim reports should include income statement data and basic and fully diluted earnings per share numbers ANSWER: A 25. Viewing each interim period as a separate period standing on its own is called: a. The integral view. b. The disjointed view. c. The discrete view. d. The linked view. ANSWER: C 26. Which of the following represents the approach to interim reporting favored by APB Opinion No. 28? a. The integral view b. Disjointed view c. The discrete view d. The linked view ANSWER: A 27. From a theoretical standpoint, which of the following represents the approach to interim reporting with the most validity? a. The integral view b. The disjointed view c. The discrete view d. The linked view ANSWER: A

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28. Which of the following is a provision of SFAS No. 131? a. Segment liabilities must be reported, but reported segment assets is optional. b. Reconciliation of segment profit or loss to consolidated profit of loss must be done before income taxes. c. A segment is constituted by having 20% or more of combined revenue of all operating segments. d. Segment reporting is based on the way management organizes the segments for making operating decisions and assessing performance. ANSWER: D ESSAY 1. How does the concept of uniformity relate to comparability in the accounting literature? ANSWER: In the accounting literature, the concept of uniformity appears to overlap with comparability. According to Sprouse, the term “comparability” is used to mean accounting for similar transactions similarly and for different circumstances differently. He sees comparability as both the process of accounting for circumstances in accordance with similarities or differences and the end result of comparing alternatives in order to make a decision. However, in the text, comparability is viewed only in the latter context, while uniformity is seen as the concept that influences comparability. The degree of comparability that users can rely on is directly dependent on the level of uniformity present in financial statements. 2. What is meant by relevant circumstances? Describe the two types of relevant circumstances. ANSWER: Relevant circumstances are economically significant circumstances that can affect broadly similar events. These economically significant circumstances are general conditions or factors associated with complex events that are expected to influence the incidence or timing of cash flows. Relevant circumstances pertain directly to the event being accounted for and influence the accounting method selected to represent that event. Those conditions known at the time of the event are referred to as present magnitudes. Factors that can be known only at a later date are called future contingencies. 3. Discuss the role of management in relevant circumstances. ANSWER: Managerial influence has been regarded as an important consideration in terms of allowing different accounting methods based on relevant circumstances. However, there is a problem in that the selection of accounting methods might be guided by motives such as: (1)

Maximizing short-run reported income if managerial compensation is based on it

(2)

Minimizing short-run reported income if there is fear of governmental intervention on antitrust grounds

(3)

Smoothing income if it is believed that stockholders perceive the firm as having a lower amount of risk than would be the case if greater fluctuations of earnings were

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present Because management is potentially capable of distorting income measurements, limiting relevant circumstances to elements beyond managerial control has been suggested. 4. Distinguish between finite uniformity, rigid uniformity and flexibility. Also, explain when each is appropriately used. ANSWER: Finite uniformity attempts to equate prescribed accounting methods with the relevant circumstances in generally similar situations. Rigid uniformity means prescribing one method for generally similar transactions even though relevant circumstances may be present. Finite uniformity should be more representationally faithful than rigid uniformity, but may be less verifiable. Rigid uniformity can improve comparability in situations where representational faithfulness is not the goal. However, improving comparability may destroy or weaken relevance or reliability. The presumption is that if finite uniformity can be attained, it is superior to rigid uniformity from the standpoint of usefulness in decision making or performance evaluation. However, meaningful finite uniformity could be obtained only at a greater cost than rigid uniformity, so the advantage is merely relative and depends on marginal benefits and costs. Flexibility applies to situations in which there are no discernible relevant circumstances but more than one possible accounting method exists, any of which may be selected at the firm's discretion. Wherever possible, flexibility should be eliminated. If it is possible to discern relevant circumstances and they can be measured and implemented in a cost-effective manner, finite uniformity should be implemented. If the event category is either a simple event or a complex event in which finite uniformity cannot be instituted in a cost-effective manner, rigid uniformity should be employed.

6. What is meant by differential disclosure? Identify the three differential disclosure proposals discussed in the text. ANSWER: Differential disclosure as it is in effect today refers to the fact that the 10-K and 10-Q reports filed annually and quarterly by management with SEC are basically aimed toward professional financial analysts. They are more detailed and technical than the annual report going to shareholders. Three additional differential disclosure proposals include: (1)

Small firms versus larger firms: The FASB specifically considers implications of disclosures for smaller firms with the express purpose of requiring discloses only where they are relevant and cost effective.

(2)

Summary annual reports (SAR): These reports are condensed financial statements that omit or boil down much of the detail contained in the body of the traditional audited financial statement and are a new development in disclosures. Management discussion and analysis, on the other hand, is generally more expansive. The SAR is intended to replace the traditional corporate annual report and to be more understandable. The wide use of SARs would be a revolutionary development in financial reporting.

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(3)

SEC attempts to streamline annual reports: The SEC has proposed that financial statements in annual reports be streamlined by reducing the number of footnotes. This proposal was abandoned shortly after it was introduced because investors thought they were being deprived of important information.

7. What is Regulation FD, and how does it relate to the disclosure of information? ANSWER: The SEC passed Regulation FD in August 2000 in an attempt to prevent the leaking of important information to favored financial analysts prior to announcing it to the general public. It attempts to eliminate selective disclosure in terms of conveying information to financial analysts and the general public. The elimination of selective disclosure is complementary to efforts to increase the level of disclosure to the public.

8. How has the FASB (and the SEC) addressed the contention that small firms incur significantly higher costs than large ones in carrying out complex accounting standards or disclosure requirements? ANSWER: The FASB specifically considers implications of disclosures for smaller firms with the express purpose of requiring disclosures only where they are relevant and cost effective. The FASB established a Small Business Advisory Committee of the Financial Accounting Standards Advisory Council for facilitating communication concerning financial reporting for both small enterprises and small public accounting firms.

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TRUE/FALSE 1.

The two general financial reporting models that have evolved in economically advanced countries are the Anglo-Saxon model and the European Model. ANSWER: FALSE

Accounting may be called “the language of business.” ANSWER: TRUE

The Anglo-Saxon model of reporting features the use of judgment to make financial statements useful. ANSWER: TRUE

The continental model of financial reporting generally presents a strong accounting profession. ANSWER: FALSE

Professional accounting societies first arose in the United Kingdom in the middle of the 19th century. ANSWER: TRUE

The Accounting Standards Board (ASB) in the UK operates along the lines of the FASB. ANSWER: TRUE

The Accounting Standards Steering Committee (ASSC) is the United Kingdom equivalent of the Securities and Exchange Commission. ANSWER: FALSE

The continental model of financial reporting generally reflects a strong governmental influence on accounting regulation. ANSWER: TRUE

In the United States, the term “present fairly” in opinions of American auditing firms is the same as the “true and fair view” of international financial reporting. ANSWER: FALSE

10. Financial accounting standard setting in New Zealand has remained within the private sector. ANSWER: TRUE

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11. The ASEAN is a group of developing nations in southeast Asia whose goal is to foster trade and development both within and outside the region. ANSWER: TRUE 12. The Netherlands is a continental nation with a largely Anglo-Saxon accounting model. ANSWER: TRUE 13. Within the continental model of financial reporting, Germany has the closest approach to a uniform national accounting system. ANSWER: FALSE 14. Harmonization of accounting standards refers to the degree of coordination or similarity among the various sets of national accounting standards and methods and the formats of financial reporting. ANSWER: TRUE 15. Many continental model countries, such as France and Germany, have viewed harmonization as an opportunity to coordinate their accounting standards with those of the United States. ANSWER: FALSE 16. The International Accounting Standards Committee was formed in an attempt at economic integration of member countries. ANSWER: FALSE 17. The United States is not a member of the G4 +1. ANSWER: FALSE 18. British standard-setters blazed the trail of accounting regulation being centered in the private sector. ANSWER: FALSE 19. Countries following the continental model include most major countries of Western Europe as well as Japan. ANSWER: TRUE 20. The key factor of difference between the Anglo-Saxon and continental models appears to be between capital-based financial markets and credit-based financial markets. ANSWER: TRUE

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21. Financial reporting is independent of the legal system of a nation. ANSWER: FALSE 22. Principles-based standards are more highly detailed than rules-based standards. ANSWER: FALSE 23. The IASB has not yet promulgated a conceptual framework. ANSWER: FALSE 24. The European Union has extended consolidation accounting to firms within its member states under a very wide group of circumstances where one firm has substantive control over one or more other firms. ANSWER: TRUE 25. Because of important national differences, a strong drive for harmonization of accounting standards has not yet been possible. ANSWER: FALSE

26. The IASB operates within an organizational structure akin to the FASB. ANSWER: TRUE 27. The ISB has increased disclosure requirements and is seen as being close to U.S. GAAP from the standpoint of harmonization. ANSWER: TRUE 28. The IASB has greatly increased the allowed number of treatments in particular event areas. ANSWER: FALSE 29. The Norwalk Agreement stated the IASB’s and FASB’s common goal of developing accounting standards usable for both domestic and cross-border financial reporting. ANSWER: TRUE 30. A major difference between the IASB’s conceptual framework and FASB’s is that the IASB’s primary user group is limited to investors and creditors. ANSWER: FALSE 31.A false sense of comparability may develop during translation of an IFRS from English into another language. ANSWER: TRUE

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MULTIPLE CHOICE 1.

Which of the following characteristics does not describe the Anglo-Saxon model of financial reporting? a. A strong accounting profession b. Strong governmental influence c. The importance of securities markets for raising equity capital d. An emphasis upon the true and fair view of audited financial statements ANSWER: B

Which of the following does not describe the continental model of financial reporting? a. A weak accounting profession b. Strong governmental influence c. The primacy of investor needs over tax influences and creditor needs d. Emphasis of debt financing over equity capital ANSWER: C

Which of the following is true regarding the Accounting Standards Board (ASB) in the UK? a. The US has a greater influence on the standard setting apparatus in the UK than does the European Union. b. ASB board members serve on a part-time basis without salary. c. The Emerging Issues Task Force (EITF) serves both the US an UK standards-setting boards. d. The ASB issues accounting standards on its own authority. ANSWER: D

Which of the following countries is a continental nation, but more closely follows the AngloSaxon financial reporting model. a. France b. Japan c. The Netherlands d. Australia ANSWER: C

Which of the following is a continental model country with some signs of moving toward the Anglo-Saxon view? a. Germany b. France c. Canada d. Japan ANSWER: A

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Which of the following is a financial reporting model that features the presence of a strong accounting profession? a. The Anglo-Saxon model b. The continental model c. The ASEAN model d. The international model ANSWER: A

The United States is an example of: a. The Anglo-Saxon model. b. The continental model. c. The ASEAN model. d. The international model. ANSWER: A

Anglo-Saxon versus continental differences have been summarized using all but which of the following characteristics? a. Strength of the accounting profession b. Population size c. Strong equity markets as opposed to credit financing from major banking institutions d. The importance of the country's legal system relative to the setting of accounting rules ANSWER: B The “true and fair view” refers to a. The use of judgment to make financial statements useful. b. The same thing as “present fairly” in opinions of American auditing firms. c. The fact that financial statements are in accordance with GAAP d. The fact that financial statements are presented correctly in accordance with the law. ANSWER: A

10. Which country has the oldest professional accounting organizations? a. The UK b. The US c. France d. Germany ANSWER: A 11. Which country has the closest approach to a uniform national accounting system? a. The UK b. The US c. France d. Germany ANSWER: C

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12. Which of the following statements are not required under Germany’s accounting standards? a. The Balance Sheet b. The Income Statement c. The Cash Flow Statement d. All of the above are required ANSWER: C 13.

Which of the following is true regarding American securities exchanges? a. The US and the UK have a system of reciprocity in place for listing the securities on one another’s stock exchanges. b. The SEC does not allow foreign companies that do not use US GAAP to be listed on American stock exchanges. c. Most Japanese firms listed for trading on American securities exchanges use US GAAP. d. Canadian companies may list existing shares for trading on American stock exchanges, but may not list new stock issues. ANSWER: C

14. Which of the following terms is used to refer to harmonization among accounting practice of different enterprises? a. Formal harmonization b. Material harmonization c. De jure harmonization. d. Convergence ANSWER: B 15. Which of the following terms is used to refer to the harmonization present among the accounting rules of different countries? a. Formal harmonization b. De jure harmonization c. Convergence d. All of the above ANSWER: D 16. Which of the following is a characteristic of rules-based accounting standards? a. They are highly detailed b. They rely heavily on judgment by management or the auditor c. They are shorter than rules-based standards. d. They are required by Sarbanes-Oxley ANSWER: A 17. The SEC drafted report required by Sarbanes-Oxley used which of the following terms to refer to a principles-based approach to standards? a. Bright line standards b. Rule oriented standards c. Objective oriented standards d. Systematic and rational standards ANSWER: C

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18. Benston, Bromwich, and Wagenhofer believe that the principles-based approach would work better in tandem with: a. A fair value measurement orientation b. A revenue-expense orientation c. An asset-liability orientation d. All of the above ANSWER: B 19. Which of the following is not a true statement regarding harmonization of accounting standards? a. Harmonization refers to the degree of coordination or similarity among the various sets of national accounting standards and methods and the formats of financial reporting. b. Among the factors underlying the desire for harmonization is the rise in importance of the multinational firm. c. The issue of harmonization is closely tied to the efforts of the IASB as well as activities of the EU. d. Many continental model countries, such as France and Germany, have viewed harmonization as an opportunity to coordinate their accounting standards with those of the United States. ANSWER: D 20. Which of the following is not a true statement regarding the IASB? a. The IASB has promulgated a conceptual framework. b. The IASB is playing an important role in the drive toward harmonization. c. Several European nations have surrendered their standard-setting powers to the IASB. d. Members of the IASB have pledged to use their best endeavors to bring the adoption of IASB standards to their countries. ANSWER: C 21. Which of the following organizations was formed in an attempt at economic integration, and has also been concerned with harmonization of accounting standard of its member nations? a. The International Accounting Standards Committee b. The International Federation of Accountants c. The European Union d. The International Organization of Security Commissions ANSWER: C 22. Which of the following is not a member of the G4+1? a. IASB b. Australia c. United States d. France ANSWER: D

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23. Which of the following is true? a. Convergence of IASB and FASB standards will be a major step towards international harmonization. b. The IASB has reduced disclosure requirements. c. The IASB has increased the allowed number of treatment in particular event areas. d. FASB and the IASB have not yet committed to convergence of IFRS and U.S. GAAP. ANSWER: A 24. The IAS designation for the preferred accounting treatment is referred to as: a. Benchmarking b. Conformity c. Reconciliation d. Convergence ANSWER: A 25. The term International Financial Reporting Standard (IFRS) refers to: a. The new numbered series of pronouncements that the IASB is issuing. b. The entire body of IASB pronouncements, including International Accounting Standards issued between 1973 -2001. c. Both a and b d. None of the above ANSWER: B 26. Harmonization of IASB and FASB standards is now being called: a. Benchmarking b. Conformity c. Uniformity d. Convergence ANSWER: D 27. Which of the following is a major difference between the IASB’s conceptual framework and the FASB’s? a. The IASB prefers replacement cost over historical cost as a measurement basis. b. FASB limits primary user groups to investors and creditors. c. FASB’s conceptual framework is considerably shorter than the IASB’s. d. The IASB’s framework is in the form of a series of Concept Statements rather than a single framework. ANSWER: B 28. Which of the following possible measurement bases listed by the IASB in the most prevalent? a. Present Value b. Exit Value c. Replacement cost d. Historical cost ANSWER: D

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29. Which of the following does not accurately characterize the IFAC? a. It produces international financial reporting standards. b. Its guidelines cannot be imposed on any member organization or nation. c. Its board produces international standards for ethics, education and public sector accounting. d. It produces international standards for auditing and assurance. ANSWER: A 30. Which of the following characterizes the United Nations involvement in financial reporting? a. The UN has developed significant regulations relative to financial reporting for multinationals. b. The US and the UK have expressed a desire to have the UN participate in developing qualifications to sit for professional accounting exams. c. The UN has shown interest in prescribing an accounting curriculum. d. The UN has had a greater role in establishing international accounting standards than the IASB. ANSWER: C

ESSAY 1. Compare and contrast the Anglo-Saxon financial reporting model with the continental model. ANSWER: The Anglo-Saxon (sometimes called the Anglo-American model) financial reporting model features the presence of a strong accounting profession, a somewhat limited role of government, the importance of securities markets for raising equity capital, and an emphasis upon the true and fair view of audited financial statements. The true and fair view refers to the use of judgment in order to make financial statements useful instruments for making investment decisions, as opposed to ensuring that they have been presented correctly in accordance with legislative fiat. The continental model generally presents a relatively weak accounting profession; reflects strong governmental influence upon accounting regulation and organization, including the primacy of tax influences and the protection of creditors in financial statement presentation rather than for investor needs and emphasizes the importance of debt financing through major banks rather than the raising of equity capital. The continental model emphasizes legalistic form over economic substance. 2. What does harmonization of accounting standards mean, and what are the two aspects of harmonization? ANSWER: Harmonization refers to the degree of coordination or similarity among the various sets of national accounting standards and methods, and formats of financial reporting. Harmonization has been broken down into two aspects: (1) material harmonization, which refers to harmonization among accounting measurements and disclosures of different countries or groups and (2) formal harmonization, which refers to the process or degree of harmonization present among the accounting rules or regulations of different countries or groups.

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3. Identify the following organizations and describe the role each plays in the drive toward harmonization: a. The IASB b. The EU ANSWER: a. The IASC (International Accounting Standards Committee) was formed in 1973 by professional accounting organizations from nine nations including the United States. In 2001 the IASB was reorganized and its name was changed to the International Accounting Standards Board (IASB). It now has over one hundred member organizations from 103 nations. The AICPA is the American organization holding membership in the IASB. No nation or any professional body from any nation has surrendered its accounting standard-setting sovereignty to the IASB. Rather, the members have pledged to use their "best endeavors" to bring the adoption of IASB standards to their countries. As of fall 2002, forty-one international accounting standards had been issued by the IASB. Many less-developed nations with a limited professional accounting infrastructure use all or at least a majority of IASB standards. The IASB has come up with what are deemed to be high quality financial standards, and has greatly reduced the allowed number of treatments in particular event areas and also increased disclosure requirements. EU countries must use IASB standards for consolidated financial statements by 2005. Similarly, American stock exchanges will accept IASB standards for domestic listing by 2005 without reconciliation. Also by 2005 Australia will accept IASB standards for financial reporting by both domestic and foreign firms. Canada may also be aboard shortly. b.

The EU (European Union) was formed in 1967 with 12 member countries. In addition to its attempts to integrate European countries economically and politically, the EU has been concerned with harmonization of accounting standards of its member nations. The Council of Ministers of the EU nations has issued several directives with important implications for accounting. Directives become binding upon the member countries, although they may not be implemented in exactly the same way by each nation. Two directives, the Fourth Directive and the Seventh Directive, contain important accounting matters. The Fourth Directive was adopted in 1978. The Fourth Directive concerns basic issues of financial reporting that are applicable to companies within the EU community. In addition to providing standard formats for financial statements, the directive states that financial statements be based on four concepts: consistency, going concern, prudence, and accrual accounting. The Fourth Directive permits current value statements in addition to historical costs and also calls for the application of the true and fair view. Since the true and fair view calls for going beyond accounting rules in order to portray economic reality, it is very questionable how it can be implemented given differences in definition, interpretation, and application among the countries constituting the EU. Furthermore, it is contended that the true and fair view is being interpreted in EU nations in terms of their own particular cultures and traditions. Increasingly, the true and fair view is seen as going from the need to "override" accepted accounting principles with full disclosures in order to show the facts and conditions of the enterprise truthfully to a diligent application of existing GAAP.

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The Seventh Directive was passed in 1983. It extends consolidation accounting to firms within the member states of the EU under a very wide group of circumstances where one firm has substantive control over one or more other firms. This directive, like the Fourth Directive, requires the true and fair view. Legislatures of member nations had all passed the Seventh Directive by 1992. While the national laws are not exactly the same, it is clear that the Seventh Directive has increased harmonization in the area of consolidations among the member nations. However, there are options allowed under the Fourth and Seventh Directives that allow for differences in some areas such as the definition of a subsidiary and consolidation exemptions where the ultimate parent is not an EU firm.

Contrast principles-based and rules-based accounting standards. Why do these approaches to standard setting tend to converge according to Schipper? ANSWER:

Rules-based standards are highly detailed, often have many exceptions, extensive implementation guidance is given, and they often have “bright line” distinctions. Frequently the bright line distinction can be subverted by management. Principles-based standards are shorter than rules-based standards and rely heavily on judgment either by management and/or the auditor to carry out the intentions of the standard setting agency in terms of relevance, reliability or attaining “economic reality.” According to Schipper, a principles-based approach would need extensive implementation guidance to enable it to work will. This would result in eroding the differences between the two approaches.

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List five differences in accounting practices between the United States and other countries. ANSWER: Possible answers include:

Event Non-capitalization of leases Partial income tax allocation Frequent revaluation of land and buildings Very limited consolidations (prior to the Seventh Directive) LIFO not used Direct adjustments to owners’ equity for unusual gains and losses Some capitalization of development costs Capitalization of research and development costs if recovery is assured beyond a reasonable doubt Very limited use of income tax allocation Goodwill charged against stockholders’equity More extensive capitalization of software development costs (including systems analysis and systems design costs)

Accounting Theory: 8th edition

Country France United Kingdom United Kingdom and Australia France, Germany, and other continental countries United Kingdom and Australia; Japan and U.S. are the only countries using LIFO Most continental countries United Kingdom Australia

Japan United Kingdom Japan

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TRUE/FALSE 1. If the balance sheet and income statement are nonarticulated, they are linked together mathematically without any loose ends. ANSWER: FALSE 2. With the articulated approach to financial statements, each statement is defined and measured independently of the other. ANSWER: FALSE 3. The comprehensive income approach required in SFAS No. 130 favors articulation. ANSWER: TRUE 4. One consequence of the revenue-expense approach is to burden the balance sheet with byproducts of income measurement rules. ANSWER: TRUE 5. There are only a few examples of accounting standards that emphasize the effects of transactions on the income statement to the exclusion of their impact on the balance sheet. ANSWER: FALSE 6. Under the revenue-expense approach, the income statement is regarded as simply a way of classifying and reporting on changes that occur in a firm's net assets. ANSWER: FALSE 7. The definition of assets establishes what types of economic factors will appear in the balance sheet. ANSWER: TRUE 8. The asset-liability approach is arguably superior to a revenue-expense approach to defining accounting elements. ANSWER: TRUE 9. Unrealized capital adjustments in owners' equity are becoming more prevalent as a result of SFAC No. 130 on comprehensive income. ANSWER: FALSE 10. The asset-liability approach complements the expense-liability approach because the former is applicable to the balance sheet and the latter is applicable to the income statement. ANSWER: FALSE

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11. Although the revenue-expense approach is the basic orientation of current financial reporting practice, some specific accounting standards reflect an asset-liability approach. ANSWER: TRUE 12. The FASB defines comprehensive income using the income-expense approach to defining accounting elements. ANSWER: FALSE 13. The "future service potential" of an asset may be realized as a direct market exchange for another asset, or through conversion in a manufacturing operation for finished goods. ANSWER: TRUE 14. An executory contract is a contract unperformed by both parties. ANSWER: TRUE 15. An asset should be initially recorded at either its historical acquisition cost or its cash equivalent purchase price, whichever is greater. ANSWER: FALSE 16. Inventory is carried at the lower of historical cost or replacement cost. ANSWER: TRUE 17. SFAS requires that abnormal amounts of idle facility costs, freight, handling and spoilage be treated as current period costs. ANSWER: TRUE 18. In SFAS No. 121, both the recognition and measurement criteria for the impairment of asset event is based on the excess of the carrying value of the asset over its fair market value less costs of disposal.. ANSWER: FALSE 19. In SFAS No. 153, when exchanged assets have significantly different cash flows, the new asset is recorded at book value of the traded in asset. ANSWER: FALSE 20. All intangible assets are initially recorded at the sacrifice incurred to acquire the assets. ANSWER: TRUE 21. A constructive obligation is one that is implied rather than expressly written. ANSWER: TRUE

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22. Although not specifically mentioned in the most recent definition of liabilities, deferred credits continue to be part of the liability section in the balance sheet under present practices. ANSWER: TRUE 23. APB Statement 4 and SFAC No. 5 indicate that liabilities are measured at amounts established in the transaction, usually amounts to be paid it the future, but never discounted. ANSWER: FALSE 24. The only method allowed by GAAP in accounting for convertible bonds is to treat the debt as conventional debt until conversion. ANSWER: TRUE 25. Manditorily redeemable financial instruments are classified as assets on the balance sheet. ANSWER: FALSE 26. Owners' equity is defined as the stockholders' residual interest in the net assets of the firm. ANSWER: TRUE 27. In a sole proprietorship, there is a legal distinction between contributed capital and earned capital. ANSWER: FALSE 28. There is a movement in accounting policy toward fair or current values on the balance sheet. ANSWER: TRUE 29. U.S. Corporations are not permitted to trade in their own securities. ANSWER: FALSE 30. Derivatives are financial instruments whose value is based upon other financial instruments, stock indexes or interest rates, or interest rate indexes. ANSWER: TRUE 31. SFAS 133 values derivatives at fair value. ANSWER: TRUE 32. SFAS No. 142 converted goodwill into a nonamortizable asset subject to its own impairment rules. ANSWER: TRUE

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MULTIPLE CHOICE 1. Which of the following is a true statement? a. Under the articulated concept, accounting elements are defined using the revenue-expense approach rather than the asset-liability approach. b. The articulated approach severs the mathematical relationships between the balance sheet and income statement. c. Under the articulated approach, contributed capital, retained earnings, and unrealized capital adjustments are subclassifications of owners' equity. d. Recent SFASs have advocated the nonarticulated approach to financial statements. ANSWER: C 2. Which of the following is a true statement? a. Under the articulation approach, all accounting transactions are reported on the income statement. b. Because income is a subclassification of retained earnings, the income statement and balance sheet articulate. c. Under articulation, adjustments to the income of prior years are reflected on the current year income statement. d. All transactions can be easily categorized using the current accounting classification system. ANSWER: B 3. Which of the following is not true regarding the revenue-expense approach to defining accounting elements? a. The revenue-expense approach defines assets and liabilities as a by-product of revenues and expenses. b. Under the revenue-expense approach, the balance sheet is burdened with by-products of income measurement rules. c. Deferred charges and deferred credits are ambiguous debits and credits that appear on the balance sheet under the revenue-expense approach. d. There are very few examples of the use of the revenue-expense approach in recent accounting standards. ANSWER: D 4. Which of the following is not true regarding the asset-liability approach to defining accounting elements? a. The asset-liability approach focuses on the measurement of net assets. b. The asset-liability approach is arguably superior to the revenue-expense approach. c. The asset-liability approach is the basic orientation of current financial reporting practices. d. SFAS No. 109 uses the asset-liability approach by focusing income tax accounting on the recognition of tax assets and liabilities. ANSWER: C

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5. Which of the following is a true statement? a. Asset-liability advocates are not prepared to tolerate a fluctuating income statement that may include unrealized holding gains and losses. b. Asset-liability advocates and revenue-expense advocates are polarized in part because the financial statements are nonarticulated. c. Revenue-expense proponents are prepared to introduce deferred charges and deferred credits in order to smooth income measurement. d. With articulation, it is possible to have a revenue-expense based income statement and an asset-liability based balance sheet. ANSWER: C 6. Which of the following is not a formal definition of assets that has been used by the accounting profession in the United States? a. Something represented by a debit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, on the basis that it represents either a property right or value acquired, or an expenditure made which has created a property or is properly applicable to the future b. Economic resources of an enterprise that are recognized and measured in conformity with generally accepted accounting principles as well as certain deferred charges that are not resources but that are recognized and measured in conformity with generally accepted accounting principles c. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events d. Only those economic resources that can be severed from the firm and sold ANSWER: D 7. Which of the following applies to the measurement and recognition of an asset? a. A pervasive principle in accounting is that an asset is measured at the market value of the consideration exchanged or sacrificed to acquire it and place it in operating condition. b. In some cases, an asset may be recorded at an amount greater than its cash equivalent purchase price. c. When the consideration given for an asset is nonmonetary, the market value of that consideration generally provides the most reliable basis for measuring acquisition cost. d. Assets are always measured and reported based on historical cost. ANSWER: A

8. Which one of the following measurement bases applies to receivables? a. Historical cost b. An approximation of net realizable value c. Selling price through factoring d. Discounted present value

ANSWER: B

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9. Which one of the following measurement bases applies to investments not subject to equity accounting that are classified as trading securities? a. Current value b. Book value c. Effective rate of interest method d. Lower-of-cost-or-market ANSWER: A 10. Which one of the following measurement bases applies to investments that are classified as heldto-maturity? a. Current value b. Book value c. Effective rate of interest method d. Lower-of-cost-or-market ANSWER: C 11. Which of the following is not a true statement regarding assets as they appear on the balance sheet? a. Historical cost gives a good indication of the productive value of assets. b. Assets held for sale and measured at net realizable value represent a high degree of certainty as to measurement reliability. c. Certain types of deferred charges do not have any direct effect on future cash flows. d. In terms of additivity, it is questionable if a balance sheet should be added. ANSWER: A 12. Which of the following statements is not true regarding the three major definitions of accounting liabilities that have evolved over time? a. Two of the three definitions imply a proprietary view of the firm. b. The first definition made no distinction between owner's equity and liabilities. c. Not all definitions have included deferred credits as liabilities. d. In all three definitions, liabilities include only credit balances that involve a debtor and creditor relation. ANSWER: D 13. Which one of the following types of liabilities is not currently recognized on balance sheets? a. Deferred credits b. Constructive obligations c. Equitable obligations d. Contingent liabilities ANSWER: C

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14. Which one of the following types of liabilities represents a duty not contractually present but which may nevertheless exist due to ethical principles of fairness? a. Deferred credits b. Constructive obligations c. Equitable obligations d. Contingent liabilities ANSWER: C 15. Which of the following types of liabilities do not represent obligations on the firm to transfer assets in the future, but are past transactions being postponed from the income statement until future periods? a. Deferred credits b. Constructive obligations c. Equitable obligations d. Contingent liabilities ANSWER: A 16. Which one of the following types of liabilities represents an existing situation involving uncertainty as to possible gain or loss that will ultimately be resolved when one or more future events occur or fail to occur? a. Deferred credits b. Constructive obligations c. Equitable obligations d. Contingent liabilities ANSWER: D 17. Which of the following is a true statement? a. There is more variety in liability groups than in asset groups. b. Most liabilities are noncontractual in nature. c. There are natural subclassifications of liabilities and assets that can be inferred from the balance sheet. d. Liabilities are measured at amounts established in the transaction, usually amounts to be paid in the future, sometimes discounted. ANSWER: D 18. Current liabilities are initially measured at: a. Face value. b. Present value based on current interest rates. c. Present value plus stated interest. d. Book value. ANSWER: A

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19. Noncurrent liabilities are initially measured at: a. Face value. b. Present value based on current interest rates. c. Present value plus stated interest. d. Book value. ANSWER: B 20. After noncurrent liabilities have been initially measured, they are recorded on subsequent balance sheets at: a. Face value. b. Present value based on current interest rates. c. Present value plus stated interest. d. Book value. ANSWER: D 21. Which of the following is a true statement regarding owners' equity? a. APB Statement 4 and SFAC No. 6 both reflect the entity view of the firm. b. Owners' equity consists of only two components: contributed capital and retained earnings. c. In a sole proprietorship, there is no legal distinction between contributed capital and earned capital. d. Dividends are legally paid only out of retained earnings. ANSWER: C 22. Contributed capital is measured by: a. The cost of assets contributed to the firm by stockholders. b. The market value of assets contributed to the firm by stockholders. c. The book value of assets contributed to the firm by stockholders. d. The discounted present value of assets contributed to the firm by stockholders. ANSWER: B

23. Which of the following is not true regarding derivatives? a. A derivative is a financial instrument whose value is based upon another financial instrument, stock index or interest rate, or interest rate index. b. Derivatives can be classified into two general types: forward-based and option-based derivatives. c. Unrealized holding gains and losses on derivatives are not recognized. d. SFAS No. 133 values derivatives at fair value. ANSWER: C

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24. Which of the following is true regarding SFAS No. 144? a. SFAS No. 144 changed the basic measurement rules of SFAS No. 121. b. SFAS No. 144 converted goodwill into a nonamortizable asset. c. Under SFAS No. 144, when several assets constitute a productive unit but the assets have different lives, a discounted cash flow analysis is performed. d. SFAS 144 supersedes Opinion No. 30 in terms of the valuation of assets in discontinued segments. ANSWER: D ESSAY 1. Respond to the following: a. b. c.

What is meant by the "articulated" approach to financial statements? How does the revenue-expense approach differ from the asset-liability approach for defining accounting elements? What, if any, would be the advantage of using a nonarticulated approach to financial statements?

ANSWER: a. Articulation means that the income statement and balance sheet are mathematically defined in such a way that net income is equal to the change in owners' equity for a period, assuming no capital transactions or prior period adjustments. b.

The revenue-expense approach focuses on defining the income statement elements. It places primary importance on the income statement, principles of income recognition, and rules of income measurement. Assets and liabilities are defined, recognized, and measured as a by-product of revenues and expenses. The assetliability approach is the antithesis of the revenue-expense approach because it emphasizes the definition, recognition, and measurement of assets and liabilities. Income is defined, recognized, and measured as a by-product of asset and liability measurement. This approach is arguably superior to the revenue-expense approach because assets and liabilities are real. It is the increase in the value of net assets that gives rise to what we call income, not vice versa. The revenue-expense approach turns things around the other way and implies that changes in net assets are the consequences of "income' measurement. Although the revenue-expense approach is the basic orientation of current financial reporting practices, some specific accounting standards reflect an asset-liability emphasis.

Revenue-expense proponents are primarily concerned with stabilizing the fluctuating effect of transactions on the income statement and are prepared to introduce deferred charges and deferred credits in order to smooth income measurement. Asset-liability advocates are mainly concerned with reporting changes in the value of net assets, and they are prepared to tolerate a fluctuating income statement that may include unrealized holding gains and losses. If the financial statements were severed, both the income-expense and asset-liability groups might be satisfied with a revenueexpense-based income statement and an asset-liability-based balance sheet.

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2. What are the three distinct types of assets that appear in the balance sheets, and what degree of certainty and measurement reliability does each represent? ANSWER: The three types of assets that appear in balance sheets are those held for sale, those that have economic value through use in production, and deferred charges. Assets held for sale and measured at net realizable value (such as receivables) represent a high degree of certainty as to realization as well as measurement reliability. Assets held for production represent more uncertainty as to the realization of future economic benefits due to the inherent uncertainty of manufacturing. Furthermore, historical cost gives little indication of the productive value of such assets. Finally, certain types of deferred charges do not have any direct effect on future cash flows. 3. Describe how the definitions of assets and liabilities have evolved over the years. ANSWER: Definitions of assets have evolved from a narrow legal orientation to a broader concept of economic resources. The first definition of assets emphasized legal property but also included deferred charges because they relate to future period income statements. This aspect of the definition represents a revenue-expense approach to the financial statements. The second definition emphasized that assets are economic resources. Anything having future economic value was considered an asset. Deferred charges were separately identified in this definition but were still grouped with assets. The third definition identified the key characteristics of an asset as: (1) its capacity to provide future economic benefits; (2) control of the asset by the firm; and (3) the occurrence of the transaction giving rise to control and the economic benefits. Deferred charges were dropped from the asset definition. The economic resources approach represents a broader concept of assets than the legal property concept and is consistent with the economic notion that an asset has value because of a future income (cash) stream. The first definition of liabilities defined them as credit balances that would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. This definition made no distinction between owners' equity and liabilities, thus implying an entity theory view of the firm. The other two liability definitions do not mention owners' equity, which seems to imply a proprietary view of the firm in which owners' equity represents owners' residual interest in the net assets. The liability portion of the first definition emphasizes legal debts. In the second definition, the liability concept is broadened to mean economic obligations. In addition, deferred credits are identified separately but are still considered to be a part of liabilities. The third and most recent definition continues the emphasis on economic obligations rather than legal debt and drops deferred credits. This definition lists three essential characteristics of an accounting liability: (1) a duty exists; (2) the duty is virtually unavoidable; and (3) the event obligating the enterprise has occurred. 4. Identify and define the five types of liabilities. ANSWER: (1) Contractual liabilities are either expressly or implicitly contractual in the legal sense of the term. (2) A constructive obligation is one that is implied rather than expressly written. (3) With equitable obligations, a duty is not contractually present but may nevertheless exist due to ethical principles of fairness. (4) Contingent liabilities represent an existing situation involving

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uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events will occur or fail to occur. A contingent liability is accrued if it is probable that a liability has occurred or an asset has been impaired, and it can be reliably measured. (5) Deferred credits continue to be part of the liability section in the balance sheet under present practices. One type of deferred credit represents prepaid revenues. The other type of deferred credit arises from income rules that defer income statement recognition of the item. These types of items impose no obligations on the firm to transfer assets in the future. They are simply past transactions being deferred from the income statement until future periods. 5. How should stock dividends be measured and accounted for? Is this treatment justified? ANSWER: ARB 3 discusses two separate accounting policies for stock dividends, depending on the size of the dividend. Large stock dividends are defined as those over 25 percent and are accounted for by reclassifying retained earnings to contributed capital based on the par value of the stock issued. Small stock dividends are defined as those less than 20 percent and are accounted for by reclassifying retained earning to contributed capital on the basis of the market value of the stock and using predividend market prices to value the dividend. Either method could be used from 20 percent to 25 percent. ASR No. 124 of the SEC sharpened the cutoff between small and large stock dividends to 25 percent to eliminate the "no man's land" where either method could be used. The contention has been made that the accounting for stock dividends arrived at by the CAP is really a matter of management intent—whether management desires to give shareholders evidence of their interest in retained earnings or desires to lower the price of the shares with the stock dividend serving as a stock split but without changing par value of the stock. However, even if this contention is correct, allowing accounting to be a matter of managerial intent would allow similar transactions to be booked differently, an example of the flexibility problem. Also, stock dividends are not distributions of real wealth. Some attempts have been made to use the size of the dividend to define relevant circumstances. However, because total market value of outstanding stock should not change because of stock dividends, little support can be given to using the predividend market price per share to value the transaction. There does not appear to be a relevant circumstance justifying two accounting methods. 6. Explain how assets and liabilities should be classified on the balance sheet. What are the problems with this classification method? ANSWER: ARB 43 requires classification of assets and liabilities based on liquidity. Two classifications are used—current and noncurrent. Current is defined as the firm's operating cycle or one year, whichever is longer. The operating cycle is the time required to go from materials acquisition to cash collection from revenues. The current-noncurrent approach gives only a crude indication of a firm's liquidity. Current assets cannot be used to assess critical cash flow capacity because the operating cycle may be a year or even longer. In addition, the current asset grouping contains some assets that do not affect current cash flows at all. A monetary-nonmonetary classification combined with a current-noncurrent classification would give a better understanding of future cash flows. Another way of subclassifying assets would be according to those held for exchange, those held for use, and those represent-

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ing deferred charges. This would provide some additional information about how economic benefits will be realized and the uncertainty surrounding realization. More detailed reporting could also be made of liabilities. Separate classifications by type would assist in evaluating the nature of the different types of obligations and which ones are legally enforceable in the event of bankruptcy.

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Chapter 12—THE INCOME STATEMENT

TRUE/FALSE 1. The current operating approach has led to the concept of comprehensive income. ANSWER: FALSE 2. Comprehensive income is the change in equity of an entity during a period of transactions and other events and circumstances, from owner and nonowner sources. ANSWER: FALSE 3. The income statement is largely a legacy of fifty years of accounting standards based on the revenue-expense approach. ANSWER: TRUE 4. The FASB appears to be continuing to take a revenue-expense approach to financial statements. ANSWER: FALSE 5. Although there are exceptions, revenue is generally recognized at the time cash is collected. ANSWER: FALSE 6. The majority of exceptions to the general rule regarding revenue recognition have evolved because new transactions have emerged that do not fit the mold of traditional transactions. ANSWER: TRUE 7. The major expense-recognition problem concerns those costs that are clearly not expired in the period incurred but are clearly not associated with the revenues of a particular period. ANSWER: TRUE 8. The distinction between losses and expenses is important under the all-inclusive income concept. ANSWER: FALSE 9. The expense recognition model based on historical cost, as well as the model based on current value, must allocate the costs incurred. ANSWER: FALSE 10. Most accountants believe that the method of cost allocation used is nothing more than an arbitrary decision. ANSWER: TRUE

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11. Recognition of a past event is sometimes governed by whether a "one-event view" or a "twoevent view" is held. ANSWER: TRUE 12. Management intent is an accepted basis for recognition of future events. ANSWER: FALSE 13. Predicting changes in future economic conditions should be a major consideration in the recognition of future events. ANSWER: FALSE 14. Predicting future legal changes that have not yet been enacted should be a major consideration in the recognition of future events. ANSWER: FALSE 15. All empirical evidence supports the all-inclusive income concept. ANSWER: FALSE 16. Research on the smoothing of year-to-year income suggests that operating income is better predicted by operating rather than all-inclusive income. ANSWER: TRUE 17. According to the "big bath theory," when firms disclose bad news, there is a positive response by the market because the firm has recognized in the financial statements that a major problem exists and is moving to redress the problem. ANSWER: TRUE 18. As a result of APB Opinion No. 30, extraordinary items other than gains and losses from early extinguishment of debt, have practically disappeared. ANSWER: TRUE 19. Extraordinary items should be disclosed net of tax. ANSWER: TRUE 20. Prior period adjustments are accounting changes that should be accounted for in comprehensive income on the income statement of the period of change. ANSWER: FALSE 21. The main reason underlying SFAS 154 is that it is part of the convergence project with the IASB. ANSWER: TRUE

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22. If a loss is expected on subsequent disposal of a business segment, the estimated loss is recognized in the financial statements as of the measurement date. ANSWER: TRUE 23. Return on investment is the most-used summary indicator to date. ANSWER: FALSE 24. The elimination of primary earnings per share by SFAS No. 128 is a case of less information leading to more usefulness. ANSWER: TRUE 25. A troubled debt restructuring occurs when a creditor, for economic or legal reasons related to the debtor's financial difficulties, grants a concession to the debtor that it would not otherwise consider. ANSWER: TRUE 26. A major problem with SFAS No. 114 is that it applies only to creditors, while debtors are still governed by SFAS No. 15. ANSWER: TRUE 27. Currently, expense is recognized when an incentive stock option is granted. ANSWER: TRUE 28. The measurement date for determining the value of a stock option is usually the exercise date. ANSWER: FALSE 29. Backdating stock options appears to be an illegal conversion of assets belonging to shareholders to members of management. ANSWER: TRUE 30. According to McVay, classification shifting within the income statement is a form of earnings management.

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MULTIPLE CHOICE 1. Which of the following best describes "comprehensive income"? a. Comprehensive income is the amount resulting from the deduction from revenues, or from operating revenues, of cost of goods sold, other expenses, and losses. b. Comprehensive income is the excess (deficit) of revenue over expenses for an accounting period. c. Comprehensive income is the change in equity of an entity during a period of transactions and other events and circumstances, from nonowner sources. d. Comprehensive income is the change in equity of an entity during a period of transactions and other events and circumstances, from owner and nonowner sources. ANSWER: C 2. Comprehensive income as displayed on the income statement represents: a. An asset-liability approach. b. A revenue-expense approach. c. A current operating approach. d. None of the above ANSWER: A 3. Which of the following is a definition of revenue that clearly represents an asset-liability approach? a. Revenue results from the sale of goods and rendering of services and is measured by the charge made to customers, clients, or tenants for goods and services furnished to them. b. Revenue represents gross increases in assets and gross decreases in liabilities measured in conformity with generally accepted accounting principles that result from those types of profit-directed activities. c. Revenue should be identified with the period during which the major economic activities necessary to the creation and disposition of goods and services has been accomplished. d. Revenues are the inflow or other enhancements of assets of an entity or settlement 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. ANSWER: D 4. Under the current-operating concept, increases in equity from peripheral or incidental transactions (transactions other than sales of products, merchandise, or services) are referred to as: a. Gains. b. Revenue. c. Comprehensive income. d. Accruals. ANSWER: A

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5. Which of the following best describes when revenues are generally recognized? a. At the completion of production b. At the point of sale when legal title is transferred c. When cash is collected d. During production ANSWER: B 6. Which of the following is the primary criterion for revenue recognition applied in practice? a. Cash collection b. Completion of the production process c. Completion of the earnings process d. When sales price is measurable ANSWER: C 7. Which of the following suggested bases of recognizing revenue is not permitted by authoritative literature? a. During production for long-term construction contracts if reliable estimates of the extent of progress and of the cost to complete can be made and if reasonable assurance of collectibility exists b. At the completion of production if immediate marketability at a quoted price exists for a product whose units are interchangeable c. On an accretion basis where product marketability at known prices exists and it is desirable to recognize changes in assets, such as growing timber d. On a cash basis if no reasonable basis exist for estimating collectibility ANSWER: C 8. Which of the following represents the attribute(s) that must be measurable before revenue is recognized? a. Sales price and cash collections b. Sales price c. Cash collections d. Sales price, cash collections, and future costs ANSWER: D 9. Which of the following is a definition of expenses that clearly represents an asset-liability approach? a. Expenses are outflows or other using up of assets or incurrence of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's major or central operations. b. Expenses are costs directly associated with the revenue of the period. c. Expenses are gross decreases in assets or gross increases in liabilities recognized and measured in conformity with generally accepted accounting principles that result from those types of profit-directed activities of an enterprise. d. Expenses in the broadest sense include all expired costs which are deductible from revenues. ANSWER: A

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10. Which of the following should be considered first in applying the matching concept? a. Costs should be matched against the revenue directly produced. b. Costs should be matched to revenue in a rational and systematic manner. c. Costs should be recognized as period expenses when incurred. d. Costs should be recognized as expenses when cash is paid. ANSWER: A 11. Which of the following is a true statement? a. When arbitrary allocations are used, income statements have very little information content. b. The calculation aspects of most expense measurements are easily resolved under historical cost accounting. c. When arbitrary allocations are used, income statements still have information content. d. Capital market research has shown that the usefulness of accounting numbers is best resolved using the deductive logic of the allocation problem. ANSWER: C 12. Which of the following is the major problem underlying future events and their impact upon event recognition? a. Management intent b. The probabilistic nature of future events c. The perception of the past event d. Future economic conditions ANSWER: B 13. Which of the following statements applies to the two-event view of past event recognition? a. It would recognize a transaction as occurring when an offer of early retirement is made to employees. b. It would be more reliant upon probabilistic estimates than the one-event view. c. It is faster than the one-event view. d. It is consistent with the asset and liability views of SFAC No. 6. ANSWER: D 14. The current operating school of thought holds that: a. All components of comprehensive income should be in the income statement. b. The income statement should contain only normal operating components of comprehensive income. c. Retained earnings should reflect only total earnings as reported in the income statement and dividend distributions, in addition to beginning and ending balances. d. Unusual or infrequently occurring gains and losses should be reported on the income statement. ANSWER: B

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15. Which of the following is an argument supporting the "current operating" income recognition school of thought? a. Most financial statement users look only to bottom-line net income to assess current performance and to make predictions regarding subsequent years' performance. b. Under this approach, management makes the decision on whether or not an item is extraordinary and therefore excluded from the income statement. c. The summation of all income displayed on the income statement for a period of years should reflect the reporting entity's net income for that period. d. Proper classification within the income statement allows both normal recurring items and unusual, infrequently occurring items to be displayed separately within the same statement. ANSWER: A 16.

SFAS No. 130 allows all but which of the following regarding comprehensive income? a. Reporting comprehensive income in a combined statement of financial performance b. Reporting comprehensive income in a separate statement of comprehensive income which would begin with net income c. Reporting comprehensive income within a statement of changes in equity d. Not reporting comprehensive income ANSWER: D 17. Which of the following methods of reporting comprehensive income is preferred by the FASB? a. Reporting comprehensive income in a combined statement of financial performance b. Reporting comprehensive income in a separate statement of comprehensive income which would begin with net income c. Reporting comprehensive income within a statement of changes in equity d. Not reporting comprehensive income ANSWER: A 18. Which of the following methods of reporting comprehensive income did the FASB members that dissented from SFAS No. 130 believe most firms would use? a. Reporting comprehensive income in a combined statement of financial performance b. Reporting comprehensive income in a separate statement of comprehensive income which would begin with net income c. Reporting comprehensive income within a statement of changes in equity d. Not reporting comprehensive income ANSWER: C 19. Which of the following is not true regarding comprehensive income? a. Comprehensive income includes foreign currency translation adjustments. b. Comprehensive income includes unrealized holding gains and losses on available-for-sale securities. c. Comprehensive income includes minimum pension liability adjustments previously classified as intangible assets. d. Earnings per share should be calculated for comprehensive income. ANSWER: D

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20. The nonoperating section of the income statement includes: a. Extraordinary items. b. Extraordinary items and discontinued operations. c. Extraordinary items, accounting principle changes, and discontinued operations. d. Extraordinary items, accounting principle changes, discontinued operations, and prior period adjustments. ANSWER: C 21. Which of the following is not considered one of the three broad categories of accounting changes? a. Change in Accounting Principle b. Change in Accounting Estimate c. Change in Reporting Entity d. Change in Accounting Application ANSWER: D 22. Which of the following is the date that management commits itself to a formal plan to dispose of a business segment? a. The measurement date b. The disposal date c. The assessment date d. The transfer date ANSWER: A 22. Which of the following is the date that management commits itself to a formal plan to dispose of a business segment? a. The measurement date b. The disposal date c. The assessment date d. The transfer date ANSWER: A 23. Which of the following is true regarding discontinued operations? a. If a loss is expected on disposal, the estimated loss is recognized in the financial statements as of the measurement date. b. If a loss is expected on disposal, the estimated loss is recognized in the financial statements as of the disposal date. c. If a loss is expected on disposal, recognition is deferred until realization. d. If a gain is expected on disposal, the estimated gain is recognized in the financial statements as of the measurement date. ANSWER: A

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24. Which one of the following summary indicators is the most used? a. Return on investment b. Earnings per share c. Debt-to-equity ratio d. Current ratio ANSWER: B 25. Which of the following is not true regarding SFAS No. 128? a. Users can now comprehend the effect upon EPS of the full amount of dilution without the presence of the artificial and confusing primary earnings per share calculation. b. It brought the United States into alignment with virtually all other nations in terms of EPS requirements. c. The elimination of primary earnings per share is a case of more information leading to more usefulness. d. The FASB and the International Accounting Standards Committee cooperated on the project together. ANSWER: C 26. Which of the following is not a true statement regarding accounting for development stage enterprises? a. SFAS No. 7 requires complete disclosure by the development stage enterprise to avoid misleading financial statement users by heavy initial losses. b. SFAS No. 7 achieved uniformity on the basis of the nature of the enterprise rather than on the basis of the nature of the transaction. c. The FASB opted for rigid uniformity in selecting a solution as opposed to finite uniformity, where a relevant circumstance might be viewed as the development stage of the enterprise. d. SFAS No. 7 requires that costs of a similar nature be accounted for similarly, regardless of the stage of development of the entity incurring the cost. ANSWER: B 27. Which of the following statements is true regarding stock options? a. When exercised, an incentive stock option has an option price exceeding the market price. b. When granted, a nonqualified stock option has an option price exceeding the market price. c. The fair value of an incentive stock option equals the current market price of the stock minus the present value of the exercise price discounted at the risk free interest rate over the number of years of life of the option. d. The value of an incentive stock option can not be determined at the grant date, ANSWER: C 28. Which of the following is not a component of the single income statement proposed by the G4+1 report? a. Pro forma earnings b. Results of operating or trading activities c. Results pertaining to financing and other treasury activities d. Other Gains and Losses ANSWER: A

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ESSAY 1. Respond to the following: a. b. c.

When is revenue generally recognized, and what are three other alternative points in time for recognizing revenue? When is each alternative revenue recognition method appropriate and why have these methods evolved? What is the primary criterion for revenue recognition applied in practice, and what attributes must be measurable before revenue is recognized.

ANSWER: a. Revenues should be identified with the period during which the major economic activities necessary to the creation and disposition of goods and services have been accomplished. Revenues generally are recognized at the point of sale when legal title is transferred. Three alternative points in time for recognizing revenue are: (1) during production; (2) at the completion of production; and (3) when cash is collected. b.

Revenue may be recognized during production for long-term construction contracts if reliable estimates of the extent of progress and of the cost to complete can be made and if reasonable assurance of collectibility exists. If immediate marketability at a quoted price exists for a product whose units are interchangeable, revenue may be recognized at the completion of production. Recognizing revenue on a cash basis, either installment or cost recovery, is allowed if no reasonable basis exists for estimating collectibility. The vast majority of exceptions to recognizing revenue at the point of sale have evolved because new transactions have emerged that do not fit the mold of traditional transactions.

The primary criterion for revenue recognition applied in practice is the completion of the earnings process. Attributes that must be measurable are: (1) sale price; (2) cash collection; and (3) future costs. If all three cannot be measured with reasonable accuracy when the earning process is complete, recognition must be delayed until reasonable measurements can be made.

2. What are the three categories of expenses identified in APB Statement 4, and what is the related hierarchy of expense recognition? ANSWER: APB Opinion No. 4 classifies expenses as: (1) costs directly associated with the revenue of the period; (2) costs associated with the period on some basis other than a direct relationship with revenue; and (3) costs that cannot, as a practical matter, be associated with any other period. If possible, costs should be matched against the revenue when directly produced. If a direct causeand-effect relationship does not exist, costs should be matched to revenue in a traditional and systematic manner. Finally, if there is not even an indirect cause and effect relationship, the costs are recognized as period expenses when incurred.

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3. Discuss the effect, if any, each of the following should have on the recognition of future events: a. b. c. d. e.

The probabilistic nature of future events Management intent Conservatism Future economic conditions Future legal requirements

ANSWER: a. The probabilistic nature of future events is the major problem underlying future events and their impact on event recognition. An example occurs in SFAS No. 5 relative to loss contingencies, which should be recognized when the loss becomes ""probable" as opposed to being merely "reasonably possible" or "remote." It is not clear what probability percentage should be attached to the concept of "probable." b.

Management intent should not be a basis of event recognition. Not only can management intent change, but its interpretation can be subject to agency theory considerations. Considering management intent could result in lower comparability.

Beaver stated that there may be a comparative advantage to reporting "bad news" (conservatism) through financial reporting as opposed to other sources for dissemination of financial information. There could be an overall favorable bias built into the reports of the financial analyst. Hence, accounting conservatism could be adding a balance to the totality of financial information flowing to users.

Changes in future economic conditions should not be predicted unless compelling evidence is present relative to future changes. For example, unless future tax rate changes have been enacted into law, future tax rates are assumed to be the same as current tax rates.

Future economic conditions should not be predicted unless they have already been enacted.

4. Contrast the current operating and the all-inclusive concepts of income and identify arguments used in supporting each. ANSWER: The current operating school of thought holds that the income statement should contain only normal operating items and that nonoperating items should be reported in the retained earnings statement. The all-inclusive school of thought maintains that all components of comprehensive income should be in the income statement and that the retained earnings statement should reflect only total earnings reported in the income statement and dividend distribution, in addition to beginning and ending balances. The current operating advocates have contended that the income statement is more useful in assessing management's performance and predicting future years' performance if items extraneous to current management decisions are excluded. If material, extraneous, nonoperating, infrequently occurring items are reported in the income statement, financial statement users would be seriously misled and might make incorrect decisions as a result.

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All-inclusive income advocates claim that current operating income lends itself to manipulation by management because it makes the decision on whether or not an item is extraordinary. Also, financial statement users may be misled because they may not realize that substantial gains or losses have been "hidden" in the retained earnings statement. In addition, the summation of all income displayed on the income statement for a period of years should reflect the reporting entity's net income for that period. Finally, they point out that proper classification within the income statement allows both normal recurring items and unusual, infrequently occurring items to be displayed separately with the same statement. 5. What is "comprehensive income," and how does SFAS No. 120 allow it to be reported? ANSWER: Comprehensive income is the change in equity of an entity during a period of transactions and other events and circumstance from non-owner sources. It includes net income as presently defined (including extraordinary items, discontinued operations, and change in accounting principle). Comprehensive income also includes those elements of profit and loss that previously bypassed the income statement. These items include foreign currency translation adjustments, unrealized holding gains and losses on available for sale securities, and minimum pension liability. SFAS No. 130 allows three methods of reporting comprehensive income: (1) in a combined statement of financial performance (in which comprehensive income components would appear below net income); (2) in a separate statement of comprehensive income which would begin with net income; and (3) reported within a statement of changes in equity. The FASB's preference is for the first method. 6. Describe how the reporting of extraordinary items is a good example of the shift away from finite uniformity to rigid uniformity in accounting standards. ANSWER: The shift in the reporting of extraordinary items away from finite uniformity to rigid uniformity was necessitated because the concept of finite uniformity was thought to be abused in accounting practice. The basis of the controversy was the impact that extraordinary items may have on financial statement users' perceptions of the rules of operations and projections of future operations for the reporting entity. Evaluating the results of current and past operations and projecting future operations relies heavily on an ability to separate normal, recurring components of comprehensive income from those that are not recurring. Prior to APB Opinion No. 9, accounting practice for extraordinary items was not uniform. APB Opinion No. 9 attempted to bring order by requiring display of all extraordinary items in a specifically designated section of the income statement. It also provided a new definition of extraordinary item as “Events and transactions of material effect which would not be expected to recur frequently and which would not be considered as recurring factors in any evaluation of the ordinary operation processes of the business.” This new definition was still ambiguous, so the APB issued APB Opinion No. 30, which resorted to rigid uniformity and virtually eliminated the existence of extraordinary items because the definition of and criteria for an extraordinary item was so restrictive. For an item to qualify as extraordinary, it had to be both unusual in nature and infrequent in occurrence.

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Chapter 12—THE INCOME STATEMENT

7. What is the pro forma earnings approach, and what problem does it present. Also, explain how pro forma earnings differs form the G4+1 income statement proposal. ANSWER: Pro forma earnings is a supplementary measure to GAAP income. The idea underlying pro forma earnings is that for predictive purposes, the exclusion of unique, one time events can be useful to investors. The problem with this approach is that management has frequently viewed the pro forma idea as a way to eliminate bad news events and maintain favorable events, making the statement biased and misleading. A G4+1 report takes an opposite tack to pro forma earnings. It proposes a single income statement with three components: (1) the results of operating or trading activities; (2) results pertaining to financing and other treasury activities; (3) other gains and losses. 8. What are nonqualified stock options and incentive stock options, and how does expense recognition differ for these two types of stock options? ANSWER: With a nonqualified stock option, a bargain purchase price is established in the plan (market price exceeds the option exercise price). In an incentive stock option, the exercise price of the stock equals or exceeds the market price at the date the option is granted. APB Opinion No. 25 requires the bargain amount of nonqualified stock options to be allocated as a periodic expense from the grant date through the period of service required to receive the benefits. The bargain amount is measured by the difference between market price and the stock option exercise price on the measurement date, when both the number of options and the exercise price are known. Usually the grant date and measurement date are the same, in which case a deferred compensation expense account is debited and contributed capital is credited for the total bargain purchase. The deferred compensation expense is amortized (to an owners' equity contra account) over the number of periods required to exercise the options. If either the number of shares or exercise price is unknown at the grant date, a yearly estimate is made of both, as well as of the market price of the stock at the future measurement date. The estimated additional compensation expense arising from the options is then accrued annually. At the measurement date, the actual compensation cost is measured by subtracting the option price from the market price on that date. The actual bargain value, less previous yearly expense recognition, is debit to deferred compensation expense and amortized over the remaining service period required to exercise the options. A corresponding amount is credited to contributed capital. In incentive stock options, expense recognition is not required. However, SFAS No. 123 requires footnote disclosure of what the effect of stock options would have been on income and earnings per share, and encourages recognition in the income statement.

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How does the matrix approach proposed by Barker differ from the one proposed by Glover, Ijiri, Levine, and Lian (GILL)? What are the advantages and disadvantages of each? ANSWER: TRUEhe Barker approach is based on the recurring-non-recurring dichotomy whereas the GILL one is based on a fact versus forecast distinction. The income statement using the Barker approach would have three columns: (1) a total column with an arrangement of operating items first and non-operating items below, (2) a “before remeasurement” column with continuing items of both an operating and non-operating nature, and )3) the “remeasurement” column consisting of non-recurring items. Barker’s breakdown would aid in predicting future cash flows from the before remeasurement column. Also, it could aid in assessing some accounting practices of management. Of the two approaches, Barkers seems most promising. GILL have several approaches to the fact versus forecast distinction, , including (1)cash only, (2) cash plus deferrals, and (3)cash, deferrals and amounts without “amount uncertainty, such as depreciation. There would be difficulties in applying fair value measurements with this approach.

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TRUE/FALSE 1. The statement of cash flows superseded the previously required sources and uses of funds statement. ANSWER: FALSE 2. In the statement of changes in financial position, sources of resources are defined as transaction debits. ANSWER: FALSE 3. The cash flow statement is the statement of financial position with funds defined as cash. ANSWER: TRUE 4. In the sources section of the statement of changes in financial position, transactions are subclassified into those affecting liquid assets and those affecting other accounts. ANSWER: FALSE 5. The statement of changes in financial position reported on changes in assets, liabilities, and owners' equity account balances. ANSWER: TRUE 6. Most firms elected to define funds in the statement of changes in financial position as cash. ANSWER: FALSE 7. The funds flow statement included only transactions affecting fund accounts. ANSWER: TRUE 8. With SFAS No. 95 defining funds as cash, the FASB has moved from a position of rigid uniformity to a flexibility orientation. ANSWER: FALSE 9. Inclusion of a cash flow statement is mandatory. ANSWER: TRUE 10. The statement of financial position is a special case of the more general cash flow statement. ANSWER: FALSE 11. According to IAS 7, interest and dividends received or paid must be classified as financing cash flows. ANSWER: FALSE

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12. Only transactions having a direct effect on fund accounts were included in the statement of changes in financial position. ANSWER: FALSE 13. The balance sheet gives insight into the cash-generating potential of the operations of a firm. ANSWER: FALSE 14. An exit-price accounting system provides an estimate of the cash conversion value of a firm's resources. ANSWER: TRUE 15. For capital leases, the interest portion is classified as an operating activity, whereas the reduction of principal portion is a financing activity. ANSWER: TRUE 16. In the cash flow statement, cash is defined as literal cash on hand or on demand deposit plus cash equivalents. ANSWER: TRUE 17. SFAS No. 95 requires that all noncash investing and financing transactions be reported in the body of the cash flow statement. ANSWER: FALSE 18. Use of the direct method on the cash flow statement frequently results in nonarticulation. ANSWER: FALSE 19. The direct method requires a schedule reconciling net operating cash flow with net income. ANSWER: TRUE 20. Interest expense and long-term notes payable both appear in the financing section of the cash flow statement. ANSWER: FALSE 21. On the statement of cash flows, the proceeds from the sale of equipment would be classified as a financing activity. ANSWER: FALSE 22. On the statement of cash flows, the direct method reports literal cash flows related to income statement classifications. ANSWER: TRUE

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23. On the statement of cash flows, the direct method starts with accrual income and adjusts it for the noncash items it contains. ANSWER: FALSE 24. With SFAS No. 95, the FASB chose to follow the entity model rather than the traditional income statement (proprietary) approach. ANSWER: FALSE 25. Research is supportive of the contention that cash and funds flow data are informative above and beyond accrual data. ANSWER: TRUE MULTIPLE CHOICE 1. Which of the following is not a true statement? a. The cash flow statement superceded the previously required statement of changes in financial position. b. The cash flow statement is the statement of financial position with funds defined as cash. c. The statement of financial position is a special case of the more general cash flow statement. d. Inclusion of a cash flow statement is mandatory. ANSWER: C 2. In the statement of changes in financial position, uses of resources are defined as: a. Transaction debits. b. Fund increases. c. Transaction credits. d. Fund decreases. ANSWER: A 3. In the statement of changes in financial position, sources of resources are defined as: a. Transaction debits. b. Fund increases. c. Transaction credits. d. Fund decreases. ANSWER: C 4. Which of the following directly preceded the statement of changes in financial position? a. The statement of cash flows b. The funds flow statement c. The sources and uses of funds statement d. The sources and uses of resources statement ANSWER: B

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5. Which of the following directly preceded the statement of cash flows? a. The funds flow statement b. The sources and uses of funds statement c. The statement of changes in financial position d. The sources and uses of resources statement ANSWER: C 6. In the sources section of the statement of changes in financial position, transactions are subclassified into those affecting: a. The fund balance and other accounts b. Cash and other accounts c. Current assets or liabilities and other accounts d. Liquid assets and other accounts ANSWER: A 7. In the uses section of the statement of changes in financial position, transactions are subclassified into those affecting: a. The fund balance and other accounts. b. Cash and other accounts. c. Current assets or liabilities and other accounts. d. Liquid assets and other accounts. ANSWER: A 8. The statement of changes in financial position reported on: a. Changes in current assets and current liabilities. b. Changes in assets. c. Changes in assets, liabilities, and owners' equity account balances d. Changes in working capital ANSWER: C 9. Most firms elected to define funds in the statement of changes in financial position as: a. Cash. b. Working capital. c. Current assets. d. Owners' equity. ANSWER: B 10. With SFAS No. 95 defining funds as cash, the FASB has: a. Moved from a flexibility orientation to a position of rigid uniformity. b. Moved from a position of rigid uniformity to one of finite uniformity. c. Moved from a position of rigid uniformity to a flexibility orientation. d. Moved from a flexibility orientation to a position of finite unity. ANSWER: A

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11. The funds flow statement included: a. All sources and uses of resources. b. Only cash transactions. c. Only transactions affecting current assets. d. Only transactions affecting fund accounts. ANSWER: D 12. APB Opinion No. 19 permitted fund balance accounts in the statement of changes in financial position to include which of the following? a. Quick assets only b. Cash and near cash only c. Working capital only d. Cash, cash and near cash, quick assets, or working capital ANSWER: D 13. Which of the following is not a function of financial statements as stated in the text? a. Assessing managerial performance b. Valuing the company c. Providing accurate information to taxing agencies d. Making credit decisions ANSWER: C 14. For capital budgeting purposes, an investment is acceptable if: a. The present value of the expected net cash flows is positive. b. Net present value is positive. c. The intrinsic value is greater than the current market price. d. All of the above. ANSWER: D 15. A FASB discussion memorandum suggested that cash flow data are a useful supplemental disclosure for all of the following reasons except: a. They provide information about the quality of income. b. They aid in assessing flexibility and liquidity. c. They help to identify the relationship between accounting income and cash flows. d. They are a better predictor of future earnings than is accounting income. ANSWER: D 16. Which of the following is a true statement? a. Liquidity is the ability of the firm to adapt to new situations and opportunities. b. Cash flow measurement is more uniform than income measurement. c. The current-noncurrent classification system in the balance sheet is a good guide to liquidity. d. The balance sheet gives insight into the cash-generating potential of operations. ANSWER: B

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17. Which of the following is a true statement regarding an exit-price accounting system? a. It measures flexibility of the firm in terms of the amount of cash that would be realized from a forced liquidation of assets. b. It provides an excellent indicator of liquidity. c. It provides an estimate of the speed of conversion of a firm's resources. d. It provides an estimate of the cash conversion value of a firm's resources. ANSWER: D 18. Which of the following is true for intrinsic values? a. It is the present value of future expected cash flows. b. It is unaffected by changes in interest rates. c. It must be below current market price for a stock purchase to be acceptable. d. It is the undiscounted value of the cash that can be taken out of a business during its remaining life. ANSWER: A 19. In the cash flow statement, cash is defined as: a. Quick assets b. Literal cash on hand or on demand deposit, plus cash equivalents. c. Literal cash on hand or on demand deposit, plus marketable securities. d. All of the above ANSWER: B 20. Which of the following is a true statement regarding SFAS No. 95? a. It requires all noncash investing and financing transactions be reported in the body of the cash flow statement. b. It requires all noncash investing and financing transactions be reported as a supplement to the cash flow statement, either in a schedule or in a narrative format. c. Only cash transactions are reported on the cash flow statement. d. Only operating transactions are reported on the cash flow statement. ANSWER: B 21. On the statement of cash flows, the proceeds from the sale of equipment would be classified as: a. An investing activity. b. An operating activity. c. A financing activity. d. Either an investing, operating, or financing activity. ANSWER: A 22. Which of the following methods reports literal cash flows related to income statement classifications? a. The indirect method b. The direct method c. Both a and b. d. None of the above ANSWER: B

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23. Which of the following methods starts with accrual income and adjusts it for the noncash items it contains? a. The indirect method b. The direct method c. Both a and b. d. None of the above ANSWER: A 24. Which of the following methods requires a separate schedule reconciling net operating cash flow with net income? a. The indirect method b. The direct method c. Both a and b d. None of the above ANSWER: B 25.

Which of the following is true about the Statement of Cash Flows (SCF)? a. The SCF is more subject to manipulation than the income statement. b. Cash flow from financing activities is considered to be the most important part of the SCF. c. Classification rules prevent manipulation of cash flows from operating activities on the SCF. d. Flexibility in applying classification rules on the SCF allows companies in the same industry to give vastly different perspectives. ANSWER: D 26. Which of the following is not true regarding free cash flows (FCFs) a. Investors can estimate the intrinsic value of a firm by discounting forecasted FCFs. b. Spending FCFs will not affect the firm’s ability to generate more. c. FCFs can be obtained directly from the Statement of Cash Flows. d. Unlike Cash From Operating Activities, FCFs do not include interest expense. ANSWER: C 27. Which of the following is a true statement? a. Research is supportive of the contention that cash and funds flow data are informative above and beyond accrual data. b. Use of the direct method in the cash flow statement frequently results in nonarticulation. c. Interest expense and long-term notes payable both appear in the financing section of the cash flow statement. d. With SFAS No. 95, the FASB chose to follow the entity model rather than the traditional income statement (proprietary) approach. ANSWER: A

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ESSAY 1. Identify and describe the two balancing sections of the statement of changes in financial position. ANSWER: The two balancing sections of the statement of changes in financial position are called sources of resources and uses of resources. Sources of resources are defined as transaction credits. Transaction credits arise from increases in liabilities and owners' equity and decreases in assets. Increases in liabilities and owners' equity represent new capital available to the firm from external sources, such as debt and stock issues, and internal sources, such as net income. Proceeds from the disposal of assets also generate internal sources of resources. Uses of resources are defined as transaction debits. Transaction debits arise from decreases in liabilities and owners' equity and increases in assets. Decreases in liabilities and owners' equity represent a reduction in the firm's capital. These types of transactions include debt retirement and capital reductions from many sources including treasury stock purchases, dividend payment, and net losses. Asset increases represent new investment. 2. Compare and contrast the two methods that may be used to present operating cash flows in the statement of cash flows. Which method is preferred by firms and by outsiders? ANSWER: SFAS No. 95 allows operating cash flows to be presented using either the direct or indirect methods. The direct method reports literal cash flows related to income statement classifications. The indirect method starts with accrual income and adjusts it for the noncash items in it. Both methods result in the same cash flow from operations number, but more new information is reported with the direct method, and FASB seems to favor it. However, the direct method may be more costly since not all companies organize their accounting records in such a way that it produces the necessary data. In addition, if the direct method is used, a separate schedule must reconcile net operating cash flow with net income. Because of the cost issue, most American firms use the indirect method. However, there has been a limited amount of empirical research that indicates that the direct method is preferred to the indirect, particularly by outside users. 3. How does the statement of cash flows sometimes cause a nonarticulation problem? ANSWER: A recent study has found that where the indirect method is used, nonarticulation occurs when the cash flows arising from the changes in the working capital accounts of consolidated enterprises are not equal to the working capital adjustments listed in the operations section of the cash flow statement. One important reason for nonarticulation occurs when acquisitions of subsidiaries occur during the year. Beginning-of-year working capital balances of acquired firms are not included in beginning consolidated balance sheets. In addition to the acquisition problem, other nonarticulation problems arise when transactions involving working capital accounts do not affect cash. These types of transactions affect nonconsolidated firms as well as consolidated ones. Examples include: (1) write-ups or writedowns of working capital items when firms are purchased; (2) depreciation allocations within manufactured inventories; and (3) any type of reclassification of working capital accounts between current and non-current categories, such as when operating notes payable that are currently due are expected to be refinanced.

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4. Identify and describe the three categories of cash flows reported on the statement of cash flows. What problems have been noted related to this classification system? ANSWER: The cash flow statement subclassifies cash receipts and payments into operating, financing, and investing activities. Operating activities include all transactions that are not investing and financing activities. These include cash received from customers and cash paid to suppliers and employees. The operating activities section also includes dividends received and interest received and paid. Income taxes paid, insurance proceeds received, and cash paid to settle lawsuits are also included in operating activities. Cash flows from investing activities include transactions involving lending money, collecting on the loans, acquiring and selling investments, and acquiring and selling plant assets. Cash flows from financing activities include transactions involving resources obtained from owners, as well as obtaining funds from creditors and repaying the amounts borrowed. This includes principal payments under capital lease obligations, proceeds from issuance of long-term debt, proceeds from issuance of common stock, and dividends paid. A problem with this method of classification is that interest and dividend receipts and interest payments are operating inflows and outflows, respectively. According to the finance literature, interest and dividend receipts are investing activities, and interest payments are financing activities. In addition, interest expense, interest revenue, and dividend revenue all appear in the operations section whereas the related balance sheet items (bonds payable, stock investment, and long-term notes receivable) are either financing or investing elements. 5. Discuss reasons why the FASB replaced the more general funds flow concept with a cash flow statement. ANSWER: Two goals of financial reporting are: (1) reporting information about the firm's net resources and changes in those resources and (2) reporting information useful in assessing futures cash flows. These two reporting goals motivated the FASB's adoption of a cash flow statement as an important supplement to accrual-based financial statements. During the FASB's deliberations that led up to the cash flow statement, a consensus emerged that funds should be defined as cash rather than net working capital mainly because net working capital is a poor measure of liquidity. Three reasons for this are: (1) deferred charges and credits are included in net working capital but have no cash flow consequences; (2) conversion of current assets can take a year or longer if the firm's operating cycle exceeds one year; and (3) items such as inventory are carried on a cost basis and thus do not explicitly reveal the cash flow potential of the inventory. 6. Discuss how Ingram and Lee used the cash flow statement in conjunction with the income statement for analytical purposes. ANSWER:

Ingram and Lee used the income statement and the cash flow statement together and posited that, over time, growing firms will have higher income and lower cash flows. This is because growing firms will have increasing inventories and accounts receivable as they expand. To some extent, the inventories and receivables will be offset by increases in payables, but the net effect of the growth in working capital is that a change in income each year will exceed the change in operating cash flow. In addition, as a firm expands, there will be net investment outflows as fixed assets are acquired and cash inflows from

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financing as new debt and equity are floated and dividends are likely cut back. For a firm that is contracting, the relationships will largely run in reverse. Ingram and Lee's statistical analysis largely supported their deductive analysis. 7.

Discuss arguments supporting the need for improving the Statement of Cash Flows (SCF). What suggestions do Broom and the authors of the text make regarding improvement? ANSWER: Broome states that SFAS No. 95’s flexibility in allowing either the direct or the indirect method on the SCF creates confusion. Some arguments supporting the need for improving the SCF include: 1. The complicated adjustments required by the indirect method are hard for a reader to understand and provide managers more leeway for manipulation. 2. The flexibility in classification between the three sections of the SCF can affect the perception of the firm’s financial strength. 3. Flexibility in allowing either the direct or indirect method creates confusion. Broom makes the following suggestions: 1. FASB require both the direct method and the associated reconciliation of net income to operating cash flow for the operating section. 2. FASB should provide more quittance on classification of cash flows for the three sections. 3. The supplementary reconciliation should begin with cash flow from operations and proceed to net income, the reverse of the current practice. Wolk, Dodd and Rozycki agree that the direct method should be required, but argue that firms should explain the source of any nonarticulation that occurs in the operating section of the SCF. They suggest firms be required to provide a schedule showing the noncash flow transactions that affect working capital accounts, allowing the user to understand the differences between balance sheet changes and the SCF. They also suggest that, in the case of mid-year acquisitions, firms should provide a schedule that reconciles the working capital adjustment in the operating section of the SCF with the respective balance sheet changes.

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Chapter 14—ACCOUNTING FOR INFLATION AND CHANGING PRICES

TRUE/FALSE 1. Inflation has posed the single greatest problem that is faced in accounting theory. ANSWER: TRUE 2. Both predictive value and representational faithfulness are impaired under historical costing. ANSWER: TRUE 3. In ASR 190, the SEC reinforced its long-standing position of forbidding the presentation of information other than historical cost. ANSWER: FALSE 4.

A general price index is broadly constructed for ascertaining the change in prices for all goods and services. ANSWER: TRUE

5. The value of an asset may be determined by multiplying its historical cost by a fraction consisting of the general price index for the current period divided by the general price index existing at the time of acquisition. ANSWER: FALSE 6. Specific price level indexes can be used to estimate the prices of assets in current year dollars. ANSWER: TRUE 7. Entry value refers to replacement cost in markets in which the asset, liability, or expense ordinarily acquired. ANSWER: TRUE 8. Current cost represents an attempt to derive the specific value or worth for a particular point or period in time of assets, liabilities, expenses, and revenues. ANSWER: TRUE 9. Monetary assets and liabilities do not include notes receivable and payable. ANSWER: FALSE 10. Monetary items gain or lose purchasing power as the price level changes. ANSWER: TRUE

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11. During a period of inflation, a firm’s net monetary asset position experiences a purchasing power loss. ANSWER: TRUE 12. During periods of deflation, a firm’s net monetary liability position experiences a purchasing power gain. ANSWER: FALSE 13. A current value income system does not include purchasing power gains and losses as an element of income. ANSWER: FALSE 14. A monetary holding gains are the difference between general price-level-adjustment amounts and current value. ANSWER: FALSE 15. Monetary holding gains and losses are capital adjustments only, and are not a component of income. ANSWER: TRUE 16. Total holding gain or loss is the sum of monetary holding gains and losses and real holding gains and losses. ANSWER: TRUE 17. Deprival value is computed by taking the lower of Present Value and Net Realizable Value and then the lower of the survivor and Entry Value. ANSWER: FALSE 18. Deprival value measures the opportunity cost to the enterprise of being deprived of the asset. ANSWER: TRUE 19. SFAS No. 33 required both constant dollar and current-cost-adjusted income. ANSWER: TRUE 20. SFAS No. 33 specified replacement cost as the basis of the primary financial statements. ANSWER: FALSE

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21. SFAS No. 33 specified that the effects of changing prices should be presented as supplementary information in annual reports. ANSWER: TRUE 22. The overall format adopted in SFAS No. 33 is one aggregation rather than disaggregation. ANSWER: FALSE 23. SFAS No. 82 eliminated the constant dollar income disclosures required by SFAS No.33. ANSWER: TRUE 24. SFAS No. 89 continued the requirement that current cost income measurement, purchasing power gain or loss and holding gain information be disclosed. ANSWER: FALSE 25. SFAS No. 157 is grounded in the belief that historical costing is more important than current values. ANSWER: FALSE 26. The fair value system of SFAS No.157 is an exit value system. ANSWER: TRUE 27. Under SFAS No. 157, prices for assets include deductions for transaction costs. ANSWER: FALSE 28. The cost approach to asset valuation involves determining the net realizable value, or exit value, of the asset. ANSWER: FALSE 29. Under SFAS No. 157, if an asset is valued from and “in-use” perspective, its value is based on its use in combination with other assets. ANSWER: TRUE 30. SFAS No. 157 may result in a decrease in financial statement comparability among firms. ANSWER: TRUE

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MULTIPLE CHOICE 1. According to the text, which of the following has posed the single greatest problem that is faced in accounting theory? a. Historical costing b. Additivity c. Inflation d. Price-level adjustments ANSWER: C 2. Which of the following qualities are impaired under historical costing? a. Additivity b. Predictive value c. Representational faithfulness d. All of the above ANSWER: D 3. Which of the following is a true statement? a. Shortly after its inception, the FASB issued an exposure draft that proposed requiring the presentation of, as supplemental information, the balance sheet and income statement restated in units of general purchasing power. b. The Trueblood Commission committed itself to support of the current value concept. c. In ASR 190, the SEC reinforced its long-standing position of forbidding the presentation of information other than historical cost. d. The AAA has always opposed price-level restated financial statements. ANSWER: A 4. Which of the following is not a true statement? a. Prior to SFAS 33, the majority of accounting literature on the subject of changing prices dealt with the possibility of restating historical cost financial statements for changes in general price levels. b. Prior to SFAS 33, the majority of accounting literature on the subject of changing prices dealt with the possibility of adopting current cost as a new measurement system. c. The need to consider the effects of changing prices in financial reports has followed a rather evolutionary development. d. Measuring current costs is easier than restating historical cost for changes in units of currency. ANSWER: A

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5. Which of the following is a true statement regarding a specific price index? a. Its computation does not require statistical sampling. b. It is narrowly constructed to determine the changing level of prices in a particular segment of the economy. c. It is broadly constructed for ascertaining the change in prices for all goods and services. d. It cannot be used to compute price-level adjusted historical cost. ANSWER: B 6. Which of the following is a true statement regarding a general price index? a. Its computation does not require statistical sampling. b. It is narrowly constructed to determine the changing level of prices in a particular segment of the economy. c. It is broadly constructed for ascertaining the change in prices for all goods and services. d. It cannot be used to compute price-level adjusted historical cost. ANSWER: C 7. Which of the following is not true statement? a. Exit value denotes the selling price that can be received from the firm’s assets when sold through a process of orderly liquidation. b. Exit value is a form of opportunity cost. c. Entry value refers to replacement cost. d. Exit value is generally preferred to replacement cost. ANSWER: D 8. Which of the following does not accurately describe purchasing power gains and losses. a. Purchasing power gains and losses arise because monetary items gain or lose purchasing power as the price level changes. b. Purchasing power gains and losses are part of SFAS No. 157’s income measurement system. c. Purchasing power gains and losses are determined by measuring the purchasing power of the monetary items and comparing it with the actual amount of the net monetary accounts. d. All systems of both general purchasing-power-adjusted income and current value income include purchasing power gains and losses as an element of income. ANSWER: B 9. Which of the following describes “deprival value”? a. It is a not a good measurement of fair value. b. It is the higher of exit value and replacement cost. c. It measures the opportunity cost to the enterprise of doing without the asset. d. It is the lower of exit value and or present value of future cash flow. ANSWER: C

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10. Which of the following was required by SFAS No. 33 as the basis of primary financial statements? a. Historical cost b. Current cost c. Present value of future cash flows d. Net realizable value ANSWER: A 11. Which of the following is not a true statement? a. Exit value denotes the selling price that can be received from the firm's assets when sold through a process of orderly liquidation. b. Exit value is a form of opportunity cost. c. Entry value refers to replacement cost. d. Exit value is generally preferred to replacement cost. ANSWER: D 12. SFAS No. 33 required enterprises to report supplementary information under a. A constant dollar approach b. A current cost approach c. Both constant dollar and current cost approaches d. None of the above ANSWER: C 13. Which of the following is not a feature of SFAS 157? a. It affects most balance sheet accounts but has little to say about related income statement considerations. b. The fair value of SFAS No. 157 is an entry value system. c. It is grounded in the belief that fair values are more relevant for decision-making purposes than historical costing. d. Prices for both assets and liabilities do not include deductions for transaction costs, except transportation. ANSWER: B 14. Which of the following is not a valuation technique that may be applied according to SFAS No. 157? a. The Net realizable value approach b. The market approach c. The income approach d. The cost approach ANSWER: A

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15. Which of the following is true regarding “unobservable inputs”? a. They pertain to level 1 prices in the fair value pricing hierarchy b. They do not appear on the fair value pricing hierarchy. c. They are higher in verifiability than level two inputs. d. They are inputs for which there is little market activity. ANSWER: D 16. Which of the following accurately refers to SFAS No. 157? a. It is an income statement oriented standard. b. It requires that unrealized monetary holding gains be included in operating income. c. Assets are valued from “in-use” and in-exchange” perspectives. d. It requires that purchasing power gains and losses be included in other comprehensive income. ANSWER: C 17. Which of the following is not a true statement regarding John C. Burton, former chief accountant of the SEC? a. His influence moved the development of accounting for changing prices significantly forward. b. He believed that any changes in financial reporting should be made to the measurement system itself. c. He believed that inflation creates greater distortions when the current cost approach to measurement is used. d. He had doubts as to whether a system using general price-level adjustments would provide any benefit. ANSWER: C 18. Which of the following type of gains and losses arises purely because of the change in the general price level during a period? a. Monetary holding gains and losses b. Real holding gains and losses c. All holding gains and losses d. Unrealized gains and losses ANSWER: A 19. SFAS No. 33 specified which of the following as the basis of primary financial statements? a. Replacement cost b. Nominal historical cost c. Current value d. Constant dollar ANSWER: B

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20.

Which of the following statements does not apply to SFAS No. 33? a. It was withdrawn in part because of the abatement of inflation. b. It required current-cost-adjusted income to be published as supplemental information. c. It required purchasing power gains and losses on monetary items to be disclosed. d. It considered constant dollar adjustments to be of little value. ANSWER: D ESSAY 1. Define inflation and describe how it and historical costing have posed a problem for accounting theory. ANSWER: Inflation is the rise in the average price level for all goods and services produced in an economy. It has posed the single greatest problem that is faced in accounting theory. Under an historical cost-based system of accounting, inflation leads to two basic problems. First, many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred, impairing representational faithfulness. Second, since the numbers on financial statements represent dollars expended at different points of time and, in turn, different amounts of purchasing power, they are not additive. Because of these two underlying problems, several relevance quality measures are badly impaired under historical costing. Predictive value is probably diminished as a result of using and combining dollars of different purchasing power. Using financial reporting to determine accountability is similarly restricted because of the shortcomings of historical costing, as is comparability among financial statements of different firms. Perhaps the principal deficiency resulting from the fundamental weaknesses of historical costs lies in the area of capital maintenance. Under historical costing, income is usually overstated relative to amounts that can be distributed to stockholders without reducing the beginning balance of the enterprise's net assets. Thus, many dividends are really liquidating in nature, rather than derived from earnings. 2. Respond to the following: a. b. c.

Explain what is meant by price indexes. Compare and contrast the two types of price indexes, specific price indexes and general price indexes. How did SFAS No. 33 make use of price indexes?

ANSWER: a. Price indexes are weighted averages of the current prices of goods and services. These averages are related to prices in a base period, and their purpose is to determine how much change has occurred. b.

A specific price index is narrowly constructed to determine the changing level of prices in a particular segment of the economy, such as capital equipment used in the steel industry. A general price index is broadly constructed for ascertaining the change in prices for all goods and services of an economy.

SFAS No. 33 required that a price index, such as the Consumer Price Index, be used

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for general price-level adjustment. Under this method, unamortized costs of nonmonetary assets and liabilities are adjusted for the change in the general level of prices that has arisen since incurrence of those costs. This adjustment is accomplished by taking the historical cost of an item and multiplying it by a fraction consisting of the general price index for the current period in the numerator divided by the general price index existing at the time of acquisition.

3. Explain the concept of purchasing power gains and losses and how these gains and losses arise. ANSWER: Purchasing power gains and losses arise as a result of holding net monetary assets or liabilities during a period when the price level changes. These gains and losses occur because monetary items, which are fixed in terms of the number of dollars to be received or paid, gain or lose purchasing power as the price level changes. Purchasing power gains and losses are determined by measuring the purchasing power of the monetary items available to a firm and comparing it with the actual amount of the net monetary accounts. Monetary assets and liabilities include cash itself and other assets and liabilities that are receivable or payable in a fixed number of dollars. 4. Distinguish between monetary holding gains and losses and real holding gains and losses. ANSWER: Monetary holding gains and losses arise purely because of the change in the general price level during the period. Real holding gains and losses are the difference between general price-leveladjusted amounts and current values. Monetary holding gains and losses are capital adjustments only; they are not a component of income. The disposition of real holding gains and losses is an important theoretical issue affecting the determination of income. 5. List and describe the three valuation techniques used by SFAS No. 157 for assets and liabilities. ANSWER: The market approach involves determining current prices for identical – or at least comparable – assets and liabilities. The income approach uses future earnings or cash flows which are then discounted to a simulated selling price. This method would also appear to pertain to liabilities such as bonds payable which require future periodic outlays of cash for interest purposes. Other valuation techniques of a more indirect nature also fall under the income approach category. These include the Black-ScholesMerton model and binomial models. These indirect methods are frequently referred to as markto-model models. The cost approach involves determining the current cost to replace the service capacity of an asset. 6. What are the there levels for securing prices in the fair value pricing hierarchy of SFAS 157? ANSWER: Level 1 prices are quoted prices in active markets for identical assets or liabilities. If the firm owns a large number of units of the asset and putting them all on the market at once would lower the per unit price from the quoted Level 1 price, the Level 1 quoted price would still be used be-

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cause aggregated values are intended to be market specific rather than entity specific under SFAS No. 157.1 Level 2 prices pertain to quoted prices for similar assets and liabilities priced in active markets. Because they are for similar rather than identical assets, they are below Level 1. However, they could be for identical as well as similar assets (or liabilities) in markets that are relatively inactive. Within Level 2, prices might also be derived from other than quoted prices from sources such as interest rates and yield curves. Level 3 inputs are derived in situations where there is little market activity. Hence these inputs are called unobservable inputs. Information from unobservable inputs are to be based on the best available information and they involve assumptions that the reporting enterprise makes relative to how market participants would establish prices. Issues of comparability and verifiability become very important relative to Level 3 inputs.

We believe that most aggregated values are a combination of market prices and entity considerations. For

example the value of a fixed asset would be based on the market price for an asset in a specific condition.

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING TRUE/FALSE 1. The income tax law of 1913 established accounting income as a basis for taxation. ANSWER: FALSE 2. Tax allocation is made necessary by the permanent differences in financial statement income and tax income. ANSWER: FALSE 3. Under comprehensive allocation, the tax liability is equal to the income expense for the period. ANSWER: FALSE 4. Intraperiod and intrastatement allocation both refer to showing income statement items such as extraordinary items and changes in accounting principle net of the tax effect. ANSWER: TRUE 5. Timing differences are now referred to as temporary differences. ANSWER: TRUE 6. Income tax allocation is grounded in the matching concept. ANSWER: TRUE 7. The tax liability would be greater than tax expense whenever revenues are recognized for tax purposes in a different period than for published reporting purposes. ANSWER: FALSE 8. Income tax allocation may be used by management to smooth income. ANSWER: FALSE 9. SFAS No. 96 switched from the revenue-expense (matching) orientation of APB Opinion No. 11 to the asset-liability viewpoint. ANSWER: TRUE 10. The most important application of income tax allocation is the use of accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. ANSWER: TRUE 11. Deferred taxes were viewed as liabilities under APB Opinion No. 11. ANSWER: FALSE

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 12. Under comprehensive allocation, only those deferred credits that can reasonably be expected to reverse in the foreseeable future on an aggregate basis are recorded on the books. ANSWER: FALSE 13. Under partial allocation, income tax expense is equal to the tax liability. ANSWER: FALSE 14. With the new form of equities approach, the credit arising under income tax allocation represents a subordinated equity investment in the firm by the federal government. ANSWER: TRUE 15. Partial allocation is an example of flexible uniformity. ANSWER: FALSE 16. From an economic standpoint, it appears reasonable that deferred tax liabilities should be shown at their present value. ANSWER: TRUE 17. In partial tax allocation, resulting credits are interpreted as liabilities that mature beyond a year. ANSWER: TRUE 18. Consistency appears to dictate that neither tax liabilities nor deferred credits, under either the comprehensive or partial allocation approaches, should be discounted. ANSWER: FALSE 19. Under SFAS No. 109, the deferred tax balance is to be classified as current or noncurrent in the same manner as the assets and liabilities to which the deferred taxes relate. ANSWER: TRUE 20. Amounts recognized as revenue on the financial statements but not yet included in tax income generate deferred tax assets. ANSWER: FALSE 21. Unused tax credits may generate deferred tax assets. ANSWER: TRUE 22. Most recent empirical research on income tax allocation has generally proved to be favorable to the use of the asset-liability orientation. ANSWER: TRUE

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 23. Comprehensive allocation is a form of rigid uniformity because the question of loan repayment is ignored. ANSWER: TRUE 24. The main problem with partial allocation is the question of timeliness. ANSWER: FALSE 25. International Accounting Standards use deferred tax assets and liabilities for recognizing temporary differences. ANSWER: TRUE 26. IAS 12 classifies deferred tax accounts as either current or noncurrent, depending on the account to which they pertain. . ANSWER: FALSE

MULTIPLE CHOICE 1. The income tax law established which of the following as a basis for taxation? a. Economic income b. Increase in wealth c. Business income d. Accounting income ANSWER: C 2. Which of the following statements was not made in ARB 43? a. Income taxes are an expense that should be allocated as other expenses are allocated. b. Income taxes should be allocated to income and other accounts as other expenses are allocated. c. The income statement should reflect tax expense properly allocable to the income included in the income statement for the year. d. Tax expense should equal the amount of tax payable based on taxable income for the year. ANSWER: D 3. When is tax allocation necessary? a. When a revenue or expenses reaches the financial statements before it appears on the tax return b. When a revenue or expense reaches the tax return before it appears on the financial statements c. When the tax basis and book basis of assets and liabilities differ d. All of the above ANSWER: D

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 4. Which of the following is not a true statement regarding comprehensive income tax allocation? a. Tax allocation is made necessary by the timing differences between when an item reaches the income statement and when it appears on the tax return. b. The difference between the income tax expense and the income tax liability numbers appears on the income statement. c. When timing differences arise, tax allocation must take place, despite the possibility of relevant circumstantial differences. d. Permanent differences between financial statements and tax returns are not subject to the allocation process. ANSWER: B 5. Which of the following is not a true statement regarding SFAS No. 96? a. It required the comprehensive allocation approach. b. It was conservative in terms of recognizing deferred tax assets. c. It was issued in 1987 and continued the approach of APB Opinion No. 11. d. SFAS NO. 109 succeeded it in 1992. ANSWER: C 6. Which of the following would create a permanent difference between published statements and tax returns? a. Municipal bond interest income b. Deductible charitable contributions c. MACRS depreciation d. Bad debt expense ANSWER: A 7. Which of the following statements does not apply to intrastatement tax allocation? a. It is also referred to as intraperiod tax allocation. b. It includes showing prior period adjustments net of tax effect. c. It includes showing extraordinary items, changes in accounting principle, and operations of discontinued segments net of tax effect. d. It is difficult to employ, and its costs appear to outweigh its benefits. ANSWER: D 8. Another term for a timing difference is: a. Permanent difference. b. Perpetual difference. c. Temporary difference. d. Interim difference. ANSWER: C

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 9. Which of the following cases would cause the tax liability to be greater than tax expense? a. Receipt of cash for rent prior to the period in which services are performed b. Income from long-term construction contracts using the percentage-of-completion approach for financial accounting and the completed-contract approach for income taxes c. Installment sale income recognized for financial purposes at the time of sale and when cash is collected for taxes d. Accelerated depreciation for taxes and straight-line depreciation for income taxes ANSWER: A 10. Comprehensive tax allocation is an example of: a. Finite uniformity. b. Rigid uniformity. c. Flexible uniformity. d. None of the above ANSWER: B 11. Partial tax allocation is an example of: a. Finite uniformity. b. Rigid uniformity. c. Flexible uniformity. d. None of the above ANSWER: A 12. Which of the following is not a true statement regarding SFAS No. 109? a. It maintained a comprehensive allocation orientation. b. It requires a matching orientation. c. It has an asset-liability viewpoint. d. It retained the mandatory nature of income tax allocation. ANSWER: B 13. Which of the following is a true statement regarding deferred taxes under APB No. 11? a. They were adjusted for tax rate changes. b. They were viewed as deferred credits. c. They resulted in balance sheet taking precedence over the income statement in accounting for income taxes. d. They were considered liabilities. ANSWER: B 14. Under which of the following income tax allocation orientations are only those deferred credits that can reasonably be expected to reverse in the foreseeable future recorded on the books? a. Comprehensive allocation b. The net-of-tax method c. Partial allocation d. The new form of equities method ANSWER: C

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 15. Under which of the following methods must allocation take place as long as timing differences arise, despite the possibility of relevant circumstantial differences? a. Comprehensive allocation b. The net-of-tax method c. Partial allocation d. The new form of equities method ANSWER: A 16. Under which of the following methods is income tax expense equal to the income tax liability? a. Comprehensive allocation b. The net-of-tax method c. Partial allocation d. The new form of equities method ANSWER: B 17. Which of the following is not a theoretical consideration relative to partial allocation? a. Agency theory b. Future events c. Financial statement articulation d. Verifiability ANSWER: C 18. In SFAS No. 109, the current or noncurrent designation of deferred tax assets and liabilities is determined by: a. Whether or not the items would reverse in the next tax year. b. The classification of the related asset or liability. c. The amount of aggregate deferred taxes. d. When the item originated. ANSWER: B 19. Which of the following reflects SFAS No. 109's position regarding tax-loss carryforwards? a. A tax-loss carryforward should not be recorded because future benefits are uncertain. b. Any excess of the tax-loss carryforward over deferred tax liabilities should not be booked. c. A tax-loss carryforward coming from an acquired corporation should not be recognized. d. A tax-loss carryforward should be booked as an asset in most cases. ANSWER: D 20. Which of the following is not a finding of previous empirical research on income tax allocation? a. Income using income tax allocation had a higher degree of association with security price behavior than income determined without income tax allocation. b. The net-of-tax method using a tax rate significantly higher than existing rates had a higher association with security prices than income tax allocation using existing rates. c. There was a better association of net deferred tax liabilities to firm value under SFAS No. 109 than under its predecessor when tax rates increased under the Revenue Reconciliation Act of 1993. d. Investors do not view deferred tax liabilities as real liabilities.ANSWER: D

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING 21. For which of the following accounts would the amount recorded under partial tax allocation be equal to the amount recorded under comprehensive tax allocation? a. Income Tax Liability b. Deferred Tax Liability c. Income Tax Expense d. None of the above ANSWER: A 22. In which of the following ways does SFAS No. 109 differ from its predecessors? a. It allows for the discounting of deferred tax assets and liabilities. b. It has a comprehensive tax allocation orientation. c. It provides a more liberal recognition policy for deferred tax assets and tax-loss carryforwards. d. It has a revenue-expense (matching) orientation. ANSWER: C ESSAY 1. Explain why tax allocation is necessary. ANSWER: Tax allocation is necessary because of timing differences between when a revenue or expense item reaches the published financial statements as opposed to when it appears on the tax return. In these situations, tax expense is based on the published before-tax income figure, while the tax liability is based on the tax return. This problem can also be viewed from the perspective of the balance sheet, where the tax basis and book basis of assets and liabilities differ. 2. Explain how comprehensive allocation differs from partial allocation. ANSWER: With comprehensive allocation, tax allocation must take place as long as timing differences arise, despite the possibility of relevant circumstantial differences. Thus, comprehensive allocation is an example of rigid uniformity. Under partial allocation, only those deferred credits that can reasonably be expected to reverse in the foreseeable future on an aggregate basis are recorded on the books. Thus, income tax expense for a given year is defined as the total tax costs attributable to the given year's operations, costs that will be levied against the firm, both in the current and future years, on a gross or aggregate basis. The resulting deferred tax credit is more clearly definable as a liability since it represents the amount expected to be paid in the future. Partial allocation is an example of finite uniformity. 3. Explain how the matching concept is applied in tax allocation and how this differs from other applications of matching. ANSWER: Matching, as it is employed in tax allocation, differs from all other applications of matching. In the usual situation, expenses are matched against revenues. However, the matching that occurs under income tax allocation attempts to normalize income tax expense with pretax accounting income. Hence, after-tax income is also correlated with pretax income. The matching brought about by tax allocation literally occurs at a lower point on the income statement than that of any

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Chapter 15—INCOME TAXES AND FINANCIAL ACCOUNTING other expense. 4. What are the arguments for discounting deferred tax liabilities? ANSWER: Long-term liabilities, such as bonds payable and noncancellable leases, as well as noninterestbearing notes receivable are carried at their present values. Consistency would appear to dictate that tax liabilities under either the comprehensive or partial approaches should be discounted. Tax liabilities under both the comprehensive and partial approaches are really interest-free loans. However, the opportunity cost doctrine from economics has been advocated as a justification for discounting by the implicit interest rate; if the funds were not received from the government in the form of lower income taxes, borrowing from another source would have been necessary. The interest rate on the funds from the next best source would be their opportunity cost. 5. Explain when a firm may recognize a deferred tax asset under SFAS No. 109. How should deferred tax assets that are not expected to be realized be accounted for? ANSWER: SFAS No. 109 allows deferred tax assets to be carried back and to be carried forward against deferred tax liabilities of future years. In addition, it allows recognition of deferred tax assets if realization is "more likely than not," which means a probability of more than 50 percent. If, from the best available evidence, all of a deferred tax asset cannot be realized, a valuation allowance for the amount that is not expected to be realized should be set up. 6. Describe the methods that are allowed to be used in accounting for the Investment Tax Credit. ANSWER: Either flow through or allocation is allowed in accounting for the Investment Tax Credit. Under the flow through method, benefits are immediately recognized in the year the asset is acquired. There are two allocation methods available. The first method leaves tax expense unaffected by the ITC and reduces the cost of the affected assets by these amounts. The second allocation method sets up a deferred investment credit account and writes if off over the life of the affected assets by means of reducing income tax expense. This deferred credit account is neither a liability nor an owner's equity account. It has only a contingent liability aspect which arises because of the ITC recapture provision if the asset is disposed of prior to the full holding period.

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Chapter 16—PENSIONS AND OTHER POSTRETIREMENT BENEFITS

TRUE/FALSE 1. Previous accounting standards have used a revenue-expense approach to pension accounting, which emphasizes the recognition and measurement of annual pension cost. ANSWER: TRUE 2. In SFAS No. 87, the asset-liability orientation is evident in both expense measurement and the balance sheet recognition of unfunded pension benefits. ANSWER: TRUE 3. Accounting for postretirement benefits is very different from pension accounting. ANSWER: FALSE 4. Accounting for defined contribution plans is more complex than accounting for defined benefit plans. ANSWER: FALSE 5. In a defined contribution plan, benefits are defined either as a specific dollar amount or by a general formula based on salary. ANSWER: FALSE 6. Benefits in a defined benefit plan may be paid either as a single lump sum amount at retirement or as a life annuity. ANSWER: TRUE 7. For all defined contribution plans, funding is shared by the employer and employee. ANSWER: FALSE 8. Vesting refers to a qualifying period of pension plan membership that must be met before contributions are made by the employer. ANSWER: FALSE 9. Benefits in a defined benefit plan may be based on either career average or final average salary. ANSWER: TRUE 10. Actuaries are often consulted to determine annual contribution levels for a defined contribution plan. ANSWER: FALSE

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11. There is a more even distribution of contribution levels when the projected benefit method is used rather than the accumulated benefit method. ANSWER: TRUE 12. Actuarial funding methods related to pensions are identical to pension expense recognition methods. ANSWER: FALSE 13. Prior to the existence of an accounting standard that addressed pensions, pension expense was equated with cash contributions to pension funds. ANSWER: TRUE 14. SFAS No. 87 was the first accounting standard to argue that the cost of providing pension benefits should be spread over the remaining service life of employees. ANSWER: FALSE 15. The fact that service giving rise to pension benefits occurred in the past was the main concern of ARB 36. ANSWER: FALSE 16. ARB 36 reduced flexibility in how the cost relating to unfunded accumulated benefits was dealt with in the income statement. ANSWER: TRUE 17. FASB Interpretation 3 was issued in response to the passage of ERISA. ANSWER: TRUE 18. ABP Opinion No. 8 was consistent with the revenue-expense approach. ANSWER: TRUE 19. SFAS No. 35 is considered a landmark standard because it set accounting and reporting standards for a new entity, the pension plan, as separate and distinct from the sponsoring company. ANSWER: TRUE 20. SFAS No. 87 was the first pension accounting standard to segregate accumulated benefits into vested and unvested benefits. ANSWER: FALSE

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21. SFAS No. 87 is no longer in effect, having been replaced by SFAS 132. ANSWER: FALSE 22. SFAS No. 87 achieved greater uniformity in measuring accrued pension expense by mandating use of one actuarial method, the accumulated benefit method. ANSWER: FALSE 23. In calculating the service cost portion of pension expense, future salaries need not be estimated. ANSWER: FALSE 24. SFAS No. 87 presumes an explicit contract in calculating accrued pension expense. ANSWER: FALSE 25. The disclosure requirements of SFAS No. 132 pertain to both pensions and OPEBs where applicable. ANSWER: TRUE 26. Prior research studies have provided evidence that a firm's unfunded pension benefits are interpreted as if they are liabilities. ANSWER: TRUE

27. With an accumulated benefit approach, the discount rate includes a general inflation factor. ANSWER: TRUE 28. Prior to SFAS No. 106, OPEB had been handled on a cash basis of accounting. ANSWER: TRUE 29. The main change brought about by SFAS No. 158 was to bring the overfunded or underfunded status of a defined benefit plan to the footnotes of the balance sheet. ANSWER: FALSE 30. Legal services and day care benefits are not included in OPEBs. ANSWER: FALSE 31. The FASB took an enormous step in SFAS No. 106 by requiring the recognition and measurement of OPEB costs and obligations. ANSWER: TRUE

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32. The core of SFAS No. 106 is the need to predict future health care costs. ANSWER: TRUE 33. The assumption that OPEBs are part of the total compensation package for covered employees clearly stamps them as being attributable to past transactions or events. ANSWER: TRUE 34. SFAS No. 106 requires a liability be recognized related to OPEB only if a legal obligation exists. ANSWER: FALSE 35. If OPEB levels are based on wages, they should reflect those in effect at the current time rather than an estimate of expected future wage levels. ANSWER: FALSE 36. SFAS No. 112 applies to both inactive and active employees who have not yet retired. ANSWER: FALSE 37. SFAS No. 112 requires that postemployment costs be handled on an actuarial basis. ANSWER: TRUE 38. Financial statement preparers strongly opposed OPEB recognition. ANSWER: TRUE 39. A shift toward the asset-liability orientation is evident in pension reporting requirements, with both expense measurement and the requirement to recognize a minimum balance sheet liability for unfunded pension benefits. ANSWER: TRUE 40. Currently, pension funds can be diverted from older employees toward younger employees through cash balance plans. ANSWER: TRUE 41. Membership in defined benefit plans is declining relative to membership in defined contribution plans. ANSWER: TRUE

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Chapter 16—PENSIONS AND OTHER POSTRETIREMENT BENEFITS

MULTIPLE CHOICE 1. What was the first pension accounting standard? a. FASB Interpretation 3 b. ARB 36 c. SFAS No. 87 d. ERISA ANSWER: B 2. Which of the following is not a characteristic of a defined contribution plan? a. The exact value is unknown prior to retirement. b. Mandatory contributions must be made to a pension fund. c. Contribution rates are normally stated as a percentage of wages or salaries. d. Actuaries are consulted to determine annual contribution levels. ANSWER: D 3. Which of the following is not a characteristic of a defined benefit plan? a. The employee makes all contributions to the plan. b. Benefits may be paid as a single lump sum amount at retirement date. c. Benefits can be based on career average salary. d. In all cases, the value of pension benefits is directly related to the employee's years of service. ANSWER: A 4. Vesting refers to: a. A qualifying period of pension plan membership that must be met before contributions are made by the employer. b. A qualifying period of pension plan membership that must be met before pension benefits legally exist. c. A qualifying period of pension plan membership after which benefits are received. d. A qualifying period of pension plan membership after which contributions may cease. ANSWER: B 5. Which of the following statements does not apply to a multiemployer pension plan. a. It is subject to collective bargaining agreements. b. Two are more employers are plan sponsors. c. There are no regulatory differences between these plans and single-employer plans. d. One employer can contribute no more than 50 percent of initial contributions. ANSWER: C

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6. Which of the following is a true statement regarding actuarial funding? a. Actuarial funding applies to both defined benefit and defined contribution plans. b. Given the same set of plan conditions and actuarial assumptions, each different actuarial funding model derives the same funding pattern over time. c. Given the same set of plan conditions and actuarial assumptions, each different actuarial funding model builds up a pension fund to the same future balance. d. Actuarial funding is synonymous with terminal funding. ANSWER: C 7. When a pension plan commences, credit is often granted to employees for past years of service, giving rise to what is called: a. Unfunded past service cost. b. Unfunded benefits. c. Unfunded actuarial liability. d. All of the above ANSWER: D 8. Benefit improvements give rise to: a. Prior service costs. b. Past service costs. c. Actuarial service costs. d. Benefit improvement costs. ANSWER: A 9. In applying actuarial funding methods, actuaries make assumptions about all but which of the following? a. Future withdrawals from the plan b. Acceptable levels of actuarial gains or losses c. The effects of future salary levels on the value of expected retirement benefits d. The rate of interest to be earned on pension fund investments ANSWER: B 10. Which one of the following statements does not apply to ERISA? a. It was a landmark piece of social legislation. b. It allowed the "rule of 45" be used as an alternative vesting formula. c. It required unfunded accumulated benefits to be funded over a maximum of fifteen years. d. It contained requirements related to investment diversification. ANSWER: C 11. Which of the following was not an objective of ERISA? a. To improve access to pension benefits for employees b. To extend vesting periods c. To override discretionary funding clauses in pension plans d. To improve the security of pension benefits for employees ANSWER: B

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12. Which one of the following would not be a party to a defined benefit plan? a. The sponsoring employer b. A pension fund c. The employee d. The actuary ANSWER: D 13. What of the following is not a true statement regarding the Pension Benefit Guaranty Corporation (PBGC)? a. The PBGC has a statutory lien against the sponsor for 100 percent of shortfalls in vested benefits. b. The PBGC was created by ERISA as a national insurer of pension plans. c. Vested benefits of participants are partially guaranteed by the PBGC if a plan is terminated. d. The PBGC is empowered to collect premiums from plans to pay for guaranteed termination benefits. ANSWER: A 14. Which of the following is not a currently allowed practice related to pensions? a. The use of cash balance plans b. Redistributing benefits away from older employees and shifting them to younger employees c. The raiding of overfunded pension plans by acquiring corporations d. Discretionary funding of defined benefit plans ANSWER: D 15. Which of the following statements applies to a voluntary termination? a. The sponsor has a legal liability under ERISA for all accrued benefits. b. The sponsor has a legal liability under ERISA for all vested benefits but not for unvested benefits. c. The sponsor has a legal liability under ERISA only for PBGC guaranteed benefits. d. None of the above statements apply to a voluntary termination. ANSWER: A 16.

Which of the following statements applies to an involuntary termination? a. The sponsor has a legal liability under ERISA for all accrued benefits. b. The sponsor has a legal liability under ERISA for all vested benefits but not for unvested benefits. c. The sponsor has a legal liability under ERISA only for PBGC guaranteed benefits. d. None of the above statements apply to an involuntary termination. ANSWER: C

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17. Which of the following is not one of the three possible methods that could be used to account for unfunded accumulated benefits under ARB 36? a. A prior period adjustment b. A component of operating income c. An extraordinary item of income d. Allocation over current and future periods ANSWER: B 18. What was the main argument of ARB 36? a. ERISA did not create a pension liability except in the likelihood of plan termination. b. The cost of providing pension benefits should be spread over the remaining service life of employees. c. Pension expense should be computed using any one of five acceptable accumulated benefit methods, regardless of cash contributions. d. The balance sheet should report unfunded vested benefits. ANSWER: B 19. What was the main argument of FASB Interpretation 3? a. ERISA did not create a pension liability except in the likelihood of plan termination. b. The cost of providing pension benefits should be spread over the remaining service life of employees. c. Pension expense should be computed using any one of five acceptable accumulated benefit methods, regardless of cash contributions. d. The balance sheet should report unfunded vested benefits. ANSWER: A 20. What was the main argument of ARB 47? a. ERISA did not create a pension liability except in the likelihood of plan termination. b. The cost of providing pension benefits should be spread over the remaining service life of employees. c. Pension expense should be computed using any one of five acceptable accumulated benefit methods, regardless of cash contributions. d. The balance sheet should report unfunded vested benefits. ANSWER: D 21. What was the main argument of APB Opinion 8? a. ERISA did not create a pension liability except in the likelihood of plan termination. b. The cost of providing pension benefits should be spread over the remaining service life of employees. c. Pension expense should be computed using any one of five acceptable accumulated benefit methods, regardless of cash contributions. d. The balance sheet should report unfunded vested benefits. ANSWER: C

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22. Which of the following accounting standards began a shift toward an asset-liability orientation in pension reporting? a. APB Opinion 8 b. SFAS No. 87 c. SFAS No. 106 d. SFAS No. 132 ANSWER: B 23. Which of the following is not a true statement regarding SFAS No. 35? a. It established accounting standards for the measurement and reporting of plan assets and plan obligation. b. It was a landmark standard because it defined the pension plan as a new entity, separate and distinct from the sponsoring company. c. It defined plan obligations as accumulated benefits, both vested and unvested. d. It required information about the sponsor's obligations to be reported as a note in the sponsor's financial statements. ANSWER: D 24. Which of the following is not a true statement regarding SFAS No. 87? a. It requires the recognition of a minimum pension liability when accumulated benefit obligations exceed the fair value of plan assets. b. It has achieved greater uniformity in measuring accrued pension expense. c. It mandates the use of the accumulated benefit method. d. It uses service cost rather than normal cost. ANSWER: C 25. Which of the following is a true statement regarding the pension liability and pension expense recognition requirements of SFAS No. 87? a. SFAS No. 87 presumes an explicit contract in calculating accrued pension expense. b. SFAS No. 87 uses an explicit contract view in requiring the recognition of a minimum pension liability. c. SFAS No. 87 may overestimate the pension liability by including future salary projections in the liability computation. d. SFAS No. 87 does not include future salary projections in the pension expense calculation. ANSWER: B 26. Which of the following is not true regarding SFAS 158? a. It brought the overfunded and underfunded status of defined benefit plan to the footnotes of the balance sheet. b. It required certain costs be charged to other comprehensive income. c. It requires a credit to other pension income for amortized prior service costs. d. An overfunded or underfunded amount for OPEBs must be shown as an asset or liability on the balance sheet. ANSWER: A

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27. Which of the following brought accrual accounting to post retirement benefits other than pensions (OPEB)? a. SFAS No. 87 b. SFAS No. 106 c. SFAS No. 132 d. ERISA ANSWER: B 28. Which of the following is not true related to OPEBs? a. Explicit health care trending makes OPEB accounting somewhat similar to the projected benefit obligation approach to pensions. b. Housing subsidies may be included in OPEBs. c. SFAS No. 106 requires recognition of OPEB costs and obligations. d. Prior to SFAS No.106, OPEBs were handled on an accrual basis of accounting. ESSAY 1. Describe the two broad types of pension plans and identify how they differ from one another. ANSWER: The two broad types of pension plans are defined contribution plans and defined benefit plans. Defined contribution plans are those in which the benefit is defined as the future value of pension fund contributions and earnings. Contribution rates for defined contribution plans are normally stated as a percentage of wages or salaries. These plans may be either noncontributory, in which all contributions are made by the employer, or contributory, where funding is shared by the employer and employee. In defined benefit plans, the pension benefit is defined either as a specific dollar amount based on years of service or by a general formula based on salary. The benefit may be paid as either a single lump sum amount at retirement or as a life annuity. 2. Explain in general terms how defined benefit pension plans are funded. ANSWER: When benefits of a defined benefit plan are based on salary, actuaries determine annual contribution levels. The principal of actuarial funding is to derive a time series of annual pension fund contributions that will accumulate to produce a projected pension fund balance sufficient to meet the cost of projected pension benefits. There are two broad types of actuarial funding methods: accumulated benefit and projected benefit. With the accumulated benefit method, the accumulation of benefits is measured using current salary levels and years of service to value current benefits. Future salary increases are not incorporated into the funding calculations. Projected benefit funding methods represent alternative ways of spreading the cost of projected benefits over time. Some methods in this group develop individual contribution rates, which are then summed to derive the total contribution of the plan. Other methods, called aggregate methods, make funding calculations for the plan as a whole. SFAS No. 87 requires that a projected benefit method, the benefits/years of service approach, be used for pension expense recognition. In general, the accumulated benefit method assigns more cost to later years of employment and a smaller amount to earlier years compared to projected benefit methods. In addition, there is more even distribution of contribution levels with projected benefit methods.

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3. Identify the four major provisions of the Employee Retirement Income Security Act of 1974 (ERISA). ANSWER: The major provisions of ERISA are: (1)

Vesting must follow one of three alternative formulas—100 percent vested after ten years of membership; graded vesting, in which benefits are 25 percent vested after five years, increasing 5 percent for the next five years, and increasing 10 percent per year thereafter; and the rule of 45, in which benefits of an employee with five or more years of membership must be 50 percent vested when the sum of age and year of membership are forty-five, with 10 percent additional vesting for each year of service (subject to the requirement that vesting be 50 percent after ten years and 100 percent after fifteen years).

(2)

Annual funding must occur and be based on an acceptable actuarial funding method. Unfunded accumulated benefits must be funded over a maximum of forty years (30 years for single employer plans established after 1973). Unfunded accumulated benefits due to actuarial losses must be funded over a maximum of fifteen years.

(3)

Pension fund managers should be concerned with diversification of investments. However, the only specific requirement is to limit investments in the sponsoring company to 10 percent of the total pension fund.

(4)

The Pension Benefit Guaranty Corporation (PBGC) was created as a national insurer of pension plans and empowered to collect premiums from plans to pay for guaranteed termination benefits.

4. Respond to the following: a. b.

What are the two major accounting issues related to a defined benefit plan? Why do pension expense and pension liability recognition problems not arise with defined contribution plans?

ANSWER: a. The major accounting issue that emerges in a defined benefit pension plan is that of whether or not the sponsor has an obligation to meet the projected cost of pension benefits arising from employee service to date. If so, any unfunded accumulated benefits give rise to an accounting liability that should be recognized. A second accounting question concerns the recognition and measurement of yearly pension expense: is it simply the cash contributed to the pension fund, or is it a more complex accrual based on the yearly increase in accumulated benefits? b.

Defined contribution plans do not present difficult accounting problems because an expense is recognized for the sponsor's contribution made in accordance with the terms of the plan. No further obligation exists because pension benefits attributable to employee service to date are restricted to the accumulation of past contributions. Accumulated benefits are fully funded by the sponsor as long as each year's required

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contributions are made. An expense and liability should be accrued for the current year's required contribution, and the liability is discharged when the contribution is made. 5. How is pension expense calculated under SFAS No. 87, and when is pension liability recognized? ANSWER: SFAS No. 87 requires the use of one actuarial method, the benefits/years-of-service approach using projected future salaries, and calculates accrued pension expense as the sum of: (1)

Service cost for the year using the accrued benefit actuarial method

(2)

Interest cost for the year relating to the actuarial present-value increase in accumulated benefits

(3)

A reduction for the effect of the expected return on plan assets

(4)

Systematic amortization of unrecognized prior service cost arising from plan adoptions and amendments, with such costs allocated over the remaining period of employee service

(5)

Corridor amortization, whereby actuarial gains/losses are amortized if the cumulative amount of such gains/losses exceed 10 percent of the greater of plan assets at fair value or the projected benefit obligation

(6)

Straight-line amortization of a transitional "net unrecognized obligation/asset" at the time of adopting SFAS No. 87

A pension liability is recognized if yearly funding is less than periodic expense and a pension asset is recognized if yearly funding exceeds the periodic expense. 6. What have research studies indicated about whether a firm's unfunded pension benefits are interpreted as liabilities? ANSWER: If a firm’s unfunded pension benefits are interpreted as liabilities, then stock prices should be lower in the presence of unfunded benefits since they would lessen the value of residual stockholder claims. Several studies have reported this to be the case. Also, there is evidence that bond ratings are lower and interest rates are higher in the presence of unfunded benefits, which is consistent with the market acting as if they are liabilities. 7. What were the major effects of SFAS No. 106 on reporting for post-retirement benefits other than pensions? ANSWER: SFAS No. 106 brought accrual accounting to OPEB. It made it clear that, like pension costs, post-retirement benefits are liabilities, and it requires the projected benefit approach be used to measure the accrued expense. The discount rate used to show the OPEB obligation at present value should be based on rates of return for high-quality fixed-income investments that are currently available on the market and whose cash flows are generally similar in amount and

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timing to OPEB payments. This is in contrast to the AAA's recommendation of a discount rate consistent with the firm's borrowing rate for unsecured debt with a similar payment structure. SFAS No. 106 also requires the discount rate to include an inflationary component geared to the expected general rate of inflation. Another important requirement of SFAS No. 106 is that OPEB costs should be spread over the period of time to the full eligibility date rather than over each employee's total work period. It also requires that prior service costs be recognized over the remaining years of service to full eligibility date of active plan participants. These costs can be amortized over future periods on either a straight-line basis or on the basis of the remaining years of service of active plan participants to their full eligibility. Where employees are already retired or are beyond their full eligibility dates, prior service costs are amortized on the basis of the remaining life expectancy of these participants. However, prior service is taken into account in measuring the OPEB obligation when the plan is amended. In addition, gains and losses arising from differences from assumed experience or changes in plan assumptions are recognized using the corridor approach. With this method, gains and losses are not recognized immediately but are amortized to the extent that the net amount exceeds 10 percent of the greater of the accumulated postretirement benefit. 8. What are the possible economic consequences of OPEB recognition? ANSWER: In addition to costs of preparation, OPEB obligations on the balance sheet mean higher debt-toequity ratios, which threaten debt covenants on bond issues. In addition, management compensation is affected by recognizing OPEB expenses. It is possible that OPEB obligation recognition could lead to an extensive scaling back of this benefit. One study found seventy-one firms that cut OPEB benefits between 1989 and 1992. Many of these firms reduced health insurance coverage due to problems related to debt covenants. Finally, OPEB recognition may put American firms at a competitive disadvantage relative to foreign firms in such areas as cost of capital and pricing of products. However, the focus should be on harmonizing accounting standards. Other nations should be using recognition and measurement techniques similar to those of SFAS No. 106.

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Chapter 17—LEASES

TRUE/FALSE 1. Leases have been the subject of more accounting standards than any other single topic. ANSWER: TRUE 2. The first lease accounting standard was issued in 1966. ANSWER: FALSE 3. It was in the 1940s that accounting policy makers first responded to the lease accounting problem. ANSWER: FALSE 4. Prior to ARB 38, the accounting procedure for lease payments was to record them as periodic revenues for lessors and as purchases of assets for lessees. ANSWER: FALSE 5. Some capital leases are treated as loans with income realized through implicit interest in each lease payment. ANSWER: TRUE 6. The legal form of a lease is an executory, or unperformed, contract. ANSWER: TRUE 7. If a lease is interpreted as a mutually unperformed executory contract, it can be argued that an asset and liability do not exist for the lessee. ANSWER: TRUE 8. Legal remedies available to lessors in the event of lessee default treat leases like unilaterally unperformed executory contracts. ANSWER: FALSE 9. There are no real differences between true leases and purchase arrangements. ANSWER: FALSE 10. ARB 38 recommended that where it was obvious a lease contract was in substance a purchase, an asset, but not a liability, should be recognized in the lessee's balance sheet. ANSWER: FALSE 11. Only leases that would be considered true leases in the eyes of the law are capitalized. ANSWER: FALSE

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12. Classifying leases as either operating or capital leases is an example of attempting to establish finite uniformity. ANSWER: TRUE 13. One of the major arguments for lease capitalization was verifiability. ANSWER: FALSE 14. An argument against lease capitalization was that the use of present value discounting techniques introduced less reliable accounting numbers into the financial statements. ANSWER: TRUE 15. A basic issue with lessor capitalization is symmetry with lessee accounting. ANSWER: TRUE 16. With financing-type leases, there is no sales revenue, only interest revenue earned from the debt financing. ANSWER: TRUE 17. The concept of full payout refers to the lessee making all required payments according to the lease agreement. ANSWER: FALSE 18. ARB 43 recommended capitalization for leases that were, in substance, installment purchases. ANSWER: TRUE 19. APB Opinion No. 5 was criticized on the grounds that it excluded many leases that should be capitalized. ANSWER: TRUE 20. SFAS No. 13 identifies four capitalization tests that are now applicable to both lessees and lessors. ANSWER: TRUE 21. All of the tests or conditions identified in SFAS No. 13 must be met before a lease can be capitalized. ANSWER: FALSE

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Chapter 17—LEASES

22. The requirements of SFAS No. 13 represent conservatism because a higher interest rate will cause a higher present value and could therefore result in lease capitalization. ANSWER: FALSE 23. Under SFAS No. 13, payments on capital leases are separated into the equivalent of principal and interest each period. ANSWER: TRUE 24. The criteria for capitalizing a real estate lease are identical to those of other leases. ANSWER: FALSE 25. Land leases are capitalized only if title passes to the lessee at the end of the lease term and the lease contract contains a bargain purchase option. ANSWER: FALSE 26. It can be argued that all leases over one year should be capitalized. ANSWER: TRUE 27. Supplemental disclosures of noncapitalized leases under SFAS No. 13 are greater than under APB Opinion No. 31. ANSWER: FALSE 28. Under current requirements, the weak disclosures of noncapitalized leases create incentives to structure leases in such a way as to avoid both capitalization and supplemental disclosure. ANSWER: TRUE 29. The initial impetus for lease capitalization was caused by concern over lessee balance sheets. ANSWER: TRUE 30. A sale and leaseback occurs when the owner of an asset sells it and enters into a lease agreement to lease the asset back. ANSWER: TRUE 31. From a lessee's point of view, a leveraged lease is very different from the other leases. ANSWER: FALSE 32. It is no less true under SFAS No. 13 than it was under ARB 38 that more leases are being capitalized than should be. ANSWER: FALSE

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33. A position paper of the G4+1 must be put into effect by each of the member organizations. ANSWER: FALSE 34. The G4+1 report on leases would make all leases financing leases. ANSWER: TRUE

MULTIPLE CHOICE 1. Which of the following is a characteristic of a true lease? a. The presence of a provision for the transfer of the title to the lessee b. The presence of interest as a factor in rental charges c. Rental charges that are competitive with those charged by other lessors of similar equipment d. The assumption of the risk of loss by the lessee ANSWER: C 2. Which of the following is not a characteristic of a true lease? a. Government agencies recognized the lessee as the owner of the leased asset. b. The rentals charged under leasing plans without an option to purchase approximate the rentals charged under plans with such an option. c. The lessor retains the right to inspect the equipment during the term of the lease. d. There is no mention of interest as a factor in rental charges. ANSWER: A 3. Which of the following is not one of the criteria that have been suggested for lease capitalization? a. Lessee builds up a material equity in the leased property. b. Lessee pays costs normally incident to ownership. c. Lease is between related parties. d. Lease agreement is cancelable. ANSWER: D 4. Which of the following is one of the criteria that have been suggested for lease capitalization? a. The lessee treats lease payments as periodic expenses. b. The lessor pays costs normally incident to ownership. c. The lessee treats the lease as a purchase for tax purposes. d. Leased property is special purpose to the lessor. ANSWER: C

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Chapter 17—LEASES

5. Which of the following is not a possible treatment of a capital lease? a. The lessee treats lease payments as periodic expenses. b. The lessor treats the lease like a sale with vendor financing. c. The lease is treated by a third party like a loan with income realized through implicit interest in each lease payment. d. The lessee treats the lease as a purchase with debt financing. ANSWER: A 6. Which of the following applies if a lease is interpreted as unilaterally unperformed by the lessee? a. The lease contract is fully executed by the lessor when possession of the leased asset is transferred to the lessee. b. An asset and liability do not exist for the lessee. c. The lessor permits use of the asset for one period at a time and only if the rentals are paid by the lessee. d. Current lease payments are expensed by the lessee. ANSWER: A 7. Which of the following is not a true statement regarding the legal remedies available to lessors in the event of lessee default? a. The lease is significantly different from other debt arrangements. b. The lessee is not liable for future lease payments. c. The lease is considered unilaterally unperformed. d. The lessor must first mitigate the loss of rents by selling the asset or leasing it again.

ANSWER: C 8. A lease must be accounted for as either a rental agreement or a purchase equivalent with debt financing by: a. The lessor. b. The lessee. c. Both the lessor and lessee. d. None of the above ANSWER: B 9. A lease must be accounted for as either a rental agreement, a sale equivalent with debt financing, or a loan equivalent by: a. The lessor. b. The lessee. c. Both the lessor and lessee. d. None of the above ANSWER: A

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Chapter 17—LEASES

10. Which of the following lease treatments interprets the lease contract as an operating lease? a. A rental agreement b. A loan equivalent c. A sale equivalent d. A purchase ANSWER: A 11. Which of the following represents the legal approach to capital leases? a. Limit capital leases to leases that are virtually conditional sales agreements with installment payments. b. Capitalize leases where a purchase equivalent has occurred. c. The lease treatment is the same for lessor and lessee. d. Capitalize leases that are not true leases. ANSWER: D 12. Which of the following represents the material equity approach to capital leases? a. Limit capital leases to leases that are virtually conditional sales agreements with installment payments. b. Capitalize leases where a purchase equivalent has occurred. c. The lease treatment is the same for lessor and lessee. d. Capitalize leases that are not true leases. ANSWER: A 13. Which of the following represents the "transfer of the benefits and risks of ownership" approach to capital leases? a. Limit capital leases to leases that are virtually conditional sales agreements with installment payments. b. Capitalize leases where a purchase equivalent has occurred. c. The lease treatment is the same for lessor and lessee. d. Capitalize leases that are not true leases. ANSWER: B 14. Which of the following is not a true statement regarding ARB 38? a. It was the first lease accounting standard. b. It recommended capitalization for leases that were in substance installment purchases. c. It was most applicable to leases that were de facto conditional sales agreements. d. Noncancellability was introduced as a precondition for capitalization. ANSWER: D

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Chapter 17—LEASES

15. Which of the following is a true statement regarding APB Opinion No. 5? a. It took a legalistic approach to determining whether a lease was in substance a purchase. b. The stated objective was to clarify ARB 38, not change it. c. Cancellability was viewed as mitigating the executory nature of lease contracts. d. It greatly increased the number of leases that were capitalized. ANSWER: B 16. Which of the following statements applies to APB Opinion No. 31? a. It was criticized on the grounds that it resulted in inconsistent capitalization of financingtype leases. b. It required disclosures adequate to permit users to informally capitalize noncapitalized lease obligations if they so desired. c. It was an omnibus opinion. d. It was concerned with lease contracts between related parties. ANSWER: B 17. Which of the following does not apply to SFAS No. 13? a. It changed capitalization criteria. b. Noncancellability and material equity were abandoned in favor of broader tests representing substantive transfers of ownership benefits and risks. c. It is intended to capitalize fewer leases than previous standards. d. It provides that the lessee use the lessor's implicit rate in the lease if it is obtainable and if the implicit rate is lower than the lessee’s incremental borrowing rate. ANSWER: C 18. Which of the following is not one of the capitalization tests now applicable to both lessees and lessors? a. Title passes to the lessee at the end of the lease term. b. The lease contract contains a bargain purchase option. c. The lease term is at least 75 percent of estimated useful life. d. Lease agreement is noncancellable for a long term. ANSWER: D 19. How many of the four capitalization tests of SFAS No. 13 must be met for a lease to be capitalized? a. One b. Two c. Three d. Four ANSWER: A

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Chapter 17—LEASES

20. Which of the following is not a supplemental disclosure by the lessee required by SFAS No. 13 for noncancellable operating leases in excess of one year? a. Future minimum rental payments in aggregate and for each of the succeeding five periods b. The present value of minimum lease payments c. Total minimum rentals to be received under noncancellable subleases d. Rental expenses with separate totals for minimum rentals, contingent rentals, and sublease rentals

ANSWER: B 21. Which of the following was the first accounting standard to address lessor accounting? a. ARB 38 in 1949 b. APB Opinion No. 7 in 1966 c. APB Opinion No. 3 in 1973 d. SFAS No. 13 in 1976 ANSWER: B 22. What was the intent of APB Opinion No. 27? a. To achieve near symmetry in lessee and lessor accounting b. To expand the use of the material-equity method c. To broaden the criteria for capitalization d. To restrict the criteria for capitalization ANSWER: C 23. Which of the following applies to SFAS No. 13? a. It applied the four criteria for a capital lease to both lessees and lessors. b. It created inconsistencies in financing-type leases. c. It eliminated asymmetry between lessor and lessee accounting. d. It requires the lessee to always use the lessor’s implicit interest rate. ANSWER: A 24. Which of the following is not a true statement regarding a sale and leaseback? a. It occurs when the owner of an asset sells the asset and enters into a lease agreement to lease the asset back. b. The lessor and lessee both use the standard criteria for classifying such a lease as operating or capital. c. The lessor is the original legal owner and the lessee is the new legal owner. d. SFAS No. 13 allows a gain or loss to be immediately recognized in cases where the original owner retains the use of a substantially smaller part of the total asset. ANSWER: C 25. Which of the following applies to leveraged leases? a. Leveraged leases are a special type of operating lease involving three parties. b. The lessor acquires an asset to be leased by borrowing money from a third party. c. From a lessor's viewpoint, this type of lease is not any different from other leases.

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Chapter 17—LEASES

d. The FASB concluded in SFAS No. 13 that the financing-type lease plus debt transaction analogy was adequate to report leveraged leases. ANSWER: B 26. The G4+1 report on leases would: a. Make all leases operating leases. b. Cause the lessee to show operating leases as assets. c. Move leases from the area of rigid uniformity to finite uniformity. d. Enhance the distinction between operating and financing leases. ANSWER: B

ESSAY 1. Respond to the following: a. b. c.

Why has so much attention been given to leases in accounting standards? Why is leasing such a popular method of acquiring assets? How have accounting procedures for leases changed since ARB 43?

ANSWER: a. The attention given to leases in accounting standards reflects the increased use of leasing in the business community and the need to clarify and standardize the accounting for this complex transaction. b.

Leasing has become popular for a number of operating and financial reasons. From an operating viewpoint, some assets are available only under lease; others are too expensive for outright purchase. Two significant financing aspects are the tax advantages (lease payments are fully deductible) and the possibility of off-balancesheet financing, which occurs when leased assets and lease obligations are not reported in the financial statements. Off-balance-sheet financing results in better debt ratios and higher accounting rates of return than a purchase alternative could produce.

The accounting controversy about leases has focused on distinguishing between the economic substance of leases and their legal form. Prior to ARB 38, the accounting procedure for lease payments was to record them as periodic revenues for lessors and as expenses for lessees. Increasingly, however, some leases came to be viewed as the equivalent of purchases with debt financing. This view now dominates, and the focus of accounting standards has been on defining those situations in which a lease is considered to be a purchase equivalent and in making such leases look like a purchase with debt financing. These types of leases are called capital leases, and the accounting procedure for them is called capitalization. Noncapitalized leases are called operating leases, and the lease payments are treated as periodic expenses.

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Chapter 17—LEASES

2. Describe the two types of capital leases that exist from the lessor's point of view. ANSWER: The two types of capital leases are sales leases and financing leases. A sales-type lease arises when a manufacturer or seller of merchandise uses leasing as a financing instrument to effect what is considered to be the equivalent of a sale. The accounting treatment is to make the transaction look like the equivalent of a sale with vendor financing. A financing-type lease occurs when a third party finances a lease rather than a manufacturer or seller. In such situations, the financing party is the lessor and the accounting attempts to make the lease look like a loan with income realized through implicit interest in each lease payment. 3. Respond to the following: a. b.

What are the current criteria for capitalization identified in SFAS No. 13? How is the minimum lease payment calculated?

ANSWER:

The four criteria for capitalization are as follows: (1) Title passes to the lessee at the end of the lease term. (2) The lease contract contains a bargain purchase option. (3) The lease term is at least 75 percent of estimated useful life (with the lease term covering more than 25 percent of the original economic life when new). (4) The present value of minimum lease payments is 90 percent of the fair market value of the lease property at the inception of the lease, less any applicable investment tax credit.

The minimum lease payment is the sum of minimum rentals excluding executory costs, a bargain purchase payment if one exists, penalty payment for nonrenewal if renewal is unlikely, and any guaranteed residual value at the end of the lease term—plus unguaranteed residual value for lessors.

4. How does the accounting prescribed in SFAS No. 13 seek to make a capital lease resemble a purchase by the lessee of an asset with debt financing? ANSWER: The present value of minimum lease payments is debited to leased assets and credited to lease obligations, subject to an upper limit of the asset's fair market value at lease inception. The asset is depreciated over its useful life if it is being leased for substantially all its useful life, with 75 percent being the materiality threshold. Otherwise, the depreciation period is the lease term, with total amortization equal to the capitalized amount less any guaranteed residual value at the end of the lease term. During the lease term, each payment is allocated between interest expense and reduction of the lease obligation. The effective interest method is used. Any executory costs such as taxes, maintenance, and insurance, are expensed as incurred.

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5. Discuss two types of economic consequences of lease accounting. ANSWER: From the viewpoint of a company preparing financial statements, there are at least two types of economic consequences of lease accounting. One is the cost of complying with lease capitalization. More detailed analyses will be required by a company and its auditor in classifying leases as operating and capital. Finite uniformity always imposes a higher compliance cost than rigid uniformity.The more critical concern has been whether lease capitalization might provide disincentives for leasing itself. From a lessee's perspective, leasing offered the possibility of off-balancesheet financing for most leases prior to SFAS No. 13. A survey of lessees indicated that the effect on financial statements was a major reason for leasing. Noncapitalization of leases improves debt ratios and accounting rate of return compared with a purchase/debt alternative. Some lessees also believed that noncapitalization of leases increased available capital because these leases do not affect borrowing restrictions in debt covenants and that the lower debt ratios that would be achieved by noncapitalization would result in better debt ratings and lower interest rates in the capital market. A study of pre-SFAS No. 13 lease accounting found that companies with high leverage levels were more likely to have reported their leases as operating rather than capital leases. 6. Discuss the effectiveness of SFAS No. 13 in addressing the lease capitalization problem. ANSWER: The problem that many leases are not being capitalized but should be continues to be true under SFAS No. 13. An inherent weakness of the finite uniformity approach is that management may prefer some accounting methods over others. In these instances, companies will be motivated to manipulate the relevant circumstances in order to get the desired accounting result. With leases, lessees continue to believe that there are advantages to off-balance-sheet financing through leases. This will always motivate companies to try to defeat the capitalization tests of lease accounting standards. It is not very difficult to structure a lease contract to defeat the four tests of SFAS No. 13 because the four tests are not stringent. A more challenging task, though, is to defeat lease capitalization tests for the lessee while satisfying them for the lessor. Lessors normally desire to capitalize leases and recognize sales revenue, but lessees prefer the effects of off-balance-sheet financing. One innovative method to accomplish both objectives is the use of third parties to guarantee residual values to the lessor, reducing the lessee's obligation under test (4) of SFAS No. 13 and, if significant enough, could lead to noncapitalization. However, there is no effect on the lessor because the lessor's accounting deals with the estimated residual value in total. No distinction is made between guaranteed and unguaranteed residual value. 7. How does lease accounting under the IASB differ from lease accounting under FAS? ANSWER: FASB has a rules based orientation with “bright lines” carefully laid out (the 75% rule). In IAS 17 a capital lease results when the lease is for “the major part” of an asset’s economic life or the present value of the minimum lease payments are “substantially all” of the leased asset’s economic value. Hence, IAS 13 requires more judgment than SFAS No. 13.

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Chapter 18—INTERCORPORATE EQUITY INVESTMENTS

TRUE/FALSE 1. Accounting standards for intercorporate equity investments represent the most extensive application of flexible uniformity in accounting practice. ANSWER: FALSE 2. The relevant circumstances that justify differential accounting for intercorporate equity investments depend on the level of influence held by the investor. ANSWER: TRUE 3. The SEC prohibits consolidation of a subsidiary company unless majority ownership exists. ANSWER: TRUE 4. The equity method is the required reporting method for all less-than-majority owned companies. ANSWER: FALSE 5. The relevant circumstance in determining the reporting method for nonconsolidated intercorporate equity investments is effective control. ANSWER: FALSE 6. In the terminology suggested by the FASB related to consolidation reporting, the term parent company refers to the company whose stockholders as a group end up with control of the voting stock of the other company entering into the business combination. ANSWER: FALSE 7. The central accounting issue in a business combination is the valuation of the assets and liabilities of the separate entities being combined for reporting purposes. ANSWER: TRUE 8. With pooling of interests, total stockholders' equity of the combined enterprise would be equal to the sum of the separate companies' equities immediately prior to the combination. ANSWER: TRUE 9.

A FASB survey found that most enterprises entering into a pooling of interest believed that the combination would not have occurred if purchase accounting had been acquired. ANSWER: FALSE

10. A purchase combination is argued to be simply the formal unification of two previously separate ownership groups. ANSWER: FALSE

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11. The new proportionate consolidation approach results in the use of current values for the assets and liabilities of all the separate entities as of the date the combination is consummated. ANSWER: FALSE 12. With the new entity approach, consolidation of assets and liabilities occurs only to the extent of the stock acquired by the parent. ANSWER: FALSE 13. Application of the purchase method may be complicated by part of the purchase price being of a noncash nature. ANSWER: TRUE 14. An advantage of proportionate consolidation is that the minority interest category does not arise. ANSWER: TRUE 15. Research has provided evidence that the stock market may be fooled by the higher income reported under the pooling method. ANSWER: FALSE 16. The equity method is questionable in terms of both relevance and representational faithfulness. ANSWER: TRUE 17. According to SFAS No. 115, the fair market value method applies for investments of less than 50 percent where market values are readily determinable ANSWER: FALSE 18. Currently, there are moves to extend consolidated reporting. ANSWER: TRUE 19. The pooling of interests consolidation method has been eliminated for new acquisitions by SFAS No. 141. ANSWER: TRUE 20. SFAS 141 requires acquisitions previously accounted for as poolings be converted to purchase accounting. ANSWER: FALSE 21. The essence of SFAS No. 142 is that goodwill must now be amortized over 40 years. ANSWER: FALSE

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22. According to SFAS No. 142, goodwill is an intangible asset with an indefinite life. ANSWER: TRUE 23. SFAS 142 equates goodwill with other intangible costs to be immediately expensed. ANSWER: FALSE 24. A reporting unit for the impairment test would be an operating segment of the firm or one level below. ANSWER: TRUE 25. The FASB was the first standard-setting body to address translation of foreign-based operations and holdings into U.S. dollars. ANSWER: FALSE 26. The U.S. dollar orientation approach to the translation of foreign operations requires an enterprise to account for foreign operations as if those operations actually occurred in U.S. dollars. ANSWER: TRUE 27. The U.S. dollar orientation approach to the translation of foreign operations assumes that foreign currency denominated assets, liabilities, revenues, and expenses are measured in the foreign currency but are translated to U.S. dollars for reporting purposes. ANSWER: FALSE 28. SFAS NO. 8 required the temporal method of translation. ANSWER: TRUE 29. Under the temporal method of translation, all balance sheet items that are carried at current or future exchange prices are translated at the current exchange rate, while items carried at past prices are translated at exchange rates existing at the time the item was acquired. ANSWER: TRUE 30. Accounting exposure is the exposure to exchange gains and losses resulting from translating U.S.-dollar-denominated financial statements into foreign denominations. ANSWER: FALSE 31. Economic exposure directly affects consolidated cash flows. ANSWER: TRUE

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32. SFAS No. 52 adopted a currency U.S. dollar orientation to accounting for foreign currency operations. ANSWER: FALSE 33. An objective of translation under SFAS No. 52 is to avoid reporting foreign-currencydenominated operations as if they had occurred in U.S. dollars. ANSWER: TRUE 34. Under SFAS No. 52, if the results of foreign-currency-denominated operations will not affect U.S. dollar cash flows, no exchange gain or loss is recorded. ANSWER: TRUE 35. The key question addressed by SFAS No. 52 involves how to report exchange gains and losses on the income statement. ANSWER: FALSE 36. Financing indicators are included in the guidelines provided by SFAS No. 52 for determining the functional currency. ANSWER: TRUE 37. The functional currency is defined as the currency of the country in which the foreign subsidiary is located. ANSWER: FALSE 38. SPEs are designed to conduct just one well defined activity. ANSWER: TRUE 39. It is difficult to attract investors to SPEs because the cash flows and the risks involved are hard to predict. ANSWER: FALSE 40. In many SPE transactions, the tax benefits were likely to outweigh maintenance costs associated with the SPE. ANSWER: TRUE 41. SPEs were widely used by U.S. companies for legitimate purposes. ANSWER: TRUE

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MULTIPLE CHOICE 1. Which of the following is not one of the three ways of reporting on intercorporate equity investments? a. Consolidated reporting as if the two separate legal entities are an accounting entity using the purchase method. b. Consolidated reporting using the pooling method c. Nonconsolidation using the equity method of accounting d. Nonconsolidation using a fair market value approach ANSWER: B 2. Which of the following criteria has been most used by standard-setting bodies as the basis for evaluating the level of investor influence? a. Controlling influence on the board of directors b. Operating control c. Managerial control d. Percentage of voting stock owned ANSWER: D 3. Which of the following is not a true statement? a. ARB 51 prohibited consolidation of a subsidiary company unless majority ownership exists. b. ARB 51 took the view that majority ownership per se did not indicate control if ownership were temporary or if for some reason control did not reside with the majority owner. c. ARB 51 permitted separate reporting for heterogeneous subsidiaries instead of consolidation. d. ARB 43 permitted separate reporting for foreign subsidiaries instead of consolidation. ANSWER: A 4. Which of the following is not a true statement regarding SFAS No. 94? a. SFAS No. 94 rejected the exclusionary arguments of ARB 51 and ARB 43. b. SFAS No. 94 requires all majority-owned companies to be consolidated except when control is only temporary or if the majority owner does not have effective control. c. SFAS No. 94 says that neither legal reorganization nor bankruptcy is an instance of noncontrol by a majority owner. d. There is some evidence that the FASB was attempting to "level the playing field" in SFAS No. 94 by requiring companies to provide more information to financial statement users who might not have been aware of debt levels carried by unconsolidated subsidiaries. ANSWER: C

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5. What is the appropriate reporting method for less than majority owned companies? a. The equity method b. The fair value method c. Either the equity method or the fair value method depending on whether the investor can exercise significant influence over operating and financial policies. d. Either the equity method or the fair value method depending on whether the investor has effective control over operating and financial policies ANSWER: C 6. In the terminology suggested by the FASB, which of the following terms refers to the accounting entity that results from a business combination? a. Parent enterprise b. Combined enterprise c. Consolidated enterprise d. Controlling enterprise ANSWER: B 7. In the terminology suggested by the FASB, which of the following terms refers to the separate business enterprises that enter into a business combination? a. Constituent companies b. Combined companies c. Subsidiary companies d. Consolidated companies ANSWER: A 8. In the terminology suggested by the FASB, which of the following terms refers to the company whose stockholders as a group end up with control of the voting stock of the other company entering into the business combination? a. Parent b. Subsidiary c. Combinee d. Combinor ANSWER: D 9. In a 1976 discussion memorandum, the FASB defined the purchase method of accounting for business combinations as a method which: a. Results in the assets and liabilities of the subsidiary being valued at market value at the time of acquisition, and the parent's assets and liabilities being valued at book value. b. Results in the assets and liabilities of the parent being valued at market value at the time of acquisition, and the subsidiary's assets and liabilities being valued at book value. c. Results in all entities' assets and liabilities being revalued to market values at the time the combination originates. d. Uses the book values of the combining companies. ANSWER: A

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10. In a 1976 discussion memorandum, the FASB defined the new entity approach to accounting for business combinations as a method which: a. Results in the assets and liabilities of the subsidiary being valued at market value at the time of acquisition, and the parent's assets and liabilities being valued at book value. b. Results in the assets and liabilities of the parent being valued at market value at the time of acquisition, and the subsidiary's assets and liabilities being valued at book value. c. Results in all entities' assets and liabilities being revalued to market values at the time the combination originates. d. Uses the book values of the combining companies. ANSWER: C 11. In a 1976 discussion memorandum, the FASB defined the pooling-of-interest method of accounting for business combinations as a method which: a. Results in the assets and liabilities of the subsidiary being valued at market value at the time of acquisition, and the parent's assets and liabilities being valued at book value. b. Results in the assets and liabilities of the parent being valued at market value at the time of acquisition, and the subsidiary's assets and liabilities being valued at book value. c. Results in all entities' assets and liabilities being revalued to market values at the time the combination originates. d. Uses the book values of the combining companies. ANSWER: D 12. A a. b. c. d.

occurs when the subsidiary's stock is sold for cash, assets, or in settlement of a debt. Spin-off Split-off Split-up Sell-off

ANSWER: D 13. A occurs when the subsidiary's stock is distributed to the combinor's shareholders as a dividend. a. Spin-off b. Split-off c. Split-up d. Sell-off ANSWER: A 14. A occurs when the shares of two or more subsidiaries are distributed to the combinor's shareholders in exchange for all of the parent's shares with the parent then liquidated. a. Spin-off b. Split-off c. Split-up d. Sell-off ANSWER: C

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15. A occurs when the subsidiary's shares are distributed to the combinor's shareholders in exchange for shares of the parent's stock. a. Spin-off b. Split-off c. Split-up d. Sell-off ANSWER: B 16. Which of the following methods of accounting for a business combination is based on the premise that no substantive transaction occurs between the companies involved? a. Pooling of interests b. The purchase method c. The new entity approach d. Proportionate consolidation ANSWER: A 17. With which of the following methods of accounting for a business combination does consolidation of assets and liabilities occur only to the extent of the stock acquired by the parent? a. Pooling of interests b. The purchase method c. The new entity approach d. Proportionate consolidation ANSWER: D 18. With which of the following methods of accounting for a business combination does a minority interest category not arise? a. Pooling of interests b. The purchase method c. The new entity approach d. Proportionate consolidation ANSWER: D 19. Which of the following methods of accounting for a business combination assumes that the parent company purchases the subsidiary and must account for the acquisition as it would for the acquisition of any asset. a. Pooling of interests b. The purchase method c. The new entity approach d. Proportionate consolidation ANSWER: B

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20. Which of the following methods of accounting for business combinations has been viewed as an important motivation for business combinations? a. Pooling of interests b. The purchase method c. The new entity approach d. Proportionate consolidation ANSWER: A 21. Which of the following is not true regarding an equity carve-out? a. It can result in the creation of minority interests. b. It arises when a combinor sells a portion of its interest in a combinee. c. It arises when a combinor dilutes its interest through an initial public offering of the subsidiary. d. The SEC requires resulting carve-out gains to be booked as non-operating income. e. It can result in the creation of minority interests. ANSWER: C 22. If the proportionate ownership method of accounting for business combinations were to be used throughout the ownership range, it would be an example of: a. Finite uniformity. b. Flexible uniformity. c. Rigid uniformity. d. Definable uniformity. ANSWER: C 23. "One-line consolidation" refers to: a. The equity method. b. The fair value method. c. The purchase method. d. Pooling of interests. ANSWER: A 24. Which of the following is not a true statement? a. Consolidated reporting emerged in the early 1900s in response to the growth of holding companies. b. Consolidation reporting presumes that the accounting fiction of a group entity is more meaningful than defining the reporting entity in legal terms. c. There are moves afoot to curtail consolidated reporting. d. The relevant circumstance in the reporting of intercorporate equity investments centers on the notion of investor control, but, in practice, the magnitude of ownership has been the guiding criterion. ANSWER: C

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25. Which of the following is not true regarding SFAS No. 142 a. Goodwill may be defined as the excess earning power of an acquisition b. Goodwill is defined as the difference between the amount paid for an acquired subsidiary and the fair market value of its individual net assets. c. Tests of goodwill impairment must be made on an annual basis. d. Because goodwill has an indefinite life, it is not subject to write-off as an expense. ANSWER: D 26. Which of the following standard-setting bodies was the first to address translation of foreignbased operations and holdings into U.S. dollars? a. CAP b. APB c. FASB d. SEC ANSWER: A 27. Which of the following does not apply to the Bretton Woods Agreement of 1944? a. The developments surrounding the agreement have heightened the importance of how translation of foreign-based operations should be handled. b. It established controlled exchange rates worldwide. c. It allowed monetary authorities to buy or sell gold or foreign exchange with the intent of maintaining an allowable exchange rate fluctuation. d. It collapsed in 1971 resulting in freer and more volatile exchange rate fluctuations. ANSWER: B 28. Which of the following applies to the U.S. dollar orientation approach to the translation of foreign operations? a. It requires an enterprise to account for foreign operations as if those operations actually occurred in U.S. dollars. b. It recognizes that the foreign operations occurred in a foreign currency and that those operations may not affect U.S. dollars. c. Foreign currency denominated assets, liabilities, revenues, and expenses are assumed to be measured in the foreign currency but are translated to U.S. dollars for reporting purposes. d. The effects of changing exchange rates are not reported in income until the net assets are exchanged. ANSWER: A 29. Which of the following is not a true statement regarding SFAS No. 8? a. SFAS was faithful to the historical cost accounting model, but from an economic viewpoint, it produced illogical results. b. SFAS No. 8 required the temporal method of translation. c. In empirical studies made of the economic impact of SFAS No. 8 on American multinational enterprises, only foreign exchange risk and management policies regarding hedging of foreign currency exposures were found to have any possible impact. d. SFAS No. 8 was consistent with the foreign currency orientation. ANSWER: D

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30. Accounting exposure is: a. The exposure to exchange gains and losses resulting from translating U.S.-dollardenominated financial statements into foreign denominations. b. The exposure to exchange gains and losses resulting from translating foreign-currencydenominated financial statements into U.S. dollars. c. The exposure to cash flow changes resulting from dealings in foreign-denominated transactions and commitments. d. A result of the need to use more U.S. dollars to settle a foreign-currency-denominated debt. ANSWER: B 31. Economic exposure is: a. The exposure to exchange gains and losses resulting from translating U.S.-dollardenominated financial statement into foreign denominations. b. The exposure to exchange gains and losses resulting from translating foreign-currencydenominated financial statements into U.S. dollars. c. The exposure to cash flow changes resulting from dealings in foreign-denominated transactions and commitments. d. A result of the need to use more foreign currency to settle U.S. dollar denominated debt. ANSWER: C 32. With the temporal method of translation: a. All balance sheet items that are carried at current or future exchange prices are translated at the current exchange rate. b. Balance sheet items carried at past prices, such as fixed assets, are translated at the current exchange rate. c. Income statement items are translated at the current exchange rate. d. Income statement items are translated at historical exchange rates. ANSWER: A 33. Which of the following directly affects consolidated cash flows? a. Accounting exposure b. Economic exposure c. Both accounting exposure and economic exposure d. Neither accounting exposure nor economic exposure ANSWER: B 34. SFAS No. 52 adopted: a. A U.S. dollar orientation to accounting for foreign currency operations. b. A functional currency orientation to accounting for foreign currency operations. c. A foreign currency orientation to accounting for foreign currency operations. d. None of the above ANSWER: B

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35. What is the objective of translation under SFAS No. 52? a. To avoid reporting accounting exchange gains and losses when an economic gain or loss has not occurred b. To avoid reporting foreign-currency-denominated operations as if they had occurred in U.S. dollars c. To maintain a U.S. dollar orientation d. Both a and b ANSWER: D 36. Which of the following is a true statement regarding SFAS No. 52? a. When a foreign entity's currency is the functional currency, net income is measured in the foreign currency and then restated into dollars at the current exchange rate at the end of the period. b. When a foreign entity's currency is the functional currency, any exchange adjustment resulting from translating balance sheet and income statement items at different exchange rates is recognized as a gain or loss on the income statement. c. When a foreign entity's currency is the functional currency, all balance sheet items are translated at the average exchange rate for the period. d. If the results of foreign-currency-denominated operations will not affect U.S. dollar cash flows, no exchange gain or loss is recorded. ANSWER: D 37. Which of the following is not a true statement regarding SFAS No. 52? a. The key question brought up in SFAS No. 52 involves how to report exchange gains and losses on the income statement. b. The six guidelines or economic factors provided by SFAS No. 52 for determining the functional currency have a differential cash flow orientation. c. The six indicators provided by SFAS No. 52 have been found to provide adequate guidance for determining the functional currency. d. The six indicators provided by SFAS No. 52 for determining the functional currency have a foreign currency component and a parent's currency component. ANSWER: A 38. Which of the following is not one of the six guidelines or economic factors provided by SFAS No. 52 for determining the functional currency? a. Sales price indicators b. Interest rate indicators c. Expense indicators d. Intercompany transactions and arrangements ANSWER: B

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39. Which of the following is not true if the functional currency of a foreign operation is U.S. dollars? a. All balance sheet items that were carried at current or future exchange prices are translated at the current exchange rate. b. All balance sheet items carried at past prices are translated at exchange rates existing at the time the item was acquired. c. All income statement items are translated at the average exchange rate for the reporting period. d. Exchange gains and losses arising from translation from the currency of record into the functional currency are recognized on the income statement. ANSWER: C 40. What is meant by the term "functional currency"? a. The functional currency is the currency of the parent corporation. b. The functional currency is the currency of the country in which the foreign subsidiary is located. c. The functional currency is the currency of the parent's primary economic environment where cash is primarily received and spent. d. The functional currency is the currency of the subsidiary's primary economic environment where cash is primarily received and spent. ANSWER: D

ESSAY 1. Respond to the following: a. What does the term functional currency mean? b. What is the accounting treatment if the foreign entity's currency in the functional currency? c. What is the accounting treatment if the U.S. currency is the functional currency?

ANSWER: a. The functional currency is the currency of the subsidiary's primary economic environment where cash is primarily received and spent. b. If the foreign entity's currency is the functional currency, net income is measured in the foreign currency and then restated into dollars at the average exchange rate for the period. All balance sheet items are translated at the current exchange rate at the end of the period. Any exchange adjustment resulting from translating balance sheet and income statement items at different exchange rates is displayed as a separate component of stockholders' equity, not as a gain or loss on the income statement. c. If the functional currency of a foreign operation is judged to be U.S. dollars, the accounting records must be converted into U.S. dollars. This is called remeasurement and is done by following the temporal approach of SFAS No. 8. With this approach, all balance sheet items that were carried at current or future exchange prices are translated at the current exchange rate, while items carried at past prices are

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translated at exchange rates existing at the time the item was acquired. Income statement items are translated at the average exchange rate for the reporting period—except that items related to balance sheet accounts that were translated at historical exchange rates, such as cost of goods sold and depreciation, are also translated at the historical rates. Exchange gains and losses arising from translation from the currency of record into the functional currency would be recognized on the income statement. 2. Respond to the following: a. What are the six guidelines that SFAS No. 52 provides for determining the functional currency? b. What were the findings of the FASB research report by Evan and Doupnik regarding these six criteria? ANSWER: a. The six guidelines that SFAS No. 52 provides for determining the functional currency are as follows: (1) Cash flow indicators a. Foreign Currency—Cash flows related to the foreign entity's individual assets and liabilities are primarily in the foreign currency and do not directly impact the parent company's cash flows. b. Parent's Currency—Cash flows related to the foreign entity's individual assets and liabilities directly impact the parent's cash flows on a current basis and are readily available for remittance to the parent company. (2) Sales price indicators a. Foreign Currency—Sales prices for the foreign entity's products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation. b. Parent's Currency—Sales prices for the foreign entity's products are primarily responsive on a short-term basis to changes in exchange rates; for example, sales prices are determined more by worldwide competition or by international prices. (3) Sales market indicators a. Foreign Currency—There is an active local sales market for the foreign entity's products, although there also might be significant amounts of exports. b. Parent's Currency—The sales market is mostly in the parent's country or sales contracts are denominated in the parent's currency. (4) Expense indicators a. Foreign Currency—Labor, materials, and other costs for the foreign entity's products or services are primarily local costs, even though there also might be imports from other countries. b. Parent's Currency—Labor, materials, and other costs for the foreign entity's products or services, on a continuing basis, are primarily costs for components obtained from the country in which the parent company is located. (5) Financing indicators a. Foreign Currency—Financing is primarily denominated in foreign currency, and funds generated by the foreign entity's operations are sufficient to service existing and normally expected debt obligations. b. Parent's Currency—Financing is primarily from the parent or other dollardenominated obligations, or funds generated by the foreign entity's operations are not sufficient to service existing and normally expected debt obligations without the infusion of additional funds from the parent company. Infusion of additional funds from the parent company for expansion is not a factor, provided funds

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(6)

generated by the foreign entity's expanded operations are expected to be sufficient to service that additional financing. Intercompany transactions and arrangements indicators a. Foreign Currency—There is a low volume of intercompany transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent company. However, the foreign entity's operations may rely on the parent's or affiliates' competitive advantages, such as patents and trademarks. b. Parent's Currency—There is a high volume of intercompany transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent company. Additionally, the parent's currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, etc., that could readily be carried on the parent's or an affiliate's books.

The FASB research report by Evans and Doupnik found that the six criteria provided adequate guidance for determining the functional currency. Furthermore, the respondents to the study agreed very strongly that the standard works well. Of the six indicators, the four that were most heavily weighted were the first four listed above. Only a small percentage of the participants had difficulty in determining the functional currency in many cases.

3. Respond to the following: a. b.

Explain the differences between the pooling of interests and purchase methods in terms of related assumptions and application. Why may companies not be indifferent to purchase and pooling accounting?

ANSWER: a. In a pooling of interests, there is a swap of equity shares in which the combinor company exchanges its shares for the outstanding shares of the combinee company. There is no purchase by one constituent of the other; thus, the assumption is that no exchange transaction occurs but that assets and liabilities are combined at their book values. Pooling is similar to the concept of a nonmonetary exchange of similar fixed assets, so the book values of the combined enterprise's assets and liabilities after the combination will be equal to the summation of the combinor's and combinee's respective book values just prior to the combination. Total stockholders' equity of the combined enterprise will also be equal to the sum of the constituent companies' equities immediately prior to the combination. There may be some changes in individual components, depending on the exchange ratio, but in aggregate the combined stockholders' equity is the sum of the precombination totals. In purchase accounting, the assumption is that the combinor is a parent company that purchases the combinee (subsidiary) and must account for the purchase as it would for the acquisition of any asset. The asset, investment in the combinee company, is recorded by the combinor at the latter's cost determined as of the date the combination is consummated. This results in the consolidated reporting of the combinee's net assets at their fair market value at the date of combination. Frequently, the total cost of the combinee is not equal to the summation of the fair values of its individual assets less liabilities, and the purchase differential must be dealt with in some manner. Traditionally, this difference has been called goodwill.

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The desirability of pooling is to avoid certain ramifications of purchase accounting: (1) by combining assets at historical costs, future income would be higher because it would avoid booking acquired assets at purchase price which would usually by higher than historical cost to the combinee, and (2) avoiding the booking of goodwill—excess of purchase price over fair value of net assets acquired—which would be written off against future income (changed by SFAS No. 142). Pooling of interests generally produces more favorable financial statements than purchase accounting because combined assets are not revalued. Pooled financial statements would thus report higher income since depreciation, cost of goods sold, etc., would not be calculated on the basis of higher valued assets, nor would there be any amortization of the purchase differential (goodwill). In addition, return on investment would be greater owing to both a higher income level and a lower asset base.

4. What is meant by proportionate consolidation, and what are its advantages? ANSWER: Under proportionate consolidation, only the proportion of assets actually acquired, as represented by the stock purchase, are consolidated. One major advantage of proportionate consolidation is that an arbitrary distinction at the 50 percent point where control is assumed does not exist under proportionate consolidation. Theoretically, proportionate consolidation could be used throughout the ownership range. Another possible advantage of proportionate consolidation is that the minority interest category does not arise. 5. What are the relevant circumstances that justify differential accounting for intercorporate equity investments? ANSWER: The relevant circumstances that justify differential accounting for intercorporate equity investments depend on the level of influence held by the investor. Standard-setting bodies have focused on a single quantitative criterion, percentage of voting stock owned, as the basis for evaluating the level of influence. Three levels of control have been defined along with three distinctly different reporting methods for each level. SFAS No. 94 requires all majority-owned companies to be consolidated except when control is only temporary or if the majority owner does not have effective control. For less-than-majority-owned companies, the appropriate reporting is either the equity method or the fair value method. The relevant circumstance is whether the investor can exercise significant influence over operating and financial policies. Effective control leads to consolidated reporting; a lesser level of control can also exist in which there is significant influence but not effective control. FASB Interpretation No. 35 established that the relevant circumstance is the ability to exercise significant influence with a 20 percent ownership level used as a guideline, but not a hard and fast rule. If there is no significant influence, then the fair value method of accounting is required under SFAS No. 115. 6. What is "one-line consolidation," and when is it used? ANSWER:

If an investor's ownership is not greater than 50 percent, but the investor can exercise significant influence over operating and financial policies, the equity method, or one-line consolidation, is used. With this method, the investment account is used to reflect the investor's underlying book value of equity in the investee. Many of the mechanical adjustments that are required for consolidated financial statements are also required for a one-

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line consolidation—except that only the net effect of those adjustments is reported in the investment account rather than a consolidated reporting of all of the individual accounts actually involved. The events that must be recorded in the investment account for each reporting period are: (1) proportionate share of investee's income or loss for the period; (2) proportionate share of investee's cash dividend for the period; and (3) amortization of the amount of the cost of the investment that is different from the underlying book value acquired. The result is that one line on the balance sheet, the investment account, and one line on the income statement, the income from equity investment account, are reported as if consolidation had occurred. 7. Discuss why the reporting of disaggregated data may be preferable to consolidated data. ANSWER: Consolidation is a useful way of summarizing overall results as if an affiliated group were one legal entity. But such a method necessarily fails to report on the real separate legal entities, and for this reason there is bound to be a loss of information with respect to the separate legal entities. A number of studies have found that disaggregated data by product line are more useful in forecasting earnings and in valuing the firm. 8. Summarize the provisions of SFAS No. 142 related to the definition of goodwill, impairment testing of goodwill, and the proper handling of goodwill in the event of the sale of an acquired subsidiary. ANSWER: The essence of SFAS No. 142 is that goodwill is converted into an intangible asset with an indefinite life but it is subject to write-off as an expense if it becomes “impaired.” Tests of impairment must be made on an annual basis. Goodwill is numerically defined as the difference between the amount paid for an acquired subsidiary and the fair market value of the individual net assets of the acquired enterprise, and might therefore be defined as the excess earning power of the acquisition. The basic impairment test after acquisition would compare (1) the fair market value of the acquisition against (2) the historical cost of the net assets plus goodwill at an annual measurement date after acquisition. If (1) is greater than (2), no impairment has occurred. However, if (2) is greater than (1), goodwill is impaired and the impaired amount is written off as a loss appearing above income from continuing operations. The loss cannot exceed the recorded amount of goodwill nor can goodwill, once written off, be restored. If circumstances merit it, tests of impairment should be done more frequently than annually. In the event of the sale of an acquired subsidiary, any goodwill attributable to the subsidiary must go off of the books.

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9. What were special purpose entities (SPEs) and what were their advantages? ANSWER: SPEs were entities created solely to carry out an activity or series of transactions directly related to specific purpose. Because SPEs were designed to conduct just one well defined activity, it was relatively easy to attract a group of investors to invest in an SPE because the cash flows and the risks involved were well understood. SPEs were used for decades as a preferred form of financing arrangements, leasing arrangements and sales/transfers of illiquid or poor performing assets. SPEs were generally recognized as legitimate financial tools because of the vital role they played in helping many companies raise capital at reasonable cost by creating liquidity in assets that were otherwise illiquid. Since the structure of an SPE was such that the sponsoring company presumably did not have control, because control rested with the outside equity investors, the sponsoring company did not have to consolidate the SPE on its books. Other advantages of using SPEs included the ability to moderate risk by transferring the economic risk and rewards of assets to a non-consolidated third party while retaining use of the assets, as well as tax advantages. In many SPE transactions, the tax benefits alone were likely to outweigh any maintenance costs associated with the SPE. 10. How and why were SPEs changed by FASB Interpretation No. 46 and Interpretation 46R? ANSWER: As a result of the abuse of SPEs by firms such as Enron, which had as many as 3500 SPEs, FASB addressed their use in Interpretation 46. FASB changed the name to variable interest entity (VIEs) and broadened the requirements for consolidation. The minimum equity interest by an outside investor to avoid consolidation was raised to 10%. However, consolidation can still be avoided if the equity investment in the VIE is sufficient to cover estimated losses. An enterprise must consolidate a VIE if it would “receive a majority of the VIE’s losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both.” A direct or an indirect ability to make major decisions for the variable interest entity is a good determinant for whether an enterprise is expected to absorb losses or receive residual gains. As a result of Interpretation 46R, consolidation must occur if equity investors : 1. do not participate in decision making by means of voting their stock; 2. do not share in returns generated by the entity; 3. do not absorb any of the VIE’s losses; 4. do not share in the expected residual returns of the VIE.

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