CHAPTER 6 CONCEPTUAL FRAMEWORK Recognition and measurement TECHNICAL KNOWLEDGE To define recognition of the elements of financial statements. To know the recognition criteria for asset, liability, income and expense. To define measurement of the elements of financial statements. . To be aware of the various financial attributes for measuring asset, liability, income and expense. OcdINIcU WILT vansRECOGNITION The Revised Conceptual Framework defines recognition ag the process of capturing for inclusion in the financial statements an item that meets the definition of an asset, liability, equity, Income or expense. The amount at which an asset, a liability or equity ig recognized in the statement of financial position is reported as carrying amount. Recognition links the elements to the statement of financial position and statement of financial performance. The statements are linked because the recognition of an item in one statement requires the recognition of the same item in another statement. For example, the recognition of income happens simultaneously with the recognition of an increase in asset or decrease in liability. The recognition of expense happens simultaneouly with the recognition of a decrease in asset or increase in liability. Recognition criteria Only items that meet the definition of an asset, a liability or equity are recognized in the statement of financial position. Similarly, only items that meet the définition of income or expense are recognized in the statement of financial performance. In addition to. meeting the definition of an element, items are recognized only when their recognition provides users of financial statements with information that is both relevant and faithfully represented. Recognition does not focus anymore on how probable economic benefits will flow to or from the entity and that the cost can be measured reliably. ‘ An asset or liability and any corresponding income or cathe can exist even if the probability of inflow or outflow ©, benefits is low. v4 ovaimmieu win camsPoint of sale income recognition The basic principle of income recognition is that income shall be recognized when earned. But the question is when is income considered to be earned? With respect to sale of goods in the ordinary course of business, the point of sale is unquestionably the point of income recognition. The reason is that it is at the point of sale that the entity has transferred to the buyer the significant risks and rewards of ownership of the goods. Stated differently, legal title to the goods passes to the buyer at the point of sale. Moreover, it is at the point of sale that the entity has transferred control of the goods to the customer. However, under certain conditions, income may be recognized at the point of production, during production and at the point of collection. Expense recognition The basic expense recognition means that expenses are recognized when incurred. But the question is when are expenses incurred? Actually, the expense recognition principle is the application of the matching principle. The generation of revenue is not without any cost. There has got to be some cost in earning a revenue. “There is no gain if there is no pain’. The matching principle requires that those costs and expenses incurred in earning a revenue shall be reported in the same period. . The matching principle has three applications, namely: a. Cause and effect association _ b. Systematic and rational allocation c. Immediate recognition 115 OCdIINICU WILIT camsCause and effect association Under this principle, the expense is recognized when the revenue ts already recognized. The reason is the presumed direct association of the expense with specific items of income This is actually the “strict matching concept”. This process, commonly referred to as the matching of cost with revenue, involves the simultaneous or combined recognition of revenue and expenses that result directly and jointly from the same transactions or events. The best example is the cost of merchandise inventory. Such cost is considered as an asset in the meantime that the merchandise is on hand. When the merchandise is sold, the cost thereof is expensed in the form of “cost of goods sold” because at such time revenue may be recognized. Other examples include doubtful accounts, warranty expense and sales commissions. Systematic and rational allocation Under this principle, some costs are expensed by simply allocating them over the periods benefited. The reason for this principle is that the cost incurred will benefit future periods and that there is an absence of a direct or clear association of the expense with specific revenue. When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognized on the basis of systematic and allocation procedures. Concrete examples include depreciation of property, plant and equipment, amortization of intangibles, and allocation of prepaid rent, insurance and other prepayments. ais ovaimieu win CamsImmediate recognition Under this principle, the cost incurred is expensed outright because of uncertainty of future economic benefits or difficulty of reliably associating certain costs with future revenue. . An expense is recognized immediately: a. When an expenditure produces no future economic benefit. b. When cost incurred does not qualify or ceases to qualify for recognition as an asset. Examples include officers’ salaries and most administrative expenses, advertising and most selling expenses, amount to settle lawsuit and worthless intangibles. Many losses, such as loss from disposal of building, loss from sale of investments, and casualty loss, are immediately recognized because they are not directly related to specific revenue. P Derecognition The Revised Conceptual Framework introduced the term derecognition. Derecognition is defined as the removal of all or part of a recognized asset or liability from the statement of financial position. Derecognition normally occurs when an item no longer meets the definition of an asset or a liability. Derecognition of an asset occurs when the entity loses control of all or part of the asset. Derecognition of a liability occurs when the entity no longer has a present obligation for all or part of the liability. 117 ¥y OCdIINICU WILIT camsMEASUREMENT Measurement is defined as quantifying in monetary terms the elements in the financial statements. The Revised Conceptual Framework mentions tye categories: a. Historical cost b. Current value HISTORICAL COST The historical cost or original acquisition cost of an asset is the cost incurréd in acquiring or creating the asset comprising the consideration paid plus transaction cost. The historical cost of a liability is the consideration received to incur the liability minus transaction cost. Simply stated, historical cost is the entry price or entry value to acquire an asset or to incur a liability. An application of the historical cost measurement is to measure financial asset and financial liability at amortized cost. The amortized cost reflects the estimate of future cash flows discounted at a rate determined at initial recognition. Historical cost updated 1. Historical cost of an asset is updated because of: a. Depreciation and amortization b. Payment received as a result of disposing part or all of the asset c. Impairment d. Accrual of interest to reflect any financing component of the asset e. Amortized cost measurement of financial asset 2. Historical cost of a liability is updated because of: a. Payment made or satisfying an obligation to deliver goods b. Increase in value of the obligation to transfer economic resources such that the liability becomes onerous c. Accrual of interest to reflect any financing component of the liability d. Amortized cost measurement of financial liability 118 ovaimieu wit camsCURRENT VALUE Current value includes: a. Fair value b. Value in use for asset c, Fulfilment value for liabilj d. Current. cost or Hability Fair value Fair value of an asset is the price that would be received to sell an asset in an orderly transaction between market participants at measurement date. Fair value of liability is the price that would paid to transfer a liability in an orderly transaction between market Participants at the measurement date. Fair value is an exit price or exit value. Fair value can be observed directly using market price of the asset or liability in an active market. In cases where fair value cannot be directly measured, an entity can use present value of cash flows. Fair value is not adjusted for transaction cost, The reason is that such cost is a characteristic of the transaction and not of the asset or liability. Value in use Value in use is the present value of the cash flows that an entity expects to derive from the use of an asset and from the ultimate disposal. Value in use does not include transaction cost on acquiring the asset but includes transaction cost on the disposal of the asset. Value in use is an exit price or exit value. Fulfillment value Fulfillment value is the present value of cash that an entity expects to transfer in paying or settling a liability. “Fulfillment value does not include transaction cost on incurring a liability but includes transaction cost on fulfillment of a liability. 4 Fulfillment value is an exit price or exit value. a OCAIINICU WILIT camsCurrent cost Current cost of an asset is the cost of an equivalent asset at the measurement date comprising the consideration paid and transaction cost. Current cost of a liability is the consideration that would be received less any transaction cost at measurement date. Similar to historical cost, current cost is also based on the entry price or entry value but reflects market conditions on measurement date. Selecting a measurement basis In selecting a measurement basis for an asset or a liability and for the related income and expense, it is necessary to consider the nature of the information that the measurement basis will produce. In most cases, no single factor will determine which measurement basis should be selected. The relative importance of each factor will depend on facts and circumstances. The information produced by the measurement basis must be useful to the users of financial statements. To achieve this, the information must be both relevant and faithfully represented. f Historical cost is the measurement basis most commonly adopted in preparing financial statements. In many situations, it is simpler and less costly to measure historical cost than it is to measure a current value. In addition, historical cost is generally well understood and verifiable. The IASB did not mandate a single measurement basis because the different measurement bases could produce useful information under different circumstances. 120 ovaimieu win CamsQUESTIONS 1. Explain recognition of the elements of financial staements. .2. Explain the recognition criteria for the elements of financial statements. ‘ 3. What is derecognition? 4. Explain the point of sale income recognition. ‘6. What are the three applications of the matching principle? 6. Explain cause and. effect association principle. Te Explain systematic and rational allocation principle. 8. Explain jinimadiats recognition principle. 9.-What are the two categories of measurement? 10. Explain historical cost. 11. Explain fair value. 12. Explain value in use. 18. Explain fulfillment value. 14. Explain current cost. 15. Explain the guideline in selecting an appropriate measurement basis. Scanned with CamSPROBLEMS Problem 6-1 Multiple choice (Conceptual Framework) g for inclusion in the financial 1. It is the process of capturin n the definition of the statements an item that meets elements of financial statements. a. Recognition b. Measurement c. Classifying d. Derecognition 2. An item is recognized in the financial statements if It is probable that economic benefits will flow to or from the entity. . b. It meets the definition of an asset, liability, equity, income and expense. c. The entity has ownership of such item. (. It is probable that economic benefits will flow to or from the entity and that the cost can be measured reliably. 3. Recognition of an element is appropriate when information results in a. Relevance b. Faithful representation c. Both relevance and faithful representation d. Neither relevance nor faithful representation 4. It is the removal of all or part of a recognized asset or liability from the statement of financial position. a. Writeoff b. Derecognition c. Extinguishment d. Retirement 5. Derecognition normally occurs when a. An item no longer meets the definition of an asset of a liability. b. The entity loses control of the asset. c. The entity no longer has a present ol liability. d. Under all of these circumstances. ligation for the — OdIIIeU WILT ne1 Ber ‘problem 6-2 Multiple choice (IAA) Generally, revenue is recognized perp At the point of sale. When cause and effect are associated. At the point of cash collection. At appropriate points throughout the operating cycle. . Which of the following is not an accepted basis for recognition of revenue? = perp o SB Passage of time Performance of service Completion of percentage of a project Upon signing of contract . Normally, revenue is recognized When the customer order is received. When the customer order is accompanied by a check. Only if the transaction will create an account receivable. When the title to the goods changes. . Which ofthe following practices may not be an acceptable deviation from recognizing revenue at the point of sale? RS op Upon receipt of cash During production Upon receipt of order End of production Which of the following represents the least desirable _ choice for the recognition of revenue? Recognition of revenue during production Recognition of revenue when a sale occurs Recognition of revenue when cash is collected Recognition of revenue when production is completed ovaimieu wit LamsProblem 6-3 Multiple choice (AICPA Adapted) 1. Revenue recognition conventionally refers to a. The process of identifying transactions to be recorded as revenue in af accounting period. b. The process of measuring and relating revenue and expenses during a period. c. The earning process which gives rise to revenue realization. d. The process of*identifying those transactions that result in an inflow of assets to the entity. 2. Which of the following in the most precise sense means the process of converting noncash resources and rights into cash or claims to cash? a. Allocation b. Collection c. Recognition d, Realization 3. Gains on assets unsold are identified, in a precise sense, by the term ; a. Unrecorded b. Unrealized c. ‘Unrecognized d. Unallocated 4. The term recognized is synonymous with the term Recorded Realized Matched Allocated peop 5. Which statdment conforms to the realization concept? Depreciation was assigned to product unit cost Equipment was sold in exchange for a note receivable Cash was collected on accounts receivable Product unit costs were assigned to cost of goods sold BO Tp OCdIINICU WILIT camsProblem 6-4 Multiple choice (AICPA Adapted) 1. Which of the following is not a theoretical basis for the allocation of: expense? oo ~ a BSoe Immediate recognition Systematic and rational allocation Cause and effect association Profit maximization Costs that can be reasonably associated with specific revenue but not with specific product should be a. b. c, d. Expensed in the period incurred Allocated to the specific product based on the best estimate of the product processing time Expensed in the period in which the related revenue is recognized Capitalized and then amortized over a reasonable period . Which of the following is an example of the cause and effect association principle? Boop Sales commission Allocation of insurance cost Depreciation of property, plant and equipment Officers' salaries Which of the following is an application of the systematic and rational allocation principle? Bore Doubtful accounts Research and development cost Warranty cost Amortization of intangible asset . Which of the following would be matched with current revenue on a basis other than association of cause and effect? a. b. c. d. Goodwill 7 Cost of goods sold ~ Sales commission Warranty. cost oOcdiiicu Will vams6. Why are certain costs of doing business capitalized when incurred and then depreciated or amortized over subsequent accounting periods? a. To reduce the income tax liability b. To aid management in the decision-making process c. To match the cost of production with revenue d. To adhere to the accounting concept of conservatism 7: Which of the following principles best describes the conceptual rationale for the method of matching depreciation with revenue? Associating cause and effect Systematic and rational allocation Immediate recognition Partial recognition pe gp 8. Which of the following should be expensed under the principle of systematic and rational allocation? a. Salesmen's monthly salaries b. Insurance premiums c. Transportation to customers d. Electricity to light office building 9. The writeoff of a worthless patent is an example of which of the following principles? Associating cause and effect Immediate recognition Systematic and rational allocation Objectivity Boop 10, What is an example of cost that cannot be directly related to particular revenue but incurred to obtain benefits that are exhausted in the period when the cost is incurred? Sales commissions Sales salaries Freight in Prepaid insurance Boop ovaiiieu win CamsProblem 6-5 Multiple choice (IAA) 1, The matching principle is best demonstrated by a b. c.. d. Not recognizing any expense unless some revenue is realized Associating effort with accomplishment Recognizing prepaid rent received as revenue Establishing an appropriation for contingency 2. Bad debt expense is recognized according to which expense recognition principle? pe op Direct matching Immediate recognition Systematic and rational allocation Critical event recognition 3. What is the general approach as to when product costs are recognized as expenses? a. b. a d. In the period when the expenses are paid. In the period when the expenses are incurred. In the period when the vendor invoice is received. In the period when the related revenue is recognized. 4. When should an expenditure be recorded as an asset rather than an expense? ao re Never Always If the amount is material When there is a right that has the potential to produce economic benefit 5, Which accounting principle is being observed when an accountant charges to expense a cost that contributed to revenue during a period? ae oP Revenue realization Matching , Monetary unit : Conservatism ovaimieu wit Lams6. Which of the following is not an acceptable basis for the recognition of expense? Systematic and rational allocation Direct matching » Immediate recognition Cash disbursement Bo op. ay . A cause and effect relationship is implicit in the a. Realization principle . b.. Historical cost principle c. Matching principle ~ d. Going concern assumption 8. An example of direct matching of an expense with revenue would be a. Depreciation expense b. Office salaries expense c. Direct labor costs incurred to produce inventory sold during a period d. Advertising expense 9. Which category of expenses is subject, to immediate recognition in the income statement? a. Utilities expense for the production line of a manufacturer b. Repairs and maintenance expense incurred on production equipment of a manufacturer e,, The salary of the production foreman d. The salary of the entity president 10. Which principle best describes the rationale for matching distribution costs and administrative expenses with revenue of the current period? a. Direct matching: b. Systematic and rational allocation c. Immediate recognition d. Partial recognition OCAIINICU WILIT vamsScanned with CamS