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ACCT5001 S1 2010

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Week 13

ACCT5001 S1 2010

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Week 13

Ch.15: Q1, Q4, Q9, Q23, BE15.9, E15.1, E15.4, E15.13, PSA15.10*, PSA15.3*

how to measure and account for economic events when recording transactions and preparing financial information. Do you believe that these benefits can actually be achieved? Answer not required for this part of Question 4.

Q1.

There are 2 concepts and 4 principles that underlie the recording of accounting information. In many cases, more than one principle or concept can apply to each transaction. For example, the monetary principle requires that only those things that can be expressed in monetary terms be included in the accounting records. Hence, all accounting transactions will be based on the monetary principle, but may also be based on others. Accounting Entity Concept This concept states that every entity can be separately identified and accounted for. Accounting Period Concept The accounting period concept states that the life of a business entity can be divided into artificial periods and that useful reports covering those periods can be prepared for the entity. Monetary Principle This principle requires that the items included in the accounting records must be able to be expressed in monetary terms. Going Concern Principle This principle states that financial statements are prepared on a going concern basis unless management either intends to or must liquidate the business or cease trading. Cost Principle The cost principle states that all assets are initially recorded in the accounts at their purchase price or cost. This is applied not only at the time the asset is purchased but also over the time the asset is held. Full Disclosure Principle The full disclosure principle requires that all circumstances and events that could make a difference to the decisions financial statement users might make should be disclosed in the financial statements.

Q9.

The objective of general-purpose financial reporting is to provide useful information for decision making. Qualitative characteristics are the attributes that make the information in financial reports useful. The four main qualitative characteristics of information contained in general-purpose financial reports include [1] understandability, [2] relevance, [3] reliability, and [4] comparability. Understandability Understandability refers to the extent to which information can be understood by proficient users, i.e. users who have reasonable knowledge of accounting and business activities. It is not practicable to require financial statements to be understandable to novices. That is why ultimately whether information is understandable depends on the capabilities of the individual user and why novice users should seek professional advice if the information is too complex for their level of understanding. Relevance Accounting information is relevant if it would make a difference in a business decision. For information to be relevant, it must have predictive value, to help users make predictions about the future, or provide feedback, to help users assess the accuracy of their past predictions and decisions. Reliability Information that can be depended upon is considered to be reliable. To be reliable, accounting information must embody a number of qualities, including that it must be a faithful representation of what it purports to be, free from material error, accounted for in accordance with its economic substance, neutral and unbiased, prudent; and complete. Comparability

Q4.

A conceptual framework consists of a set of concepts defining the nature, purpose and content of general-purpose financial reporting to be followed by preparers of general-purpose financial reports and standard setters. The advantages or benefits of a conceptual framework are that it improves the standard-setting process and consistency in accounting practice. To illustrate, prior to the late 1970s there was no generally accepted theory of financial accounting. This meant that the development of accounting standards for financial accounting practice was piecemeal as the standards were not based on any particular theory. This resulted in some inconsistencies between standards and therefore inconsistencies in accounting practice. The development of a conceptual framework in relation to financial reporting is beneficial in that it outlines the objectives of financial reporting, the required qualitative characteristics for financial information and to provide clear guidance on

Comparability is achieved when an entity uses the same or consistent accounting principles each year and different entities use the same accounting principles.

The two constraints that must be imposed on the preparation of financial reports are timeliness and cost versus benefit. Timeliness Financial information may lose its relevance if it is not reported in a timely manner. Application of the timeliness constraint means that the preparer should not take so long to collect and prepare financial information that the reported information loses its relevance.

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Cost versus Benefits

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ACCT5001 S1 2010 BRIEF EXERCISE 15.9 (a) Fundamental

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Preparers and standard setters seek to ascertain that the costs of preparing certain financial information are not greater than the benefits to be derived from using that information.

(b) Neither fundamental nor enhancing but a constraint (c) Enhancing (d) Enhancing (e) Neither fundamental nor enhancing but a constraint (f) Enhancing

Q23.

The four bases of measurement as outlined in the Framework are: [1] Historical Cost Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. [2] Current Cost Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. [3] Realisable (Settlement) Value Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. [4] Present Value Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. There are some common alternative measurement bases that can be found in general-purpose financial reports. Some assets that are originally recorded at cost are reported on a revalued basis in balance sheet. This means the assets were revalued either upward or downward to their fair value. Fair value is a subset of the realisable (settlement) value in the Framework. Another alternative measurement base is the fair value less any costs incurred in selling the asset. For example, inventories are usually reported at the lower of cost and net realisable value.

(g) Neither fundamental nor enhancing - not included at all. (h) Fundamental (i) Enhancing

EXERCISE 15.1

Accounting Entity Concept:

Tony is the sole owner of Tonys Pizza Palace. Recently, he purchased a bicycle for his own personal use from his business bank account. He never delivers pizza using the bicycle. At the time of purchase, Tony recorded the transaction in his business accounts as:

Dr Withdrawals Cr Bank

Accounting Period Concept: A company with a December year end purchased a 1-year fire insurance policy for $12,000 on October 1, 2009. In order to report the correct income and asset figures in the financial statements ending December 2009, the transaction was recorded as: Dr Prepaid Insurance $9,000 Dr Insurance Expense $3,000 Cr Cash $12,000

This transaction recognises a $3000 expense in period one and a 9,000 expense in the following accounting period. Alternatively the $12,000 could have been initially recorded using either the asset method or the expense method and then adjusted at year end. Note that asset and expense definitions and recognition criteria are also relevant and related.

Going Concern Principle: Company A purchased equipment for $1 million. A year later, the equipment is still reported at its book value (purchase price minus accumulated depreciation), not liquidation value.

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Cost Principle:

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ACCT5001 S1 2010

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Company A purchased a piece of land for $ 1,000,000 after obtaining a loan. At the time of purchase, the company was considered to be a going concern and the land was recorded in the balance sheet at $ 1,000,000.

(b) A violation of Accounting Period Concept has occurred. The accounting period concept states that the life of a business entity can be divided into artificial periods and that useful reports covering those periods can be prepared for the entity. In this case no reports have been prepared.

Dr Land $ 1,000,000 Bank Loan $ 1,000,000 In the next reporting period, the land will still be recorded at $1,000,000 under the cost principle, although the price of the land may have increased to $1,200,000.

Full Disclosure Principle:

(c) In this case no violation is evident as the inventory is being carried at the lower of cost or net realisable value. Although the cost principle states that assets are to be recorded at their cost, AASB 102 Inventories mandates that inventories shall be measured at the lower of cost and net realisable value (para.9). Furthermore, the Framework also provides expense recognition criteria. Expenses should be recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably (paragraph 94). In this case the net realisable value is lower than the cost of inventory so there has been a decrease in an asset (inventory) and an increase in an expense (inventory write-down expense).

Company A was sued for defective products that resulted in customer injuries. The legal representation for the company assessed that the company is likely to lose the case and will be required to pay a large amount of money as compensation. While the payment is probable, however at this stage it cannot be reliably estimated. While no amount is recorded in the financial statements, Company A discloses information about the law suit and likely losses in its notes to the financial statements.

EXERCISE 15.4

(d) A violation of going concern principle is evident in this case. The going concern principle states that financial statements are prepared on a going basis unless management either intends to or must liquidate the business or cease trading. In this case, liquidation is unlikely, so property plant and equipment should not be reported at the amount for which it could be sold at short notice, but either cost or revalued basis. In addition, property, plant and equipment and bills payable also need to be classified as non-current assets and liabilities respectively.

(a) A violation of revenue recognition criteria has occurred. AASB 118 and NZ IAS 18 Revenue prescribe principles for the recognition of revenue for the sale of goods. Revenue is recognised on the sale of goods when all of the following conditions are satisfied: (1) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; (2) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; (3) the amount of revenue can be measured reliably; (4) it is probable that the economic benefits of the revenue will flow to the entity; and (5) the associated costs can be measured reliably (paragraph 14).

(e) A violation of cost principle in this case. The cost principle states that all assets are initially recorded in the accounts at their purchase price or cost. This is applied not only at the time the asset is purchased, but also over the time the asset is held. If the net realisable value is lower than cost, then Full of Beans Ltd should report the inventory at net realisable value.

(f) A violation of accounting entity concept is evident in this case. This concept states that every entity can be separately identified and accounted for. In other words, owners personal transactions must be clearly separated from the entitys transactions. Hence a computer that is purchased for personal use should not be included in the company records.

In this case no sale has occurred however, revenue has been recognised. Normally, the transfer of significant risks and rewards of ownership occurs when legal title passes to the buyer. Further, in the question we are also told that the amount cannot be reliably measured at this stage a further violation of the recognition criteria.

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 EXERCISE 15.13

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ACCT5001 S1 2010

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As defined in the Framework expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Expenses should be recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of liability has arisen that can be measured reliably. (a) A payment of public liability insurance 1 year in advance does not meet the definition criteria of an expense. No expense is recognised because no depletion of assets or incurrence of liabilities that result in decreases in equity has occurred. Instead, an asset account has decreased (cash) and another asset account has increased (prepaid insurance) by the same amount (hence there is no change in total assets). Insurance expense will start to be recognised next month when the insurance fee for the 1st month expires. The journal entry is: Prepaid Insurance Cash

(e) Fees paid in advance by members are not recorded as expenses. There has been no decrease yet in economic benefit i.e. outflows or depletions of assets (cash) or incurrence of liabilities that result in decreases in equity. Rather, Rosevillia Golf Course should recognise the fees received in advance as a liability, because the fees have created a present obligation for Rosevillia to provide facilities/services to its members, which will result in outflows of its resources or future economic benefits. The transaction should be recorded as: Cash 3,000,000 Revenue Received in Advance 3,000,000 An asset account (cash) is increased by $3 million and a liability account (Revenue Received in Advance) is increased by $3 million. (f) The electricity bill is recorded as an accrued expense. The company has used the electricity for the period and incurred a liability to pay for the electricity used that results in a decrease in equity other than those relating to distributions to equity participants and the amount can be measured reliably. The journal entry: Electricity Expense Electricity Payable

240,000 240,000

X X

(b) A payment of dividends is a distribution of profit and not an expense. Expenses are outflows or depletions of assets (cash) or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants. In this case the depletion of assets relates to equity participants in the form of dividend payments. (c) Interest payment is an expense. There is a decrease in economic benefit in the form of a depletion of assets (cash) and the amount can be measured reliably. The journal entry: Interest Expense Cash

X X

(d) Discount allowed is recorded as an expense. There is a decrease in future economic benefit in the form of depletion of assets (i.e. reduction in the amount of cash received from customers) that result in decreases in equity. If no discount was allowed more cash would have been received. The journal entry: Cash Discount Allowed Accounts Receivable

X 2000 XX

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

ACCT5001 S1 2010

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ACCT5001 S1 2010

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GAAP consists of accounting standards, underlying accounting concepts and principles and the Framework. PROBLEM SET A 15.10* The conceptual framework (the Framework) consists of a set of concepts defining the nature, purpose and content of general purpose financial reporting to be followed by preparers of general-purpose financial reports and standard setters. The Framework has 4 main components: [1] the reporting entity (SAC 1), In your notes you may like to use the summary table provided in Chapter 15 Figure 15.9 p.919. The summary of the various aspects of GAAP is as follows: GAAP Conceptual element of Source Authority GAAP Statement of Accounting Concepts 1 financial Statement of Accounting Concepts 2 Statement of Accounting Concepts 2 [2] the objective of general-purpose financial reports and users (SAC 2), [3] the qualitative characteristics and Reporting question [4] the definition of elements in financial statements.

(a) GAAP consists of Accounting Standards, underlying accounting concepts and principles, and the Framework.

Who is required to prepare Reporting entity general-purpose financial reports (preparers)? What is the purpose of Objective general-purpose financial reporting reporting? of

The reporting entity is defined in the Framework as an entity for which it is reasonable to expect the existence of users who depend on general-purpose financial reports for information to enable them to make economic decisions (SAC 1). The objective of general-purpose financial reporting is to provide information to users that is useful for making and evaluating decisions about the allocation of scarce resources (SAC 2). There are 3 categories of main users: [a] resource providers which include investors, employees, contributors, members, taxpayers (public sector), rate payers (public sector), creditors, lenders and donors, [b] Recipients of goods and services which include customers and beneficiaries, and [c] parties performing a review or oversight function which include parliaments, regulatory agencies, employer groups, media, special-interest groups, governments, trade unions and analysts. Qualitative characteristics of information contained in general-purpose financial statements are understandability, relevance, reliability and comparability. Understandability refers to the extent to which information can be understood by proficient users; that is, users who have reasonable knowledge of accounting and business activities. Accounting information is deemed to be relevant if it would make a difference in a business decision. Users of financial information need to make many decisions based on the information contained in general-purpose financial reports (which include a statement of comprehensive income, a statement of financial position, a statement of cash flows, a statement of changes in equity and the relevant notes). Information that can be depended upon is considered to be reliable. To be reliable, accounting information must embody a number of qualities, including that it must be a faithful representation of what it purports to be, free from material error, accounted for in accordance with its economic substance, neutral and unbiased, prudent; and complete. In accounting, comparability is achieved when an entity uses the same or consistent accounting principles each year and different entities use the same accounting principles. Financial reports are subject to a number of constraints. The two constraints that must be imposed on the preparation of financial reports are timeliness and costs versus benefits. In relation to timeliness financial information may lose its relevance if it is not reported in a timely manner, hence the preparer should not take so long to collect and prepare financial information that the reported information loses its relevance. The second constraint is costs versus benefits. An important consideration is the costs versus benefits of financial

Who uses general- Users of financial reports purpose financial reports (recipients)?

What is reported in Qualitative characteristics The Framework, and general-purpose financial and constraints Accounting Standards reports? How are items reported in Definition of elements and The Framework general-purpose financial recognition criteria reports? Concepts and principles Evolved over time, the Framework, Accounting Standards Rules Measurement Accounting Standards, Corporations Act The Framework, accounting standards

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ACCT5001 S1 2010

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information. Preparers and standard setters seek to ascertain that the costs of preparing certain financial information are not greater than the benefits to be derived from using that information. The definitions of asset, liability, equity, income and expense are outlined in the Framework. Assets are defined in the Framework as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (paragraph 49(a)). A liability is defined in the Framework as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (paragraph 49(b)). Equity is defined in the Framework as the residual interest in the assets of the entity after deducting all its liabilities (paragraph 49(c)). Income is defined in the Framework as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (paragraph 70(a)). Finally, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (paragraph 70(b)). In addition to the Framework, other aspects of GAAP include the corporations act, accounting concepts and principles, accounting standards including the measurement rules as outlined in the standards. There are 2 concepts and 4 principles that underlie the recording of accounting information: Accounting Entity Concept: every entity can be separately identified and accounted for. It is important to identify the order in which the various aspects of GAAP must be applied. After the Corporations Act accounting standards are the first point of guidance for preparers. Accounting standards and authoritative interpretations of accounting standards must be followed as they have legislative backing, which means they are required by law. If the standards are silent on an accounting issue, preparers can seek guidance from the conceptual framework (the Framework plus SAC 1 and SAC 2). The concepts and principles that traditionally underlie accounting are applied where there is no guidance on an issue in the conceptual framework. Further, if any conflicts arise between standards, the conceptual framework or concepts and principles, the various aspects of GAAP are still applied in the order listed above. To summarise, GAAP is applied as follows: first the Corporations Act, then accounting standards and interpretations are consulted, then the conceptual framework and finally the underlying concepts and principles.

Accounting Period Concept: the life of a business entity can be divided into artificial periods and that useful reports covering those periods can be prepared for the entity.

(b) The various aspects of GAAP do not operate in isolation, but are interrelated. Examples of the interrelationships include: reporting entities are required to prepare general-purpose financial reports and the objective of general-purpose financial reports is to provide decision-useful information to users. the objective of general-purpose financial reporting is to provide decision-useful information to users and usefulness is dependent upon the informations qualitative characteristics. the accounting period concept and the revenue and expense recognition criteria are interrelated. Revenue (expense) recognition criteria require that revenues (expenses) are recognised in the period when the increase (decrease) in assets or decrease (increase) in liabilities become probable and can be measured reliably. In other words, only the increase/decrease in assets or liabilities that occur in a certain period can be recognised as revenue or expense in that period. This is consistent with the accounting period concept.

Monetary Principle: the items included in the accounting records must be able to be expressed in monetary terms.

Going Concern Principle: financial statements are prepared on a going concern basis unless management either intends to or must liquidate the business or cease trading.

Cost Principle: all assets are initially recorded in the accounts at their purchase price or cost. This is applied not only at the time the asset is purchased but also over the time the asset is held. Full Disclosure Principle: all circumstances and events that could make a difference to the decisions financial statement users might make should be disclosed in the financial statements.

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ACCT5001 S1 2010

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PROBLEM SET A 15.3*

The conceptual framework consists of a set of concepts defining the nature, purpose and content of general purpose financial reporting to be followed by preparers of generalpurpose financial reports and standard setters. The conceptual framework in Australia, also known as the Framework, has 4 main components: [1] the reporting entity (SAC 1), [2] the objective of general-purpose financial reports (SAC 2), [3] the qualitative characteristics, and [4] the definition of elements of financial statements.

(a) The conceptual framework is also called the Framework (Correct). It looks like a window that you can see the world through (In the text book, the analogy of the window is used to help students understand how the Framework works. That is, the Framework is likened to a window because it allows users, standard setters and preparers to view the economic world in a particular way. The Framework itself does not look like a window; this student has not understood the analogy correctly). and has four sections. (There are 4 sections in the Framework. This is correctly pointed out). It talks about accounting concepts. (A conceptual framework indeed outlines accounting concepts, so this is correct). It talks about what accounting is about. (More specificity is required in the answer, the Framework identifies the objective of financial reporting rather than what it is about.) It tells accountants how to prepare financial statements. (Correct, the Framework provides guidance for standard setters and preparers). It is helpful to standard setters. (Correct, see comments above). The four parts are: (a) the accounting entity, which states that the transactions of the owners should be separate from that of the business. (Incorrect. The student should refer to the reporting entity, not the accounting entity. The reporting entity is an entity in which it is reasonable to expect the existence of users who depend on general-purpose financial reports for information to enable them to make economic decisions). (b) the objective of businesses, which states the objective of a business, is to make profit to be able to pay dividends to the owners. (Incorrect. The Framework explains the objective of general-purpose financial reporting. The objective of generalpurpose financial reporting is to provide information to users that is useful for making and evaluating decisions about the allocation of scarce resources). (c) the qualitative characteristics, which include the monetary principle, the accounting period concept and the going concern and cost principles. (Incorrect. The qualitative characteristics as outlined in the Framework are understandability, relevance, reliability and comparability). (d) the definition of elements in the financial statements, which is the last window. For example, accounts receivable is defined as the right to receive cash upon the sale of goods or provision of services to a customer. (Incorrect. The Framework defines the major elements of general purpose financial reports namely assets, liabilities, equity, income and expenses). (b) A possible model or correct answer:

The reporting entity is defined in the Framework as an entity for which it is reasonable to expect the existence of users who depend on general-purpose financial reports for information to enable them to make economic decisions (SAC 1). The objective of general-purpose financial reporting is to provide information to users that is useful for making and evaluating decisions about the allocation of scarce resources. There are 3 categories of main users: [a] resource providers which include investors, employees, contributors, members, taxpayers (public sector), rate payers (public sector), creditors, lenders and donors, [b] Recipients of goods and services which include customers and beneficiaries, and [c] parties performing a review or oversight function which include parliaments, regulatory agencies, employer groups, media, special-interest groups, governments, trade unions and analysts (SAC 2). The four main qualitative characteristics of information contained in the general-purpose financial reports as outlined in the Framework are understandability, relevance, reliability and comparability. Understandability refers to the extent to which information can be understood by proficient users; that is, users who have reasonable knowledge of accounting and business activities. Accounting information is deemed to be relevant if it would make a difference in a business decision. Users of financial information need to make many decisions based on the information contained in general-purpose financial reports (which include a statement of comprehensive income, a statement of financial position, a statement of cash flows, a statement of changes in equity and the relevant notes). Information that can be depended upon is considered to be reliable. To be reliable, accounting information must embody a number of qualities, including that it must be a faithful representation of what it purports to be, free from material error, accounted for in accordance with its economic substance, neutral and unbiased, prudent; and complete. In accounting, comparability is achieved when an entity uses the same or consistent accounting principles each year and different entities use the same accounting principles. Financial reports are subject to a number of constraints. The two constraints that must be imposed on the preparation of financial reports are timeliness and costs versus benefits. In relation to timeliness financial information may lose its relevance if it is not reported in a timely manner, hence the preparer should not take so long to collect and prepare financial information that the reported information loses its relevance. The second constraint is costs

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versus benefits. An important consideration is the costs versus benefits of financial information. Preparers and standard setters seek to ascertain that the costs of preparing certain financial information are not greater than the benefits to be derived from using that information. The definitions of asset, liability, equity, income and expense are also outlined in the Framework. Assets are defined in the Framework as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (paragraph 49(a)). A liability is defined in the Framework as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (paragraph 49(b)). Equity is defined in the Framework as the residual interest in the assets of the entity after deducting all its liabilities (paragraph 49(c)). Income is defined in the Framework as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (paragraph 70(a)). Finally, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (paragraph 70(b)).

ACCT5001 S1 2010 Week 13 Self-Study Solutions.doc 30/05/2010

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