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Conservatism and Matching Principles in Financial Accounting

Case 5-7: Matching Concept

The accounting profession has employed the matching concept to determine what to report in the income statement and to determine how to measure items reported in the income statement and to determine how to measure items reported in the income statement. This concept implies that expenses should be measured directly, and thus balance sheet measure are residuals. The matching concept is therefore an income statement approach to the measurement and reporting of revenues and expenses.

SFAC No. 5 defined earnings as the change in net assets exclusive of investments by owners and distributions to owners, a capital maintenance concept of earnings measurement. Under this concept, asset and liabilities would be measured directly, and changes to them would flow through the income statement. Thus the SFAC No. 5 definition would flow through the income statement. Thus the SFAC No. 5 definition of earnings represents a balance sheet approach to the measurement and report of revenues and expenses.

Required:
(a) Describe and discuss the matching concept and its importance to income reporting.
(b) Give specific examples of how the matching concept is used in practice.
(c) Describe and discuss the balance sheet approach and its importance to income reporting.
(d) Give specific examples of how balance sheet measurements affect the measurement and reporting of earnings.

Case 5-8: The Concept of Conservatism

The concept of conservation has been influential in the development of accounting theory and practice. A major effect of conservatism is that accountants tend to recognize losses but not gains. For example, when the value of an asset is impaired, it is written down to fair value an unrealized loss is recognized in the income statement. However, when the asset's value appreciates, its value is not written up to fair value. (An exception is current accounting for investments in securities having readily determinable fair values.) Stated differently, accountants tend to recognize holding losses but not holding gains.

Required:
(a) Define conservatism.
(b) Why do you believe conservatism has affected financial reporting? Explain.
(c) Do you believe that financial statements that recognize losses but not gains provide information that is relevant and representationally faithful? Explain.
(d) Do you believe that the concept of conservatism is consistent with the physical capital maintenance concept? Explain.
(e). Do you believe that the concept of conservatism is consistent with the financial capital maintenance concept? Explain.

Solution Summary

This solution looks at the definition of the Matching Principle of Accounting, and Conservatism. This solution helps to simplify and instruct as to the principles used in accounting for revenue and profit.

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