Chapter 5

Postulates, Principles, and Concepts

TRUE/FALSE

1. The APB was the first to successfully derive an underlying framework of

postulates and principles.
ANS: F

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.
ANS: T

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.
ANS: T

4. Postulates are generally defined as basic assumptions that cannot be verified.

ANS: T

5. A principle contains elements observable by empirical techniques.

ANS: F

6. The key group in Moonitzs set of postulates consists of postulates stemming from
accounting itself.
ANS: F

7. The key imperative postulate in ARS 1 appears to be stability of the monetary

unit.
ANS: T

8. There are eight broad principles in ARS 3.

ANS: T

9. Accounting concepts have largely evolved from practical operating necessities,

including income tax laws.
ANS: T

10. Principles are basic assumptions concerning the business environment.

ANS: F
11. Output-oriented principles are broad rules that guide the accounting function.
ANS: F

12. The going-concern postulate states that unless there is evidence to the contrary, it
is assumed that the firm will continue indefinitely.
ANS: T

13. The time period idea is somewhat artificial because it creates definite segments
out of what is a continuing process.
ANS: T

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 owner.
ANS: F

15. Matching refers to the fact that all expenses can be directly identified with
either specific revenues or specific time periods.
ANS: F

16. Conservatism, materiality, and disclosure are examples of constraining principles.

ANS: T

17. The lower-of-cost or market valuation of inventories is an example of the

disclosure principle.
ANS: F

18. Conservatism has been called the dominant principle of accounting.

ANS: T

19. Disclosure will become more important in the future because of market efficiency.
ANS: T

20. 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.
ANS: F

21. Proprietary theory assumes that the owners and the firm are virtually identical.
ANS: T

22. The balance sheet equation for entity theory is Total Assets Total Liabilities =
Owners Equities.
ANS: F

23. The proprietary theory approach largely coincides with the components of income
measurement as it is presently construed in historical cost-based systems.
 ANS: T

24. Under entity theory, creditors are considered equity holders.

ANS: T

25. Preferred stockholders are residual equity holders.

ANS: F

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. XXXXX
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.

2. Which of the following is a true statement?

a. A principle contains elements observable by empirical techniques.
b. The APBs 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. XXXXX

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 it should not be replaced by a
newer system. XXXXX
d. Principles are general statements that influence the way we view
phenomena and the way we think about problems.

4. Which of the following is a true statement regarding Moonitzs 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. XXXXX
d. He was unconcerned about the experiential and empirical aspects of
accounting.

5. Which of the following is the key group in Moonitzs set of postulates?

a. The Environmental group
b. The Imperatives XXXXX
c. The Economic group
d. Postulates stemming from accounting itself

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. XXXXX

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. XXXXX

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. XXXXX
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.

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. XXXXX
b. All of its principles were derived form 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.

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. XXXXX
d. Nothing is said about the users of accounting information and what their
needs and abilities might be.

11. Which of the following is an accurate overall label for the terms postulates and
principles?
a. Constraints
b. Concepts XXXXX
c. Axioms
d. Conventions

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 XXXXX
b. Principles
c. Postulates
d. Axioms

13. Which of the following are defined in the text as basic assumptions concerning
the business environment?
a. Concepts
b. Principles
c. Postulates XXXXX
d. Axioms

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 XXXXX
c. Postulates
d. Axioms

15. Which of the following are defined in the text as broad rules that guide the
accounting function?
a. Input-oriented principles XXXXX
b. Output-oriented principles
c. Basic principles
d. Axioms

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 XXXXX
d. Going Concern, Time Period, Financial Statements, Monetary Unit

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 XXXXX

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 XXXXX

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.
XXXXX
d. It allows interim reports to include estimates of annual amounts.

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. XXXXX
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).

21. Who are residual equity holders?

a. Preferred stockholders
b. Managers
c. Bondholders
d. Common stockholders XXXXX

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 XXXXX
d. Commander theory

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 XXXXX
c. Entity theory
d. Commander theory

24. Which of the following theories assumes that the owners and the firm are virtually
identical?
a. Residual equity theory
b. Proprietary theory XXXXX
c. Entity theory
d. Commander theory

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 XXXXX
d. Commander theory

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 XXXXX
c. Constraining principles
d. Both a and c

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 XXXXX

28. Recognition and Matching are examples of:

a. Input-oriented principles XXXXX
b. Output-oriented principles
 c. Constraining principles
d. both a and c

29. Which of the following concepts applies to users of financial statements?

a. Comparability XXXXX
b. Consistency
c. Uniformity
d. Both b and c

30. Which of the following concepts focuses on preparers of financial information?

a. Comparability
b. Consistency
c. Uniformity
d. Both b and c XXXXX

ESSAY QUESTIONS

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.

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 posses 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
circumstance, 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 firms 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.

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. Input-oriented 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 firms 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 firms 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
goods 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. 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 to 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 firms
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.

8. 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 managements 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.