1460T c02.gxd 11:11:2005 09:45 Page 48 Nishant-16 NIshant-16:Desktop polder:prakash 11/11: EQA 48 Chapter 2 Conceptual Framework Underlying Financial Accounting QUESTIONS 1.What is a conceptual framework?Why is a conceptual 14.When is revenue generally recognized?Why has that framework necessary in financial accounting? date been chosen as the point at which to recognize the 2.What are the primary objectives of financial reporting revenue resulting from the entire producing and selling as indicated in Statement of Financial Accounting Concepts process? No.1? 15.Magnus Eatery operates a catering service specializing 3.What is meant by the term "qualitative characteristics of in business luncheons for large corporations.Magnus accounting information"? requires customers to place their orders 2 weeks in 4.Briefly describe the two primary qualities of useful ac- advance of the scheduled events.Magnus bills its counting information. customers on the tenth day of the month following the 5.According to the FASB conceptual framework,the date of service and requires that payment be made within 30 days of the billing date.Conceptually,when objectives of financial reporting for business enterprises should Magnus recognize revenue related to its cater- are based on the needs of the users of financial state- ing service? ments.Explain the level of sophistication that the Board assumes about the users of financial statements. 16.What is the difference between realized and realizable? Give an example of where the concept of realizable is 6.What is the distinction between comparability and used to recognize revenue. consistency？ 17.What is the justification for the following deviations from 7.Why is it necessary to develop a definitional framework recognizing revenue at the time of sale? for the basic elements of accounting? (a)Installment sales method of recognizing revenue. 8.Expenses,losses,and distributions to owners are all de- creases in net assets.What are the distinctions among (b)Recognition of revenue at completion of production them? for certain agricultural products. 9.Revenues,gains,and investments by owners are all in- (c)The percentage-of-completion basis in long-term creases in net assets.What are the distinctions among construction contracts. them? 18.Jane Hull Company paid $135,000 for a machine in 2007. 10.What are the four basic assumptions that underlie the fi- The Accumulated Depreciation account has a balance of nancial accounting structure? $46,500 at the present time.The company could sell the machine today for $150,000.The company president be- 11.The life of a business is divided into specific time periods, lieves that the company has a "right to this gain."What usually a year,to measure results of operations for each does the president mean by this statement?Do you such time period and to portray financial conditions at agree? the end of each period. 19.Three expense recognition methods (associating cause (a)This practice is based on the accounting assumption and effect,systematic and rational allocation,and im- that the life of the business consists of a series of mediate recognition)were discussed in the text under time periods and that it is possible to measure the matching principle.Indicate the basic nature of each accurately the results of operations for each period. of these types of expenses and give two examples of each. Comment on the validity and necessity of this assumption. 20.Statement of Financial Accounting Concepts No.5identifies four characteristics that an item must have before it is (b)What has been the effect of this practice on account- recognized in the financial statements.What are these ing?What is its relation to the accrual system?What four characteristics? influence has it had on accounting entries and methodology? 21.Briefly describe the types of information concerning financial position,income,and cash flows that might be 12.What is the basic accounting problem created by the provided:(a)within the main body of the financial state- monetary unit assumption when there is significant in- ments,(b)in the notes to the financial statements,or flation?What appears to be the FASB position on a sta- (c)as supplementary information. ble monetary unit? 22.In January 2008,Alan Jackson Inc.doubled the amount 13.The chairman of the board of directors of the company of its outstanding stock by selling on the market an ad- for which you are chief accountant has told you that he ditional 10,000 shares to finance an expansion of the busi- has little use for accounting figures based on cost.He be- ness.You propose that this information be shown by a lieves that replacement values are of far more signifi- footnote on the balance sheet as of December 31,2007. cance to the board of directors than "out-of-date costs." The president objects,claiming that this sale took place Present some arguments to convince him that account- after December 31,2007,and,therefore,should not be ing data should still be based on cost. shown.Explain your position
48 • Chapter 2 Conceptual Framework Underlying Financial Accounting 1. What is a conceptual framework? Why is a conceptual framework necessary in financial accounting? 2. What are the primary objectives of financial reporting as indicated in Statement of Financial Accounting Concepts No. 1? 3. What is meant by the term “qualitative characteristics of accounting information”? 4. Briefly describe the two primary qualities of useful accounting information. 5. According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on the needs of the users of financial statements. Explain the level of sophistication that the Board assumes about the users of financial statements. 6. What is the distinction between comparability and consistency? 7. Why is it necessary to develop a definitional framework for the basic elements of accounting? 8. Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them? 9. Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them? 10. What are the four basic assumptions that underlie the financial accounting structure? 11. The life of a business is divided into specific time periods, usually a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period. (a) This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption. (b) What has been the effect of this practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology? 12. What is the basic accounting problem created by the monetary unit assumption when there is significant inflation? What appears to be the FASB position on a stable monetary unit? 13. The chairman of the board of directors of the company for which you are chief accountant has told you that he has little use for accounting figures based on cost. He believes that replacement values are of far more significance to the board of directors than “out-of-date costs.” Present some arguments to convince him that accounting data should still be based on cost. 14. When is revenue generally recognized? Why has that date been chosen as the point at which to recognize the revenue resulting from the entire producing and selling process? 15. Magnus Eatery operates a catering service specializing in business luncheons for large corporations. Magnus requires customers to place their orders 2 weeks in advance of the scheduled events. Magnus bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Magnus recognize revenue related to its catering service? 16. What is the difference between realized and realizable? Give an example of where the concept of realizable is used to recognize revenue. 17. What is the justification for the following deviations from recognizing revenue at the time of sale? (a) Installment sales method of recognizing revenue. (b) Recognition of revenue at completion of production for certain agricultural products. (c) The percentage-of-completion basis in long-term construction contracts. 18. Jane Hull Company paid $135,000 for a machine in 2007. The Accumulated Depreciation account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company president believes that the company has a “right to this gain.” What does the president mean by this statement? Do you agree? 19. Three expense recognition methods (associating cause and effect, systematic and rational allocation, and immediate recognition) were discussed in the text under the matching principle. Indicate the basic nature of each of these types of expenses and give two examples of each. 20. Statement of Financial Accounting Concepts No. 5 identifies four characteristics that an item must have before it is recognized in the financial statements. What are these four characteristics? 21. Briefly describe the types of information concerning financial position, income, and cash flows that might be provided: (a) within the main body of the financial statements, (b) in the notes to the financial statements, or (c) as supplementary information. 22. In January 2008, Alan Jackson Inc. doubled the amount of its outstanding stock by selling on the market an additional 10,000 shares to finance an expansion of the business. You propose that this information be shown by a footnote on the balance sheet as of December 31, 2007. The president objects, claiming that this sale took place after December 31, 2007, and, therefore, should not be shown. Explain your position. QUESTIONS 1460T_c02.qxd 11:11:2005 09:45 Page 48 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd12/31/0509:10 am Page49 EQA Brief Exercises·49 23.Describe the two major constraints inherent in the pres- costs incurred from this year's sales should be en- entation of accounting information. tered as an expense this year instead of an expense 24.What are some of the costs of providing accounting in- in the period in the future when the warranty is made formation?What are some of the benefits of accounting good. information?Describe the cost-benefit factors that (b)When sales are made on account,there is always should be considered when new accounting standards uncertainty about whether the accounts are col- are being proposed. lectible.Therefore,the treasurer recommends record- 25.How are materiality (and immateriality)related to the ing the sale when the cash is received from the proper presentation of financial statements?What fac- customers. tors and measures should be considered in assessing the (c)A personal liability lawsuit is pending against the materiality of a misstatement in the presentation of a fi- company.The treasurer believes there is an even nancial statement? chance that the company will lose the suit and have 26.The treasurer of Joan Osborne Co.has heard that con- to pay damages of $200,000 to $300,000.The treas- servatism is a doctrine that is followed in accounting urer recommends that a loss be recorded and a lia- and,therefore,proposes that several policies be followed bility created in the amount of $300,000. that are conservative in nature.State your opinion with (d)The inventory should be valued at "cost or market, respect to each of the policies listed below. whichever is lower"because the losses from price (a)The company gives a 2-year warranty to its cus- declines should be recognized in the accounts in the tomers on all products sold.The estimated warranty period in which the price decline takes place. BRIEF EXERCISES (L0 4)BE2-1 Discuss whether the changes described in each of the cases below require recognition in the CPA's audit report as to consistency.(Assume that the amounts are material.) (a)The company changed its inventory method to FIFO from weighted-average,which had been used in prior years. (b)The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years. (c)The estimated remaining useful life of plant property was reduced because of obsolescence. (d)The company is using an inventory valuation method that is different from those used by all other companies in its industry. (L0 4)BE2-2 Identify which qualitative characteristic of accounting information is best described in each item below.(Do not use relevance and reliability.) (a)The annual reports of Best Buy Co.are audited by certified public accountants. (b)Black Decker and Cannondale Corporation both use the FIFO cost flow assumption. (c)Starbucks Corporation has used straight-line depreciation since it began operations. (d)Motorola issues its quarterly reports immediately after each quarter ends. (L0 5)BE2-3 For each item below,indicate to which category of elements of financial statements it belongs (a)Retained earnings (e)Depreciation (h)Dividends (b)Sales (f)Loss on sale of equipment (i)Gain on sale of investment (c)Additional paid-in capital (g)Interest payable (j)Issuance of common stock (d)Inventory (L0 6)BE2-4 Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b)Solectron Corporation,Inc.does not adjust amounts in its financial statements for the effects of inflation. (c)Walgreen Co.reports current and noncurrent classifications in its balance sheet. (d)The economic activities of General Electric and its subsidiaries are merged for accounting and re- porting purposes
23. Describe the two major constraints inherent in the presentation of accounting information. 24. What are some of the costs of providing accounting information? What are some of the benefits of accounting information? Describe the cost-benefit factors that should be considered when new accounting standards are being proposed. 25. How are materiality (and immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement? 26. The treasurer of Joan Osborne Co. has heard that conservatism is a doctrine that is followed in accounting and, therefore, proposes that several policies be followed that are conservative in nature. State your opinion with respect to each of the policies listed below. (a) The company gives a 2-year warranty to its customers on all products sold. The estimated warranty costs incurred from this year’s sales should be entered as an expense this year instead of an expense in the period in the future when the warranty is made good. (b) When sales are made on account, there is always uncertainty about whether the accounts are collectible. Therefore, the treasurer recommends recording the sale when the cash is received from the customers. (c) A personal liability lawsuit is pending against the company. The treasurer believes there is an even chance that the company will lose the suit and have to pay damages of $200,000 to $300,000. The treasurer recommends that a loss be recorded and a liability created in the amount of $300,000. (d) The inventory should be valued at “cost or market, whichever is lower” because the losses from price declines should be recognized in the accounts in the period in which the price decline takes place. Brief Exercises • 49 BRIEF EXERCISES BE2-1 Discuss whether the changes described in each of the cases below require recognition in the CPA’s audit report as to consistency. (Assume that the amounts are material.) (a) The company changed its inventory method to FIFO from weighted-average, which had been used in prior years. (b) The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years. (c) The estimated remaining useful life of plant property was reduced because of obsolescence. (d) The company is using an inventory valuation method that is different from those used by all other companies in its industry. BE2-2 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and reliability.) (a) The annual reports of Best Buy Co. are audited by certified public accountants. (b) Black & Decker and Cannondale Corporation both use the FIFO cost flow assumption. (c) Starbucks Corporation has used straight-line depreciation since it began operations. (d) Motorola issues its quarterly reports immediately after each quarter ends. BE2-3 For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings (e) Depreciation (h) Dividends (b) Sales (f) Loss on sale of equipment (i) Gain on sale of investment (c) Additional paid-in capital (g) Interest payable (j) Issuance of common stock (d) Inventory BE2-4 Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes. (L0 4) (L0 4) (L0 5) (L0 6) 1460T_c02.qxd 12/31/05 09:10 am Page 49
1460T_c02.qxd 11:11:2005 09:45 Page 50 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11: EQA 50.Chapter 2 Conceptual Framework Underlying Financial Accounting (L0 7)BE2-5 Identify which basic principle of accounting is best described in each item below. (a)Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b)Yahoo,Inc.recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c)Oracle Corporation reports information about pending lawsuits in the notes to its financial state- ments. (d)Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it,even though the estimated fair market value is greater. (LO 8)BE2-6 What accounting constraints are illustrated by the items below? (a)Zip's Farms,Inc.reports agricultural crops on its balance sheet at market value. (b)Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000. (c)Wildcat Company does not disclose any information in the notes to the financial statements unless the value of the information to financial statement users exceeds the expense of gath- ering it. (d)Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired. (LO 8)BE2-7 Presented below are three different transactions related to materiality.Explain whether you would classify these transactions as material. (a)Marcus Co.has reported a positive trend in earnings over the last 3 years.In the current year,it reduces its bad debt allowance to ensure another positive earnings year.The impact of this ad- justment is equal to 3%of net income. (b)Sosa Co.has an extraordinary gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of investments.It decides to net the gain and loss because the net effect is con- sidered immaterial.Sosa Co.'s income for the current year was $10 million. (c)Seliz Co.expenses all capital equipment under $25,000 on the basis that it is immaterial.The com- pany has followed this practice for a number of years. ⊕ (LO 6)BE2-8 If the going concern assumption is not made in accounting,discuss the differences in the amounts shown in the financial statements for the following items. (a)Land. (b)Unamortized bond premium. (c)Depreciation expense on equipment. (d)Merchandise inventory. (e)Prepaid insurance. (L0 6,BE2-9 What accounting assumption,principle,or modifying convention does Target Corporation use 7,8)in each of the situations below? (a)Target uses the lower of cost or market basis to value inventories. (b)Target was involved in litigation over the last year.This litigation is disclosed in the financial state- ments. (c)Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets. (d)Target records the purchase of a new Dell PC at its cash equivalent price. (L0 5)BE2-10 Explain how you would decide whether to record each of the following expenditures as an as- set or an expense.Assume all items are material. (a)Legal fees paid in connection with the purchase of land are $1,500. (b)Benjamin Bratt,Inc.paves the driveway leading to the office building at a cost of $21,000. (c)A meat market purchases a meat-grinding machine at a cost of $3,500. (d)On June 30,Alan and Alda,medical doctors,pay 6 months'office rent to cover the month of July and the next 5 months. (e)Tim Taylor's Hardware Company pays $9,000 in wages to laborers for construction on a building to be used in the business. (f)Nancy Kwan's Florists pays wages of $2,100 for November to an employee who serves as driver of their delivery truck
BE2-5 Identify which basic principle of accounting is best described in each item below. (a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater. BE2-6 What accounting constraints are illustrated by the items below? (a) Zip’s Farms, Inc. reports agricultural crops on its balance sheet at market value. (b) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000. (c) Wildcat Company does not disclose any information in the notes to the financial statements unless the value of the information to financial statement users exceeds the expense of gathering it. (d) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired. BE2-7 Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material. (a) Marcus Co. has reported a positive trend in earnings over the last 3 years. In the current year, it reduces its bad debt allowance to ensure another positive earnings year. The impact of this adjustment is equal to 3% of net income. (b) Sosa Co. has an extraordinary gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of investments. It decides to net the gain and loss because the net effect is considered immaterial. Sosa Co.’s income for the current year was $10 million. (c) Seliz Co. expenses all capital equipment under $25,000 on the basis that it is immaterial. The company has followed this practice for a number of years. BE2-8 If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in the financial statements for the following items. (a) Land. (b) Unamortized bond premium. (c) Depreciation expense on equipment. (d) Merchandise inventory. (e) Prepaid insurance. BE2-9 What accounting assumption, principle, or modifying convention does Target Corporation use in each of the situations below? (a) Target uses the lower of cost or market basis to value inventories. (b) Target was involved in litigation over the last year. This litigation is disclosed in the financial statements. (c) Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets. (d) Target records the purchase of a new Dell PC at its cash equivalent price. BE2-10 Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material. (a) Legal fees paid in connection with the purchase of land are $1,500. (b) Benjamin Bratt, Inc. paves the driveway leading to the office building at a cost of $21,000. (c) A meat market purchases a meat-grinding machine at a cost of $3,500. (d) On June 30, Alan and Alda, medical doctors, pay 6 months’ office rent to cover the month of July and the next 5 months. (e) Tim Taylor’s Hardware Company pays $9,000 in wages to laborers for construction on a building to be used in the business. (f) Nancy Kwan’s Florists pays wages of $2,100 for November to an employee who serves as driver of their delivery truck. 50 • Chapter 2 Conceptual Framework Underlying Financial Accounting (L0 7) (L0 8) (L0 8) (L0 6) (L0 5) (L0 6, 7, 8) 1460T_c02.qxd 11:11:2005 09:45 Page 50 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd 11:11:2005 09:45 Page 51Nishant-16 NIshant-16:Desktop:prakash 11/11: EQA Exercises·51 EXERCISES s (L04, E2-1 (Qualitative Characteristics)SFAC No.2 identifies the qualitative characteristics that make ac- 8) counting information useful.Presented below are a number of questions related to these qualitative char- acteristics and underlying constraints. (a)What is the quality of information that enables users to confirm or correct prior expectations? (b)Identify the two overall or pervasive constraints developed in SFAC No.2. (c) The chairman of the SEC at one time noted,"If it becomes accepted or expected that accounting principles are determined or modified in order to secure purposes other than economic meas- urement,we assume a grave risk that confidence in the credibility of our financial information system will be undermined."Which qualitative characteristic of accounting information should ensure that such a situation will not occur?(Do not use reliability.) (d)Billy Owens Corp.switches from FIFO to average cost to FIFO over a 2-year period.Which qual- itative characteristic of accounting information is not followed? (e)Assume that the profession permits the savings and loan industry to defer losses on investments it sells,because immediate recognition of the loss may have adverse economic consequences on the industry.Which qualitative characteristic of accounting information is not followed?(Do not use relevance or reliability.) (f)What are the two primary qualities that make accounting information useful for decision making? (g) Rex Chapman,Inc.does not issue its first-quarter report until after the second quarter's results are reported.Which qualitative characteristic of accounting is not followed?(Do not use rele- vance.) (h)Predictive value is an ingredient of which of the two primary qualities that make accounting in- formation useful for decision-making purposes? ( Ronald Coles,Inc.is the only company in its industry to depreciate its plant assets on a straight- line basis.Which qualitative characteristic of accounting information may not be followed?(Do not use industry practices.) (GjD Jeff Malone Company has attempted to determine the replacement cost of its inventory.Three different appraisers arrive at substantially different amounts for this value.The president,never- theless,decides to report the middle value for external reporting purposes.Which qualitative characteristic of information is lacking in these data?(Do not use reliability or representational faithfulness.) (L0 4)E2-2 (Qualitative Characteristics)The qualitative characteristics that make accounting information useful for decision-making purposes are as follows. Relevance Timeliness Representational faithfulness Reliability Verifiability Comparability Predictive value Neutrality Consistency Feedback value Instructions Identify the appropriate qualitative characteristic(s)to be used given the information provided below. (a) Qualitative characteristic being employed when companies in the same industry are using the same accounting principles. (b)Quality of information that confirms users'earlier expectations. (c) Imperative for providing comparisons of a company from period to period (d)Ignores the economic consequences of a standard or rule. (e) Requires a high degree of consensus among individuals on a given measurement. () Predictive value is an ingredient of this primary quality of information. (g) Two qualitative characteristics that are related to both relevance and reliability. (h)Neutrality is an ingredient of this primary quality of accounting information. () Two primary qualities that make accounting information useful for decision-making purposes p Issuance of interim reports is an example of what primary ingredient of relevance? (LO 5)E2-3 (Elements of Financial Statements)Ten interrelated elements that are most directly related to measuring the performance and financial status of an enterprise are provided below. Assets Distributions to owners Expenses Liabilities Comprehensive income Gains Equity Revenues Losses Investments by owners
EXERCISES E2-1 (Qualitative Characteristics) SFAC No. 2 identifies the qualitative characteristics that make accounting information useful. Presented below are a number of questions related to these qualitative characteristics and underlying constraints. (a) What is the quality of information that enables users to confirm or correct prior expectations? (b) Identify the two overall or pervasive constraints developed in SFAC No. 2. (c) The chairman of the SEC at one time noted, “If it becomes accepted or expected that accounting principles are determined or modified in order to secure purposes other than economic measurement, we assume a grave risk that confidence in the credibility of our financial information system will be undermined.” Which qualitative characteristic of accounting information should ensure that such a situation will not occur? (Do not use reliability.) (d) Billy Owens Corp. switches from FIFO to average cost to FIFO over a 2-year period. Which qualitative characteristic of accounting information is not followed? (e) Assume that the profession permits the savings and loan industry to defer losses on investments it sells, because immediate recognition of the loss may have adverse economic consequences on the industry. Which qualitative characteristic of accounting information is not followed? (Do not use relevance or reliability.) (f) What are the two primary qualities that make accounting information useful for decision making? (g) Rex Chapman, Inc. does not issue its first-quarter report until after the second quarter’s results are reported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.) (h) Predictive value is an ingredient of which of the two primary qualities that make accounting information useful for decision-making purposes? (i) Ronald Coles, Inc. is the only company in its industry to depreciate its plant assets on a straightline basis. Which qualitative characteristic of accounting information may not be followed? (Do not use industry practices.) (j) Jeff Malone Company has attempted to determine the replacement cost of its inventory. Three different appraisers arrive at substantially different amounts for this value. The president, nevertheless, decides to report the middle value for external reporting purposes. Which qualitative characteristic of information is lacking in these data? (Do not use reliability or representational faithfulness.) E2-2 (Qualitative Characteristics) The qualitative characteristics that make accounting information useful for decision-making purposes are as follows. Relevance Timeliness Representational faithfulness Reliability Verifiability Comparability Predictive value Neutrality Consistency Feedback value Instructions Identify the appropriate qualitative characteristic(s) to be used given the information provided below. (a) Qualitative characteristic being employed when companies in the same industry are using the same accounting principles. (b) Quality of information that confirms users’ earlier expectations. (c) Imperative for providing comparisons of a company from period to period. (d) Ignores the economic consequences of a standard or rule. (e) Requires a high degree of consensus among individuals on a given measurement. (f) Predictive value is an ingredient of this primary quality of information. (g) Two qualitative characteristics that are related to both relevance and reliability. (h) Neutrality is an ingredient of this primary quality of accounting information. (i) Two primary qualities that make accounting information useful for decision-making purposes. (j) Issuance of interim reports is an example of what primary ingredient of relevance? E2-3 (Elements of Financial Statements) Ten interrelated elements that are most directly related to measuring the performance and financial status of an enterprise are provided below. Assets Distributions to owners Expenses Liabilities Comprehensive income Gains Equity Revenues Losses Investments by owners Exercises • 51 (L0 4, 8) (L0 4) (L0 5) 1460T_c02.qxd 11:11:2005 09:45 Page 51 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd12/31/0509:10 am Page52 EQA 52 Chapter 2 Conceptual Framework Underlying Financial Accounting Instructions Identify the element or elements from page 51 associated with the 12 items below. (a)Arises from peripheral or incidental transactions. (b)Obligation to transfer resources arising from a past transaction. (c)Increases ownership interest. (d)Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. (f)Items characterized by service potential or future economic benefit. (g) Equals increase in assets less liabilities during the year,after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity's ongoing major or central operations. () Residual interest in the assets of the enterprise after deducting its liabilities. Increases assets during a period through sale of product. (k) Decreases assets during the period by purchasing the company's own stock. S Includes all changes in equity during the period,except those resulting from investments by own- ers and distributions to owners. (L06, E2-4 (Assumptions,Principles,and Constraints) Presented below are the assumptions,principles,and 7,8) constraints used in this chapter. 1. Economic entity assumption 5.Historical cost principle 9.Materiality Going concern assumption 6 Matching principle 10.Industry practices 3. Monetary unit assumption 7.Full disclosure principle 11.Conservatism 4.Periodicity assumption 8.Cost-benefit relationship Instructions Identify by number the accounting assumption,principle,or constraint that describes each situation be- low.Do not use a letter more than once. (a)Allocates expenses to revenues in the proper period. (b)Indicates that market value changes subsequent to purchase are not recorded in the accounts.(Do ⊕ not use revenue recognition principle.) (c) Ensures that all relevant financial information is reported (d)Rationale why plant assets are not reported at liquidation value.(Do not use historical cost principle.) (e) Anticipates all losses,but reports no gains. (f) Indicates that personal and business record keeping should be separately maintained (g) Separates financial information into time periods for reporting purposes. (h)Permits the use of market value valuation in certain specific situations. (1 Requires that information significant enough to affect the decision of reasonably informed users should be disclosed.(Do not use full disclosure principle.) ) Assumes that the dollar is the "measuring stick"used to report on financial performance. (L06, E2-5 (Assumptions,Principles,and Constraints)Presented below are a number of operational guide- 7,8) lines and practices that have developed over time. Instructions Select the assumption,principle,or constraint that most appropriately justifies these procedures and prac- tices.(Do not use qualitative characteristics.) (a)Market value changes are not recognized in the accounting records (b)Lower of cost or market is used to value inventories. (c)Financial information is presented so that investors will not be misled. (d)Intangible assets are capitalized and amortized over periods benefited. (e) Repair tools are expensed when purchased. (⑤ Agricultural companies use market value for purposes of valuing crops (g) Each enterprise is kept as a unit distinct from its owner or owners. (h) All significant postbalance sheet events are reported. ) Revenue is recorded at point of sale. (G) All important aspects of bond indentures are presented in financial statements. (k) Rationale for accrual accounting. ) The use of consolidated statements is justified. (m)Reporting must be done at defined time intervals (n)An allowance for doubtful accounts is established. (o)All payments out of petty cash are charged to Miscellaneous Expense.(Do not use conservatism.)
Instructions Identify the element or elements from page 51 associated with the 12 items below. (a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. (f) Items characterized by service potential or future economic benefit. (g) Equals increase in assets less liabilities during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entity’s ongoing major or central operations. (i) Residual interest in the assets of the enterprise after deducting its liabilities. (j) Increases assets during a period through sale of product. (k) Decreases assets during the period by purchasing the company’s own stock. (l) Includes all changes in equity during the period, except those resulting from investments by owners and distributions to owners. E2-4 (Assumptions, Principles, and Constraints) Presented below are the assumptions, principles, and constraints used in this chapter. 1. Economic entity assumption 5. Historical cost principle 9. Materiality 2. Going concern assumption 6. Matching principle 10. Industry practices 3. Monetary unit assumption 7. Full disclosure principle 11. Conservatism 4. Periodicity assumption 8. Cost-benefit relationship Instructions Identify by number the accounting assumption, principle, or constraint that describes each situation below. Do not use a letter more than once. (a) Allocates expenses to revenues in the proper period. (b) Indicates that market value changes subsequent to purchase are not recorded in the accounts. (Do not use revenue recognition principle.) (c) Ensures that all relevant financial information is reported. (d) Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.) (e) Anticipates all losses, but reports no gains. (f) Indicates that personal and business record keeping should be separately maintained. (g) Separates financial information into time periods for reporting purposes. (h) Permits the use of market value valuation in certain specific situations. (i) Requires that information significant enough to affect the decision of reasonably informed users should be disclosed. (Do not use full disclosure principle.) (j) Assumes that the dollar is the “measuring stick” used to report on financial performance. E2-5 (Assumptions, Principles, and Constraints) Presented below are a number of operational guidelines and practices that have developed over time. Instructions Select the assumption, principle, or constraint that most appropriately justifies these procedures and practices. (Do not use qualitative characteristics.) (a) Market value changes are not recognized in the accounting records. (b) Lower of cost or market is used to value inventories. (c) Financial information is presented so that investors will not be misled. (d) Intangible assets are capitalized and amortized over periods benefited. (e) Repair tools are expensed when purchased. (f) Agricultural companies use market value for purposes of valuing crops. (g) Each enterprise is kept as a unit distinct from its owner or owners. (h) All significant postbalance sheet events are reported. (i) Revenue is recorded at point of sale. (j) All important aspects of bond indentures are presented in financial statements. (k) Rationale for accrual accounting. (l) The use of consolidated statements is justified. (m) Reporting must be done at defined time intervals. (n) An allowance for doubtful accounts is established. (o) All payments out of petty cash are charged to Miscellaneous Expense. (Do not use conservatism.) 52 • Chapter 2 Conceptual Framework Underlying Financial Accounting (L0 6, 7, 8) (L0 6, 7, 8) 1460T_c02.qxd 12/31/05 09:10 am Page 52
1460T_c02.qxd12/31/0509:10 am Page53 EQA Exercises·53 (p)Goodwill is recorded only at time of purchase. (q)No profits are anticipated and all possible losses are recognized. (r)A company charges its sales commission costs to expense (LO 7)E2-6 (Full Disclosure Principle)Presented below are a number of facts related to R.Kelly,Inc.Assume that no mention of these facts was made in the financial statements and the related notes. Instructions Assume that you are the auditor of R.Kelly,Inc.and that you have been asked to explain the appropri- ate accounting and related disclosure necessary for each of these items. (a)The company decided that,for the sake of conciseness,only net income should be reported on the income statement.Details as to revenues,cost of goods sold,and expenses were omitted. (b)Equipment purchases of $170,000 were partly financed during the year through the issuance of a $110,000 notes payable.The company offset the equipment against the notes payable and reported plant assets at $60,000. (c) R.Kelly has reported its ending inventory at $2,100,000 in the financial statements.No other in- formation related to inventories is presented in the financial statements and related notes (d)The company changed its method of valuing inventories from weighted-average to FIFO.No men- tion of this change was made in the financial statements (L07) E2-7 (Accounting Principles-Comprehensive)Presented below are a number of business transac- tions that occurred during the current year for Fresh Horses,Inc. Instructions In each of the situations,discuss the appropriateness of the journal entries in terms of generally accepted accounting principles. (a)The president of Fresh Horses,Inc.used his expense account to purchase a new Suburban solely for personal use.The following journal entry was made. Miscellaneous Expense 29,000 Cash 29,000 (b)Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000,the ex- pected selling price less estimated selling costs.The following entry was made to record this in- crease in value. Merchandise Inventory 70,000 Revenue 70,000 (c)The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product.Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation.Nevertheless,the com- pany decides to make the following entry. Loss from Lawsuit 500,000 Liability for Lawsuit 500,000 (d)Because the general level of prices increased during the current year,Fresh Horses,Inc.deter- mined that there was a $16,000 understatement of depreciation expense on its equipment and de- cided to record it in its accounts.The following entry was made. Depreciation Expense 16,000 Accumulated Depreciation 16,000 (e)Fresh Horses,Inc.has been concerned about whether intangible assets could generate cash in case of liquidation.As a consequence,goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows. Retained Earnings 800,000 Goodwill 800,000 (f)Because of a"fire sale,"equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made. Equipment 200,000 Cash 155,000 Revenue 45,000 (LO 7)E2-8 (Accounting Principles-Comprehensive)Presented on page 54 is information related to Garth Brooks,Inc
(p) Goodwill is recorded only at time of purchase. (q) No profits are anticipated and all possible losses are recognized. (r) A company charges its sales commission costs to expense. E2-6 (Full Disclosure Principle) Presented below are a number of facts related to R. Kelly, Inc. Assume that no mention of these facts was made in the financial statements and the related notes. Instructions Assume that you are the auditor of R. Kelly, Inc. and that you have been asked to explain the appropriate accounting and related disclosure necessary for each of these items. (a) The company decided that, for the sake of conciseness, only net income should be reported on the income statement. Details as to revenues, cost of goods sold, and expenses were omitted. (b) Equipment purchases of $170,000 were partly financed during the year through the issuance of a $110,000 notes payable. The company offset the equipment against the notes payable and reported plant assets at $60,000. (c) R. Kelly has reported its ending inventory at $2,100,000 in the financial statements. No other information related to inventories is presented in the financial statements and related notes. (d) The company changed its method of valuing inventories from weighted-average to FIFO. No mention of this change was made in the financial statements. E2-7 (Accounting Principles—Comprehensive) Presented below are a number of business transactions that occurred during the current year for Fresh Horses, Inc. Instructions In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles. (a) The president of Fresh Horses, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made. Miscellaneous Expense 29,000 Cash 29,000 (b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value. Merchandise Inventory 70,000 Revenue 70,000 (c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry. Loss from Lawsuit 500,000 Liability for Lawsuit 500,000 (d) Because the general level of prices increased during the current year, Fresh Horses, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made. Depreciation Expense 16,000 Accumulated Depreciation 16,000 (e) Fresh Horses, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows. Retained Earnings 800,000 Goodwill 800,000 (f) Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made. Equipment 200,000 Cash 155,000 Revenue 45,000 E2-8 (Accounting Principles—Comprehensive) Presented on page 54 is information related to Garth Brooks, Inc. Exercises • 53 (L0 7) (L0 7) (L0 7) 1460T_c02.qxd 12/31/05 09:10 am Page 53
1460T_c02.qxd 11:11:2005 10:23 Page 54 Nishant-16 NIshant-16:Desktop:prakash 11/11: EQA 54.Chapter 2 Conceptual Framework Underlying Financial Accounting Instructions Comment on the appropriateness of the accounting procedures followed by Garth Brooks,Inc. (a) Depreciation expense on the building for the year was $60,000.Because the building was increasing in value during the year,the controller decided to charge the depreciation expense to retained earnings instead of to net income.The following entry is recorded. Retained Earnings 60,000 Accumulated Depreciation-Buildings 60,000 (b)Materials were purchased on January 1,2006,for $120,000 and this amount was entered in the Materials account.On December 31,2006,the materials would have cost $141,000,so the follow- ing entry is made. Inventory 21,000 Gain on Inventories 21,000 (c)During the year,the company purchased equipment through the issuance of common stock.The stock had a par value of $135,000 and a fair market value of $450,000.The fair market value of the equipment was not easily determinable.The company recorded this transaction as follows. Equipment 135,000 Common Stock 135,000 (d)During the year,the company sold certain equipment for $285,000,recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future,she de- cided to defer the gain and amortize it over the life of any new equipment purchased. (e)An order for $61,500 has been received from a customer for products on hand.This order was shipped on January 9,2007.The company made the following entry in 2006. Accounts Receivable 61,500 Sales 61,500 See the book's website,www.wiley.com/college/kieso,for Additional Exercises. ⊕ CONCEPTS FOR ANALYSIS CA2-1 (Conceptual Framework-General)Roger Morgan has some questions regarding the theoreti- cal framework in which standards are set.He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation.Yet,Roger's su- pervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e.,in the real world).Roger did notice that accounting standards seem to be established after the fact rather than before.He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Roger feels that some of his anxiety about accounting theory and accounting semantics could be al- leviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work.By doing this,he hopes to develop an appropriate connection between the- ory and practice. Instructions (a)Help Roger recognize the purpose of and benefit of a conceptual framework. (b)Identify any Statements of Financial Accounting Concepts issued by FASB that may be helpful to Roger in developing his theoretical background. CA2-2 (Conceptual Framework-General)The Financial Accounting Standards Board (FASB)has developed a conceptual framework for financial accounting and reporting.The FASB has issued seven Statements of Financial Accounting Concepts.These statements are intended to set forth objectives and fundamentals that will be the basis for developing financial accounting and reporting standards.The objectives identify the goals and purposes of financial reporting.The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions,events,and circumstances to be accounted for;their recognition and measurement;and the means of summarizing and communicating them to interested parties. The purpose of Statement of Financial Accounting Concepts No.2,"Qualitative Characteristics of Accounting Information,"is to examine the characteristics that make accounting information useful.The
Instructions Comment on the appropriateness of the accounting procedures followed by Garth Brooks, Inc. (a) Depreciation expense on the building for the year was $60,000. Because the building was increasing in value during the year, the controller decided to charge the depreciation expense to retained earnings instead of to net income. The following entry is recorded. Retained Earnings 60,000 Accumulated Depreciation — Buildings 60,000 (b) Materials were purchased on January 1, 2006, for $120,000 and this amount was entered in the Materials account. On December 31, 2006, the materials would have cost $141,000, so the following entry is made. Inventory 21,000 Gain on Inventories 21,000 (c) During the year, the company purchased equipment through the issuance of common stock. The stock had a par value of $135,000 and a fair market value of $450,000. The fair market value of the equipment was not easily determinable. The company recorded this transaction as follows. Equipment 135,000 Common Stock 135,000 (d) During the year, the company sold certain equipment for $285,000, recognizing a gain of $69,000. Because the controller believed that new equipment would be needed in the near future, she decided to defer the gain and amortize it over the life of any new equipment purchased. (e) An order for $61,500 has been received from a customer for products on hand. This order was shipped on January 9, 2007. The company made the following entry in 2006. Accounts Receivable 61,500 Sales 61,500 54 • Chapter 2 Conceptual Framework Underlying Financial Accounting See the book’s website, www.wiley.com/college/kieso, for Additional Exercises. wi el moc. y c/ ollege/kieso CONCEPTS FOR ANALYSIS CA2-1 (Conceptual Framework—General) Roger Morgan has some questions regarding the theoretical framework in which standards are set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Roger’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Roger did notice that accounting standards seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Roger feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice. Instructions (a) Help Roger recognize the purpose of and benefit of a conceptual framework. (b) Identify any Statements of Financial Accounting Concepts issued by FASB that may be helpful to Roger in developing his theoretical background. CA2-2 (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued seven Statements of Financial Accounting Concepts. These statements are intended to set forth objectives and fundamentals that will be the basis for developing financial accounting and reporting standards. The objectives identify the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties. The purpose of Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” is to examine the characteristics that make accounting information useful. The 1460T_c02.qxd 11:11:2005 10:23 Page 54 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd 11:11:2005 09:45 Page 55 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11: EQA Concepts for Analysis.55 characteristics or qualities of information discussed in SFAC No.2 are the ingredients that make infor- mation useful and the qualities to be sought when accounting choices are made Instructions (a)Identify and discuss the benefits that can be expected to be derived from the FASB's conceptual framework study. (b)What is the most important quality for accounting information as identified in Statement of Fi- nancial Accounting Concepts No.2?Explain why it is the most important. (c)Statement of Financial Accounting Concepts No.2 describes a number of key characteristics or qual- ities for accounting information.Briefly discuss the importance of any three of these qualities for financial reporting purposes. (CMA adapted) CA2-3 (Objectives of Financial Reporting)Regis Gordon and Kathy Medford are discussing various aspects of the FASB's pronouncement Statement of Financial Accounting Concepts No.1,"Objectives of Financial Reporting by Business Enterprises.Regis indicates that this pronouncement provides little,if any,guidance to the practicing professional in resolving accounting controversies.He believes that the statement provides such broad guidelines that it would be impossible to apply the objectives to present- day reporting problems.Kathy concedes this point but indicates that objectives are still needed to pro- vide a starting point for the FASB in helping to improve financial reporting. Instructions (a)Indicate the basic objectives established in Statement of Financial Accounting Concepts No.1. (b)What do you think is the meaning of Kathy's statement that the FASB needs a starting point to resolve accounting controversies? CA2-4 (Qualitative Characteristics)Accounting information provides useful information about busi- ness transactions and events.Those who provide and use financial reports must often select and evalu- ate accounting alternatives.FASB Statement of Financial Accounting Concepts No.2,"Qualitative Charac- teristics of Accounting Information,"examines the characteristics of accounting information that make it useful for decision making.It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information. Instructions (a)Describe briefly the following characteristics of useful accounting information. (1) Relevance (4)Comparability (2)Reliability (5)Consistency (3)Understandability (b)For each of the following pairs of information characteristics,give an example of a situation in which one of the characteristics may be sacrificed in return for a gain in the other. (1)Relevance and reliability. (3)Comparability and consistency. (2)Relevance and consistency. (4)Relevance and understandability. (c)What criterion should be used to evaluate trade-offs between information characteristics? CA2-5 (Revenue Recognition and Matching Principle)After the presentation of your report on the ex- amination of the financial statements to the board of directors of Bones Publishing Company,one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is earned with the publication of every issue of the company's magazine.She feels that the "crucial event"in the process of earning revenue in the magazine business is the cash sale of the subscription.She says that she does not understand why most of the revenue cannot be "recognized"in the period of the sale. Instructions (a)List the various accepted times for recognizing revenue in the accounts and explain when the methods are appropriate. (b)Discuss the propriety of timing the recognition of revenue in Bones Publishing Company's ac- counts with: (1)The cash sale of the magazine subscription. (2)The publication of the magazine every month. (3)Both events,by recognizing a portion of the revenue with the cash sale of the magazine sub- scription and a portion of the revenue with the publication of the magazine every month. CA2-6 (Revenue Recognition and Matching Principle)On June 5,2006,McCoy Corporation signed a con- tract with Sulu Associates under which Sulu agreed (1)to construct an office building on land owned by Mc- Coy,(2)to accept responsibility for procuring financing for the project and finding tenants,and (3)to manage the property for 35 years.The annual net income from the project,after debt service,was to be divided equally between McCoy Corporation and Sulu Associates.Sulu was to accept its share of future net income as full payment for its services in construction,obtaining finances and tenants,and management of the project
characteristics or qualities of information discussed in SFAC No. 2 are the ingredients that make information useful and the qualities to be sought when accounting choices are made. Instructions (a) Identify and discuss the benefits that can be expected to be derived from the FASB’s conceptual framework study. (b) What is the most important quality for accounting information as identified in Statement of Financial Accounting Concepts No. 2? Explain why it is the most important. (c) Statement of Financial Accounting Concepts No. 2 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for financial reporting purposes. (CMA adapted) CA2-3 (Objectives of Financial Reporting) Regis Gordon and Kathy Medford are discussing various aspects of the FASB’s pronouncement Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises.” Regis indicates that this pronouncement provides little, if any, guidance to the practicing professional in resolving accounting controversies. He believes that the statement provides such broad guidelines that it would be impossible to apply the objectives to presentday reporting problems. Kathy concedes this point but indicates that objectives are still needed to provide a starting point for the FASB in helping to improve financial reporting. Instructions (a) Indicate the basic objectives established in Statement of Financial Accounting Concepts No. 1. (b) What do you think is the meaning of Kathy’s statement that the FASB needs a starting point to resolve accounting controversies? CA2-4 (Qualitative Characteristics) Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives. FASB Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” examines the characteristics of accounting information that make it useful for decision making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information. Instructions (a) Describe briefly the following characteristics of useful accounting information. (1) Relevance (4) Comparability (2) Reliability (5) Consistency (3) Understandability (b) For each of the following pairs of information characteristics, give an example of a situation in which one of the characteristics may be sacrificed in return for a gain in the other. (1) Relevance and reliability. (3) Comparability and consistency. (2) Relevance and consistency. (4) Relevance and understandability. (c) What criterion should be used to evaluate trade-offs between information characteristics? CA2-5 (Revenue Recognition and Matching Principle) After the presentation of your report on the examination of the financial statements to the board of directors of Bones Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is earned with the publication of every issue of the company’s magazine. She feels that the “crucial event” in the process of earning revenue in the magazine business is the cash sale of the subscription. She says that she does not understand why most of the revenue cannot be “recognized” in the period of the sale. Instructions (a) List the various accepted times for recognizing revenue in the accounts and explain when the methods are appropriate. (b) Discuss the propriety of timing the recognition of revenue in Bones Publishing Company’s accounts with: (1) The cash sale of the magazine subscription. (2) The publication of the magazine every month. (3) Both events, by recognizing a portion of the revenue with the cash sale of the magazine subscription and a portion of the revenue with the publication of the magazine every month. CA2-6 (Revenue Recognition and Matching Principle) On June 5, 2006, McCoy Corporation signed a contract with Sulu Associates under which Sulu agreed (1) to construct an office building on land owned by McCoy, (2) to accept responsibility for procuring financing for the project and finding tenants, and (3) to manage the property for 35 years. The annual net income from the project, after debt service, was to be divided equally between McCoy Corporation and Sulu Associates. Sulu was to accept its share of future net income as full payment for its services in construction, obtaining finances and tenants, and management of the project. Concepts for Analysis • 55 1460T_c02.qxd 11:11:2005 09:45 Page 55 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd 11:11:2005 09:45 Page 56 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11: EQA 56.Chapter 2 Conceptual Framework Underlying Financial Accounting By May 31,2007,the project was nearly completed,and tenants had signed leases to occupy 90%of the available space at annual rentals totaling $4,000,000.It is estimated that,after operating expenses and debt service,the annual net income will amount to $1,500,000. The management of Sulu Associates believed that (a)the economic benefit derived from the contract with McCoy should be reflected on its financial statements for the fiscal year ended May 31,2007,and directed that revenue be accrued in an amount equal to the commercial value of the services Sulu had rendered during the year,(b)this amount should be carried in contracts receivable,and(c)all related expenditures should be charged against the revenue. Instructions (a)Explain the main difference between the economic concept of business income as reflected by Sulu's management and the measurement of income under generally accepted accounting prin- ciples. (b)Discuss the factors to be considered in determining when revenue should be recognized for the purpose of accounting measurement of periodic income. (c)Is the belief of Sulu's management in accordance with generally accepted accounting principles for the measurement of revenue and expense for the year ended May 31,2007?Support your opin- ion by discussing the application to this case of the factors to be considered for asset measure- ment and revenue and expense recognition. (AICPA adapted) CA2-7 (Matching Principle)An accountant must be familiar with the concepts involved in determin- ing earnings of a business entity.The amount of earnings reported for a business entity is dependent on the proper recognition,in general,of revenue and expense for a given time period.In some situations, costs are recognized as expenses at the time of product sale.In other situations,guidelines have been de- veloped for recognizing costs as expenses or losses by other criteria. Instructions (a)Explain the rationale for recognizing costs as expenses at the time of product sale. (b)What is the rationale underlying the appropriateness of treating costs as expenses of a period in- stead of assigning the costs to an asset?Explain. (c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an ⊕ expense?Explain. (d)Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost.Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost. (e)Identify the conditions under which it would be appropriate to treat a cost as a loss. (AICPA adapted) CA2-8 (Matching Principle)Accountants try to prepare income statements that are as accurate as pos- sible.A basic requirement in preparing accurate income statements is to match costs against revenues properly.Proper matching of costs against revenues requires that costs resulting from typical business operations be recognized in the period in which they expired. Instructions (a)List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period. (b)As generally presented in financial statements,the following items or procedures have been crit- icized as improperly matching costs with revenues.Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the fi- nancial information. (1)Receiving and handling costs (2)Valuation of inventories at the lower of cost or market (3)Cash discounts on purchases. CA2-9 (Matching Principle)Carlos Rodriguez sells and erects shell houses,that is,frame structures that are completely finished on the outside but are unfinished on the inside except for flooring,partition studding,and ceiling joists.Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring,plumbing,wall completion and finishing,and other work necessary to make the shell houses livable dwellings. Rodriguez buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing,doors,windows,and similar materials necessary to complete a shell house.Upon commencing operations in a new area,Rodriguez buys or leases land as a site for its local warehouse,field office,and display houses.Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages.The chief element of cost of the display houses is the unassembled packages
By May 31, 2007, the project was nearly completed, and tenants had signed leases to occupy 90% of the available space at annual rentals totaling $4,000,000. It is estimated that, after operating expenses and debt service, the annual net income will amount to $1,500,000. The management of Sulu Associates believed that (a) the economic benefit derived from the contract with McCoy should be reflected on its financial statements for the fiscal year ended May 31, 2007, and directed that revenue be accrued in an amount equal to the commercial value of the services Sulu had rendered during the year, (b) this amount should be carried in contracts receivable, and (c) all related expenditures should be charged against the revenue. Instructions (a) Explain the main difference between the economic concept of business income as reflected by Sulu’s management and the measurement of income under generally accepted accounting principles. (b) Discuss the factors to be considered in determining when revenue should be recognized for the purpose of accounting measurement of periodic income. (c) Is the belief of Sulu’s management in accordance with generally accepted accounting principles for the measurement of revenue and expense for the year ended May 31, 2007? Support your opinion by discussing the application to this case of the factors to be considered for asset measurement and revenue and expense recognition. (AICPA adapted) CA2-7 (Matching Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenue and expense for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria. Instructions (a) Explain the rationale for recognizing costs as expenses at the time of product sale. (b) What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain. (c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense? Explain. (d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost. (e) Identify the conditions under which it would be appropriate to treat a cost as a loss. (AICPA adapted) CA2-8 (Matching Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to match costs against revenues properly. Proper matching of costs against revenues requires that costs resulting from typical business operations be recognized in the period in which they expired. Instructions (a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period. (b) As generally presented in financial statements, the following items or procedures have been criticized as improperly matching costs with revenues. Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information. (1) Receiving and handling costs. (2) Valuation of inventories at the lower of cost or market. (3) Cash discounts on purchases. CA2-9 (Matching Principle) Carlos Rodriguez sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses livable dwellings. Rodriguez buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Rodriguez buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages. The chief element of cost of the display houses is the unassembled packages, 56 • Chapter 2 Conceptual Framework Underlying Financial Accounting 1460T_c02.qxd 11:11:2005 09:45 Page 56 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11:
1460T_c02.qxd 11:11:2005 09:45 Page 57 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11: EQA Concepts for Analysis.57 inasmuch as erection is a short,low-cost operation.Old sample models are torn down or altered into new models every 3 to 7 years.Sample display houses have little salvage value because dismantling and mov- ing costs amount to nearly as much as the cost of an unassembled package. Instructions (a)A choice must be made between (1)expensing the costs of sample display houses in the periods in which the expenditure is made and(2)spreading the costs over more than one period.Discuss the advantages of each method. (b)Would it be preferable to amortize the cost of display houses on the basis of(1)the passage of time or (2)the number of shell houses sold?Explain. (AICPA adapted) CA2-10 (Qualitative Characteristics)Recently,your Uncle Waldo Ralph,who knows that you always have your eye out for a profitable investment,has discussed the possibility of your purchasing some cor- porate bonds.He suggests that you may wish to get in on the"ground floor"of this deal.The bonds be- ing issued by Cricket Corp.are 10-year debentures which promise a 40%rate of return.Cricket manu- factures novelty/party items. You have told Waldo that,unless you can take a look at Cricket's financial statements,you would not feel comfortable about such an investment.Believing that this is the chance of a lifetime,Uncle Waldo has procured a copy of Cricket's most recent,unaudited financial statements which are a year old.These statements were prepared by Mrs.John Cricket.You peruse these statements,and they are quite impres- sive.The balance sheet showed a debt-to-equity ratio of 0.10 and,for the year shown,the company re- ported net income of $2,424,240. The financial statements are not shown in comparison with amounts from other years.In addition, no significant note disclosures about inventory valuation,depreciation methods,loan agreements,etc.are available. Instructions Write a letter to Uncle Waldo explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you.Be sure to explain why these financial statements are neither relevant nor reliable. CA2-11 (Matching)Hinckley Nuclear Power Plant will be "mothballed"at the end of its useful life (approximately 20 years)at great expense.The matching principle requires that expenses be matched to revenue.Accountants Jana Kingston and Pete Henning argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs. Instructions Answer the following questions. (a)What stakeholders should be considered? (b)What ethical issue,if any,underlies the dispute? (c)What alternatives should be considered? (d)Assess the consequences of the alternatives. (e)What decision would you recommend? CA2-12 (Cost-Benefit)The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting. 1.Business reporting should exclude information outside of management's expertise or for which management is not the best source,such as information about competitors. 2.Management should not be required to report information that would significantly harm the com- pany's competitive position. 3. Management should not be required to provide forecasted financial statements.Rather,management should provide information that helps users forecast for themselves the company's financial future. 4. Other than for financial statements,management need report only the information it knows.That is,management should be under no obligation to gather information it does not have,or does not need,to manage the business. 5. Companies should present certain elements of business reporting only if users and management agree they should be reported-a concept of flexible reporting. 6. Companies should not have to report forward-looking information unless there are effective de- terrents to unwarranted litigation that discourages companies from doing so. Instructions For each item,briefly discuss how the proposed constraint addresses concerns about the costs and bene- fits of financial reporting
inasmuch as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package. Instructions (a) A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method. (b) Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain. (AICPA adapted) CA2-10 (Qualitative Characteristics) Recently, your Uncle Waldo Ralph, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the “ground floor” of this deal. The bonds being issued by Cricket Corp. are 10-year debentures which promise a 40% rate of return. Cricket manufactures novelty/party items. You have told Waldo that, unless you can take a look at Cricket’s financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Waldo has procured a copy of Cricket’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. John Cricket. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240. The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available. Instructions Write a letter to Uncle Waldo explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor reliable. CA2-11 (Matching) Hinckley Nuclear Power Plant will be “mothballed” at the end of its useful life (approximately 20 years) at great expense. The matching principle requires that expenses be matched to revenue. Accountants Jana Kingston and Pete Henning argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs. Instructions Answer the following questions. (a) What stakeholders should be considered? (b) What ethical issue, if any, underlies the dispute? (c) What alternatives should be considered? (d) Assess the consequences of the alternatives. (e) What decision would you recommend? CA2-12 (Cost-Benefit) The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting. 1. Business reporting should exclude information outside of management’s expertise or for which management is not the best source, such as information about competitors. 2. Management should not be required to report information that would significantly harm the company’s competitive position. 3. Management should not be required to provide forecasted financial statements. Rather, management should provide information that helps users forecast for themselves the company’s financial future. 4. Other than for financial statements, management need report only the information it knows. That is, management should be under no obligation to gather information it does not have, or does not need, to manage the business. 5. Companies should present certain elements of business reporting only if users and management agree they should be reported—a concept of flexible reporting. 6. Companies should not have to report forward-looking information unless there are effective deterrents to unwarranted litigation that discourages companies from doing so. Instructions For each item, briefly discuss how the proposed constraint addresses concerns about the costs and benefits of financial reporting. Concepts for Analysis • 57 1460T_c02.qxd 11:11:2005 09:45 Page 57 Nishant-16 NIshant-16:Desktop Folder:prakash 11/11: