Question & Answer

Do the following events represent business transactions?

Explain your answer in each case.

(a) A computer is purchased on account.

(b) A customer returns merchandise and is given credit on account.

(c) A prospective employee is interviewed.

(d) The owner of the business withdraws cash from the business for personal use.

(e) Merchandise is ordered for delivery next month.

Give an example of a transaction that results in:

(a) A decrease in an asset and a decrease in a liability.

(b) A decrease in one asset and an increase in another asset.

(c) A decrease in one liability and an increase in another liability.

provided the following disclosure in a recent annual report. New accounting pronouncement (partial) . . . the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101—“Revenue Recognition in Financial Statements” (SAB 101). This SAB deals with various revenue recognition issues, several of which are common within the retail industry.

As a result of the issuance of this SAB . . . the Company is currently evaluating the effects of the SAB on its method of recognizing revenues related to layaway sales and will make any accounting method changes necessary during the first quarter of [next year].

In response to SAB 101, Wal-Mart changed its revenue recognition policy for layaway transactions, in which Wal-Mart sets aside merchandise for customers who make partial payment. Before the change,

Wal-Mart recognized all revenue on the sale at the time of the layaway. After the change, Wal-Mart does not recognize revenue until customers satisfy all payment obligations and take possession of the merchandise.

Instructions

(a) Discuss the expected effect on income (1) in the year that Wal-Mart makes the changes in its revenue recognition policy, and (2) in the years following the change.

(b) Evaluate the extent to which Wal-Mart’s previous revenue policy was consistent with the revenue recognition principle.

(c) If all retailers had used a revenue recognition policy similar to Wal-Mart’s before the change, are there any concerns with respect to the qualitative characteristic of comparability? Explain.

Instructions

Go to the book’s companion website, and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.

(a) What are the primary lines of business of these two companies as shown in their notes to the financial statements?

(b) Which company has the dominant position in beverage sales?

(c) How are inventories for these two companies valued? What cost allocation method is used to report inventory? How does their accounting for inventories affect comparability between the two companies?

(d) Which company changed its accounting policies, which then affected the consistency of the financial results from the previous year? What were these changes?

Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with IFRS. She has also heard that certain terms have special meanings in accounting relative to everyday use. She would like you to explain the meaning of terms she has come across related to accounting.

Instructions

Access the IASB Framework at the IASB website (http://eifrs.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to prepare responses to the following items. (Provide paragraph citations.)

(a) How is “materiality” defined in the framework?

(b) Briefly discuss how materiality relates to (1) the relevance of financial information, and (2) completeness.

(c) Your aunt observes that under IFRS, the financial statements are prepared on the accrual basis.

According to the framework, what does “accrual basis” mean?

As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops accounting standards for many international companies. The IASB also has developed a conceptual frameworkto help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ.

Instructions

Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as

 related to elements and their definitions.

What are some of the challenges to the FASB and IASB in developing a converged conceptual framework?

What are some of the differences in elements in the IASB and FASB conceptual frameworks?

Do the IASB and FASB conceptual frameworks differ in terms of the role of financial reporting?

Explain.

What two assumptions are central to the IASB conceptual framework?

Your aunt recently received the annual report for a company in which she has invested. The report notes that the statements have been prepared in accordance with “generally accepted accounting principles.”

She has also heard that certain terms have special meanings in accounting relative to everyday use. Shewould like you to explain the meaning of terms she has come across related to accounting. Instructions

Go to http://www.fasb.org and access the FASB Concepts Statements and respond to the following items.

(Provide paragraph citations.) When you have accessed the documents, you can use the search tool in your Internet browser.

(a) How is “materiality” defined in the conceptual framework?

(b) The concepts statements provide several examples in which specific quantitative materiality guidelines are provided to firms. Identity at least two of these examples. Do you think the materiality guidelines should be quantified? Why or why not?

(c) The concepts statements discuss the concept of “articulation” between financial statement elements.

Briefly summarize the meaning of this term and how it relates to an entity’s financial statements.

Anderson Nuclear Power Plant will be “mothballed” at the end of its useful life (approximately 20 years) at great expense. The expense recognition principle requires that expenses be matched to revenue. Accountants Ana Alicia and Ed Bradley 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?

Recently, your uncle, Carlos Beltran, 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 Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures  novelty/party items.

You have told Neville that, unless you can take a look at its financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. 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 Carlos 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 representationally faithful.

Daniel Barenboim 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.

Barenboim 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, Barenboim 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, 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.

Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and 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 recognizing costs. 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) Cash discounts on purchases.

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 revenues and expenses 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.

After the presentation of your report on the examination of the financial statements to the board of directors of Piper Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is recognized 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 cash sale.

Instructions

Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with:

(a) The cash sale of the magazine subscription.

(b) The publication of the magazine every month.

(c) 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.

Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives. The FASB statement on 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) Faithful representation. (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 faithful representation. (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?

Homer Winslow and Jane Alexander are discussing various aspects of the FASB’s concepts statement on the objective of financial reporting. Homer 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 toapply the objective to present-day reporting problems. Jane concedes this point but indicates that the objective is still needed to provide a starting point for the FASB in helping to improve financial reporting.

Instructions

(a) Indicate the basic objective established in the conceptual framework.

(b) What do you think is the meaning of Jane’s statement that the FASB needs a starting point to resolve accounting controversies?

The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies 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 the statement on qualitative characteristics is to examine the characteristics that make accounting information useful. These characteristics or qualities of information 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 the conceptual framework? Explain why it is the most important.

(c) Statement of Financial Accounting Concepts No. 8 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.

Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules 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. Wayne 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 Wayne recognize the purpose of and benefit of a conceptual framework.

(b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.

Presented below is information related to Cramer, Inc.

Instructions

Comment on the appropriateness of the accounting procedures followed by Cramer, 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, 2014, for $120,000 and this amount was entered in the

Materials account. On December 31, 2014, 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 value of $450,000. The fair 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, 2015. The company made the following entry in 2014.

Accounts Receivable 61,500

Sales Revenue 61,500

Presented below are a number of business transactions that occurred during the current year for Gonzales, 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 Gonzales, 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.

Inventory 70,000

Sales 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, Gonzales, 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—Equipment 16,000

(e) Gonzales, 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

Sales Revenue 45,000

Presented below are a number of facts related to Weller, 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 Weller, 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) Weller 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.