Conceptual Framework for Financial Reporting

Question: 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 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.

What is a conceptual framework? Why is a conceptual framework necessary in financial accounting?

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.

1. 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.
2. What has been the effect of the practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?

The chairman of the company’s board of directors for which you are the chief accountant has told you that he has little use for accounting figures based on historical 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 He believes that replacement values are of far more significance to the board of directors than “out-of-date costs.”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 historical cost.

Mogilny Company paid \(135,000 for a machine. The Accumulated Depreciation- Equipment account has a balance of \)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?

What is the primary objective of financial reporting?

Question: Describe the major constraint inherent in the presentation of accounting information.

Question: 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.

What is meant by term “qualitative characteristics of accounting information”?

Briefly describe the two fundamental qualities of useful accounting information.

Question: BE2-5 (L03) Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material.(

a) Blair 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) Hindi Co. has an unusual 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. Hindi Co.'s income for the current year was \(10 million.

(c) Damon 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.

How is materiality (or 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?

What are the enhancing qualities of the qualitative characteristics? What is the role of enhancing qualities in the conceptual framework?

According to the FASB conceptual framework, the objective of financial reporting for business enterprises is 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.

What is the distinction between comparability and consistency?

Why is it necessary to develop a definitional framework for the basic elements of accounting?

Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them?

Revenues, gains, and investments by owners are all increasing in net assets. What are the distinctions among them?

What are the four basic assumptions that underlie the financial accounting structure?

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?

What is the definition of fair value?

Briefly describe the fair value hierarchy.

Explain the revenue recognition principle.

What are the five steps used to determine the proper time to recognize revenue?

Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane 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 Selane recognize revenue related to its catering service

Three expense recognition methods (associating cause and effect, systematic and rational allocation, and immediate recognition) were discussed in the text under the expense recognition principle. Indicate the basic nature of each of these expense recognition methods and give two examples of each.

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?

In January 2018, Jane way 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, 2017. The president objects, claiming that this sale took place after December 31, 2017, and therefore should not be shown. Explain your position.

The treasurer of Landowska Co. has 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.

1. 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.
2. 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.
3. 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.

BE2-1 (L03) Match the qualitative characteristics below with the following statements. 1. Relevance 5. Comparability 2. Faithful representation 6. Completeness 3. Predictive value 7. Neutrality 4. Confirmatory value 8. Timeliness (a) Quality of information that permits users to identify similarities in and differences between two sets of economic phenomena. (b) Having information available to users before it loses its capacity to influence decisions. (c) Information about an economic phenomenon that has value as an input to the processes used by capital providers to form their own expectations about the future. (d) Information that is capable of making a difference in the decisions of users in their capacity as capital providers. (e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.

Match the qualitative characteristics below with the following statements.1. Timeliness                                         5. Faithful representation2. Completeness                                   6. Relevance3. Free from error                                  7. Neutrality4. Understandability                              8. Confirmatory value 

1. Quality of information that assures users that information represents the economic phenomena that it purports to represent.
2. Information about an economic phenomenon that corrects past or present expectations based on previous evaluations.
3. The extent to which information is accurate in representing the economic substance of a transaction.
4. Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports to represent.
5. Quality of information that allows users to comprehend its meaning.

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). 

1. The company changed its inventory method to FIFO from weighted-average, which had been used in prior years.
2. The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years.
3. The estimated remaining useful life of plant property was reduced because of obsolescence.

Describe the basic assumptions of accounting. 

Identify which basic principle of accounting is best described in each item below.(a) Norfolk Southern Corporation reports revenue in its income statement when the performance obligation is satisfied instead of when the cash is collected.(b) Yahoo! 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) Gap, Inc. reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is greater.

Question: For each item below, indicate to which category of elements of financial statements it belongs.

      (a) Retained earnings                               (f) Loss on sale of equipment

      (b) Sales                                                     (g) Interest payable

      (c) Additional paid-in capital                    (h) Dividends

      (d) Inventory                                             (i) Gain on sale of investment

      (e) Depreciation                                       (j) Issuance of common stock

Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material.
 

 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 non-current classifications in its balance sheet. 

d)The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.

BE2-9 (L05) If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in thefinancial statements for the following items.

(a) Land.                                                        (d) Inventory.

(b) Unamortized bond premium.                (e) Prepaid insurance.(c) Depreciation expense on equipment.

BE2-10 (L06) Identify which basic principle of accounting is best described in each item below.

1. Norfolk Southern Corporation reports revenue in its income statement when the performance obligation is satisfied instead of when the cash is collected.
2. Yahoo! recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.
3. Oracle Corporation reports information about pending lawsuits in the notes to its financial statements.
4. Gap, Inc. reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is greater.

BE2-11 (L06) Vande Velde Company made three investments during 2017. 

(1) It purchased 1,000 shares of Sastre Company, a start-up company. Vande Velde made the investment based on valuation estimates from an internally developed model.

(2) It purchased 2,000 shares of GE stock, which trades on the NYSE.

(3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an active market, their value closely tracks movements in U.S. Treasury bonds.

Where will Vande Velde report these investments in the fair value hierarchy?

(Usefulness, Objective of Financial Reporting) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position.

1. Accounting rule-making that relies on a body of concepts will result in useful and consistent pronouncements.
2. General-purpose financial reports are most useful to company insiders in making strategic business decisions.
3. Accounting standards based on individual conceptual frameworks generally will result in consistent and comparable accounting reports.
4. Capital providers are the only users who benefit from general-purpose financial reporting.
5. Accounting reports should be developed so that the users without knowledge of economics and business can become informed about the financial results of a company.
6. The objective of financial reporting is the foundation from which the other aspects of the framework logically result.

E2-2 (L01,2,3) (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position. 

1. The fundamental qualitative characteristics that make accounting information useful are relevance and verifiability. 
2. Relevant information only has predictive value, confirmatory value, or both.
3. (c) Information that is a faithful representation is characterized as having predictive or confirmatory value. 
4. Comparability pertains only to the reporting of information in a similar manner for different companies. 
5. Verifiability is solely an enhancing characteristic for faithful representation. 
6. In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of business and economic activities.

E2-3 (L03,7) GROUPWORK (Qualitative Characteristics) SFAC No. 8 identifies the qualitative characteristics that make accounting information useful. Presented below are a number of questions related to these qualitative characteristics and underlying constraint.

(a) What is the quality of information that enables users to confirm or correct prior expectations?

(b) Identify the pervasive constraint developed in the conceptual framework.

(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 faithful representation.)

(d) Muruyama 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 faithful representation.)

(f) What are the two fundamental qualities that make accounting information useful for decision-making?

(g) Watteau 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 fundamental qualities that make accounting information useful for decision-making purposes?

(i) Duggan, 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?

(j) Roddick 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 relevance or faithful representation.)

What accounting assumption, principle, or constraint would Target Corporation use in each of the situations below?

(a) Target was involved in litigation over the last year. This litigation is disclosed in the financial statements.

(b) Target allocates the cost of its depreciable assets over the life it expects to receive revenue from these assets.

(c) Target records the purchase of a new Dell PC at its cash equivalent price.

Question: 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.

E2-4 (L03) (Qualitative Characteristics) The qualitative characteristics that make accounting information useful for decision-making purposes are as follows.

Relevance                                Neutrality                          Verifiability

Faithful representation        Completeness                    Understandability

Predictive value                      Timeliness                          Comparability

Confirmatory value                 Materiality                         Free from error

InstructionsIdentify 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 fundamental quality of information.

(g) Four qualitative characteristics that are related to both relevance and faithful representation.

(h) An item is not recorded because its effect on income would not change a decision.

(i) Neutrality is an ingredient of this fundamental quality of accounting information.

(j) Two fundamental qualities that make accounting information useful for decision-making purposes.

(k) Issuance of interim reports is an example of what enhancing quality of relevance?

(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

Instructions

Identify the element or elements 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.

(Assumptions, Principles, and Constraint) Presented below are the assumptions, principles, and constraints used in this chapter.

1. Economic entity assumption 6. Measurement principle (fair value)2. Going concern assumption                 7. Expense recognition principle3. Monetary unit assumption                            8. Full disclosure principle4. Periodicity assumption                                     9. Cost constraint5. Measurement principle (historical cost) 10. Revenue recognition principle

Instructions

Identify by number the accounting assumption, principle, or constraint that describes each situation below. Do not use a number more than once

.(a) Allocates expenses to revenues in the proper period.

(b) Indicates that fair 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) Indicates that personal and business record keeping should be separately maintained.(f) Separates financial information into time periods for reporting purposes.

(g) Assumes that the dollar is the “measuring stick” used to report on financial performance.

E2-7 (L05,6) (Assumptions, Principles, and Constraint) 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.)

1. Fair value changes are not recognized in the accounting records. 
2. Financial information is presented so that investors will not be misled. 
3. Intangible assets are amortized over periods benefited. 
4. Agricultural companies use fair value for purposes of valuing crops. 
5. Each enterprise is kept as a unit distinct from its owner or owners. 
6. All significant post-balance-sheet events are disclosed. 
7. Revenue is recorded when the product is delivered. 
8. All important aspects of bond indentures are presented in financial statements. 
9. Rationale for accrual accounting. 
10. The use of consolidated statements is justified. 
11. Reporting must be done at defined time intervals. 
12. An allowance for doubtful accounts is established. 
13. Goodwill is recorded only at time of purchase. 
14. A company charges its sales commission costs to expense

(Full Disclosure Principle) Presented below are a number of facts related to Weller, Inc. Assume that no mentionof 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.