Conceptual Framework for Financial Reporting

GROUPWORK (Accounting Principles and Assumptions—Comprehensive) 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 29,000Cash 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 70,000Sales 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 500,000Liability 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 entryDepreciation Expense 16,000Accumulated 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.

(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 2000Cash 155,000Sales Revenue 45,000

Question: Comment on the appropriateness of the accounting procedures followed by Cramer, Inc.

           Retained Earnings                                    60,000

               Accumulated Depreciation—Buildings           60,000

                             Inventory                         21,000

                                    Gain on Inventories            21,000

                         Equipment         135,000

                                 Common Stock        135,000

                         Accounts Receivable   61,500

                                   Sales Revenue                61,500

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.

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.

(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.

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 to apply 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

1. Indicate the basic objective established in the conceptual framework.
2. What do you think is the meaning of Jane’s statement that the FASB needs a starting point to resolve accounting controversies?

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.     

2. Relevance     and consistency.     

3. Comparability     and consistency.     

4. Relevance     and understandability.  

c) What     criterion should be used to evaluate trade-offs between information     characteristics?         

(Revenue Recognition Principle) 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) Over time, as the magazines are published and delivered to customers.

Question: 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

1. Explain the rationale for recognizing costs as expenses at the time of product sale.
2. What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.
3. In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense?
4. 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.
5. Identify the conditions under which it would be appropriate to treat a cost as a loss.

CA2-7 (Expense Recognition Principle) 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.

Question: 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 liveable 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 \(30,000 to \)40,000 including the cost of the unassembled packages. The chief element of cost of display houses is the unassembled packages, in as much 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

1. 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.
2. 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.

Question: (Qualitative Characteristics) 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 Uncle Carlos that, unless you can take a look at Neville’s 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.

ETHICS (Expense Recognition Principle) 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 recognized as assets are used up or liabilities are incurred. 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?

Question: Wal-Mart Stores, Inc. 

Wal-Mart Stores, Inc. 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.

Question: William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2017. He invested \(20,000 of his own savings in the business. He paid \)6,000 cash to have a small building constructed to house the operations and spent \(800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land for \)1,000 per month. (He paid the first month’s rent in cash.) During the first month, advertising costs totaled \(750, of which \)150 was unpaid at the end of the month. Murray paid his three nephews \(400 for retrieving golf balls. He deposited in the company’s bank account all revenues from customers (\)4,700). On May 15, Murray withdrew \(800 in cash for personal use. On May 31, the company received a utility bill for \)100 but did not immediately pay it. On May 31, the balance in the company bank account was \(15,100.

Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of \)4,900 to a profit of \(1,650. 

Accounting 

Prepare a balance sheet at May 31, 2017. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of \)1,650? How could Murray conclude that the business operated at a loss of \(4,900? 

Analysis 

Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him \)10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain.

Principles 

What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate?

Briefly describe how the organization of the FASB Codification corresponds to the elements of financial statements.

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

Question: Which of the following statements about the IASB and FASB conceptual frameworks is not correct?

1. The IASB conceptual framework does not identify the element comprehensive income.
2. The existing IASB and FASB conceptual frameworks are organized in similar ways.
3. The FASB and IASB agree that the objective of financial reporting is to provide useful information to investors and creditors.
4. IFRS does not allow use of fair value as a measurement basis.

Question: Companies that use IFRS: 

(a) must report all their assets on the statement of financial position (balance sheet) at fair value. 

(b) may report property, plant, and equipment and natural resources at fair value. 

(c) may refer to a concept statement on estimating fair values when market data are not available. 

(d) may only use historical cost as the measurement basis in financial reporting.

Question: The issues that the FASB and IASB must address in developing a conceptual framework include all of the following except: 

(a) should the characteristic of relevance be traded-off in favor of information that is verifiable? 

(b) should a single measurement method such as historical cost be used? 

(c) what are the key elements of asset and liability definitions? 

(d) should the role of financial reporting focus on internal decision-making as well as providing information to assist users in decision-making?

Which of the following statements about the IASB and FASB conceptual frameworks is not correct?

(a) The IASB conceptual framework does not identify the element comprehensive income.

(b) The existing IASB and FASB conceptual frameworks are organized in similar ways.

(c) The FASB and IASB agree that the objective of financial reporting is to provide useful information to investors and creditors.

(d) IFRS does not allow use of fair value as a measurement basis.

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

Question: What two assumptions are central to the IASB conceptual framework?

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

Financial Reporting Case IFRS2-5 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 framework to 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 FASB and IASB conceptual frameworks as related to elements and their definitions.