FMGT 3110 Chapter 1 and 2 Homework
During the current year, Sheridan Inc. changed its shipment policy from f.o.b. destination to f.o.b shipping point. This would result in an additional $50,000 of revenue being recorded for fiscal 2020.
Agree This is a change in how Sheridan does business. The revenue recognition principle requires that the risks and rewards of ownership (control) be transferred to the purchaser for the sale to be recognized. That is when the performance obligation is satisfied. While the shipping terms have been changed, further investigation should be undertaken to ensure that customer business practices are aligned with this changed policy. For example, if the company will continue to replace items lost or damaged in transit, the risks have not passed, irrespective of the change in shipping terms, and the timing of revenue recognition should not change.
What criterion should be used to evaluate trade-offs between information characteristics?
Financial information must be relevant and representationally faithful. Often the other enhancing characteristics of useful information may have to be sacrificed. Although trade-offs result in the sacrifice of some desirable quality of information, the overall result should be information that is more useful for decision-making. What the proper trade-off is will depend on the facts and circumstances - ultimately, this will come down to professional judgement about the users' needs. The accounting profession is continually striving to produce financial information that meets all the qualitative characteristics of useful information.
If you had to explain or define "generally accepted accounting principles," what essential characteristics would you include in your explanation?
"Generally Accepted Accounting Principles" also known as GAAP, are a common set of standards and procedures used to prepare financial information with the assumption that most of the users' needs will be met. These standards are generally accepted and universally practiced. If GAAP did not exist, each entity would have to formulate their own set of standards and procedures and users of financial statements would have difficulty comparing financial statements from company to company. These principles are either (1) those that have substantive authoritative support, for instance the CPA Canada Handbook, or (2) principles that have arisen through the joint application of professional judgement and the conceptual framework. Professional judgement is a key aspect of GAAP as GAAP includes general principles which require interpretation. GAAP includes rules, practices, procedures, as well as broad principles, theories, methods and conventions that are recognized widely by CPAs.
Accounting information provides useful data about business transactions and events. The people who provide and use financial reports must often select and evaluate accounting alternatives. The conceptual framework that was discussed in this chapter examines the characteristics of accounting information that make it useful for decision-making. It also points out that various limitations that are part of the measurement and reporting process can make it necessary to trade off or sacrifice some of the characteristics of useful information. For each of the following pairs of qualitative characteristics, give an example of a situation in which one of the characteristics may be sacrificed for a gain in the other:
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Transactions from Gravenhurst Inc.'s current year follow. Gravenhurst follows IFRS. In each of the above situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles. For the purposes of your discussion, assume that the financial statements, particularly net income, will be used by the court in a divorce settlement for the company president's spouse.
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You are hired to review the accounting records of Sheridan Inc. (a public corporation) before it closes its revenue and expense accounts as at December 31, 2020, the end of its current fiscal year. The following information comes to your attention. State whether or not you agree with each of the accounting decisions made by Sheridan Inc.
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Because the general level of prices increased during the current year, Gravenhurst Inc. determined that there was a $15,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made: Depreciation Expense 15,000 (Debit) Accumulated Depreciation—Equipment 15,000 (Credit)
Accounting standards do not recognize price-level adjustments in the accounts unless the company is in a hyperinflationary economy and constrained by IFRS. Hence, it is misleading to deviate from the assumption that the value of the measuring unit does not change. It should also be noted that depreciation is not a matter of valuation, but rather a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of costs against revenues as the asset benefits are used to earn income. This error, by reducing net income, would incorrectly lower the divorce settlement available to the president's spouse.
The estimated remaining useful life of its manufacturing equipment was reviewed by management and increased by five years. This reduced depreciation expense by $30,000 during fiscal 2020.
Agree Depreciation is a means of cost allocation on a systematic charge against revenues. As it is based on best estimates, the useful life, and resulting depreciation expense, should be revised when economic or business events dictate that an asset will remain useful for a longer period. While comparability is impaired, changes in estimates are accounted for prospectively. Restatement would not provide decision useful information, since depreciation in the prior periods was determined with the best estimates available at the time. All estimates and judgements used to prepare the financial information should be free from bias, error, or omission. The change is acceptable as long as it is supported by evidence that the equipment is likely to last longer and is not a change simply to reduce annual depreciation expense and thereby increase income.
Relevance and comparability
Comparability is what occurs when information that has been measured and reported in a similar manner for different companies is considered comparable. And relevance we know is a characteristic where financial information makes a difference in decisions for users. Comparability also has an aspect of consistency. For example, there are two companies listed on the NYSE. One company is from within the US and reports using US GAAP (this is relevant to where it is based and the market it's within) and another company is international and follows IFRS (this is relevant so that the international public company can have access to global capital markets). US GAAP is more rules-based whereas IFRS is more principles-based, this may occasionally create differences in how financial information is prepared and interpreted which could cause an issue with comparability. Textbook Answer: Proposed new accounting methods may be more relevant to many decision makers than existing methods. However, if adopted, they would make comparisons of an enterprise's results with other businesses in the industry, which have not yet adopted the new methods, difficult or impossible.
Due to the recent deterioration in the age of outstanding accounts receivable, Sheridan's controller changed the percentage of accounts receivable from 4.5% to 6% when arriving at the allowance for doubtful accounts for the year ended December 31, 2020. This revision in the percentage used was applied to the previous year and an additional $50,000 was recorded as bad debt expense for the year ended December 31, 2019.
Disagree As estimate is used as the basis for arriving at the amount of accounts receivable that is expected to be uncollectible. The change in the estimate should not be applied retroactively to the previous 2019 fiscal year. The additional bad debt expense of $50,000 for 2019 should not be recorded. The deterioration in the age of the accounts is a current-year event and is a reflection of the conditions that exist for the current year. These conditions did not exist in the previous fiscal year and the percentage used in 2019 of 4.5% was judged appropriate at that time and was not an error.
During the year, Sheridan had an opportunity to buy equipment at an auction when its competitor went bankrupt. The equipment had to be purchased as bundles. Some of the equipment in the bundle purchased could be used by Sheridan immediately. Some of the equipment in the bundle did not fit the company's operations and had to be held for resale. The resale was expected to take place early in 2021. The purchase price of the bundle of equipment was added to property, plant, and equipment and depreciated in 2020. The controller mentioned that the price paid for the equipment was such a bargain that any future gain or loss from the resale of equipment will not have any material effect on net income.
Disagree It is reasonable for the controller to argue that the realizable value of the equipment held for resale may not differ materially from its historical cost. Where there is an issue is in classifying the equipment as property, plant, and equipment, as the assets should be classified instead as equipment held for sale with current assets. In addition, no depreciation should be recorded as the equipment has not been used in operations.
To maintain customer goodwill, Sheridan voluntarily recalled some products during the year. Sheridan has not established an accrual and is recording the sales returns as they happen.
Disagree The voluntary recall establishes an unconditional economic burden for Sheridan. This is a present obligation that is legally enforceable based on Sheridan's recall announcement. A liability should be provided at the time the recall is made.
The controller changed the classification of one expense on the comprehensive income statements for 2020 and 2019. The expense had been previously reported as a selling expense and is now reclassified as an administrative expense. The controller didn't agree with the treatment given in prior years. Nothing was mentioned in the financial statements concerning implementing this change as he reasoned that net income and any key financial ratios remained unaffected.
Disagree While it may be more appropriate to classify the expense as an administrative instead of selling expense, failing to disclose the reclassification is not allowed. Users of the financial statement rely on the consistent application of grouping of accounts in captions appearing on the comprehensive income statement from year to year. This assists in assessing performance and predicting future cash flows. A note to the financial statement should be added stating that the classification of the expense adopted in the current fiscal year has been applied to the comparative statement of comprehensive income to allow for better comparisons.
During fiscal 2020, new government legislation was passed requiring companies like Sheridan to install additional health and safety devices in their offices by 2025. Although Sheridan does not intend to retrofit the required new devices until 2025, an accrual for $375,500 has been established in the year-end financial statements for the future installation costs.
Disagree While there is an economic burden as a result of the new legislation, this is not a present obligation since the new law cannot be enforced until 2026. A liability does not exist in fiscal 2021.
Verity Retail Limited was a private company that experienced cash flow difficulties and hired new management to turn the company around. The company then went public and the shares sold at $15 per share. Within months, however, the share price plummeted and Beatle Clothing Inc. acquired the company for $1 per share when Verity was on the threshold of bankruptcy. (b)Who were the stakeholders in this situation?
Employees Auditors Current Investors Creditors Suppliers Management
The company is being sued for $500,000 by a customer who claims damages for personal injury that was allegedly caused by a defective product. Company lawyers 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: Litigation Expense 450,000 (Debit) Litigation Liability 450,000 (Credit)
General recognition criteria state that an item should be recognized when it meets the definition of an element, it is probable, and it is measurable. In this case, the lawyers have given an opinion that the loss is not probable. Further, the definition of a liability has not been met as there is not a current obligation requiring future settlement. The payment is contingent upon a future event and might be covered partially by some insurance. It is not clear that the company is at fault and at present, they have broken no laws or created any expectations that they will settle. The existence uncertainly is event would not require recognition based on these general criteria. Further, neutrality is likely violated by this overly conservative accounting. It might appear as if the loss had been recorded to reduce net income and to lower the divorce settlement available to the president's spouse.
How does information asymmetry hurt investors in the capital marketplace?
Information Asymmetry is the state that exists when one party has access to more information than another party. A very common circumstance is management having access to more information than investors. We know that the capital markets such as stock exchanges are not fully efficient because not all information is factored into stock prices of corporations. For instance, this information could be hidden or insider information that management may decide not to include in financial statements. There's two theories in regard to information asymmetry: (1) Moral Hazard - which is the concern that certain parties, such as management, who have additional information which is not available to others, such as investors, may act in their own self-interest to the detriment of others. For instance, management may wish to show only positive information about a company in order to ensure access to capital markets or maximize their own personal bonuses. (2) Adverse Selection - which is a result of information asymmetry where the capital marketplace could potentially attract the wrong market participants that think this self-interest based behaviour is acceptable.
Gravenhurst Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a result, goodwill arising from a business acquisition during the current year and recorded at $800,000 was written off as follows: Retained Earnings 800,000 (Debit) Goodwill 800,000 (Credit)
Most accounting methods are based on the assumption that the business enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation policies justifiable and appropriate. Therefore, it is incorrect to change to a liquidation value as Gravenhurst, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable. In addition, the acquisition of the goodwill was a current period transaction, so it is doubtful the goodwill would be considered impaired after so little time. It is unlikely that any entry should be made in this situation. Also note that when goodwill is tested for impairment and needs to be written down, the debit is made to an Impairment Loss - Goodwill account - not directly to retained earnings as indicated in the journal entry provided. This error causes a direct reduction to retained earnings and to assets. It does not impact net income, and therefore would not impact the divorce settlement.
Verity Retail Limited was a private company that experienced cash flow difficulties and hired new management to turn the company around. The company then went public and the shares sold at $15 per share. Within months, however, the share price plummeted and Beatle Clothing Inc. acquired the company for $1 per share when Verity was on the threshold of bankruptcy. a) Which GAAP should the company have followed when it went public? Explain.
Overview: -When the company went public, IFRS became a legal constraint.-The company was in the retail sales business and was struggling to maintain financial solvency. It had hired new management to turn the company around - they may have had an interest in showing the company in a better light than in reality. When it went public, the company appeared as though it had turned a corner (presumably thanks to the new management team). Thus the shares sold at $15 per share. Note that the selling price would consider sustainable earnings. -Subsequently, after going public, the company could not sustain its earnings and the share price dropped. Many shareholders lost their investments. Prior to Verity Retail Limited going public, it would have been required to follow IFRS for several years prior to the initial public offering in order to have comparative financial information prepared on a consistent basis.
What is the difference between principles-based and rules-based accounting standards? In which category does IFRS belong? ASPE? Explain.
Principles-based standards are considered to be based on a conceptual framework and the accounting principles that result may require significant professional judgement in interpreting and applying the standards to ensure compliance. Rules-based standards are generally quite detailed, and in many instances follow a "check-box" mentality that some contend may shield accountants, auditors and companies from legal liability. IFRS and ASPE tend to follow the principles-based standard-setting system, while U.S. GAAP is generally considered more rules-based (even though it is based on principles). This is because it is more prescriptive and detail-oriented.
Merchandise inventory that cost $630,000 was reported on the statement of financial position at $690,000, which is the expected selling price less estimated selling costs. The following entry was made to record this increase in value: Inventory 60,000 (Debit) Sales Revenue 60,000 (Credit)
The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time establishing a sales value for a given item without actually selling it. It should further be noted that the revenue recognition principle provides the answer as to when revenue should be recognized. Revenue should be recognized when the performance obligations have been satisfied. In this situation, this has definitely not taken place. This error inflates net income and would have increased the divorce settlement available to the president's spouse.
Because of a "fire sale," equipment that was obviously worth $200,000 was acquired at a bargain price of $155,000. The following entry was made: Equipment 200,000 (Debit) Cash 155,000 (Credit) Revenue. 45,000 (Credit)
The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. The equipment should have been recorded at its cash cost. The gain would have the effect of increasing the divorce settlement.
Relevance and timeliness
Timeliness is a characteristic of relevance that states that information should be available for decision-makers before it loses its capacity to influence their decision. And relevance we know is a characteristic where financial information makes a difference in decisions for users. For example, let's say a company is approaching their year end deadline but unfortunately they had multiple oil tankers that sunk in the ocean and financial information pertaining to that incident is very relevant to the financial statements. In this instance, they would not be able to inspect what the loss of the incident was prior to the deadline. The company chooses to submit their financial statements late which sacrifices timeliness but chooses to be relevant by still providing that financial information even after the deadline. Textbook Answer: Before issuing financial statements, a business experiences a loss due to a fire. If the business postpones the issuance of the financial statements for three weeks, it will be in a better position to provide information to the financial statement users. In this case, not postponing issuing the financial statements would hurt relevance but would improve the timeliness in which the information reached the users.
Relevance and understandability
Understandibility is the quality of information that permits reasonably informed users to perceive its significance. On the other hand, that information must be relevant and reliable. This information must be both relevant and understandable to an extent, as users who should have a reasonable knowledge of business and financial accounting matters will be analyzing the information in the financial statements. Sometimes however, this relevant information may be too complex for a user to digest and this is where those that are preparing financial statements will have to decide between understandability and relevancy. For example, a company may be going through a complex lawsuit and are having to decide if they want to disclose information about the lawsuit and how much they want to disclose because they do not know what will result from this disclosure. For relevancy stake, the lawsuit would be relevant to disclose but may not be understandable due to lack of information disclosure. Textbook Answer: Occasionally, relevant information is exceedingly complex. Judgement is required in determining the optimum trade-off between relevance and understandability. Information about the impact of general and specific price changes may be highly relevant but not understandable by all users.
Relevance and verifiability
Verifiability exists when knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction. Relevance is a characteristic where financial information makes a difference in decisions for users. For example, if a corporation is in the process of preparing their financial statements and they need to include pension liabilities. They may not be able to easily verify the numbers but by including them it will be relevant to the companies financials. Textbook Answer: Forecasts of future operating results and projections of future cash flows may be highly relevant to some decision makers. However, they would not be as verifiable as historical cost information about past transactions. Additionally, such information would require estimates and assumptions that would increases the subjectivity of the information.
Verity Retail Limited was a private company that experienced cash flow difficulties and hired new management to turn the company around. The company then went public and the shares sold at $15 per share. Within months, however, the share price plummeted and Beatle Clothing Inc. acquired the company for $1 per share when Verity was on the threshold of bankruptcy. (c)Explain what was at stake and why and how stakeholders were affected when the share price plummeted.
When the share price plummeted, Verity Retail Limited was at risk of bankruptcy and then was acquired - this resulted in a lot at stake for stakeholders. For current employees, they could lose their jobs. For auditors, they would lose profits as the company is their client. For investors, they would lose money on their investment's. For creditors, they could lose out on being repaid on their loans they provided a company. For suppliers, their revenue will decrease as stores will begin to liquidate as Verity Retail Limited's nears bankruptcy or demand for product will decrease and reduce revenues or Verity Retail Limited's will be acquired by a company that desires new suppliers. For management, they could lose their job as they were hired to turn the company around but instead in months the share prices plummeted. Consequently, they would have their reputation at stake.
Gravenhurst Inc. thinks it should dispose of its excess land. While the carrying value is $50,000, current market prices are depressed and only $25,000 is expected upon disposal. The following journal entry was made: Loss on Disposal of Land. 25,000 (Debit) Land 25,000 (Credit)
With a modification of the accounts used, the entry could be appropriate as long as the land is determined to be impaired or is designated as held for sale by the company. The debit in the entry should have been to an Impairment Loss account. Losses are generally recognized when they are likely or probable and measurable. As prices are depressed, the company should review for impairment and/or make a decision as to whether the land is held for sale. If impaired, the land would be reduced to its recoverable amount which is the higher of the value in use and the fair value less cost to sell. If designated as held for sale, the land would be written down to fair value less cost to sell. The entry that was made reduces net income and would lower the divorce settlement available to the president's spouse. Care should be taken regarding the above analysis to ensure that it is properly supported with evidence of current market prices.
