Kieso Chapter 2 Intermediate Accounting Chapter-End ANSWERS

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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.

(1) 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 free from error as historical cost information about past transactions.

(a) Describe briefly the following characteristics of useful accounting information. (2) Faithful representation.

(2) Faithful representation is one of the two primary decision-specific characteristics of useful accounting information. Reliable information can be depended upon to represent the conditions and events that it is intended to represent. Representational faithfulness is correspondence or agreement between accounting information and the economic phenomena it is intended to represent stemming from completeness, neutrality, and free from error.

(2) Proposed new accounting methods may be more relevant to many decision makers than exist-ing methods. However, if adopted, they would impair consistency and make trend comparisons of an enterprise's results over time difficult or impossible.

(3) There presently exists much diversity among acceptable accounting methods and procedures. In order to facilitate comparability between enterprises, the use of only one accepted account-ing method for a particular type of transaction could be required. However, consistency would be impaired for those firms changing to the new required methods.

(a) Describe briefly the following characteristics of useful accounting information. (3) Understandability.

(3) Understandability is a user-specific characteristic of information. Information is understandable when it permits reasonably informed users to perceive its significance. Understandability is a link between users, who vary widely in their capacity to comprehend or utilize the information, and the decision-specific qualities of information.

(a) Describe briefly the following characteristics of useful accounting information. (4) Comparability.

(4) Comparability means that information about enterprises has been prepared and presented in a similar manner. Comparability enhances comparisons between information about two different enterprises at a particular point in time.

(4) Occasionally, relevant information is exceedingly complex. Judgment 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.

(a) Describe briefly the following characteristics of useful accounting information. (5) Consistency.

(5) Consistency means that unchanging policies and procedures have been used by an enterprise from one period to another. Consistency enhances comparisons between information about the same enterprise at two different points in time.

(a) Describe briefly the following characteristics of useful accounting information. (1) Relevance.

(a) (1) Relevance is one of the two primary decision-specific characteristics of useful accounting information. Relevant information is capable of making a difference in a decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Information must also be timely in order to be considered relevant.

BE2-1 Match the qualitative characteristics below with the following statements. 1. Relevance 2. Faithful representation 3. Predictive value 4. Confirmatory value 5. Comparability 6. Completeness 7. Neutrality 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.

(a) 5. Comparability (b) 8. Timeliness (c) 3. Predictive value (d) 1. Relevance (e) 7. Neutrality

BE2-2 Match the qualitative characteristics below with the following statements. 1. Timeliness 2. Completeness 3. Free from error 4. Understandability 5. Faithful representation 6. Relevance 7. Neutrality 8. Confirmatory value (a) Quality of information that assures users that information represents the economic phenomena that it purports to represent. (b) Information about an economic phenomenon that corrects past or present expectations based on previous evaluations. (c) The extent to which information is accurate in representing the economic substance of a transaction. (d) Includes all the information that is necessary for a faithful representation of the economic phenomena that it purports to represent. (e) Quality of information that allows users to comprehend its meaning.

(a) 5. Faithful representation (b) 8. Confirmatory value (c) 3. Free from error (d) 2. Completeness (e) 4. Understandability

1. Economic entity assumption 2. Going concern assumption 3. Monetary unit assumption 4. Periodicity assumption 5. Measurement principle (historical cost) 6. Measurement principle (fair value) 7. Expense recognition principle 8. Full disclosure principle 9. Cost constraint 10. Revenue recognition principle 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.

(a) 7. Expense recognition principle. (b) 5. Measurement (historical cost principle.) (c) 8. Full disclosure principle. (d) 2. Going concern assumption. (e) 1. Economic entity assumption. (f) 4. Periodicity assumption. (g) 3. Monetary unit assumption.

CA2-1 (Conceptual Framework—General) 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.

(a) A conceptual framework is like a constitution. Its objective is to provide a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary so that standard setting is useful, i.e., standard setting should build on and relate to an established body of concepts and objectives. A well-developed conceptual framework should enable the FASB to issue more useful and consistent standards in the future. Specific benefits that may arise are: (1) A coherent set of standards and rules should result. (2) New and emerging practical problems should be more quickly soluble by reference to an existing framework. (3) It should increase financial statement users' understanding of and confidence in financial reporting. (4) It should enhance comparability among companies' financial statements. (5) It should help determine the bounds for judgment in preparing financial statements. (6) It should provide guidance to the body responsible for establishing accounting standards.

BE2-5 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.

(a) Because the change was used to create a positive trend in earnings, the change is considered material.

(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

(a) Depreciation is an allocation of cost, not an attempt to value assets. As a consequence, even if the value of the building is increasing, costs related to this building should be matched with revenues on the income statement, not as a charge against retained earnings.

BE2-6 For each item below, indicate to which category of elements of financial statements it belongs. (a) Retained earnings(h) Dividends (b) Sales (c) Additional paid-in capital (d) Inventory (e) Depreciation (f) Loss on sale of equipment (g) Interest payable (h) Dividends (i) Gain on sale of investment (j) Issuance of common stock

(a) Equity (b) Revenues (c) Equity (d) Assets (e) Expenses (f) Losses (g) Liabilities (h) Distributions to owners (i) Gains (j) Investments by owners

CA2-2 (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued 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. (a) Identify and discuss the benefits that can be expected to be derived from the FASB's conceptual framework study.

(a) FASB's Conceptual Framework should provide benefits to the accounting community such as: (1) guiding the FASB in establishing accounting standards on a consistent basis. (2) determining bounds for judgment in preparing financial statements by prescribing the nature, functions and limits of financial accounting and reporting. (3) increasing users' understanding of and confidence in financial reporting.

E2-2 (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. (a) The fundamental qualitative characteristics that make accounting information useful are relevance and verifiability. (b) Relevant information only has predictive value, confirmatory value, or both. (c) Information that is a faithful representation is characterized as having predictive or confirmatory value. (d) Comparability pertains only to the reporting of information in a similar manner for different companies. (e) Verifiability is solely an enhancing characteristic for faithful representation. (f) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of business and economic activities.

(a) False - The fundamental qualitative characteristics that make account¬ing information useful are relevance and faithful representation. (b) False - Relevant information must also be material. (c) False - Information that is relevant is characterized as having predictive or confirmatory value. (d) False - Comparability also refers to comparisons of a firm over time (consistency). (e) False - Enhancing characteristics relate to both relevance and faithful representation. (f) True.

BE2-11 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.

(a) Full disclosure (b) Expense recognition (c) Historical cost

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.

(a) Gains, losses. (b) Liabilities. (c) Investments by owners, comprehensive income. (also possible would be revenues and gains). (d) Distributions to owners. (Note to instructor: net effect is to reduce equity and assets). (e) Comprehensive income (also possible would be revenues and gains). (f) Assets. (g) Comprehensive income. (h) Revenues, expenses. (i) Equity. (j) Revenues. (k) Distributions to owners. (l) Comprehensive income.

BE2-3 Discuss whether the changes described in each of the cases below require recognition in the CPA's audit report as to consistency. (Assume that the amounts are material.) (a) The company changed its inventory method to FIFO from weighted-average, which had been used in prior years.

(a) If the company changed its method for inventory valuation, the consis-tency, and therefore the comparability, of the financial statements have been affected by a change in the method of applying the accounting principles employed. The change would require comment in the auditor's report in an explanatory paragraph.

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.

(a) It is well established in accounting that revenues and cost of goods sold must be disclosed in an income statement. It might be noted to students that such was not always the case. At one time, only net income was reported but over time we have evolved to the present reporting format. (b) The proper accounting for this situation is to report the equipment as an asset and the notes payable as a liability on the balance sheet. Offsetting is permitted in only limited situations where certain assets are contractually committed to pay off liabilities. (c) According to GAAP, the basis upon which inventory amounts are stated (lower of cost or market) and the method used in determining cost (LIFO, FIFO, average cost, etc.) should also be reported. The dis-closure requirement related to the method used in determining cost should be emphasized, indicating that where possible alternatives exist in financial reporting, disclosure in some format is required. (d) Consistency requires that disclosure of changes in accounting principles be made in the financial statements. To do otherwise would result in financial statements that are misleading. Financial statements are more useful if they can be compared with similar reports for prior years.

BE2-10 If the going concern assumption is not made in accounting, discuss the differences in the amounts shown in the financial statements for the following items. (a) Land. (b) Unamortized bond premium. (c) Depreciation expense on equipment. (d) Inventory. (e) Prepaid insurance.

(a) Net realizable value. (b) Would not be disclosed. Liabilities would be disclosed in the order to be paid. (c) Would not be disclosed. Depreciation would be inappropriate if the going concern assumption no longer applies. (d) Net realizable value. (e) Net realizable value (i.e., redeemable value).

BE2-8 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.

(a) Revenue recognition

BE2-12 Explain how you would decide whether to record each of the following expenditures as an asset or an expense. Assume all items are material. (a) Legal fees paid in connection with the purchase of land are $1,500. (b) Eduardo, Inc. paves the driveway leading to the office building at a cost of $21,000. (c) A meat market purchases a meat-grinding machine at a cost of $3,500. (d) On June 30, Monroe and Meno, medical doctors, pay 6 months' office rent to cover the month of July and the next 5 months. (e) Smith's Hardware Company pays $9,000 in wages to laborers for construction on a building to be used in the business. (f) Alvarez's Florists pays wages of $2,100 for the month an employee who serves as driver of their delivery truck

(a) Should be debited to the Land account, as it is a cost incurred in acquir¬ing land. (b) As an asset, preferably to a Land Improvements account. The driveway will last for many years, and therefore it should be capitalized and depreciated. (c) Probably an asset, as it will last for a number of years and therefore will contribute to operations of those years. (d) If the fiscal year ends December 31, this will all be an expense of the current year that can be charged to an expense account. If statements are to be prepared on some date before December 31, part of this cost would be expense and part asset. Depending upon the circumstances, the original entry as well as the adjusting entry for statement purposes should take the statement date into account. (e) Should be debited to the Building account, as it is a part of the cost of that plant asset which will contribute to operations for many years. (f) As an expense, as the service has already been received; the contri-bution to operations occurred in this period.

CA2-5 (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 (a) The cash sale of the magazine subscription.

(a) The "crucial event" in determining when revenue is recognized is when a performance obligation is satisfied. In the case of subscriptions, the performance obligation is met when the magazines are delivered (including ads contained therein). The new director suggests that this principle does not apply in the magazine business and that revenue from subscription sales and advertising should be recognized in the accounts when the difficult task of selling is accomplished and not when the magazines are published and delivered to fill the subscriptions or to carry the advertising. The director's view that there is a single crucial event in the process of earning revenue in the magazine business is questionable even though the amount of revenue is determinable when the subscription is sold. Although the firm cannot prosper without good advertising contracts and while advertising rates depend substantially on magazine sales, it also is true that readers will not renew their subscriptions unless the content of the magazine pleases them. Unless subscriptions are obtained at prices that provide for the recovery in the first subscription period of all costs of selling and filling those subscriptions, the editorial and publishing activities are as crucial as the sale in the earning of the revenue. Even if the subscription rate does provide for the recovery of all associated costs within the first period, however, the editorial and publishing activities still would be important since the firm has an obligation (in the amount of the present value of the costs expected to be incurred in connection with the editorial and publication activities) to produce and deliver the magazine. Not until this obligation is fulfilled should the revenue associated with it be recognized in the accounts since the revenue is the result of delivering on a promise (selling and filling subscriptions) and not just the first one. The director's view also presumes that the cost of publishing the magazines can be computed accurately at or close to the time of the subscription sale despite uncertainty about possible changes in the prices of the factors of production and variations in efficiency. Hence, only a portion-not most-of the revenue should be recognized in the accounts at the time the subscription is sold.

CA2-3 (Objective of Financial Reporting) 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. (a) Indicate the basic objective established in the conceptual framework

(a) The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

(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

(a) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.

26. 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.

(a) To be recognized in the main body of financial statements, an item must meet the definition of an element. In addition the item must have been measured, recorded in the books, and passed through the double-entry system of accounting. (b) Information provided in the notes to the financial statements amplifies or explains the items presented in the main body of the statements and is essential to an understanding of the per-formance and position of the enterprise. Information in the notes does not have to be quanti-fiable, nor does it need to qualify as an element. (c) Supplementary information includes information that presents a different perspective from that adopted in the financial statements. It also includes management's explanation of the financial information and a discussion of the significance of that information

E2-1 (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. (a) Accounting rule-making that relies on a body of concepts will result in useful and consistent pronouncements. (b) General-purpose financial reports are most useful to company insiders in making strategic business decisions. (c) Accounting standards based on individual conceptual frameworks generally will result in consistent and comparable accounting reports. (d) Capital providers are the only users who benefit from general-purpose financial reporting. (e) Accounting reports should be developed so that users without knowledge of economics and business can become informed about the financial results of a company. (f) The objective of financial reporting is the foundation from which the other aspects of the framework logically result.

(a) True. (b) False - General-purpose financial reports helps users who lack the ability to demand all the financial information they need from an entity and therefore must rely, at least partly, on the information in financial reports. (c) False - Standard-setting that is based on personal conceptual frame¬works will lead to different conclusions about identical or similar issues. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones. (d) False - Information that is decision-useful to capital providers may also be useful to users of financial reporting who are not capital providers. (e) False - An implicit assumption is that users need reasonable knowl¬edge of business and financial accounting matters to understand the information contained in the financial statements. (f) True.

BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (a) The annual reports of Best Buy Co. are audited by certified public accountants.

(a) Verifiability

E2-3 (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 decisionmaking? (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.)

(a) confirmatory value (b) cost/benefit (c) neutrality (d) comparability (consistency) (e) neutrality (f) relevance and faithful representation (g) timeliness (h) relevance (i) comparability (j) verifiability

(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

(b) A gain should not be recognized until the inventory is sold. Accoun-tants follow the measurement principle (historical cost) approach and write-ups of assets are not permitted. It should also be noted that the revenue recognition principle states that revenue should not be recognized until it is realized or realizable and is earned.

BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (b) Black & Decker and Cannondale Corporation both use the FIFO cost flow assumption.

(b) Comparability

BE2-5 Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material (b) Hindi Co. has an extraordinary gain of $3.1 million on the sale of plant assets and a $3.3 million loss on the sale of investments. It decides to net the gain and loss because the net effect is considered immaterial. Hindi Co.'s income for the current year was $10 million.

(b) Each item must be considered separately and not netted. Therefore each transaction is considered material.

BE2-8 Identify which basic principle of accounting is best described in each item below. (b) Yahoo! recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue.

(b) Expense recognition

BE2-3 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.) (b) The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years.

(b) If the company disposed of one of its two subsidiaries that had been included in its consolidated statements for prior years, no comment as to consistency needs to be made in the CPA's audit report. The compara¬bility of the financial statements has been affected by a business trans¬action, but there has been no change in any accounting principle employed or in the method of its application. (The transaction would probably require informative disclosure in the financial statements).

BE2-7 Identify which basic assumption of accounting is best described in each item below. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation.

(b) Monetary unit

(b) Recognizing in the accounts all the revenue in equal portions with the publication of the magazine every month is subject to some of the same criticism from the standpoint of theory as the suggestion that all or most of the revenue be recognized in the accounts at the time the subscription is sold. Although the journalistic efforts of the magazine are important in the process of earning revenue, the firm could not prosper without magazine sales and the advertising that results from paid circulation. Hence, some revenue could be recognized in the accounts at the time of the subscription sale, to the extent that part of the performance obligation to the subscriber and advertisers has been met. That is, the ads are in the public domain. This approach requires the magazine to allocate the proportion of the revenue related to advertising from that related to subscriptions. For this reason, and because the task of estimating the amount of revenue associated with the subscription sale often has been considered subjective, recognizing revenue in the accounts with the monthly publication of the magazine has received support even though it does not meet the tests of revenue recognition as well as the next alternative.

CA2-1 (Conceptual Framework—General) 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. (b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.

(b) The FASB has issued eight Statements of Financial Accounting Concepts (SFAC) that relate to business enterprises. Their titles and brief description of the focus of each Statement are as follows: (1) SFAC No. 1, "Objectives of Financial Reporting by Business Enterprises," presents the goals and purposes of accounting. (2) SFAC No. 2, "Qualitative Characteristics of Accounting Information," examines the character-istics that make accounting information useful. (3) SFAC No. 3, "Elements of Financial Statements of Business Enterprises," provides definitions of the broad classifications of items in financial statements. (4) SFAC No. 5, "Recognition and Measurement in Financial Statements," sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial statements and when. (5) SFAC No. 6, "Elements of Financial Statements," replaces SFAC No. 3, "Elements of Financial Statements of Business Enterprises," and expands its scope to include not-for-profit organizations. (6) SFAC No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements," provides a framework for using expected future cash flows and present values as a basis for measurement. (7) SFAC No. 8, Chapter 1, "The Objective of General Purpose Financial Reporting," and Chapter 3, "Qualitative Characteristics of Useful Financial Information," replaces SFAC No. 1 and No. 2

(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

(b) 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 in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.

CA2-2 (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued 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. (b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important.

(b) The most important quality for accounting information is usefulness for decision making. Relevance and faithful representation are the primary qualities leading to this decision usefulness. Usefulness is the most important quality because, without usefulness, there would be no benefits from information to set against its costs.

CA2-3 (Objective of Financial Reporting) 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. (b) What do you think is the meaning of Jane's statement that the FASB needs a starting point to resolve accounting controversies?

(b) The purpose of this statement is to set forth fundamentals on which financial accounting and reporting standards may be based. Without some basic set of objectives that everyone can agree to, inconsistent standards will be developed. For example, some believe that accountability should be the primary objective of financial reporting. Others argue that prediction of future cash flows is more important. It follows that individuals who believe that accountability is the primary objective may arrive at different financial reporting standards than others who argue for prediction of cash flow. Only by establishing some consistent starting point can accounting ever achieve some underlying consistency in establishing accounting principles. It should be emphasized to the students that the Board itself is likely to be the major user and thus the most direct beneficiary of the guidance provided by this pronouncement. However, knowledge of the objectives and concepts the Board uses should enable all who are affected by or interested in financial accounting standards to better understand the content and limitations of information provided by financial accounting and reporting, thereby furthering their ability to use that information effectively and enhancing confidence in financial accounting and reporting. That knowledge, if used with care, may also provide guidance in resolving new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements.

(c) A cost should be capitalized, that is, treated as a measure of an asset when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period's revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise on hand at the end of an accounting period, costs of insurance coverage relating to future periods, and the cost of self-constructed plant or equipment.

(c) 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.

(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

(c) Assets should be recorded at the fair value of what is given up or the fair market value of what is received, whichever is more clearly evident. It should be emphasized that it is not a violation of the measurement principle (historical cost) principle to use the fair value of the stock. Recording the asset at the par value of the stock has no conceptual validity. Par value is merely an arbitrary amount usually set at the date of incorporation.

BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (c) Starbucks Corporation has used straight-line depreciation since it began operations.

BE2-8 Identify which basic principle of accounting is best described in each item below. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements.

BE2-7 Identify which basic assumption of accounting is best described in each item below. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet.

BE2-3 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.) (c) The estimated remaining useful life of plant property was reduced because of obsolescence.

(c) If the company reduced the estimated remaining useful life of plant property because of obsolescence, the comparability of the financial statements has been affected. The change is not a matter of consistency; it is a change in accounting estimate required by altered conditions and involves no change in accounting principles employed or in their method of application. The change would probably be disclosed by a note in the financial statements. If commented upon in the CPA's report, it would be as a matter of disclosure rather than consistency.

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

(c) In general, companies that follow an "expense all capital items below a certain amount" policy are not in violation of the materiality concept. Because the same practice has been followed from year to year, Damon's actions are acceptable.

(c) Recognizing in the accounts a portion of the revenue at the time a cash subscription is obtained and a portion each time an issue is published meets the tests of revenue recognition better than the other two alternatives. A portion of the net income is recognized in the accounts at the time of each major or crucial event - that is, when a performance obligation has been met. Each crucial event is clearly discernible and is a time of interaction between the publisher and subscriber. A legal sale is transacted before any revenue is recognized in the accounts. Prior to the time the revenue is recognized in the accounts, it already has been received in distributable form. Finally, the total revenue is measurable with more than the usual certainty, and the revenue attributable to each crucial event is determinable using reasonable (although sometimes conceptually unsatisfactory) assumptions about the relationship between revenue and costs when the costs are indirect.

(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

(c) The expense recognition principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and (2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.)

CA2-2 (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued 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. (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.

(c) There are a number of key characteristics or qualities that make accounting information desirable. The importance of three of these characteristics or qualities is discussed below. (1) Understandability—information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it, or who misuse it. (2) Relevance—the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations (including is material). (3) Faithful representation—the faithful representation of a measure rests on whether the numbers and descriptions matched what really existed or happened, including completeness, neutrality, and free from error. (Note to instructor: Other qualities might be discussed by the student, such as enhancing qualities. All of these qualities are defined in the textbook).

(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

(d) At the present time, accountants do not recognize price-level adjust-ments in the accounts. Hence, it is misleading to deviate from the measurement principle (historical cost) principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is 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 expired costs against revenues. (Note to instructor: It might be called to the students' attention that the FASB does encourage supplemental disclosure of price-level information.)

BE2-7 Identify which basic assumption of accounting is best described in each item below. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.

(d) Economic entity

(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.

(d) In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Thus, when it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance.

BE2-8 Identify which basic principle of accounting is best described in each item below. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair value is greater

(d) Measurement (historical cost)

(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.

(d) The gain should be recognized at the point of sale. Deferral of the gain should not be permitted, as it is realized and is earned. To explore this question at greater length, one might ask what justification other than the controller's might be used to justify the deferral of the gain. For example, the rationale provided in APB Opinion No. 29, noncompletion of the earnings process, might be discussed.

BE2-4 Identify which qualitative characteristic of accounting information is best described in each item below. (Do not use relevance and faithful representation.) (d) Motorola issues its quarterly reports immediately after each quarter ends.

(d) Timeliness

(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

(e) It appears from the information that the sale should be recorded in 2015 instead of 2014. Regardless of whether the terms are f.o.b. shipping point or f.o.b. destination, the point is that the inventory was sold in 2015. It should be noted that if the company is employing a perpetual inventory system in dollars and quantities, a debit to Cost of Goods Sold and a credit to Inventory is also necessary in 2015.

(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

(e) Most accounting methods are based on the assumption that the busi-ness enterprise will have a long life. Acceptance of this assumption provides credibility to the measurement principle (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 and amortization policies justifiable and appropriate. Therefore, it is incorrect to assume liquidation as Gonzales, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.

(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

(f) The answer to this situation is the same as (b). (b) 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 in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.

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

1. A conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial account-ing and financial statements. A conceptual framework is necessary in financial accounting for the following reasons: (1) It enables the FASB to issue more useful and consistent standards in the future. (2) New issues will be more quickly solvable by reference to an existing framework of basic theory. (3) It increases financial statement users' understanding of and confidence in financial reporting. (4) It enhances comparability among companies' financial statements.

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

10. Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity's ongoing major or central operations. Losses arise from peripheral or incidental transactions.

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

11. Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity's ongoing major or central operations. Gains arise from peripheral or incidental transactions.

13. The life of a business is divided into specific time periods, usually a year, to measure results of operations for each such time period and to portray financial conditions at the end of each period. (a) This practice is based on the accounting assumption that the life of the business consists of a series of time periods and that it is possible to measure accurately the results of operations for each period. Comment on the validity and necessity of this assumption. (b) What has been the effect of this practice on accounting? What is its relation to the accrual system? What influence has it had on accounting entries and methodology?

13. (a) In accounting it is generally agreed that any measures of the success of an enterprise for periods less than its total life are at best provisional in nature and subject to correction. Measurement of progress and status for arbitrary time periods is a practical necessity to serve those who must make decisions. It is not the result of postulating specific time periods as measurable segments of total life. (b) The practice of periodic measurement has led to many of the most difficult accounting prob-lems such as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition tests. The accrual system calls for associating related revenues and expenses. This becomes very difficult for an arbitrary time period with incomplete transactions in process at both the beginning and the end of the period. A number of accounting practices such as adjusting entries or the reporting of corrections of prior periods result directly from efforts to make each period's calculations as accurate as possible and yet recognizing that they are only provisional in nature.

15. The chairman of the board of directors of the company for which you are chief accountant has told you that he has little use for accounting figures based on 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.

15. Some of the arguments which might be used are outlined below: (1) Cost is definite and reliable; other values would have to be determined somewhat arbitrarily and there would be considerable disagreement as to the amounts to be used. (2) Amounts determined by other bases would have to be revised frequently. (3) Comparison with other companies is aided if cost is employed. (4) The costs of obtaining replacement values could outweigh the benefits derived.

16. What is the definition of fair value?

16. Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Fair value is therefore a market-based measure.

17. What is the fair value option? Explain how use of the fair value option reflects application of the fair value principle.

17. The fair value option gives companies the option to use fair value (referred to as the fair value option as the basis for measurement of financial assets and financial liabilities.) The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities.

19. Explain the revenue recognition principle.

19. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case a selling a product, the performance obligation is met when the product is delivered. Companies follow a five-step process to analyze revenue arrangements to determine when revenue should be recognized: (1) Identify the contract(s) with the customer; (2) Identify the separate performance obligations in the contract; (3) Determine the transaction price; (4) Allocate the transaction price to separate performance obligations; and (5) Recognize revenue when each performance obligation is satisfied.

2. What is the primary objective of financial reporting?

2. The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

20. What is a performance obligation, and how is it used to determine when revenue should be recognized?

20. A performance obligation is a promise to deliver a product or provide a service to a customer. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered.

22. 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?

22. Revenues are recognized when a performance obligation is met. The most common time at which these two conditions are met is when the product or merchandise is delivered or services are rendered to customers. Therefore, revenue for Selane Eatery should be recognized at the time the luncheon is served.

23. 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?

23. The president means that the "gain" should be recorded in the books. This item should not be entered in the accounts, however, because it has not been realized.

24. 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.

24. The cause and effect relationship can seldom be conclusively demonstrated, but many costs appear to be related to particular revenues and recognizing them as expenses accompanies recognition of the revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and cost of products sold or services provided. Systematic and rational allocation means that in the absence of a direct means of associating cause and effect, and where the asset provides benefits for several periods, its cost should be allocated to the periods in a systematic and rational manner. Examples of expenses that are recognized in a systematic and rational manner are depreciation of plant assets, amortization of intangible assets, and allocation of rent and insurance. Some costs are immediately expensed because the costs have no discernible future benefits or the allocation among several accounting periods is not considered to serve any useful purpose. Examples include officers' salaries, most selling costs, amounts paid to settle lawsuits, and costs of resources used in unsuccessful efforts.

27. In January 2015, Janeway 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, 2014. The president objects, claiming that this sale took place after December 31, 2014, and therefore should not be shown. Explain your position.

27. The general guide followed with regard to the full disclosure principle is to disclose in the financial statements any facts of sufficient importance to influence the judgment of an informed reader. The fact that the amount of outstanding common stock doubled in January of the subsequent reporting period probably should be disclosed because such a situation is of importance to present stockholders. Even though the event occurred after December 31, 2014, it should be disclosed on the balance sheet as of December 31, 2014, in order to make adequate disclosure. (The major point that should be emphasized throughout the entire discussion on full disclosure is that there is normally no "black" or "white" but varying shades of grey and it takes experience and good judgment to arrive at an appropriate answer).

28. Describe the major constraint inherent in the presentation of accounting information.

28. Accounting information is subject to the cost constraint. Information is not worth providing unless the benefits exceed the costs of preparing it.

29. 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.

29. The costs of providing accounting information are paid primarily to highly trained accountants who design and implement information systems, retrieve and analyze large amounts of data, prepare financial statements in accordance with authoritative pronouncements, and audit the information presented. These activities are time-consuming and costly. The benefits of providing accounting information are experienced by society in general, since informed financial decisions help allocate scarce resources to the most effective enterprises. Occasionally new accounting standards require presentation of information that is not readily assembled by the accounting systems of most companies. A determination should be made as to whether the incremental or additional costs of providing the proposed information exceed the incremental benefits to be obtained. This deter-mination requires careful judgment since the benefits of the proposed information may not be readily apparent.

3. What is meant by the term "qualitative characteristics of accounting information"?

3. "Qualitative characteristics of accounting information" are those characteristics which contribute to the quality or value of the information. The overriding qualitative characteristic of accounting infor-mation is usefulness for decision making.

4. Briefly describe the two fundamental qualities of useful accounting information.

4. Relevance and faithful representation are the two primary qualities of useful accounting information. For information to be relevant, it should should be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations. Faithful representation of a measure rests on whether the numbers and descriptions match what really existed or happened.

5. How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and mea-sures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement?

5. The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation. An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items. The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital. The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The auditor will note the effects of misstatements on key ratios such as gross profit, the current ratio, or the debt/equity ratio and will consider such special circumstances as the effects on debt agreement covenants and the legality of dividend payments. There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% to 20% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income.

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

6. Enhancing qualities are qualitative characteristics that are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from less-useful information. Enhancing characteristics are comparability, verifiability, timeliness, and understandability.

7. 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.

7. In providing information to users of financial statements, the Board relies on general-purpose financial statements. The intent of such statements is to provide the most useful information possible at minimal cost to various user groups. Underlying these objectives is the notion that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that in the preparation of financial statements a level of reasonable competence can be assumed; this has an impact on the way and the extent to which information is reported.

8. What is the distinction between comparability and consistency?

8. Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency, a type of comparability, facilitates comparisons between information about the same enterprise at two different points in time.

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

9. At present, the accounting literature contains many terms that have peculiar and specific meanings. Some of these terms have been in use for a long period of time, and their meanings have changed over time. Since the elements of financial statements are the building blocks with which the statements are constructed, it is necessary to develop a basic definitional framework for them.

(e) Identify the conditions under which it would be appropriate to treat a cost as a loss

A cost should be treated as a loss when no revenue results. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses result from events that are not anticipated as necessary in the process of producing revenue. There is no simple way of identifying a loss because ascertaining whether a cost should be a loss is often a matter of judgment. The accounting distinction between an asset, expense, loss, and prior period adjustment is not clear-cut. For example, an expense is usually voluntary, planned, and expected as necessary in the generation of revenue. But a loss is a measure of the service potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecur-ring and is usually not taken into direct consideration in planning the size of the revenue stream.

30. The treasurer of Landowska Co. has heard that conservatism is a doctrine that is followed in accounting and, therefore, proposes that several policies be followed that are conservative in nature. State your opinion with respect to each of the policies listed. (a) The company gives a 2-year warranty to its customers on all products sold. The estimated warranty costs incurred from this year's sales should be entered as an expense this year instead of an expense in the period in the future when the warranty is made good. (b) When sales are made on account, there is always uncertainty about whether the accounts are collectible. Therefore, the treasurer recommends recording the sale when the cash is received from the customers. (c) A personal liability lawsuit is pending against the company. The treasurer believes there is an even chance that the company will lose the suit and have to pay damages of $200,000 to $300,000. The treasurer recommends that a loss be recorded and a liability created in the amount of $300,000.

In general, conservatism should not be the basis for determining the accounting for transactions. (a) Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can be estimated accurately, they should be matched against the related sales revenue. (b) Not acceptable. Most accounts are collectible or the company will be out of business very soon. Hence sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Landowska Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts. (c) Not acceptable. A provision for the possible loss can be made through an appropriation of retained earnings but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB ASC 450-10-05 for additional discussion if desired.) Note disclosure is required if the loss is not recorded; however, conservatism is not part of the conceptual framework

Vande Velde Company made three investments during 2014. (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?

Investment 1—Level 3 Investment 2—Level 1 Investment 3—Level 2

BE2-7 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.

Periodicity

(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.

Some costs are assigned as expenses to the current accounting period because (1) their incurrence during the period provides no discernible future benefits; (2) they are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; (3) they must be incurred each accounting year, and no build-up of expected future benefits occurs; (4) by their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; (5) the amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; (6) and uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose. Thus, many costs are called "period costs" and are treated as expenses in the period incurred because they have neither a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers' salaries, advertising, research and development, and auditors' fees.

(a) Explain the rationale for recognizing costs as expenses at the time of product sale.

Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This presumed direct association has been identified both as "associating cause and effect" and as "matching (expense recognition principle)." Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognizing them as expenses accompanies recognition of the revenue. Generally, the expense recognition principle requires that the revenue recognized and the expenses incurred to produce the revenue be given concurrent periodic recog-nition in the accounting records. Only if effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the expense recognition principle is a recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided

18. Briefly describe the fair value hierarchy (3)

The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels. Fair Value Hierarchy Level 1: Observable inputs that reflect quoted prices for Least Subjective identical assets or liabilities in active markets. (LEAST subjective) Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company's own data or assumptions). (MOST Subjective) As indicated, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. At the least-reliable level, Level 3, much judgment is needed based on the best information available to arrive at a relevant and reliable fair value measurement.

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

The five steps in the revenue recognition process are: Step 1 Identify the contract(s) with the customer. A contract is an agreement between two parties that creates enforceable rights or obligations. Step 2 Identify the separate performance obligations in the contract. A performance obligation is ether a promise to provide a service or deliver a product, or both. Step 3. Determine the transaction price. Transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service. Step 4. Allocate the transaction price to separate performance obligations. This is usually done by estimating the value of consideration attributable to each product or service. Step 5. Recognize revenue when each performance obligation is satisfied. This occurs when the service is provided or the product is delivered. Note that many revenue transactions pose few problems because the transaction is initiated and completed at the same time.

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

The four basic assumptions that underlie the financial accounting structure are: (1) An economic entity assumption. (2) A going concern assumption. (3) A monetary unit assumption. (4) A periodicity assumption.

25. 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?

The four characteristics are: (1) Definitions—The item meets the definition of an element of financial statements. (2) Measurability—It has a relevant attribute measurable with sufficient reliability. (3) Relevance—The information is capable of making a difference in user decisions. (4) Reliability—The information is representationally faithful, verifiable, and neutral.

14. 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?

The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so that dollars of different years can be added without any adjustment. When the value of the dollar fluctuates greatly over time, the monetary unit assumption loses its validity. The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be used to measure items recognized in financial statements. Only if circumstances change dramatically will the Board consider a more stable measurement unit.

(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?

a - comparability b - confirmatory value c - comparability (consistency) d - neutrality e - verifiability f - relevance g - comparability, verifiability, timeliness, and understandability h - materiality i - relevance and faithful representation j - relevance and faithful representation k - timeliness

Select the assumption, principle, or constraint that most appropriately justifies these procedures and practices. (Do not use qualitative characteristics.) (a) Fair value changes are not recognized in the accounting records. (b) Financial information is presented so that investors will not be misled. (c) Intangible assets are capitalized and amortized over periods benefited. (d) Repair tools are expensed when purchased. (e) Agricultural companies use fair value for purposes of valuing crops. (f) Each enterprise is kept as a unit distinct from its owner or owners. (g) All significant post-balance-sheet events are reported. (h) Revenue is recorded at point of sale. (i) All important aspects of bond indentures are presented in financial statements. (j) Rationale for accrual accounting. (k) The use of consolidated statements is justified. (l) Reporting must be done at defined time intervals. (m) An allowance for doubtful accounts is established. (n) Goodwill is recorded only at time of purchase. (o) A company charges its sales commission costs to expense

a - measurement (historical cost) principle b - full disclosure principle c - expense recognition principle d - materiality e- measurement (fair value) principle f - economic entity assumption g - full disclosure principle h- revenue recognition principle i- full disclosure principle j- expense recognition and revenue recognition principles k- economic entity assumption l- periodicity assumption m- measurement (fair value) principle n- measurement (historical cost) principle o- expense recognition principle

Kieso Chapter 2 Intermediate Accounting Chapter-End ANSWERS

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