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P1-6. Relevance versus faithful representation (LO 1-1)
Requirement 1:
The Blue Book average price is more relevant to the car buying
decision than is the list (or fisticker”) price shown on the
manufacturer’s web site. Why? Because it better represents the
price you can expect to pay for the automobile.
The Blue Book price describes the average price actually paid by
recent buyers for comparably equipped automobiles. Actual prices
are the result of arms-length negotiations between willing buyers
Requirement 2:
The Blue Book price of $19,500 is less representationally faithful
than the manufacturer’s list price. To understand why, notice that
recent selling prices have ranged from $18,000 to $22,000. This
In this setting, reliability refers to price variation and there is more
P1-7. Accounting Information Characteristics (LO 1-1)
Requirement 1:
fiCash” and fiNet accounts receivable” are both relevant to the loan
decision because they provide information about cash flows and
thus about the company’s ability to make principal and interest
Requirement 2:
fiCash” is the most representationally faithful balance sheet item.
The amount of cash on hand and in the bank at a particular moment
in time can be determined with a high degree of accuracy. fiNet
accounts receivable” is less so because its determination requires
P1-8. Accounting Conservatism (LO 1-1)
Requirement 1:
Accounting conservatism requires that the land now be shown on
the balance sheet at the lower amount $3 million, its estimated fair
Requirement 2:
Accounting conservatism requires that the land continue to be
shown on the balance sheet at the price paid two months ago ($3
million) rather than the higher estimated fair value ($5 million).
P1-9. Factors Affecting Financial Reporting (LO 1-2, LO 1-3, LO 1-4)
1) Accounting is not an exact science. One reason this is the case
is that many financial statement numbers are based on estimates of
future conditions (e.g., future bad debts and warranty claims).
2) While some managers may select accounting methods that
produce the most accurate picture of a company’s performance and
condition, other managers may make financial reporting decisions
that are self-serving and strategic. Consider the following examples:
Managers who receive a bonus based on reported earnings or
return on equity may make financial reporting decisions that
Managers who must adhere to limits on financial accounting
More generally, managers are likely to make financial reporting
decisions that portray them in a good light.
The moral is that financial analysts should approach financial
3) This is probably true. Financial accounting is a slave to many
masters. Many different constituencies have a stake in financial
accounting and reporting practices—existing shareholders,
prospective shareholders, financial analysts, managers, employees,
4) This is false. Even without mandatory disclosure rules by the
FASB and SEC, companies have incentives to voluntarily disclose
5) This is true. If the information is value-relevant—meaning,
important for investors to know—there is no obvious reason not to
6) The best response is that the statement is false because:
Managers have incentives to develop and maintain a good
relationship with financial analysts. Failing to disclose
Under the U.S. securities laws, shareholders can sue managers
for failing to disclose material financial information on a timely
7) This may be true or false. If a company discloses so little
information that investors and lenders cannot adequately assess the
expected return and risk of its securities, then its cost of capital will
P1-10. Economic Consequences of Accounting Standards (LO 1-3)
Requirement 1:
There are several economic consequences that could arise when
companies are forced to alter their past accounting methods—in this
case, by recording a new liability and corresponding expense.
Mandatory changes in accounting methods of this sort can disrupt
contracts that are defined in terms of accounting ratios. One
example is a loan agreement that restricts the firm from exceeding
In response to the possibility of violating the loan agreement,
management may decide to sell some otherwise productive assets.
The cash raised could then be used to pay down debt, and the
And, as described in requirement 2, management may decide to
reduce or curtail employee healthcare benefits so that the recorded
Requirement 2:
There are widely divergent views on whether the FASB should
consider the economic consequences of its actions when
formulating accounting standards.
On the one hand, SFAC No. 2 states that fineutrality” is a desired
characteristic of financial statement information. Neutrality means
that the information cannot be selected to favor one set of interested
A more practical problem is that it is exceedingly difficult to quantify
those consequences in any meaningful way. How can the FASB
determine which firms will likely violate their lending agreements or
what it will cost them if they do so? And what about the economic
Of course, the interested parties themselves fervently believe the
FASB should consider the economic consequences of alternative
P1-11. Two Sets of Books (LO 1-1)
Requirement 1:
Companies maintain a set of fitax” books to properly compute
taxable income according to IRS rules. Companies maintain a set of
Requirement 2:
There are several reasons why it might not be a good idea to force
companies to issue the same financial statements for both IRS and
SEC purposes. For instance:
The two regulatory agencies have entirely different financial
reporting goals. The IRS is concerned with the timely collection
of tax revenues in accordance with federal income tax law. The
IRS rules for computing taxable income are determined by tax
laws intended to achieve a variety of social purposes. The
Political compromises have a substantial impact on tax law, and
thus on IRS accounting. Requiring IRS and SEC conformity (i.e.,
P1-12. Accounting quality and the audit committee (LO 1-4)
1) By identifying the key business and financial risks facing the
company, the audit committee can ensure that those risks are
properly disclosed in the MD&A (Management Discussion &
2) By identifying areas where subjective judgments and estimates
are used, the audit committee can probe management about the
fiquality” (objectivity and accuracy) of the estimates, benchmark to
estimates of other firms, and gauge the impact of estimate changes
The answers to this question—how are those judgments made and
estimates determined—are important for the reasons outlined
3) By identifying significant areas where the company’s accounting
policies were difficult to determine, the audit committee can probe
management about its choice of accounting methods in situations
4) Significant accounting deviations from usual industry practice are
a fired flag” for stock analysts and investors. That’s because the
deviation is often viewed as an indication that the financial
5) Changes in accounting methods can sometimes have a dramatic
impact on financial statements and on the company’s stock price if
investors react negatively to the change. The audit committee will
6) Here the audit committee is asking for a fiheads up” about
potential changes in accounting practices—both those required by
7) fiSerious problems” can include internal control lapses,
incomplete documentation of transactions, errors (inadvertent failure
to record a transaction), and accounting fiirregularities” (intentionally
booking revenue earlier than GAAP allows). The audit committee is
8) There are two reasons the audit committee is interested in the
answer to this question. First, outsiders may have uncovered a real
accounting quality threat that is as yet unknown to the committee.
9) The answers to this question can also uncover areas where
accounting quality can be threatened. The committee will want to
P1-13. Worldwide Convergence of Accounting Standards (LO 1-6)
Requirement 1:
There are at least two arguments supporting worldwide
convergence of accounting standards. These arguments involve
One argument for a common set of accounting standards is the
global convergence of financial markets themselves. Foreign
stocks and foreign investors make up an increasing fraction of the
trading activity on most major stock exchanges today. A single set
A second—and more controversial—argument is based on the
notion that IASB standards are superior to those in use locally.
According to this view, worldwide convergence eliminates local
As this chapter has stressed, the economics of accounting standard
setting involves complicated cost and benefit tradeoffs. So, an
obvious potential disadvantage of worldwide convergence is that,
for many individual firms, the cost of convergence may exceed the
benefits obtained. This might be especially true for small, publicly
Requirement 2:
According to Mr. Tweedie’s remarks, convergence will likely
increase investor confidence in China’s capital markets and
financial reports. This benefits the Chinese investor who buys
Requirement 3:
U.S. investors benefit in several ways. First, the cost of processing
financial statement information about Chinese companies is
reduced because U.S. investors would no longer need to be
knowledgeable in both local and global GAAP (enhanced
