978-1259722653 Chapter 1 Solution Manual Part 2

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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