Accounting Chapter 2 Not Until This Obligation Fulfilled Should The

EXERCISE 2.9 (Continued)

(d) At the present time, accountants generally do not recognize price-

level adjustments in the accounts. Hence, it is misleading to deviate

(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 historical cost principle, which would be of

(f) The historical cost principle indicates that assets and liabilities are

recorded at cost. If we were to select current value, for example, we

would have an extremely difficult time in attempting to establish a

EXERCISE 2.10

(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

EXERCISE 2.10 (Continued)

(c) Assets should be recorded at the fair value of what is given up or the

fair value of what is received, whichever is more clearly evident. It

(d) The gain should be recognized at the point of sale. Deferral of the

gain should not be permitted. Revenue should be recognized when

the performance obligation has been satisfied (when the equipment is

delivered to the customer).

TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS

CA 2.1 (Time 20–25 minutes)

Purpose—to provide the student with the opportunity to comment on the purpose of the conceptual

framework.

CA 2.2 (Time 25–35 minutes)

CA 2.3 (Time 25–35 minutes)

CA 2.4 (Time 30–35 minutes)

CA 2.5 (Time 25–30 minutes)

CA 2.6 (Time 20–25 minutes)

Purpose—to provide the student with an opportunity to assess different points to report costs as

expenses. Direct cause and effect, indirect cause and effect, and rational and systematic approaches

are developed.

CA 2.7 (Time 20–30 minutes)

CA 2.8 (Time 20–30 minutes)

CA 2.9 (Time 20–25 minutes)

CA 2.10 (Time 30–35 minutes)

Purpose—to provide the student with the opportunity to discuss the cost constraint.

SOLUTIONS TO CONCEPTS FOR ANALYSIS

CA 2.1

(a) A conceptual framework establishes the concepts that underlie financial reporting. A conceptual

framework is a coherent system of concepts that flow from an objective. The objective identifies

the future.

(b) Specific benefits that may arise are:

(1) A coherent set of standards and rules should result.

CA 2.2

(a) The Conceptual Framework should provide benefits to the accounting community such as:

(1) A coherent set of standards and rules should result.

(b) The Conceptual Framework identifies the most important quality for accounting information as

usefulness for decision making. Relevance and faithful representation are the fundamental qualities

Fundamental Qualities

Relevance To be relevant, accounting information must be capable of making a difference in a

decision. Information with no bearing on a decision is irrelevant. Financial information is capable of

making a difference when it has predictive value, confirmatory value, or both.

Faithful Representation For accounting information to be useful, it must be a faithful represen-

CA 2.2 (Continued)

Enhancing Qualities

Comparability. Information that is measured and reported in a similar manner for different

companies is considered comparable. Comparability enables users to identify the real similarities

Verifiability. Occurs when independent measurers, using the same methods obtain similar results.

Timeliness. Timeliness means having information available to decision makers before it loses its

capacity to influence decisions. Having relevant information available sooner can enhance its

capacity to influence decisions, and a lack of timeliness can rob information of its usefulness.

CA 2.3

(a) The objective of general purpose financial reporting is to provide financial information about the

reporting entity that is useful to present and potential equity investors, lenders, and other

(b) The purpose of the Conceptual Framework is to set forth fundamentals on which financial

accounting and reporting standards may be based. Without an objective 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

CA 2.4

(a) (1) Relevance is one of the two fundamental 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.

(2) Faithful representation is one of the two fundamental decision-specific characteristics of

(3) Understandability is an enhancing characteristic of information. Information is understandable

(4) Comparability means that information about companies has been prepared and presented in a

(5) Neutrality means that a company cannot select information to favor one set of parties over

another. Reporting unbiased information must be the overriding consideration. If financial

reporting is biased, financial reports will lose their credibility.

(b) (Note to instructor: There are a multitude of answers possible here. The suggestions below are

intended to serve as examples.)

(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 representationally faithful as historical

cost information about past transactions.

CA 2.5

(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

advertising.

CA 2.5 (Continued)

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

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.

(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

(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

(Note to instructor: CA 2.5 might also be assigned in conjunction with Chapter 18.)

CA 2.6

(a) Some costs are recognized as expenses on the basis of a presumed direct association with

specific revenue. This presumed direct association has been identified as the expense recognition

principle, or in this case as “associating cause and effect” (“matching concept.”)

Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs

(b) Some costs are assigned as expenses to the current accounting period because their incurrence

during the period provides no discernible future benefits and uncertainty exists regarding whether

allocating them to current and future periods will serve any useful purpose. Thus, many costs are

(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

(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

CA 2.6 (Continued)

(e) 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

CA 2.7

(a) The preferable treatment of the costs of the sample display houses is expensing them over

more than one period. These sample display houses are assets because they represent rights to

future service potentials or economic benefits. According to the expense recognition principle, the

costs of service potentials should be amortized as the benefits are received. Thus, costs of the

sample display houses should be matched with the revenue from the sale of the houses which is

receivable over a period of more than one year. As the sample houses are left on display for three

(b) If all of the shell houses are to be sold at the same price, it may be appropriate to allocate the

costs of the display houses on the basis of the number of shell houses sold. This allocation would

be similar to the units-of-production method of depreciation and would result in a good matching of

costs with revenues. On the other hand, if the shell houses are to be sold at different prices, it may

be preferable to allocate costs on the basis of the revenue contribution of the shell houses sold.

CA 2.8

Date

Dear Uncle Carlos,

I received the information on Neville Corp. and appreciate your interest in sharing this venture with me.

However, I think that basing an investment decision on these financial statements would be unwise

because they are neither relevant nor a faithful representation.

One of the most important characteristics of accounting information is that it is relevant, i.e., it will make

a difference in my decision. To be relevant, this information must have predictive value, confirmatory

value, or both. Being timely is also important. Because Neville’s financial statements are a year old,

I do appreciate the trouble you went through to get me this information. Under the circumstances,

however, I do not wish to invest in the Neville bonds and would caution you against doing so. Before

you make a decision in this matter, please call me.

Sincerely,

CA 2.9

(a) The stakeholders are investors, creditors, etc.; i.e., users of financial statements, current and future.

(b) Honesty and integrity of financial reporting, job protection, profit.

CA 2.10

1. Information about competitors might be useful for benchmarking the company’s results but if

management does have expertise in providing the information, it could lack reliability. In addition, it is

likely very costly for management to gather sufficiently reliable information of this nature.

2. While users of financial statements might benefit from receiving internal information, such as

company plans and budgets, competitors might also be able to use this information to gain a

competitive advantage relative to the disclosing company.

4. It would be excessively costly for companies to gather and report information that is not used in

managing the business.