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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.
