EXERCISE 2-9 (Continued)
(d) At the present time, accountants do not recognize price-level adjust-
ments in the accounts. Hence, it is misleading to deviate from the
historical cost principle because conjecture or opinion can take place.
It should also be noted that depreciation is not so much a matter of
information).
(e) Most accounting methods are based on the assumption that the busi–
ness enterprise will have a long life. Acceptance of this assumption
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,
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EXERCISE 2-10 (Continued)
(c) Assets should be recorded at the fair market 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
historical cost principle to use the fair market value of the stock.
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. In addition, a discussion of the Concepts Statements issued by the FASB is required.
CA 2-2 (Time 25–35 minutes)
Purpose—to provide the student with the opportunity to identify and discuss the benefits of the con–
ceptual framework. In addition, the most important quality of information must be discussed, as well as
other key characteristics of accounting information.
CA 2-3 (Time 25–35 minutes)
Purpose—to provide the student with some familiarity with the Conceptual Framework. The student is
asked to indicate the broad objectives of accounting, and to discuss how this statement might help to
establish accounting standards.
CA 2-4 (Time 30–35 minutes)
Purpose—to provide the student with some familiarity with the Conceptual Framework. The student is
asked to describe various characteristics of useful accounting information and to identify possible trade-
offs among these characteristics.
CA 2-5 (Time 25–30 minutes)
Purpose—to provide the student with the opportunity to indicate and discuss different points at which
revenues can be recognized. The student is asked to discuss the “crucial event” that triggers revenue
recognition.
CA 2-6 (Time 30–35 minutes)
Purpose—to provide the student with familiarity with an economic concept of income as opposed to the
GAAP approach. Also, factors to be considered in determining when net revenue should be recognized
are emphasized.
CA 2-7 (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 2-8 (Time 20–25 minutes)
Purpose—to provide the student with familiarity with the expense recognition principle in accounting.
Specific items are then presented to indicate how these items might be reported using the expense
recognition principle.
CA 2-9 (Time 20–30 minutes)
Purpose—to provide the student with a realistic case involving association of costs with revenues. The
advantages of expensing costs as incurred versus spreading costs are examined. Specific guidance is
asked on how allocation over time should be reported.
CA 2-10 (Time 20–30 minutes)
Purpose—to provide the student with the opportunity to discuss the relevance and faithful
representation of financial statement information. The student must write a letter on this matter so the
case does provide a good writing exercise for the students.
CA 2-11 (Time 20–25 minutes)
Purpose—to provide the student with the opportunity to discuss the ethical issues related to expense
recognition.
CA 2-12 (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 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.
(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:
CA 2-2
(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.
CA 2-2 (Continued)
(b) The most important quality for accounting information as 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.
CA 2-3
(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.
CA 2-4
(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.
(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 free from error as historical cost
CA 2-5
(a) The various accepted times of recognizing revenue in the accounts are as follows:
(1) Time of sale. This time is currently acceptable when the costs and expenses related to the
particular transaction are reasonably determinable at the time of sale and when the collection
of the sales price is reasonably certain.
CA 2-5 (Continued)
(b) (1) The “crucial event”–that is, the most difficult task in the cycle of a complete transaction–in the
process of earning revenue may or may not coincide with the rendering of service to the
subscriber. The new director suggests that they do not coincide 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 to
fill the subscriptions or to carry the advertising.
(2) 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 pro–
cess of earning revenue, the firm could not prosper without magazine sales and the advertising
that results from paid circulation. Hence, some revenue should be recognized in the accounts
at the time of the subscription sale.
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CA 2-5 (Continued)
(3) 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
CA 2-6
(a) The economist views business income in terms of wealth of the entity as a whole resulting from an
accretion attributable to the whole process of business activity. The accountant must measure the
“wealth” of the entity in terms of its component parts, that is, individual assets and liabilities. The
(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.
In the context of revenue recognition, recognition involves consideration of two factors, (a) being
realized or realizable and (b) being earned, with sometimes one and sometimes the other being
the more important consideration.
CA 2-6 (Continued)
(c) No. The factor apparently relied upon by Lopez Associates is that revenue is recognized as the
services giving rise to it are performed. The firm has completed the construction of the building,
obtained financing for the project, and secured tenants for most of the space. Management of the
CA 2-7
(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 both as “associating cause
and effect” and as “matching (expense recognition principle).”
(b) 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;
CA 2-7 (Continued)
(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.
CA 2-8
(a) Costs should be recognized as expiring in a given period if they are not chargeable to a prior
period and are not applicable to future periods. Recognition in the current period is required when
any of the following conditions or criteria are present:
(1) A direct identification of association of charges with revenue of the period, such as goods
CA 2-8 (Continued)
(b) (1) Although it is generally agreed that inventory costs should include all costs attributable to placing
the goods in a salable state, receiving and handling costs are often treated as cost expirations in
the period incurred because they are irregular or are not in uniform proportion to sales.
(2) Cash discounts on purchases are treated as “other revenues” in some financial statements in
violation of the expense recognition principles (or matching). Revenue is not recognized when
goods are purchased or cash disbursed. Furthermore, inventories valued at gross invoice price
are recorded at an amount greater than their cash outlay resulting in misstatement of inventory
cost in the current period and inventory cost expirations in future periods.
CA 2-9
(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.
There is uncertainty not only as to the life of a sample display house but also as to whether a
sample display house will be torn down or altered. If it is altered rather than torn down, a portion of
the cost of the original house may be attributable to the new model.
2-32
CA 2-9 (Continued)
There is uncertainty regarding the number of homes of a particular model which will be sold as a
result of the display sample. The success of this amortization method is dependent upon accurate
CA 2-10
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 reliable.
These financial statements are also not representationally faithful. In order to be representationally
faithful, their assertions must be verifiable by several independent parties. Because no independent
auditor has verified these amounts, there is no way of knowing whether or not they are represented
faithfully. For instance, I would like to believe that this company earned $2,424,240, and that it had a
very favorable debt-to-equity ratio. However, unaudited financial statements do not give me any
reasonable assurance about these claims.
CA 2-11
(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 2-12
1. Information about competitors might be useful for benchmarking the company’s results but if
management does not have expertise in providing the information, it could be highly subjective. In
addition, it is likely very costly for management to gather sufficiently verifiable information of this
nature.
4. It would be excessively costly for companies to gather and report information that is not used in
managing the business.
5. Flexible reporting allows companies to “fine–tune” their financial reporting to meet the information
needs of its varied users. In this way, they can avoid the cost of providing information that is not
demanded by its users.
2-34
FINANCIAL REPORTING PROBLEM
(a) From Note 1. Revenue Recognition—Sales are recognized when revenue
is realized or realizable and has been earned. Most revenue transactions
represent sales of inventory. The revenue recorded is presented net of
sales and other taxes we collect on behalf of governmental authorities
and includes shipping and handling costs, which generally are included
(b) Most of the information presented in P&G’s financial statements is
reported on an historical cost basis. Examples are: Property, Plant,
and Equipment, Inventories (which is not in excess of market),
Goodwill, and Intangible Assets. Regarding the use of fair value, all of
the company’s marketable investments are reported at fair value
(quoted market prices). In addition, the fair value of the company’s
financial instruments and the fair value of pension assets are disclosed.
FINANCIAL REPORTING PROBLEM (Continued)
COMPARATIVE ANALYSIS CASE
(a) Coca-Cola indicates its business is nonalcoholic beverages, principally
soft drinks, but also a variety of noncarbonated beverages. It notes
that it is the world’s largest manufacturer, distributor, and marketer of
concentrates and syrups to produce nonalcoholic beverages. In its
PepsiCo views itself as a leading global snack and beverage company.
It manufactures manufacture or use contract manufacturers, market
and sell a variety of salty, convenient, sweet and grain-based snacks,
carbonated and non-carbonated beverages, and foods. It is organized
in three business units:
(b) Coca–Cola’s net operating revenues for 2009 was $30,990 million which
was comprised principally of beverage sales. PepsiCo reported net sales
of $43,232 million of which soft drinks is an estimated $22,546 ($10,116 +
$6,727 + $5,703) million. The remainder is related to sales in the Frito–
Lay and Quaker Foods segments. Based on these amounts, Coca–
Cola has the dominant position in beverage sales.