Chapter 2 The Amount The Contract Price Recognized Should

2-12

C2-9

Accounting information is relevant if it can make a difference in a decision by helping

users predict the outcomes of past, present, and future events or confirm or correct prior

expectations. To be relevant, accounting information must be timely and must possess

Accounting information is reliable if it is reasonably free from error and bias and faithfully

represents what it purports to represent. Information is reliable when it has

representational faithfulness and is verifiable and neutral. Representational faithfulness is

the degree of correspondence between the reported accounting measurements or

descriptions and the economic resources and obligations and the transactions and events

C2-10 (AICPA adapted solution)

STATEMENT 1

2. Accounting is a service activity that provides quantitative financial information for making

economic decisions. One area of accounting, called managerial accounting, is

concerned primarily with providing quantitative information to management. Another

C2-10 (continued)

STATEMENT 2

1. Fallacy: That financial statements prepared with due regard for the conservatism

convention can be free from bias with respect to continuing, prospective, and retiring

2. The conventional definition of conservatism, “to anticipate all possible losses but no

possible gains,” tends to result in the reported income and net assets of a company being

(2) sell at a price that is less than would otherwise be the case.

Freedom from bias is often advanced as a desirable standard or ideal for accounting

information; this probably is unattainable with respect to general-purpose financial

C2-11 (AICPA adapted solution)

1. a. The conventional or traditional approach has been to define the accounting entity in

terms of a specific company or enterprise unit that is separate and apart from the

owner or owners and from other companies having separate legal and accounting

frames of reference. For example, partnerships and sole proprietorships are

C2-11 (continued)

1. a. (continued)

An alternative approach is to define the accounting entity in terms of an area of

b. The accounting-entity concept defines the area of interest and thus narrows the

range and establishes the boundaries of the possible objects, activities, or attributes

2. a. Yes, units created by or under law would include corporations, partnerships, and,

occasionally, sole proprietorships. Thus, legal units probably are the most common

types of accounting entities.

d. Yes, although the accounting entity often is defined in terms of a company that is

separate and distinct from other activities of the owner or owners, it is also possible for

an accounting entity to embrace all of the activities of an owner or a group of

owners. Examples include financial statements for an individual (personal financial

statements) and the financial report of a person’s estate.

C2-11 (continued)

2. (continued)

C2-12 (AICPA adapted solution)

Note to Instructor: Parts of this case may be slightly advanced for students at this point but

are included to stimulate discussion.

1. The point of sale is the most widely used basis for the timing of revenue recognition

because, in most cases, it provides the degree of verifiable evidence accountants

consider necessary for reliable measurement of periodic business income. In other words,

2. a. Although it is recognized that revenue is earned throughout the entire production

process, generally it is not feasible to measure revenue on the basis of operating

activity because of the absence of suitable criteria for consistently and objectively

b. To criticize the sale basis as not being sufficiently conservative because accounts

receivable do not represent disposable funds, it is necessary to assume that the

collection of receivables is the decisive step in the earning process and that periodic

C2-12 (continued)

2. b. (continued)

3. a. During production: This basis of recognizing revenue is frequently used by companies

whose major source of revenue is long-term construction projects. For these

companies, the point of sale is far less significant to the earning process than is

production activity because the sale is assured under the contract, except, of

course, where performance is not substantially in accordance with the contract

terms.

b. When cash is received: The most common application of this timing of revenue

recognition is in connection with installment sales contracts. Its use is justified on the

grounds that, due to the length of the collection period, increased risks of default,

and higher collection costs, there is too much uncertainty to warrant the recognition

of revenue until cash is actually received.

C2-13 (AICPA adapted solution)

1. Accrual accounting recognizes and reports the effects of transactions and other events

on the assets and liabilities of a company in the time periods to which they relate rather

than only when cash is received or paid. Accrual accounting attempts to match

revenues and the expenses associated with those revenues in order to determine net

income for an accounting period. Revenues are recognized and recorded when earned.

Expenses are recognized and recorded as follows:

• Associating Cause and Effect. Some expenses are recognized and recorded on a

presumed direct association with specific revenue.

An accrual represents a transaction that affects the determination of income for the

period but has not yet been reflected in the cash accounts of that period. Accrued

revenue is revenue earned but not yet collected in cash. An example of accrued

A deferral represents a transaction that has been reflected in the cash accounts of the

period but has not yet affected the determination of income for that period. Deferred

2. In cash accounting, the effects of transactions and other events on the assets and

liabilities of a company are recognized and reported only when cash is received or paid;

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C2-14

Note to Instructor: These answers are based on what students would be expected to

understand from the discussion of the revenue recognition methods presented in the

chapter. If desired, more comprehensive class discussion may be directed at matching

expenses against these revenues.

A. Company A should recognize revenue under the percentage of completion method

during production based upon the percentage of the highway completed each period.

C2-15

A. Violation of the matching principle; cost of goods sold should be matched against the

revenues when the goods are sold, not purchased.

B. Violation of the historical cost principle; the historical cost (exchange price) should be

retained in the accounting records until the economic resources have been consumed,

sold, or liquidated.

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C2-16 (CMA adapted)

1. The FASB’s conceptual framework study should provide benefits to the accounting

community such as

2. Statement of Financial Accounting Standards No. 2 identifies the most important quality

for accounting information as usefulness for decision-making. Relevance and reliability

3. A number of key characteristics of qualities that make accounting information desirable

are described in the Statement of Financial Accounting Concepts No. 2. The importance

of three of these characteristics or qualities are discussed below.

• Understandability — information provided by financial reporting should be

comprehensible to those who have a reasonable understanding of business and

economic activities and are willing to study the information with reasonable

C2-17

The objective of general purpose external financial reporting is to provide financial

information about a company (including the entities under its control) that is useful to

external users in making decisions in their capacity as capital providers. The primary user

C2-17 (continued)

Faithful representation of economic phenomena occurs when the related information is

complete, neutral, and free from material error. Completeness means including all

information necessary for faithful representation in financial reporting. Neutral means that

there is an absence of bias to attain a predetermined result or induce a particular

behavior. Free from material error means that the information (including estimates)

presented is as accurate as possible, reflecting the best available inputs.

C2-18

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

issues are raised for discussion purposes.

From a financial reporting perspective, Watson Company is not following GAAP because it

recognizes revenues as cash is collected and expenses as cash is paid. This is called cash-

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C2-18 (continued)

From an ethical perspective, the issue is whether cash basis accounting responds to the

rights of, and is fair to, all the stakeholders. In this situation, the primary stakeholders are

the stockholders, creditors, and Chris. It can be argued that cash basis accounting does