Solution manual intermediate accounting 9e by nicolai

Q1-5 The three major financial statements of a company and what they summarize are: 1 the balance sheet or statement of financial position which summarizes the company's financial positi

CHAPTER 1

THE ENVIRONMENT OF FINANCIAL REPORTING

CONTENT ANALYSIS OF CASES

C1-1 Pronouncements Matching a list of descriptive statements

with a list of pronouncements establishing or related to generally accepted accounting principles

5-10

C1-2 Accounting Organizations Matching of a list of descriptive

statements with a list of abbreviations of accounting organizations Identify complete name of each organization

10-15

C1-3 History of Establishment of GAAP Discuss CAP, APB, FASB, and

related pronouncements

15-30

C1-4 (AICPA adapted) Accounting Principles Define accounting

principles Discuss sources of GAAP

10-20

C1-5 (CMA adapted) Standard Setting Describe why there is

political action and social involvement in the standard setting process

10-20

C1-6 Organization of the FASB Summarize the structure of the FASB,

its documents (GAAP pronouncements), and its operating procedures

10-20

C1-7 GAAP and the AICPA Summarize the GAAP-related

C1-8 Code of Professional Conduct Identify, briefly discuss, and

provide examples to illustrate the first five principles of CPC 10-20 C1-9 GAAP Hierarchy Define GAAP, indicate where to find GAAP,

and identify which GAAP are more important (hierarchy) 10-20 C1-10 Lobbying the FASB Discuss pros and cons of lobbying FASB by

C1-11 Ethical Dilemma Discuss steps to take in an ethical dilemma

("misplaced" book in library)

10-20

C1-12 Ethical Responsibilities Discuss steps to take in an ethical

dilemma (cheating by friend on exam)

10-20

ANSWERS TO QUESTIONS

Q1-1 Primary markets are those capital markets where the exchanges of stocks and bonds

are directly between a corporation and investors Secondary markets are those where the exchanges are among the investors themselves

Q1-2 The decision makers, or the users of financial information, can be divided into two

major categories: external users and internal users These two groups have

somewhat different decision making information needs because of their differing relationships with the company providing economic information External users need information for three basic decisions whether to buy, to hold, or to sell (or in the case

of creditors, whether to extend credit, maintain the credit relationship, or not extend credit) These users rely mainly on financial statements in their decision processes Internal users (i.e., a company's management) need information to make operating decisions and may request any type of information they need which the accounting system is capable of providing

Q1-3 Financial accounting is the information accumulation, processing, and

communication system designed to satisfy the investment and credit

decision-making information needs of external users of accounting information Financial accounting information is communicated through published financial statements, and is constrained by the pronouncements of several policy-making groups

Managerial accounting is the information accumulation, processing, and

communication system designed to meet the decision-making information needs of internal users Managerial accounting information is communicated via internal company reports and is not subject to the policy standards that apply to externally communicated information It is constrained by the usefulness of the information provided for a specific decision and the cost of providing that information

Q1-4 Financial reporting is the process of communicating financial accounting information

about a company to external users The primary way a company's financial

accounting information is reported is in its annual report

Q1-5 The three major financial statements of a company and what they summarize are:

(1) the balance sheet (or statement of financial position) which summarizes the company's financial position at a given date, (2) the income statement which

summarizes the results of the company's income-producing activities for a period of time, and (3) the statement of cash flows which summarizes the cash inflows and cash outflows for a period of time Many companies also present the statement of changes in stockholders' equity, which summarizes the changes in each item of stockholders' equity for a period of time, as a fourth major financial statement Q1-6 Generally accepted accounting principles (GAAP) are the guidelines, procedures,

and practices that a company is required to use in recording and reporting the accounting information in its audited financial statements The four accounting bodies that have established generally accepted accounting principles are the Financial Accounting Standards Board (FASB), Accounting Principles Board (APB), American Institute of Certified Public Accountants (AICPA), and Securities and Exchange Commission (SEC)

Q1-7 There are five categories of GAAP in the hierarchy of generally accepted

accounting principles The pronouncements included in Category A are FASB

Statements of Financial Accounting Standards and Interpretations, APB Opinions, and AICPA Accounting Research Bulletins (as well as SEC Regulation S-X and

Financial Reporting Releases for companies that file with the SEC)

Q1-8 The CAP was the Committee on Accounting Procedure This group was given the

authority to issue pronouncements on accounting procedures and practice These pronouncements were published as Accounting Research Bulletins The CAP was replaced by the APB in 1959

The APB was the Accounting Principles Board It was formed as an attempt to create

a policy-making body whose rules would be binding rather than optional The

pronouncements of the APB were termed Opinions of the Accounting Principles Board The APB was phased out and replaced in 1973 by the FASB

The FASB is the Financial Accounting Standards Board This Board was formed upon the recommendations of the Wheat Committee The FASB issues four types of

documents which constitute generally accepted accounting principles: Statements

of Financial Accounting Standards, Interpretations, Technical Bulletins, and

Statements of Financial Accounting Concepts

Q1-9 Before issuing a Statement of Concepts or Standards, the FASB generally completes a

multistage process as follows:

(1) identifies topic

(2) appoints task force

(3) conducts research

(4) issues Discussion Memorandum or Invitation to Comment

(5) holds public hearings

(6) deliberates on findings

(7) issues Exposure Draft

(8) holds public hearings

(9) modifies Exposure Draft

(10) votes

After a 4-3 positive majority vote is attained, the Statement is issued

Q1-10 The FASB issues four types of pronouncements:

1 Statements of Financial Accounting Standards These pronouncements are releases indicating the methods and procedures required on specific accounting issues

2 Interpretations These pronouncements provide clarifications of conflicting or unclear issues relating to previously issued FASB Statements, APB Opinions, or Accounting Research Bulletins

3 Technical Bulletins These pronouncements are issued by the staff of the FASB

to provide guidance on accounting and reporting problems related to Statements of Standards or Interpretations

Q1-10 (continued)

4 Statements of Financial Accounting Concepts These pronouncements are a series establishing a theoretical foundation upon which to base financial accounting and reporting standards They are the output of the FASB's

"conceptual framework" project

Q1-11 The organizations other than the FASB that have had an impact on the

development of generally accepted accounting principles are the: (1) Securities' and Exchange Commission, (2) American Institute of Certified Public Accountants, (3) FASB Emerging Issues Task Force, (4) Cost Accounting Standards Board,

(5) Internal Revenue Service, (6) American Accounting Association, (7) International Accounting Standards Committee, (8) Governmental Accounting Standards Board, and (9) G4 + 1

Q1-12 The IASB is the International Accounting Standards Board The IASB has 12 full-time

members (and 2 part-time members) from various countries It issues International Accounting Standards To do so, its operating procedures include study of the topic, issuance of an Exposure Draft, evaluation of comments, and consideration of a revised draft If approved by at least 8 members of the IASB, the International

Accounting Standard is issued

Q1-13 The professional organizations that play an important role in the accounting

standard-setting process include the: (1) Financial Executives Institute, (2) Institute of Management Accountants, and (3) Association for Investment Management and Research

Q1-14 The Code of Professional Conduct is a document published by the AICPA to help

guide members in public practice, industry, government, and education in

performing their responsibilities in an ethical and professional manner The six areas covered by the Principles include: (1) responsibilities, (2) public interest, (3) integrity, (4) objectivity and independence, (5) due care, and (6) scope and nature of services

Q1-15 The steps a person should follow to determine whether an action is ethical include:

(1) gathering the facts (e.g., who are the "stakeholders," what are my

responsibilities); (2) asking whether the action is acceptable according to three ethical criteria, (a) utility: does the action optimize the satisfactions of all

stakeholders? (b) rights: does the action respect the rights of all individuals, and (c) justice: is the action fair and just?; (3) considering whether there are any

"overwhelming factors" such as conflicts between criteria that may justify

disregarding one or more of the ethical criteria; and (4) deciding whether the action is ethical based on an evaluation of the applicable ethical criteria

Q1-16 Creative thinking is the process of finding new relationships or ideas among items of

information that potentially can be used to solve a problem It involves using

imagination and insight in order to view issues in a different light

A creative thinker may be described as being insightful, intuitive, imaginative, sensitive, flexible, original, adaptable, and tolerant of ambiguity

Q1-17 Critical thinking is the process of testing new relationships or ideas in order to

determine how well they will work It involves the use of inductive or deductive reasoning to analyze an issue in a logical manner

A critical thinker may be described as being objective, independent, analytical, logical, rational, able to synthesize, consistent, and organized

C 1 Committee on Accounting Procedure (CAP)

G 2 Cost Accounting Standards Board (CASB)

A 3 Internal Revenue Service (IRS)

D 4 International Accounting Standards Board (IASB)

J 5 Governmental Accounting Standards Board (GASB)

H 6 Financial Accounting Standards Board (FASB)

I 7 American Accounting Association (AAA)

F 8 Financial Accounting Standards Advisory Council (FASAC)

B 9 Accounting Principles Board (APB)

E 10 Securities and Exchange Commission (SEC)

K 11 American Institute of Certified Public Accountants (AICPA)

L 12 Emerging Issues Task Force (EITF)

In 1938, the AICPA formed the CAP This group was responsible for issuing pronouncements

to narrow the differences in accounting procedures and practice These pronouncements were published as Accounting Research Bulletins From the CAP's inception until 1953, it issued 42 Accounting Research Bulletins, and in 1953 these pronouncements were

reviewed and codified into Accounting Research Bulletin No 43 The CAP subsequently issued eight more Accounting Research Bulletins, ending with No 51 The CAP was

replaced by the APB in 1959, but all Accounting Research Bulletins still constitute generally accepted accounting principles unless specifically superseded or amended by other authoritative bodies

C1-3 (continued)

In 1959, the APB was formed by the AICPA as an attempt to (1) alleviate the criticism of the methods of formulating accounting principles, and (2) create a policy-making body whose rules would be binding rather than optional The pronouncements of the APB were termed Opinions of the Accounting Principles Board, and ultimately 31 of these Opinions were issued All APB Opinions are sources of generally accepted accounting principles, unless specifically amended or rescinded Many of these Opinions were based upon Accounting Research Studies which were written by individuals commissioned by the APB

By the late 1960s criticism again arose about the development of accounting principles This criticism centered on independence, representation, and response time As a result, the AICPA appointed the Wheat Committee which recommended that the APB be

abolished and that a new full-time body be established

Thus, the APB was phased out and replaced in 1973 by the FASB Appointees to the FASB are full-time members with no other organizational ties and are selected to represent a wider cross section of interests The FASB issues four types of pronouncements: Statements

of Financial Accounting Standards, Interpretations, Technical Bulletins, and Statements of Financial Accounting Concepts

Statements of Financial Accounting Standards are releases indicating the methods and procedures required on specific accounting issues Interpretations provide clarification of conflicting or unclear issues relating to previously issued FASB Statements of Standards, APB Opinions, or Accounting Research Bulletins Technical Bulletins are issued by the staff of the FASB to provide guidance on accounting and reporting problems related to Statements of Standards or Interpretations Statements of Financial Accounting Concepts are a series establishing a theoretical foundation upon which to base financial accounting and

reporting standards They are the output of the FASB's "conceptual framework" project All

of these pronouncements are sources of generally accepted accounting principles

C1-4 (AICPA adapted solution)

1 The term "accounting principles" in the auditor's report includes not only accounting

principles but also practices and the methods of applying them Though the term quite naturally emphasizes the primary or fundamental character of some principles, it includes general rules adopted or professed as guides to action in practice The term does not connote, however, rules from which there can be no deviation In some cases, the

question is which of several partially relevant principles has determining applicability Neither is the term "accounting principles" necessarily synonymous with accounting theory Accounting theory is the broad area of inquiry devoted to the definition of objectives to

be served by accounting, the development and elaboration of relevant concepts, the promotion of consistency through logic, the elimination of faulty reasoning, and the

evaluation of accounting practice

2 Generally accepted accounting principles are those principles (whether or not they have only limited usage) that have substantial authoritative support Whether a given principle has authoritative support is a question of fact and a matter of judgment The CPA is

responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within the bounds of generally accepted

C1-4 (continued)

2 (continued)

Pronouncements of the FASB, APB, AICPA, and SEC, if there are any on the subject in question, would be given greater weight than other single sources Pronouncements of the FASB, APB, and AICPA constitute substantial authoritative support, and the evidence would tend to be conclusive if the SEC has issued an affirmative opinion on the same subject These pronouncements include FASB Statements of Standards and Interpretations, APB Opinions, AICPA Accounting Research Bulletins, and SEC Regulation S-X and Financial Reporting Releases for companies that file with the SEC However, substantial authoritative support also can exist for accounting principles in other pronouncements

Other evidence of authoritative support may be found in the FASB's Technical Bulletins, Questions and Answers, and Statements of Concepts, the AICPA's Interpretations, Audit Guides, Accounting Guides, Statements of Position, Issue Papers, Technical Practice Aids, and, Practice Bulletins, and the FASB EITF Consensus Positions The affirmative opinions of practitioners and academicians in articles, textbooks, and expert testimony may also provide evidence Similarly, the views of stock exchanges, commercial and investment bankers, and regulatory commissions influence the general acceptance of accounting principles and hence are considered in determining whether an accounting principle has substantial authoritative support Business practice also is a source of evidence Finally, because they influence business practice, the tax code and state laws are also sources of evidence

C1-5 (CMA adapted)

Financial accounting standards inspire or encourage political action and social

involvement during the standard setting process because the effects of accounting

standards are wide-ranging and impact many varying groups The setting of accounting standards is a social decision and the user groups play a significant role and have

to be "generally accepted accounting principles" and, as such, they must be followed in the preparation of financial statements Public accounting firms and independent CPAs are prohibited from expressing opinions on financial statements unless they conform to these principles Therefore, the formulation of standards is of vital interest to these groups

as well as the client organizations responsible for the financial statements

C1-6

The Financial Accounting Foundation is the parent organization of the FASB It is governed by a 16-member Board of Trustees appointed from the memberships of nine organizations (the AICPA, Financial Executives Institute, Institute of Management Accountants, Association for Investment Management and Research, American Accounting Association, Securities Industry Association, Government Finance Officers Association, Comptrollers and Treasurers, and National Association

of State Auditors, Controllers, and Treasurers) interested in the formulation of accounting

principles The primary responsibilities of the Financial Accounting Foundation are to provide general oversight to its operations and appoint the members of the Financial Accounting

Standards Advisory Council (FASAC) and the FASB The FASAC consists of about 33 influential members; it is responsible for advising the FASB about major policy issues, the priority of topics, the selection of task forces, the suitability of tentative decisions, and other matters

There are seven members of the FASB Appointees to the FASB are full-time, fully paid members with no other organizational ties and are selected to represent a wide cross-section of interests Each Board member is required to have a knowledge of accounting, finance, and business; high intelligence, integrity, and discipline; and a concern for the public interest regarding

financial reporting Currently, the FASB includes (1) five members who are CPAs and who have been in public practice, and (2) two members from other areas related to accounting (e.g., academia and industry) The FASB is responsible for identifying financial accounting issues, conducting research to address these issues, and resolving them The FASB is supported by a research and technical staff that performs numerous functions such as researching issues,

communicating with constituents, and drafting preliminary findings The administrative staff assists the FASB by handling library, publications, personnel, and other activities

The FASB issues several types of pronouncements:

1 Statements of Financial Accounting Standards These pronouncements establish generally accepted accounting principles They are releases indicating the methods and

procedures required on specific accounting issues

2 Interpretations These pronouncements provide clarification of conflicting or unclear issues relating to previously issued FASB Statements of Standards, APB Opinions, or Accounting Research Bulletins Interpretations also establish or clarify generally accepted accounting principles

3 Technical Bulletins These pronouncements are issued by the staff of the FASB to provide guidance on accounting and reporting problems related to Statements of Standards or Interpretations The guidance may clarify, explain, or elaborate upon an underlying

standard

4 Statements of Financial Accounting Concepts These pronouncements establish a

theoretical foundation upon which to base financial accounting and reporting standards These Statements are the output of the FASB's "Conceptual Framework" project

5 Other Pronouncements On a major topic, the FASB staff may also issue a Guide for

Implementation which is in the form of questions and answers (referred to as FASB Q's and A's)

C1-6 (continued)

Before issuing a statement of concepts or standards, the FASB generally completes a multistage process, although the sequence and numbers of steps may vary Initially, a topic or project is identified and placed on the FASB's agenda This topic may be the result of suggestions from the FASAC, the accounting profession, industry, or other interested parties On major issues a Task Force may be appointed to advise and consult with the FASB's Research and Technical Staff on such matters as the scope of the project and the nature and extent of additional research The Staff then conducts any research specifically related to the project

A Discussion Memorandum or Invitation to Comment, which outlines the research related to the issues, is then usually published and a public comment period is set During this period, public hearings, similar to those conducted by Congress, may be held The intent is to receive

information from and views of interested individuals and organizations on the issues Many parties submit written comments ("position papers") or make oral presentations These parties include representatives of CPA firms and interested corporations, security analysts, members of professional accounting associations, and academicians, to name a few After deliberating on the views expressed and information collected, the FASB issues an Exposure Draft of the

proposed Statement Interested parties generally have 30-90 days to provide written comments

of reaction On major issues, more public hearings may be held Sometimes, "field tests" of the proposed standards are conducted with selected companies to evaluate implementation issues A modified draft is prepared, if necessary, and brought to the FASB for a final vote After

4 to 3 positive vote is attained, the Statement is issued

C1-7

The AICPA publishes numerous documents that may be considered as sources of GAAP For example, Industry Audit Guides and Industry Accounting Guides are publications designed to assist independent auditors in examining and reporting on financial statements of various types

of entities in specialized industries Statements of Position are publications intended to influence the development of financial accounting principles that best serve the public interest Practice Bulletins are publications that provide guidance on specific technical issues Issue Papers help the FASB identify accounting areas that need to be addressed and clarified

The AICPA also annually publishes Accounting Trends and Techniques which provides a study of the latest accounting practices and trends, as identified from a survey of 600 published annual reports The AICPA has also issued numerous Accounting Interpretations to provide timely guidance on accounting issues without the formal procedures necessary for an APB Opinion C1-8

The first five principles of the AICPA's Code of Professional Conduct are as follows:

1 Responsibilities: In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities For example, when a member chooses a depreciation method, she must carefully analyze each

alternative based upon well-defined criteria before making a final choice

2 The Public Interest: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate a commitment to

professionalism When a member refuses to ignore internal control deficiencies in a

company with publicly traded stock, but instead enumerates these deficiencies in the Auditor's report, she is adhering to the public interest principle

C1-8 (continued)

3 Integrity: To maintain and broaden public confidence, members should perform all

professional responsibilities with the highest sense of integrity For example, a member who carefully and conscientiously performs each step of an audit without skipping those steps that are tedious or of less interest is exercising the integrity principle

4 Objectivity and Independence: A member should maintain objectivity and be free from conflicts of interest in discharging professional responsibilities A member in public practice should be independent in fact and appearance when providing auditing and other

attestation services For example, a member who declines to audit the financial

statements of the company for which his father is a marketing vice president is adhering to this principle

5 Due Care: A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of standards, strive continually to improve competence and the quality of services, and discharge professional responsibility

to the best of the member's ability When a member reads current accounting literature and strives to employ current principles and procedures, she is exercising due care

C1-9

The "rules" for financial accounting are called generally accepted accounting principles Generally accepted accounting principles (GAAP) are the guidelines, procedures, and practices that a company is required to use in recording and reporting the accounting information in its audited financial statements GAAP define accepted accounting

practices at a particular time and provide a standard by which to report financial results They are like laws that must be followed in financial reporting

There are several accounting policy-making bodies that have established GAAP, including the Financial Accounting Standards Board (FASB), Accounting Principles Board (APB), American Institute of Certified Public Accountants (AICPA), and Securities and Exchange Commission (SEC) There is no single document that includes all the accounting standards [However, there are electronic data bases, such as the FASB Financial Accounting

Research System (FARS) that include most accounting standards.] In addition, the FASB standards are published each year as part of the FASB's Accounting Standards series These standards are included in two-volume set entitled Original Pronouncements which contains each major pronouncement as of its date of publication Another two-volume set entitled Current Text (General Standards and Industry Standards), is a topical

integration of currently effective accounting and reporting standards as of its date of publication The AICPA and SEC standards are also published on an annual basis

bodies (FASB, APB, CAP, SEC)

Pronouncements of bodies of expert

accountants that have been

exposed for public comment

Pronouncements of bodies of expert

accountants that have not been

exposed for public comment

Widely accepted practices and

pronouncements representing

prevalent practice in a particular

industry or applications to specific

circumstances

Other accounting literature

FASB Statements of Financial Accounting Standards and Interpretations, APB Opinions, and CAP (AICPA) Accounting Research Bulletins (as well as SEC Regulation S-X and Financial Reporting Releases for companies that file with the SEC)

FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides, and AICPA Statements

of Position FASB Emerging Issues Task Force Consensus Positions and AICPA Practice Bulletins

AICPA Accounting Interpretations, FASB Q's and A's, and AICPA Accounting Trends and

Techniques

For instance, FASB Statements of Financial Accounting Concepts, APB Statements, AICPA Issue Papers, AICPA Technical Practice Aids, and accounting texts and articles

These categories are listed in descending order of importance, with Category A as the most important Accountants must follow the GAAP established by the pronouncements applicable

to this category unless, in unusual circumstances, they result in misleading financial statements

In these circumstances or in situations where the accounting for a transaction or event is not specified by a pronouncement in category A, then pronouncements in categories B through D may be used to identify GAAP Generally, pronouncements in category B take precedence over those in category C which, in turn, take precedence over those in category D When none

of the pronouncements in categories A through D are applicable, then the accountant may consider other accounting literature (category E)

C1-10

On balance, most people would agree that it is a good idea for the FASB to allow written

comments and oral presentations in which interested parties can lobby for a particular ruling However, there are both pros and cons to allowing interested parties to provide input to its deliberation process They include:

Advantages

Enables FASB to get input from different perspectives

Provides users a forum to express concerns

Provides preparers a forum to express concerns

Provides auditors a forum to express concerns

Overcomes criticism of failing to listen to constituencies

Allows for consideration of views of all interested parties

Rulings appear more fair to all constituencies

Rulings consider the costs and benefits of implementation

Standards are established that are the most acceptable

Allows for clarification of rules

Allows for corrections of any errors

Allows for consideration of implementation issues

Disadvantages

Rulings sometimes appear to be biased in favor of certain user group

Rulings sometimes are inconsistent with other Statements of Standards

Rulings sometimes are inconsistent with Statements of Concepts

Rulings sometimes appear illogical

FASB is too slow in establishing standards

Standards are too complex and difficult to implement

C1-11

Note to Instructor: Listed below are some possible findings that students may discuss at each step in the moral reasoning process:

I Gather facts: (A) What has occurred? (1) there is only one copy of the needed book,

(2) everyone in my class is required to use the book to write a report, (3) the book has been intentionally misfiled (B) Who are the stakeholders? (1) me, (2) classmate who has misfiled the book, (3) other member of the class, (4) the professor, (5) other students wanting to use the book, (6) library staff (C) What are my responsibilities? (1) to write a report (2) to be socially responsible

C1-11 (continued)

II Ask whether the action (my classmate misfiling the book) is acceptable according to

three ethical criteria: (A) Utility: Does the action optimize the satisfactions of all

stakeholders? (1) the classmate who misfiled the book can satisfactorily use the book without having to wait his turn, (2) I am unable to use the book to finish my report, (3) the rest of the class cannot use the book to finish their reports, (4) the professor cannot collect the assignment on the regularly scheduled due date, (5) others wanting

to use the book cannot find it, (6) library staff will be forced to search for the book (B) Rights: Does the action respect the rights of all? (1) the classmate who misfiled the book has the right to use the book, (2) other members of the class as well as other students have the right to use the book, but cannot if it is misfiled, (3) the professor cannot exercise his/her right to set due dates and expect them to be adhered to, (4) the library staff cannot effectively and efficiently perform its job (C) Justice: Is the act fair and just? (1) purposely preventing others from completing an assignment is not fair, (2) making it difficult for others to find a book is not just, (3) inhibiting the library staff's ability to perform its job is not fair, (4) forcing the professor to accept late reports is not just

III Consider whether there are any overwhelming factors affecting criteria: In this situation,

there do not appear to be overwhelming factors but students may bring up issues like: (1) classmate has full-time job, (2) classmate is disabled, (3) classmate has family (or other) obligations, (4) library has limited hours

IV Decide what ethical action to take: Students may decide on a number of alternative

courses of action, including: (1) doing nothing, (2) discussing with classmate, (3)

discussing with other students to exert pressure on classmate to refile book, (4) reporting

to professor (in person or anonymously)

C1-12

Note to Instructor: Listed below are some possible findings that students may discuss at each step in the moral reasoning process:

I Gather facts: (A) What has occurred? (1) my friend copied an answer, (2) she

received an A on the test, (3) I received a B on the test, (4) our professor is unaware that she cheated, (5) I am aware that she cheated (B) Who are the stakeholders: (1) my friend who cheated, (2) me, (3) student from whom my friend copied the answer, (4) our professor, (5) other members of the class, (6) all students in other sections of the same course, (7) all accounting students at my school who have taken the same class, (8) all students who will be competing with my friend for jobs, (9) all accountants, (10) company that hires her

C1-12 (continued)

II Ask whether the action (my friend's cheating) is acceptable according to three ethical

criteria: (A) Utility: Does the action optimize the satisfaction of all stakeholders? (1) her copying led to a short-term satisfaction in the form of an A However, in the long-run, this A may prove to be harmful to her if she views the A as a reward for cheating and continues to cheat in the future, (2) my receipt of a lower grade puts her at an unfair advantage over me, (3) others in the class who received the same grade as her had to rely on their own effort and intelligence, whereas she was rewarded with the same grade for relying on someone else's work, (4) others in the class who received a lower grade than her are at a disadvantage to her even though they may be equally

intelligent, (5) because recruiters compare the grades of all their applicants, she will appear more qualified because her A will cause her GPA to increase, (6) the professor may be placed in a position of giving her a higher recommendation than warranted, (7) her future employer may be depending on higher qualifications than she has (B) Rights: Does the action respect the rights of all? (1) my friend forfeited her right to a good grade by cheating, (2) others in the class had their rights violated because they can no longer compete fairly, (3) the professor can no longer exercise his/her right to distribute grades fairly, (4) recruiters cannot exercise their right to use GPA as a

quantitatively reliable guide for selecting employees (C) Justice: Is the act fair and just? (1) cheating is not generally accepted as being fair, (2) receiving a better grade through deceit is not just, (3) having an advantage in recruiting due to dishonesty is not fair

III Consider whether there are any overwhelming factors between criteria: In this situation,

there do not appear to be overwhelming factors but students may bring up issues like: (1) friend has full-time job, (2) friend is disabled, (3) friend has family (or other)

obligations, (4) friend was sick before class, (5) friend was an athlete

IV Decide what ethical action to take: Students may decide on a number of alternative

courses of action, including: (1) doing nothing, (2) discussing with friend, (3) discussing with student from whom friend copied (or other students) to exert pressure on friend to confess action to professor, (4) reporting to professor (in person or anonymously)

CHAPTER 2

FINANCIAL REPORTING: ITS CONCEPTUAL FRAMEWORK

CONTENT ANALYSIS OF CASES

C2-1 Qualitative Characteristics Matching of definitions to the

qualities of useful accounting information 10-20 C2-2 Accounting Assumptions and Conventions Matching of a list

of descriptive statements with a list of assumptions and conventions

5-15

C2-3 Objectives of Financial Reporting Discuss general through

C2-4 Qualitative Characteristics Identify and discuss qualities of

C2-5 (AICPA adapted) Cost and Expense Recognition Rationale

for expense recognition at time of sale, in an accounting period, or due to systematic and rational allocation

15-30

C2-6 (CMA adapted) Characteristics of Useful Information Define

relevance and reliability (and their ingredients), as well as comparability, consistency, and materiality

20-30

C2-7 (CMA adapted) Objectives, Users, and Stewardship Discuss

the primary objectives of financial reporting, the sophistication level of users, and the stewardship responsibilities of

management

20-30

C2-8 Segment Reporting Discuss what types of useful information

for investment decision making is provided by a company's disclosures of the revenues, operating profits, and assets of its lines of business

10-15

C2-9 Relevance Versus Reliability Define relevance and reliability,

and ingredients of each Discuss which is most important 10-15 C2-10 (AICPA adapted) Inconsistent Statements about GAAP

Evaluate and discuss two statements containing fallacies, truths, circular reasoning, errors, and inconsistencies

half-15-30

C2-11 (AICPA adapted) Accounting Entity Define and discuss an

accounting entity; give illustrations

15-30

Number Content

Time Range (minutes) C2-12 (AICPA adapted) Timing of Revenue Recognition Discuss

why point-of-sale recognition is usual Discuss merits of alternative revenue recognition bases

20-40

C2-13 (AICPA adapted) Accruals and Deferrals Discuss accrual

accounting, including accruals and deferrals Contrast with cash accounting

10-15

C2-14 Revenue Recognition Describe when revenue should be

recognized in four cases, and indicate what method should be used

15-20

C2-15 Violation of Assumptions and Conventions For seven situations,

identify what accounting assumption or convention each procedure or practice violates Indicate what should be done

to rectify each violation

15-25

C2-16 (CMA adapted) Conceptual Framework Describe and

discuss benefits of FASB conceptual framework and qualities of useful accounting information

20-30

C2-17 Ethics and Income Reporting Discuss the financial reporting

and ethical issues regarding revenue and expense recognition based on cash receipts and payments

10-15

ANSWERS TO CASES

Q2-1 The "conceptual framework" of the FASB is a theoretical foundation of interrelated

objectives and concepts that provides a logical structure and direction to financial accounting and reporting The titles of the "Statements of Concepts" issued by the FASB are: Statement No 1 "Objectives of Financial Reporting by Business Enterprises," Statement No 2 "Qualitative Characteristics of Accounting Information," Statement

No 3 "Elements of Financial Statements of Business Enterprises," (replaced by

Statement No 6 "Elements of Financial Statements"), Statement No 4 "Objectives of Financial Reporting by Nonbusiness Organizations," and Statement No 5 "Recognition and Measurement in Financial Statements of Business Enterprises."

Q2-2 The most general objective is that financial reporting should provide useful

information for present and potential investors, creditors, and other external users in making their investment, credit, and similar decisions Investors include both equity security holders (stockholders) and debt security holders (bondholders), while

creditors include suppliers, customers and employees with claims, individual lenders, and lending institutions

Q2-3 The "derived external user objective" is to provide information that is useful to external

users in assessing the amounts, timing, and uncertainty of prospective cash receipts This objective is important because individuals and institutions make cash outflows for investing and lending activities primarily to increase their cash inflows Financial information is needed to help establish expectations about the timing and amount of prospective cash receipts (e.g., dividends, interest, proceeds from resale or

repayment) and assess the risk involved

Q2-4 The "derived company objective" is to provide information to help investors, creditors,

and others in assessing the amounts, timing, and uncertainty of prospective net cash inflows to the related company Information about (1) a company's economic resources, obligations, and owners' equity; (2) a company's comprehensive income and its components; and (3) a company's cash flows should be reported to satisfy the "derived company objective."

Q2-5 Information about the "economic resources and claims to those resources" of a

company is useful to external users for four reasons:

1 To identify the company's financial strengths and weaknesses and to assess its liquidity;

2 To provide a basis to evaluate information about the company's performance during a period;

3 To provide direct indications of the cash flow potentials of some resources and the cash needed to satisfy obligations; and

4 To indicate the potential cash flows that are the joint result of combining various resources in the company's operations

Information about the "comprehensive income and its components" of a company is useful to external users in:

1 Evaluating management's performance;

2 Estimating the "earning power" or other amounts perceived as representative of its long-term income producing ability;

3 Predicting future income; and

4 Assessing the risk of investing in or lending to the company

Information about the cash flows of a company is useful to external users:

1 To help understand its operations;

2 To evaluate its financing and investing activities;

3 To assess its liquidity; and

4 To interpret the comprehensive income information provided

Q2-6 The terms are defined as follows: (a) return on investment provides a measure of

overall company performance, (b) risk is the uncertainty or unpredictability of the future results of a company, (c) financial flexibility is the ability of a company to take effective actions to change the amounts and timing of cash flows, (d) liquidity is the term used to describe how quickly an asset can be converted into cash or a liability paid, and (e) operating capability refers to the ability of a company to maintain a given physical level of operations

Q2-7 Decision usefulness is the overall qualitative characteristic of useful accounting

information The two primary qualities of decision usefulness are relevance and reliability

Q2-8 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 have either predictive value or feedback value, or both Predictive value is present when the information helps decision makers forecast the outcome of past or present events more accurately Feedback value is present when the accounting information enables decision makers to confirm or correct prior expectations

Timeliness is having information available to decision makers before it loses its

capacity to influence decisions

Q2-9 Accounting information is reliable if it is reasonably free from error and bias and

faithfully represents what it purports to represent To be reliable the information must

be verifiable, neutral, and possess representational faithfulness Verifiability is the ability of accountants to agree that the selected method has been used without error or bias Representational faithfulness is the degree of correspondence between the reported accounting measurements and the economic resources, obligations, and the transactions and events causing changes in these items Neutrality is present when there is an absence of bias intended to influence behavior in a particular direction Neutrality also implies a completeness of information

Q2-10 The secondary quality of useful accounting information is comparability

Comparability of accounting information enables users to identify and explain

similarities and differences between two (or more) sets of economic phenomena Comparability is enhanced by consistency Consistency means conformity from period to period with unchanging accounting policies and procedures Without consistency, it would be difficult to determine whether differences in results were caused by economic differences or simply differences in accounting methods Q2-11 Materiality refers to the magnitude of an omission or misstatement of accounting

information that makes it likely that the judgment of a reasonable person relying on the information would have been influenced by the omission or misstatement

Materiality is closely linked to relevance Both characteristics are defined in terms of the influences that affect a decision maker However, relevance deals with the need that the users may have for that information, while materiality results because the amount is large enough to make a difference

Q2-12 The continuity assumption (or going-concern assumption) is the assumption that a

company will continue to operate in the near future, unless substantial evidence to

Q2-13 The period-of-time assumption is the assumption that a company has adopted the

year, either calendar or fiscal, as the reporting period This assumption is important to financial accounting because it is the basis for the adjusting entry process in

accounting If a company's financial statements were not prepared on a yearly (or shorter time) basis, there would be no reason to determine the time frame affected

by particular transactions

Q2-14 Historical cost is the exchange price that is retained in the accounting records as the

value of that item Reliability provides the rationale behind the use of historical cost;

it possesses representational faithfulness, neutrality, and verifiability (i.e., source documents are usually available to substantiate the recorded amount)

Q2-15 Realization is the process of converting noncash resources and rights into cash or

rights to cash Recognition is the process of formally recording and reporting an item

in the financial statements of a company Two other factors provide guidance for revenue recognition Revenues should be recognized when: (1) realization has taken place, and (2) the revenues have been earned Revenues are considered to

be earned when a company has substantially completed what it must do to be entitled to the benefits generated by the revenues Thus, revenue is usually

recognized at the point of sale

Q2-16 Accrual accounting is the process of relating the financial effects of transactions,

events, and circumstances having cash consequences to the period in which they occur rather than when the cash receipt or payment occurs This process is related

to the matching principle, which states that to determine the income of a company for an accounting period the company computes the total expenses involved in obtaining the revenues of the period and relates these total expenses to (matches them against) the total revenues recorded in the period

Q2-17 The three principles for matching expenses against revenues are:

1 Associating cause and effect;

2 Systematic and rational allocation; and

3 Immediate recognition

Q2-18 Conservatism states that when alternative accounting valuations are equally

possible, the accountant should select the alternative which is least likely to overstate assets and income in the current period Conservatism, however, can conflict with neutrality Conservative financial statements may be unfair to present stockholders and biased in favor of prospective stockholders because the net valuation of the company may not fully include future expectations The result may be a relatively lower current market price of the company's common stock

Q2-19 A balance sheet (or statement of financial position) is a financial statement that

summarizes the financial position of a company on a particular date (usually the end

of the accounting period) There are three elements of a balance sheet: (a) assets, (b) liabilities, and (c) equity

Q2-20 An income statement is a financial statement that summarizes the results of a

company's operations (i.e., net income) for a period of time (generally a one-year or

Q2-21 A statement of cash flows is a financial statement that summarizes the cash inflows

and outflows of a company for a period of time (generally one year or one-quarter) There are three elements of a statement of cash flows: (a) operating cash flows, (b) investing cash flows, and (c) financing cash flows

Q2-22 A statement of changes in equity summarizes the changes in a company's equity for

a period of time (generally one year or one-quarter) There are two elements of a statement of changes in equity: (a) investments by owners, and (b) distributions to owners

Q2-23 The IASC Framework states that the objective of financial statements is to provide

information about the financial position, performance, and changes in financial position of a company that is useful to a wide range of users in making economic decisions The Framework has two underlying assumptions; that a company is a going concern and uses accrual accounting It identifies four qualitative characteristics of financial statements–understandability, relevance (including materiality), reliability ( including faithful presentation, substance over form, neutrality, prudence, and

completeness), and comparability Three constraints on relevant and reliable

information are identified; they include timeliness, balance between benefit and cost, and balance between the qualitative characteristics The Framework calls for financial statements that present a true and fair view of the company and a fair presentation of the company’s activities

to have a reasonable understanding of business and economic activities and be willing to study the information with reasonable diligence in order to comprehend the financial information

The second objective is the "derived external user objective." It states that financial

reporting should provide information that is useful to external users in assessing the

amounts, timing, and uncertainty of prospective cash receipts This objective is important

C2-3 (continued)

The third objective is the "derived company objective." It states that financial reporting should provide information to help external users in assessing the amounts, timing, and uncertainty of prospective net cash inflows to the related company Companies, like external users, invest cash in noncash resources to earn more cash and receive a return on their investment in addition to a return of their investment The company's ability to

generate net cash inflows affects both its ability to pay dividends and interest and the market prices of its securities, which, in turn, impact on investors' and creditors' cash flows The next three, more specific, objectives indicate the types of information about a

company that should be provided in financial reports The first is to provide information about a company's economic resources, obligations, and owners' equity This information

is useful to external users for four reasons: (a) to identify the company's financial strengths and weaknesses and to assess its liquidity, (b) to provide a basis to evaluate information about the company's performance during a period, (c) to provide direct indications of the cash flow potentials of some resources and the cash needed to satisfy obligations, and (d) to indicate the potential cash flows that are the joint result of combining various resources in the company's operations

The second specific objective of financial reporting is to provide information about a company's financial performance during a specified period The primary focus here is information concerning a company's comprehensive income and its components This information about a company is useful to external users in (a) evaluating management's performance, (b) estimating the "earning power" or other amounts perceived as

representative of its long-term earning ability, (c) predicting future income, and

(d) assessing the risk of investing in or lending to the company

Although comprehensive income is the primary concern, the third specific objective of financial reporting is to provide information about a company's cash flows External users use cash (or cash and cash equivalents) flow information about a company (a) to help understand its operations, (b) to evaluate its financing and investing activities, (c) to assess its liquidity, and (d) to interpret the comprehensive income information provided

Other issues (objectives) of financial reporting are to provide information about how the management of a company has discharged its stewardship responsibility for the

company's resources and to provide for full disclosure to help external users understand the information presented to them

C2-4 (continued)

Decision usefulness is the overall qualitative characteristic to be used in judging the quality

of accounting information Usefulness depends on the decision to be made, the way in which the decision is made, the information already available, and the decision maker's ability to process the information To evaluate decision usefulness, however, this overall quality can be separated into the primary qualities of relevance and reliability If either of these is completely missing, the information will not be useful

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 either predictive value or feedback value, or both Timeliness refers to having information available to decision makers before it loses its capacity to influence decisions If

information is not available when needed, it lacks relevance and is of little or no use Predictive value refers to accounting information that helps decision makers forecast the outcome of past or present events more accurately Feedback value is present in

accounting information that enables decision makers to confirm or correct prior

expectations Often, information has both predictive value and feedback value because knowledge about the previous actions of a company will generally improve the decision makers' abilities to predict the results of similar future actions

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 causing changes in these items Having a high degree of representational faithfulness is useful in reducing measurement bias Verifiability is the ability of measurers to agree that the selected method has been used without error or bias Verification is useful in reducing measurer bias Neutrality results when there is an absence of bias intended to attain a predetermined result or to influence behavior in a particular direction Neutrality implies a completeness of information

Comparability and consistency are secondary qualities, interacting with both relevance and reliability to contribute to information usefulness Comparability is an interactive quality of the relationship between two or more items of information Comparability of accounting information enables users to identify and explain similarities and differences between two (or more) sets of economic phenomena Consistency means conformity from period to period, with unchanging accounting policies and procedures Consistency

is an important condition to enhance comparability across periods Without consistency, it would be difficult to determine whether differences in results were caused by economic differences or simply differences in accounting methods However, some sacrifice in consistency must be made at certain times in order to improve the usefulness of

accounting information

These characteristics, however, are bound by two constraints One constraint is that in order to justify providing the information, the benefits must be greater than the costs of the information The second constraint is materiality; the dollar amount of the information must be large enough to make a difference in decision making

C2-5 (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 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 the "matching concept."

Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognizing them as

expenses accompanies recognition of the revenue Generally, the matching concept requires that the revenue recognized and the expenses incurred to produce the revenue

be given concurrent periodic recognition in the accounting records Only if effort is properly related to accomplishment will the results, called income, have useful

significance concerning the efficient utilization of business resources Thus, applying the matching principle is a recognition of the cause-and-effect relationship that exists

between expense and revenue

Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided

2 Some costs are assigned as expenses to the current accounting period because (a) their incurrence during the period provides no discernible future benefits; (b) they are measures

of assets recorded in previous periods from which no future benefits are expected or can

be discerned; (c) they must be incurred each accounting year, and no build-up of

expected future benefits occurs; (d) by their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; (e) the amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; (f) uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose Thus, many costs are called "period costs" and are treated as expenses in the period incurred because they have neither a direct relationship to revenue earned nor can their

occurrence be directly shown to give rise to an asset The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment Examples of costs treated as period expenses would include officers' salaries, advertising, research and development, and auditors' fees

3 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 close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist Therefore, the asset cost is allocated to the accounting periods by some method The allocation method used should appear

reasonable to an unbiased observer and should be followed consistently from period to period Examples of systematic and rational allocation of asset cost would include

depreciation of fixed assets, amortization of intangibles, and allocation of rent and

insurance

C2-6 (CMA adapted)

1 a Relevance means relating to the matter at hand Therefore, relevant accounting

information has the capacity to:

make a difference in a decision

help users to form predictions about the outcomes of future events (predictive value)

confirm or correct prior expectations (feedback value)

b Predictive value is that quality of information that improves the decision-maker's ability to determine expected outcomes Feedback value is that quality of

information that assists the decision-maker to confirm or change previously

determined expected outcomes The predictive and feedback qualities are

interactive in that knowledge of actual results (feedback) generally improves the results of similar future actions (predictive) Timeliness is that quality of information that makes it available to the user before it loses its capacity to influence the

decision Timeliness may be a trade-off with a degree of precision; however, lack of timeliness can reduce relevance

2 a Reliability is the quality of accounting information that assures that it is reasonably

free from error and bias and faithfully represents what it purports to represent

Reliability is the quality that gives users confidence that they can depend on the information provided in financial statements because the level of accuracy is higher

b Verifiability is that quality of information that assures that accounting information would be substantially duplicated by independent measurers using the same

measurement methods Verifiability implies a consensus among accountants on the measurement of an economic event and the way it is reported Neutrality is the absence of bias in reported information with no intention to attain a predetermined result or to induce a particular mode of behavior Accounting information should be arrived at by choosing the proper accounting alternatives without regard for the outcome Representational faithfulness is that quality of information that indicates an agreement between an economic event and its measure or description

3 a Comparability is that quality of accounting information that enables users to identify

similarities in and differences between two sets of economic phenomena

Comparability allows users to relate accounting information over time and among similar companies

b Consistency is the application of accounting standards from period to period in the same manner Through the consistent application of accounting standards,

comparability of accounting information is enhanced

c Materiality in the context of accounting information means being of substance or significance Materiality judgments are situation specific; however, the essence of the materiality concept is stated in FASB Concepts Statement No 2 as follows, "The omission or misstatement of an item in a financial report is material if, in the light of

C2-7 (CMA adapted)

1 The primary objectives of financial reporting are to provide information that is useful:

to present and potential investors, creditors, and other users of financial statements in making rational investment and credit decisions

in assessing future cash flows related to the company's operations and its ability to meet financial obligations and pay dividends

in assessing the economic resources of the company and claims against these resources

2 Although the level of sophistication related to business and financial accounting matters varies both within and between user groups, users are expected to possess a reasonable understanding of business and economic activities and are expected to be willing to study the information with reasonable diligence Financial information is intended to be a useful tool to those who are able and willing to use it

3 One of the results of the corporate form of organization has been the tendency to

separate ownership from management Thus, the stewardship function has been added

to the management responsibilities of recording and reporting financial information The stewardship responsibilities of management include the following:

Periodic accountability to the owners not only for the custody and safekeeping of the company's resources but also for their efficient and profitable use

Accountability to prospective investors and to the general public when the

company's securities are offered to the public

C2-8

By requiring a company that is organized in different operating segments to disclose the revenues, profits, and assets of each major operating segment, several types of useful information for investment decision making are provided First, information about risk is provided because the revenues and profits of each operating segment can be

compared over time to assess the uncertainty or unpredictability about the future

operating results of the segment Second, information about return on investment is provided because the profits of each operating segment can be compared with the assets invested to achieve the profits Third, information about operating capability is provided because the revenues of each operating segment can be compared to its assets to assess the company's ability to maintain a given physical level of operations in the operating segment

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 either predictive value or feedback value, or both Timeliness refers to having information available to decision makers before it loses its capacity to influence decisions If

information is not available when needed, it lacks relevance and is of little or no use Predictive value refers to accounting information that helps decision makers to more accurately forecast the outcome of past or present events Feedback value is present in accounting information that enables decision makers to confirm or correct prior

The FASB's conceptual framework was not designed to assign priorities among the

qualitative characteristics in all circumstances To be useful, accounting information must have both the qualitative characteristics of relevance and reliability to a minimum

degree If importance is to be assigned, relevance would be the most important

characteristic because of their order of occurrence The information gathered is first narrowed down to include only that information which is pertinent (relevant) to the

decision at hand Then, all relevant accounting information is examined for its reliability C2-10 (AICPA adapted solution)

Auditing or the attest function, often considered to be a part of accounting, is concerned primarily with providing an opinion by an independent expert that a communication of

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 stockholders

Half-truth: That financial statements can be free from bias, even if the conservatism

convention is not applied, except possibly with respect to the outlook of the processor or preparer of the data

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 less than they otherwise might be (for example, using the lower of cost or market

approach for inventories, or recognizing revenue on a completed contract basis where the percentage of completion method would be more appropriate) Thus, to the extent (a) that reported income is reduced thereby and (b) that reported income affects the price of a share of the stock of a company, the market price per share will be less, and the retiring stockholders may be encouraged to (1) sell rather than hold their shares and (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

statements because of the conflicting interests among the many users of the statements (for example, management versus owners or owners versus employees and creditors)

It often appears that many accountants relate the freedom-from-bias concept to the attitude of the accountant or auditor and the closely related concept of independence But the freedom-from-bias concept is concerned primarily with the ability of the

measurement method to portray accurately the activity being measured Thus, the

accountant may be completely independent in attitude, yet, by the choice of

measurement methods, may introduce bias into the accounting information

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

accounted for separately from the owners, although such a distinction might not exist legally Thus, it is recognized that the transactions of the entity should be accounted for and reported upon separately from those of the owners

An extension of this approach is to define the accounting entity in terms of an

economic unit that controls resources, makes and carries out commitments, and conducts economic activity In the broadest sense, an accounting entity could embrace any object, event, or attribute of an object or event for which there is an input-output relationship Such an accounting entity may be an individual, a profit-seeking or not-for-profit company, or any subdivision or attribute thereof for which a system of accounts is maintained Thus, this approach is oriented toward the unit for which financial reports are prepared

C2-11 (continued)

1 a (continued)

An alternative approach is to define the accounting entity in terms of an area of economic interest to a particular individual, group, or institution The boundaries of such an economic entity would be identified by determining (1) the interested

individual, group, or institution, and (2) the nature of that individual's, group's, or institution's interest Thus, this approach is oriented to the users of financial reports

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

of objects or activities that may be selected for inclusion in accounting records and reports Further, postulates as to the nature of the entity also may aid in determining (1) what information to include in reports of the entity and (2) how best to present information of the entity so that relevant features are disclosed and irrelevant

features do not cloud the presentation

The applicability of all the other generally accepted concepts (or principles or

postulates) of accounting (such as continuity, money measurement, and time

periods) depends upon the established boundaries and nature of the accounting entity The other accounting concepts lack significance without reference to an entity The entity must be defined before the balance of the accounting model can

be applied and the accounting can begin Thus, the accounting-entity concept is

so fundamental that it pervades all of accounting

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

b Yes, a product line operating segment of a company, such as a division,

department, profit center, branch, or cost center, could be an accounting entity The stimuli for financial reporting by operating segments include investors, the SEC, financial executives, and the accounting profession

c Yes, most large corporations issue consolidated financial reports for two or more legal entities that constitute a controlled economic entity Accounting for investments in subsidiary companies by the equity method also is an example of an accounting unit that extends beyond the legal entity The financial reports for a company that

includes two or more product-line operating segments would also be a form of a consolidated report that most commonly would be considered to be the report of a single legal entity

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

e Yes, the accounting entity could embrace an industry Examples include financial data compiled for an industry by a trade association (industry averages) or by the federal government Probably the best examples of an industry being the

C2-11 (continued)

2 (continued)

f Yes, the accounting-entity concept can embrace the economy of the United States

An example is the national income accounts compiled by the U.S Department of Commerce Another area where the entity concept is applicable is in the yet-to-be-developed area of socioeconomic accounting

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, sales transactions with outsiders represent the point in the revenue-generating process at which most of the uncertainty about the final outcome of business activity has been alleviated

It is also at the point of sale in most cases that substantially all of the costs of generating revenues are known, and they can at this point be matched with the revenues generated

to produce a reliable statement of a company's effort and accomplishment for the

period Any attempt to measure business income prior to the point of sale would, in the vast majority of cases, introduce considerably more subjectivity into financial reporting than most accountants are willing to accept

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 arriving at a periodic determination of the amount of revenue to take up Also, in most situations the sale represents the most important single step in the earning process Prior to the sale, the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales The accumulation of costs during production does not alone generate revenue; rather, revenues are earned by the entire process, including making sales Thus, as a general rule the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition Except in unusual circumstances,

revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount

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 revenue measurements, and therefore net income, should depend on the amount of cash generated during the period This assumption disregards the fact that the sale usually represents the decisive factor in the earning process and substitutes for it the administrative function of managing and collecting receivables In other words, the investment of funds in receivables should be regarded as a policy designed to

increase total revenues, properly recognized at the point of sale; and the cost of managing receivables (such as bad debts and collection costs) should be matched

C2-12 (continued)

2 b (continued)

The fact that some revenue adjustments (for example, sales returns) and some

expenses (for example, bad debts and collection costs) may occur in a period subsequent to the sales does not detract from the overall usefulness of the sales basis for the timing of revenue recognition Both can be estimated with sufficient

accuracy so as not to detract from the reliability of reported net income

Thus, in the vast majority of cases for which the sales basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later time

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

To defer revenue recognition until the completion of long-term construction projects could impair significantly the usefulness of the intervening annual financial

statements because the volume of completed contracts during a period is likely to bear no relationship to production volume During each year that a project is in process a portion of the contract price is therefore appropriately recognized as that year's revenue The amount of the contract price to be recognized should be

proportionate to the year's production progress on the project

It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the

contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured

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

The mere fact that sales are made on an installment contract basis does not justify using the cash receipts basis of revenue recognition The justification for this

departure from the sales basis depends essentially upon an absence of a reasonably objective basis for estimating the amount of collection costs and bad debts that will

be incurred in later periods If these expenses can be estimated with reasonable accuracy, the sales basis should be used

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

Systematic and Rational Allocation In the absence of a direct association with specific revenue, some expenses are recognized and recorded by attempting to allocate expenses in a systematic and rational manner among the periods in which benefits are provided

Immediate Recognition Some costs are associated with the current accounting period as expenses because (1) costs incurred during the period provide no

discernible future benefits, (2) costs recorded as assets in prior periods no longer provide discernible benefits, or (3) allocating costs either on the basis of association with revenues or among several accounting periods is considered to serve no useful purpose

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

revenue is accrued interest revenue earned on bonds from the last interest payment date

to the end of the accounting period An accrued expenses is an expense incurred but not yet paid in cash An example of an accrued expense is salaries incurred for the last week of the accounting period that are not payable until the subsequent accounting period

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 (prepaid) revenue is revenue collected or collectible in cash but not yet earned An example of deferred (prepaid) revenue is rent collected in advance by a lessor in the last month of the accounting period, which represents the rent for the first month of the

subsequent accounting period A deferred (prepaid) expense is an expense paid or payable in cash but not yet incurred An example of a deferred (prepaid) expense is an insurance premium paid in advance in the current accounting period, which represents insurance coverage for the subsequent accounting period

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; while in accrual accounting, these effects are recognized and reported in the time

periods to which they relate Because cash accounting does not attempt to match revenues and the expenses associated with those revenues, cash accounting is not in conformity with generally accepted accounting principles

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 This approach is reasonable because realization takes place based upon the degree completed, and at that point a percentage of the revenue has been earned

B Company B should recognize revenue at the time of sale because realization has

occurred and revenue has been earned because the earning process is substantially complete

C Company C should recognize revenue periodically under the proportional performance method based on the services completed to date Although realization occurred at the time the contracts were signed, revenue was not yet earned because the earning process had not been completed

D Company D should recognize revenue periodically under the installment method or cost recovery method until the roads and clubhouse are completed This is because

realization is uncertain up to this point and the revenue has not been earned because the earning process has not been substantially completed

C Violation of period-of-time assumption; the financial statements should be prepared at least once a year

D Violation of the realization convention; revenue should not be recognized until realization has taken place and the earning process is substantially complete (i.e., the revenue has been earned)

E Violation of the stable monetary unit assumption; the financial statements should not be adjusted for the effects of inflation

F Violation of entity assumption; Thomas should maintain separate records of his personal and business transactions and prepare his company's financial statements based only on the business transactions

G Violation of continuity assumption (and historical cost convention); the economic

C2-16 (CMA adapted)

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

community such as

guiding the FASB in establishing accounting standards on a consistent basis

determining bounds for judgement in preparing financial statements by prescribing the nature, functions, and limits of financial accounting and reporting

increasing users' understanding of and confidence in financial reporting

2 Statement of Financial Accounting Standards No 2 identifies the most important quality for accounting information as usefulness for decision-making Relevance and reliability 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

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

diligence Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it or who misuse it

Relevance the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations

Reliability the reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has representational quality

C2-17

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-basis accounting Under GAAP, revenues are recognized when realization has taken place (cash or receivables are obtained) and they have been earned The expenses involved in obtaining the revenues are matched against the revenues recorded during the period This is called accrual accounting, which is the process of relating the financial effects of transaction, events, and circumstances that have cash consequences to the period in which they occur rather than when the cash receipt or payment occurs Use of accrual accounting provides relevant and reliable information about a company's return

on investment, risk, financial flexibility, liquidity, and operating capability that helps users in

C2-17 (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 not provide relevant information that has predictive value (for forecasting purposes) and feedback value (for evaluating prior expectations) While Chris claims the information under cash basis accounting is reliable and conservative, it may not portray a valid

description of the company's income-earning activities and may not be neutral Even though use of cash basis accounting may be "easy" for Chris, it may not be fair for Watson Company to use this method because stockholders and creditors need accrual-basis accounting information for their decision making Accrual-based accounting makes information comparable across companies On the other hand, since Watson Company's stock is not publicly traded, there is no requirement that it follow GAAP Because the company is small and has few stockholders, cash-basis accounting may be acceptable if the stockholders have sufficient access to the company's operating information for their investment decision making Furthermore, if the creditors are short-term and the amounts owed are small, cash basis accounting may provide them with enough information to assess the liquidity of the company in regard to paying its short-term debts

ANSWERS TO MULTIPLE CHOICE

CHAPTER 3

THE BALANCE SHEET AND STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E3-1 Current Assets Partial balance sheet preparation from listed

E3-6 Balance Sheet Preparation from accounts listed in random

order Calculation of debt ratio

15-20

E3-7 Balance Sheet Preparation from accounts listed in

alphabetical order Calculation of working capital and current ratio

15-20

E3-8 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements 15-25 E3-9 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements

15-25

E3-10 Corrections Preparation of a properly classified balance sheet

from one prepared erroneously

10-15

E3-11 Changes in Stockholders' Equity Stock issuance, income

earned, dividends paid Statement of changes in stockholders' equity

10-15

E3-12 Changes in Stockholders' Equity Stock issuance, income

earned, dividends paid Statement of changes in stockholders' equity

10-15

P3-1 Balance Sheet Matching various accounts with major

P3-2 Balance Sheet Format preparation, no amounts 20-40

P3-3 Balance Sheet Preparation from accounts listed in

alphabetical order Identification of possible disclosures

Computation of working capital and current ratio

30-45

P3-4 Balance Sheet Preparation from accounts listed in random

order

20-40

P3-5 Balance Sheet Preparation from alphabetical adjusted trial

balance Calculation of debt ratio

20-30

P3-6 Balance Sheet Preparation from accounts listed in random

order Notes Calculation of current ratio, liquid assets, and separable assets

45-60

P3-7 Comprehensive Preparation of balance sheet from accounts

listed in alphabetical order Notes Statement of changes in stockholders' equity Calculation of debt ratio and discussion

75-90

P3-8 Corrections Preparation of a properly classified balance sheet

from one prepared incorrectly, using account breakdowns 30-45 P3-9 Corrections Preparation of a properly classified balance sheet

from one prepared incorrectly, using additional available information

30-45

P3-10 Balance Sheet Calculations Calculate missing information,

given amounts of selected balance sheet elements

20-30

P3-11 Errors Identification of balance sheet errors Preparation of a

properly classified balance sheet from one prepared erroneously

30-45

P3-12 (AICPA adapted) Complex Balance Sheet Preparation of

corrected balance sheet from unaudited balance sheet and additional information

45-60

P3-13 Changes in Stockholders' Equity Stock issuance, treasury stock,

paid dividends, donation, earned income Statement of changes in stockholders' equity

10-15

P3-14 Balance Sheet Disclosures Questions relating to the review of

The Coca-Cola Company balance sheet disclosures in Appendix A

20-40

ANSWERS TO QUESTIONS

Q3-1 The major financial statements of a company are:

1 A balance sheet, which summarizes the company's financial position at the end

of the accounting period

2 An income statement, which summarizes the results of operations of the

company for the accounting period

3 A statement of cash flows, which summarizes the cash inflows and cash

outflows of a company for the accounting period

Many companies also include a statement of changes in stockholders' equity, which summarizes the changes in each item of a company's stockholders' equity for the accounting period, as a fourth major financial statement

Q3-2 The financial position of a company includes its economic resources (i.e., assets),

economic obligations (i.e., liabilities), and equity, and their relationships to each other

at a moment in time

Q3-3 One purpose of a company's balance sheet is to provide information about its

liquidity, financial flexibility, and operating capability A second purpose of the balance sheet is to provide a basis for evaluating the company's income-producing performance during a period

Q3-4 Liquidity refers to how quickly an asset of a company can be converted into cash or

a liability paid Financial flexibility refers to the ability of a company to use its financial resources to adapt to change Operating capability refers to the ability of a

company to maintain a given physical level of operations

Q3-5 Financial capital is the monetary value of the net assets contributed by stockholders

and the value of the increase in net assets resulting from earnings retained by the corporation (cumulative income in excess of cumulative dividends) Capital

maintenance refers to maintaining the stockholders' equity of the corporation in order to provide a return of investment Information about the maintenance of a corporation's capital is important in assessing the adequacy of a corporation's

profitability and its ability to provide a return on investment

Q3-6 Recognition is the process of formally recording and reporting an element in the

financial statements It includes depiction of an element in both words and numbers, with the amount included in the totals

Q3-7 An asset is a probable future economic benefit obtained or controlled by a

company as a result of a past transaction or event To be considered an asset, an economic resource must have three characteristics First, the resource must singly, or

in combination with other resources, have the capacity to contribute directly or indirectly to the company's future net cash inflows Second, the company must be able to obtain the future benefit and control others' access to it Third, the

transaction or event giving the company the right to or control over the benefit must have already occurred

Q3-8 A liability is a probable future sacrifice of economic benefits arising from a present

obligation of a company to transfer assets or provide services to other entities in the

future as a result of a past transaction or event An obligation of a company must

have three characteristics to be considered a liability First, it must entail a

responsibility to another entity or entities that will be settled by a sacrifice involving

the transfer of assets, providing services, or other use of assets at a specified or

determinable date, on occurrence of a specified event, or on demand Second, the

responsibility must obligate the company in a way that it has little or no discretion to

avoid the future sacrifice Third, the transaction or other event obligating the

company must have occurred

Q3-9 Stockholders' equity is the residual interest in the assets of a corporation that remains

after deducting its liabilities

Q3-10 The five alternatives for measuring (valuing) assets are: historical cost, current cost to

replace, current market value in orderly liquidation, net realizable value in due

course of business, and present value of future cash flows The latter four alternatives

are ways of measuring the fair value of an asset Historical cost is the valuation

method usually used in a company's balance sheet

Q3-11 A company's balance sheet is divided into three major sections each with the

Current assets may include five items: (1) cash (and cash equivalents), (2) temporary

investments in marketable securities, (3) receivables, (4) inventories, and (5) prepaid

items

Q3-12 (continued)

Examples of current liabilities are accounts payable, taxes payable, unearned rent, salaries payable, estimated liabilities for warranties, and the current portion of long-term debt

Q3-13 A company's operating cycle is the average time taken by the company to spend

cash for inventory, process and sell the inventory, and collect the receivables,

converting them back into cash

Working capital of a company relates primarily to the financial resources utilized in its operating cycle

Working capital is computed by subtracting current liabilities from current assets Q3-14 a If management expects to hold investments for more than one year or the

operating cycle, whichever is longer, these investments are classified as term Long-term investments include:

long-1 Noncurrent investments in available-for-sale debt and equity securities

2 Investments in held-to-maturity debt securities

3 Investments in noncurrent notes receivable of unaffiliated companies and long-term advances to unconsolidated affiliated companies

4 Financial instruments (such as options to buy stock) that are noncurrent

5 Investments in property and equipment being held for use in future operations

6 Special funds established for long-term purposes, such as the retirement of bonds or the acquisition of equipment

7 Miscellaneous investments, such as the cash surrender value of life insurance

b All tangible assets used in the operations of a company are classified as property, plant, and equipment They include: