2 Conceptual Framework for Financial Reporting CONCEPTS FOR ANALYSIS 2
CONCEPTS FOR ANALYSIS
CA2-1 (Conceptual Framework—General) Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework.
Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice.
Instructions
(a) Help Wayne recognize the purpose of and benefit of a conceptual framework.
(b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.
CA2-2 WRITING (Conceptual Framework—General) The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties.
The purpose of the statement on qualitative characteristics is to examine the characteristics that make accounting information useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made.
Instructions
(a) Identify and discuss the benefits that can be expected to be derived from the FASB’s conceptual framework.
(b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important.
(c) Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for financial reporting purposes. (CMA adapted)
CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various aspects of the FASB’s concepts statement on the objective of financial reporting. Homer indicates that this pronouncement provides little, if any, guidance to the practicing professional in resolving accounting controversies. He believes that the statement provides such broad guidelines that it would be impossible to apply the objective to present-day reporting problems. Jane concedes this point but indicates that the objective is still needed to provide a starting point for the FASB in helping to improve financial reporting.
Instructions
(a) Indicate the basic objective established in the conceptual framework.
(b) What do you think is the meaning of Jane’s statement that the FASB needs a starting point to resolve accounting controversies?
CA2-4 GROUPWORK (Qualitative Characteristics) Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives.
The FASB statement on qualitative characteristics of accounting information examines the characteristics of accounting information that make it useful for decision-making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information.
Instructions
(a) Describe briefly the following characteristics of useful accounting information.
(1) Relevance. (4) Comparability.
(2) Faithful representation. (5) Consistency.
(3) Understandability.
(b) For each of the following pairs of information characteristics, give an example of a situation in which one of the characteristics may be sacrificed in return for a gain in the other.
(1) Relevance and faithful representation. (3) Comparability and consistency.
(2) Relevance and consistency. (4) Relevance and understandability.
(c) What criterion should be used to evaluate trade-offs between information characteristics?
CA2-5 (Revenue Recognition Principle) After the presentation of your report on the examination of the financial statements to the board of directors of Piper Publishing Company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is recognized with the publication of every issue of the company’s magazine. She feels that the “crucial event” in the process of earning revenue in the magazine business is the cash sale of the subscription. She says that she does not understand why most of the revenue cannot be “recognized” in the period of the cash sale.
Instructions
Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with:
(a) The cash sale of the magazine subscription.
(b) The publication of the magazine every month.
(c) Over time, as the magazines are published and delivered to customers.
CA2-6 (Expense Recognition Principle) An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenues and expenses for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria.
Instructions
(a) Explain the rationale for recognizing costs as expenses at the time of product sale.
(b) What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.
(c) In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense?
Explain.
(d) Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost.
(e) Identify the conditions under which it would be appropriate to treat a cost as a loss.
(AICPA adapted)
CA2-7 (Expense Recognition Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired.
Instructions
(a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period.
(b) As generally presented in financial statements, the following items or procedures have been criticized as improperly recognizing costs. Briefly discuss each item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information.
(1) Receiving and handling costs.
(2) Cash discounts on purchases.
CA2-8 (Expense Recognition Principle) Daniel Barenboim sells and erects shell houses, that is, frame structures that are completely finished on the outside but are unfinished on the inside except for flooring, partition studding, and ceiling joists. Shell houses are sold chiefly to customers who are handy with tools and who have time to do the interior wiring, plumbing, wall completion and finishing, and other work necessary to make the shell houses livable dwellings.
Barenboim buys shell houses from a manufacturer in unassembled packages consisting of all lumber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon commencing operations in a new area, Barenboim buys or leases land as a site for its local warehouse, field office, and display houses. Sample display houses are erected at a total cost of $30,000 to $44,000 including the cost of the unassembled packages. The chief element of cost of the display houses is the unassembled packages, inasmuch as erection is a short, low-cost operation. Old sample models are torn down or altered into new models every 3 to 7 years. Sample display houses have little salvage value because dismantling and moving costs amount to nearly as much as the cost of an unassembled package.
Instructions
(a) A choice must be made between (1) expensing the costs of sample display houses in the periods in which the expenditure is made and (2) spreading the costs over more than one period. Discuss the advantages of each method.
(b) Would it be preferable to amortize the cost of display houses on the basis of (1) the passage of time or (2) the number of shell houses sold? Explain. (AICPA adapted)
CA2-9 WRITING (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the “ground floor” of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.
You have told Uncle Carlos that, unless you can take a look at Neville’s financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville’s most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.
The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available.
Instructions
Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.
CA2-10 ETHICS (Expense Recognition Principle) Anderson Nuclear Power Plant will be “mothballed” at the end of its useful life (approximately 20 years) at great expense. The expense recognition principle requires that expenses be recognized as assets are used up or liabilities are incurred. Accountants Ana Alicia and Ed Bradley argue whether it is better to allocate the expense of mothballing over the next 20 years or ignore it until mothballing occurs.
Instructions
Answer the following questions.
(a) What stakeholders should be considered?
(b) What ethical issue, if any, underlies the dispute?
(c) What alternatives should be considered?
(d) Assess the consequences of the alternatives.
(e) What decision would you recommend?
CA2-11 (Cost Constraint) The AICPA Special Committee on Financial Reporting proposed the following constraints related to financial reporting.
1. Business reporting should exclude information outside of management’s expertise or for which management is not the best source, such as information about competitors.
2. Management should not be required to report information that would significantly harm the company’s competitive position.
3. Management should not be required to provide forecasted financial statements. Rather, management should provide information that helps users forecast for themselves the company’s financial future.
4. Other than for financial statements, management need report only the information it knows. That is, management should be under no obligation to gather information it does not have, or does not need, to manage the business.
5. Companies should present certain elements of business reporting only if users and management agree they should be reported— a concept of flexible reporting.
6. Companies should not have to report forward-looking information unless there are effective deterrents to unwarranted litigation that discourages companies from doing so.
Instructions
For each item, briefly discuss how the proposed constraint addresses concerns about the costs and benefits of financial reporting.
