CHAPTER 11. Financial Reporting Concepts ANSWERS TO QUESTIONS

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1 CHAPTER 11 Financial Reporting Concepts ANSWERS TO QUESTIONS 2. (a) The main objective of financial reporting is to provide information that is useful for decision-making. More specifically, the conceptual framework states that the objective of general purpose financial reporting is to provide financial information that is useful to present and potential investors, lenders, and other creditors in making decisions about a business. (b) The objective identifies the specific users to ensure that all possible points of view are included in fulfilling the needs of users. 3. (a) Going Concern: The company will continue operating for the foreseeable future long enough to achieve its goals and respect its commitments. The going concern assumption is necessary because many accounting principles require us to assume that a company is going to continue to operate in the future. For example, if a company was not going to continue to operate into the future, depreciation of long-lived assets would not be justifiable and appropriate. (b) The going concern assumption supports reporting the cost of an asset because if a company is not going to sell its assets, cost (the amount given up to acquire the asset) becomes more relevant than fair values. When a company is no longer a going concern, assets would be valued at fair or liquidation values rather than at historical cost. The timing of when the asset will be converted to cash or used in operations and when liabilities are to be paid determines their classification on the statement of financial position. Since the business is expected to remain in operation for the foreseeable future, these elements can continue to be reported in accordance with their respective current or non-current classifications. 11-1

2 Questions (Continued) (a) The concept of materiality means that an item may be so small that failure to follow generally accepted accounting principles will not influence the decision of a reasonably prudent investor or creditor. For example, the expensing of a $20 calculator would not be in accordance with GAAP since the calculator will probably have a useful life beyond one year. However, the cost is so insignificant that it will have no impact on users decisions and therefore, this GAAP deviation is not considered to be material. (b) In order to be relevant to a financial statement user, a transaction or amount must make a difference to the user when making a decision. If an omission or misstatement does not influence a user, it is said to be immaterial or not material. Materiality is not only a matter of size, but also has to do with the nature of the omission or misstatement (for instance, illegal acts). The two fundamental qualitative characteristics should be applied first before the four enhancing characteristics. Relevance should be applied first, followed by faithful representation. Relevance is applied first to identify which information would impact a user s decision. Faithful representation is applied second to ensure the relevant information represents its substance. Comparability, verifiability, timeliness and understandability enhance the communication of information that is relevant and representationally faithful. 10. While the conceptual framework for IFRS identifies two fundamental and four enhancing characteristics, the framework for ASPE identifies four principal qualitative characteristics: understandability, relevance, reliability, and comparability. ASPE also recognizes conservatism as a qualitative characteristic of financial information The revenue recognition criteria state that revenue is recognized when there is an increase in an asset or a decrease in a liability due to profitgenerating activities. 15. The five conditions that must be met for revenue to be recognized include: the risks and rewards of ownership must be transferred; the seller does not have control over the goods; the amount of revenue can be reliably measured; collection must be reasonably assured; and 11-2

3 costs can be reliably measured. 16. I disagree. The risks and rewards of ownership did not get transferred to the buyer until the customer took possession of the shipment. This transfer did not legally occur in 2013 and so the sale should not have been included in the December 31, 2013 income statement. There exists an added risk to recording the sale in December which could bring about an error. Since the goods were not shipped as of the end of the fiscal year, they would be included in the physical count of inventory. Consequently, the inventory would be included on JRT s balance sheet as well as the accounts receivable from the sale. This error has a significant effect on gross profit and profit for the year, making the results misleading to any reader. 17. (a) The $10,000 cash receipt on March 24, 2014 should be recorded as unearned revenue as no landscaping services have yet been performed. The unearned revenue should appear as a current liability on Greenthumb s balance sheet at April 30, (b) Since Greenthumb s practice is to prepare monthly financial statements, the revenue from providing landscaping services should be allocated to the month in which the services are performed. In this case the amount of $10,000 will be allocated to the five month period from May through September 2014 at the rate of $2,000 per month. 19. When goods are sold together with a service component, the amount collected from the sale must be divided between the two sources of revenue. The revenue from the sale of the goods should be recognized at the point of sale, while the service component must be recognized over the period in which the services are delivered. 20. Unless the company can reasonably and reliably estimate the amount of the returns it expects following the sale, in order to accrue the returns at the point of sale, the company should postpone the recognition of the sale until the return period has expired. Failing to do so would be in violation of the revenue recognition criteria. 21. Expenses should be recognized when there is a decrease in an asset or increase in a liability, excluding transactions with owners. The timing of expenses recognition on the income statement depends on the nature of the expense. If there is a direct association between the cost and revenue, the expense is recognized on the income statement in the same period as the related revenue. Where there is no direct relationship between expense and revenue, a rational and systematic allocation process is adopted. In addition, for expenditures that do not qualify for recognition as assets, or previously recognized assets that cease to have future benefits, expenses are recognized immediately. 11-3

4 Questions (Continued) 23. Profits might be overstated on purpose by management to satisfy the owners expectations of performance or to allow certain members of the management to earn a bonus which is based on profits. For example, the seller might recognize sales revenues for goods that are shipped FOB destination when the goods are shipped instead of when the customer receives the goods. This would overstate revenues if the goods were shipped just prior to the company s fiscal year end and received by the customer after the year end. Another means of overstating profits is to recognize revenue from the sale of extended warranties when the cash is collected instead of when the work is performed. 11-4

5 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 11-3 (a) (b) (c) (d) (f) Revenues Liabilities Assets Expenses (e) 3.Owner s equity 1. Assets BRIEF EXERCISE 11-5 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) BRIEF EXERCISE 11-6 (a) (b) (c) (d) (e) Going concern assumption Economic entity concept Full disclosure Materiality Cost 11-5

6 BRIEF EXERCISE 11-7 (a) (b) (c) (d) (e) (f) (g) Full disclosure Expense recognition Revenue recognition Fair value Cost Revenue recognition Matching BRIEF EXERCISE Revenue from Sales of $400,000 should be recorded for the month of December. The $25,000 for the sale of extended warranties should be initially recorded as unearned warranty revenue to recognize that Willow Appliances Company has an obligation (liability) to provide warranty service in the future. Warranty revenue will be recognized when the Willow satisfies its obligation by providing warranty service. BRIEF EXERCISE Operating expenses from adjusted trial balance Add: Loss on damaged inventory Accrual of sales commissions expense Total operating expenses $55,000 4,000 2,500 $61,500 BRIEF EXERCISE The measurement criteria for cost has been violated. The accountant should not have recorded the increase in the value from the original cost to the fair value as this is not allowed under ASPE. 2. There is a violation of revenue recognition criteria. Since the musical production for which the ticket sales were made has not yet taken place as of the end of January, none of 11-6

7 the revenue had been earned. Instead, Unearned Revenue should have been credited in the entry made by the accountant. SOLUTIONS TO EXERCISES EXERCISE 11-3 (a) (b) (c) (d) (e) (f) (g) (h) EXERCISE 11-5 Revenue recognition criteria Full disclosure Expense recognition criteria Going concern assumption; full disclosure principle No violation (lower of cost and net realizable value) Timeliness characteristic Cost concept Economic entity concept 9. Cost constraint

8 EXERCISE This is a violation of the cost measurement concept, because the inventory was recorded at its estimated fair value and not its cost. The correct journal entry is: Merchandise inventory... Cash... 42,000 42, This is a violation of the economic entity concept. The treatment of the transaction treats Evan Ellis and Ellis Company as one entity when they are two separate entities. No journal entry should have been made since Evan Ellis should have used personal assets to purchase the computer. If cash assets of the company were used, the debit entry could be to Accounts Receivable E. Ellis, or to E. Ellis, Drawings and the credit entry to Cash. 3. This is a violation of the cost measurement and matching concepts. Since the advertising has already appeared on television, the cost should be expensed immediately. The correct journal entry is: Advertising Expense Cash. 5,000 5, There is no violation of generally accepted accounting principles. The merchandise inventory is properly reported at the lower of cost and net realizable value. 5. This is a question of matching, materiality and cost constraint. In theory, the coffee machine should be depreciated to match the expense with revenue, since the coffee machine has estimated useful life of 5 years. However, because the cost of the coffee machine is not material, the cost of accounting for it as a long-lived asset will exceed any benefits from doing so. Office Expense Cash

9 EXERCISE 11-6 (Continued) 6. This is a violation of the revenue recognition criteria. The revenue should be recognized when the service is provided in April. When the cash is received, it should be credited to an unearned revenue account until the revenue is earned. Cash 650 Unearned Revenue

10 EXERCISE Since the service is not provided until the flight actually occurs, revenue should not be recognized until December. This will record the revenue in the period the expense occurs, as well. 2. If collection can be reasonably assured and an estimate of uncollectible amounts can be made, then revenue can be recognized at the point of sale. Otherwise, the revenue should be recognized at the time cash is collected. However, it is highly unlikely that Cygman would sell to customers with no credit check and that it would not be able to reasonably estimate its doubtful accounts based on past experience. 3. Revenue should be recognized on a per game basis over the season from April to October. 4. If collection can be reasonably assured and an estimate of uncollectible amounts can be made, then revenue can be recognized when the merchandise is received by the customer. 5. Tuition revenue should be recognized evenly over the term, from September through December. This will record the revenue in the period the expenses (e.g., teaching salaries, utilities expense, etc.) occur, as well. 6. If the Bookstore can estimate the volume of returns, revenue should be recorded at the point of sale along with an allowance for returns. Otherwise, recognition should be delayed until the right of return expires

11 EXERCISE 11-7 (Continued) 7. The portion of the sales that is attributed to the three-year service contract should be deferred and recorded to unearned revenue and subsequently adjusted to revenue as the services are provided over the three year period, when the updates are delivered. The rest of the sale can be recognized at the point of delivery. EXERCISE $2,000 4 = $8,000. By applying the revenue recognition criteria, one can determine that 3 months of rent (or $6,000) should be recognized as revenue in 2014, while the remaining amount of $2,000 is revenue in $16,000. Ownership of the property transfers at December 31, 2014 because the terms are FOB shipping point. Thus, a sale took place in 2014 and revenue of $16,000 and the cost of goods sold in the amount of $9,000 should be recorded in $2,000,000 ($300,000 $1,400,000) = $428,517. If 3/14 ths or 21.4% of the costs have been incurred, then the same percentage of the total revenue should be recognized, using the percentage-of-completion method. 4. $0. No revenue should be recognized since the right of return cannot be reliably measured. This means that the amount of revenue cannot be reliably measured. In addition, collectability is not reasonably certain since the customers have an extended payment period. There is no indication that Mitrovica does credit checks on its customers to ensure that 11-11

12 payment will be made. 5. $5,000 4% 4/12 = $67. Interest revenue should be recognized for the four months the note was outstanding in $0. Even though collection is assured, the revenue has not been earned. The ownership of the product is not transferred until

13 EXERCISE Byer s Innovations Co. should record rent expense in 2014 in the amount of $6,000 for the months of November and December at the rate of $3,000 per month. 2. The full amount of $35,000 for research must be expensed immediately as there is no assurance of any future benefit to be derived from the research activity. 3. An estimate can be made of the amount of monthly power and water expenses that should be accrued for the month of December 2014 in the amount of $5,000 ($55,000 5). Consequently the cost of power and water for the fiscal year will be in the amount of $60,000 ($55,000 + $5,000). 4. No depreciation expense should be recognized in the 2014 fiscal year as the packaging equipment was not yet available for use

14 SOLUTIONS TO PROBLEMS PROBLEM 11-4A (a) and (b) 1. Expense recognition criteria (matching concept). The cost of equipment should not be expensed immediately. Only costs which have no probable future benefits are recognized immediately as expenses. Therefore, the following entries are necessary: Equipment Cash 80, ,000 Depreciation Expense [$80,000 (100% 5 2)]... 32,000 Accumulated Depreciation Equipment 32, Expense recognition criteria (matching concept). The cost of property, plant, and equipment should be allocated over its useful life in a rational and systematic manner. Deferring depreciation is not rational and systematic. Therefore, the following entry is necessary: Depreciation Expense... Accumulated Depreciation ,000 43,000 Measurement criteria (cost basis). Recording the transaction at its estimated fair value would not be proper because estimated fair value in this case does not represent an exchange price. The purchase should be recorded at cost, not at a fair value that someone believes the equipment is worth. The correct entry is: 11-14

15 Equipment Cash...36, ,000 PROBLEM 11-4A (Continued) (a) and (b) (Continued) 4. Going concern assumption. Liquidation value is not appropriate because it assumes that the enterprise will not continue. No entry is necessary. Only when liquidation appears imminent is the going concern assumption inapplicable. Otherwise, the cost measurement basis applies. 5. Expense recognition criteria (matching concept). Expensing the cost of the rent immediately does not allow a proper matching of the expense with the revenue that will be earned over the next 6 months. The correct entry is: Prepaid Rent Cash 18,000 18,000 An adjusting entry is made at December 31 to record the proper rent expense. Rent Expense Prepaid Rent 12, ,000 Alternatively, the entry debiting Rent Expense can be recorded, but the adjusting entry at December 31 would then be as follows: Prepaid Rent Rent Expense 6, ,000 If financial statements are prepared only once at the end of the fiscal year, it really doesn t matter what entry is made originally (although debiting an asset account such as Prepaid Rent tends to result in better internal control), as 11-15

16 long as the correct allocation is made at year end between the asset and the expense account

17 PROBLEM 11-4A (Continued) (a) and (b) (Continued) 6. Measurement criteria (cost basis). Appreciation in value does not justify recognizing a gain on the land, until the land is sold (since Kwick Kopy has not adopted the revaluation model for accounting for its property, plant, and equipment). Appreciation does not involve an exchange transaction. No entry is necessary. 7. Revenue recognition criteria. Kwick Kopy will not begin to perform the service until January Therefore the revenue has not been earned in 2014 and it would be inappropriate for the company to record any revenue in No entry is necessary in Taking It Further: A liquidation basis may be appropriate for property, plant, and equipment if the company can no longer apply the going concern assumption. In such a case, the company s demise would be imminent and liquidation is likely

18 PROBLEM 11-5A (a) and (b) 1. The sale should be recorded in the next year instead of the current year. Legal title of the goods does not change hands until the next year. Therefore, the revenue recognition criteria are violated. It should be noted that if the company is employing a perpetual inventory system in dollars and quantities, a debit to cost of goods sold and a credit to inventory are also necessary in the next year. Correcting entry required: Sales 90,000 Accounts Receivable... Unearned Revenue ,000 10,000 The $5,000 for the sale of extended warranties should be recorded as unearned revenue to recognize that Durkovitch Company has an obligation (liability) to provide warranty service in the future. Warranty revenue will be recognized when the company satisfies its obligation by providing warranty service. Correcting entry required: Sales 5,000 Unearned Revenue ,000

19 PROBLEM 11-5A (Continued) (a) and (b) (Continued) 3. Depreciation is a means of cost allocation. Assets are not depreciated on the basis of the level of profitability, but are depreciated on the basis of systematic charges of expired costs against revenues. Recording additional depreciation to manipulate the current and future profit performance shows a violation of the representational faithfulness of the events that actually occurred and the expenses that were incurred to earn revenue. Correcting entry to reverse entry made is required: Accumulated Depreciation... Depreciation Expense ,000 60,000 This entry violates the expense recognition criteria. The merchandise has not been sold and should not be shown on the income statement until it is sold. This will match the cost of merchandise sold against the revenue when recorded. Since the merchandise has probable future economic benefits, it should be shown on the balance sheet as an asset. Correcting entry required: Inventory...78,000 Cost of Goods Sold ,000

20 PROBLEM 11-5A (Continued) (a) and (b) (Continued) 5. Durkovitch Company has not adopted the revaluation model of accounting for its property, plant, and equipment. A loss should not be recognized based on the cost measurement criteria. In some circumstances, land may be written down if it is considered impaired. Correcting entry required: Land 30,000 Loss on Fair Value Adjustment of Land 30,000 Taking It Further: Yes, the answer would have been different. If the Durkovitch Company was a real estate company, the land would be inventory rather than property, plant, and equipment. For inventory, the measurement basis is cost combined with fair value, as lower of cost and net realizable value. This modified basis is considered more relevant to users needs because it provides information on the company s liquidity and solvency. As part of inventory, the expectation is that the land will be sold in the short-term and its future economic benefits will be realized in the coming year. Any declines in value below original cost affect those future benefits in the current year, and should be recorded as such

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22 PROBLEM 11-7A Net sales to November 30, 2014 Add: Gross sales for December, 2014 Less: Sales returns, December, 2014 Goods sold FOB shipping point Estimated sales returns $1,200, ,000 $1,325,000 $20,000 12,000 11,000 43,000 Cost of goods sold to November 30, 2014 Add: Cost of goods sold for Dec $635,000 66,250 $701,250 Less: Cost of goods returned, Dec Goods sold FOB shipping point Estimated cost of goods return Cost of goods sold Gross profit $10,600 6,300 5,800 Net sales $1,282,000 22, ,550 $603,450 Taking It Further: If sales returns did not result in goods being returned to inventory for resale, the cost of these goods would not be deducted in the calculation of the cost of goods sold. Consequently, the results of the calculation would be as follows: Net sales $1,282,000 Cost of goods sold to November 30, 2014 Add: Cost of goods sold for Dec Less: Goods sold FOB shipping point Cost of goods sold Gross profit $635,000 66,250 $701,250 6, ,950 $587,050

23 PROBLEM 11-8A (a) (b) Dave s Deep Discount Furniture Store s source of revenue comes from the sale of goods. Revenue is recognized when all of the following conditions are met: The seller has transferred the significant risks and rewards of ownership this condition is usually met when the customer takes possession of the furniture. In Dave s case, it appears that delivery is included in the furniture purchase. Ownership would be transferred when the furniture arrives at the customer s home. The seller does not have control over the goods or continuing managerial involvement. This criterion does not apply specifically to the sale of furniture. Control of the goods is transferred when the customer takes possession of the goods. The amount of the revenue can be reliably measured. This criterion is satisfied when there is an agreed-upon price, usually at the point of sale. It is probable cash will be collected. For Dave s, collectability seems to be reasonably assured since they conduct credit checks of their customers. Costs relating to the sale of the goods can be reliably measured. For furniture sales, the costs usually relate to the cost of sales, sales commissions and delivery costs. These costs can be measured and matched to revenue. The critical factors are the transfer of ownership and collectability. For the sale of merchandise, the point where legal ownership is transferred is a critical factor since it represents the point where the risks and rewards of ownership are transferred. It also usually indicates the end of the earning process in that no future costs are associated with the process

24 PROBLEM 11-8A (Continued) (b) (Continued) In some cases, costs such as warranty costs occur after the transfer of ownership, but revenue is recognized when ownership is transferred if these costs can be reliably estimated and recognized in the same period as the revenue. If collectability is reasonably ensured at the transfer of ownership, revenue is recognized at this point. The risk of non-collection can be reliably measured as bad debts expense and recognized in the same period as the sale. If the risk of non-collection cannot be reliably estimated, revenue recognition should be deferred until cash is received. (c) Revenue of $310,000 should be recognized = Total sales $325,000 $15,000 goods delivered in January Taking It Further: Yes. The amount of revenue that Dave s should recognize in 2012 would be $60,000. This is the amount of revenue for furniture delivered before year-end that has been collected in full. A thorough credit check is a critical factor since it provides support that cash will be collected, or that bad debts will be minimal and can be reasonably estimated and accrued. Since Dave s opened for business in 2012, they do not have any prior experience to determine collectability on its credit sales

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26 PROBLEM 11-10A (a) Financial statements help the bank assess the financial position, profitability and liquidity of their customers. With accurate and complete financial information, the bank can determine the impact the expansion plans might have on Kamloop s profitability and ability to repay any current and additional loans obtained. (b) In order to ensure that the financial information provided by Kamloops is reliable, the bank will request that the financial statements be reviewed by an independent accountant

27 PROBLEM 11-10A (Continued) (c) Current assets Add: Cost of goods in transit (1) Sale has not Less: occurred (2) Accrued sales returns (3) Eliminate prepaid advertising (4) Revised current assets *($26,000 5%) Current liabilities Add: Invoice for goods in transit (1) Revised current liabilities $120,000 15,000 (8,400) (1,300)* (3,500) $121,800 $ 80,000 15,000 $ 95,000 Net sales Less: Accrued sales returns (3) Sale has not occurred, no transfer of ownership (2) Revised net sales 560,000 (1,300) (8,400) $550,300 Total operating expenses Add: Advertising expense (4) Revised total operating expenses $106,000 3,500 $109, Goods in transit must be included in inventory and accounts payable as the terms of shipment indicate that Kamloops owned the inventory as of December 31, Kamloops has double counted the inventory items in accounts receivable and in inventory. The merchandise inventory was sold and so the recording of the sale and corresponding cost of goods sold is correctly recorded. The amount of the cost of the items sold must be removed from the inventory count and balance. 3. Sales returns for the last 15 days of the fiscal year need to be accrued as a reduction of sales and a reduction of accounts receivable. The amount accrued is 5% of $26,000 or $1,

28 PROBLEM 11-10A (Continued) 4. The promotional expense recorded as a prepaid expense must be expensed and there is no measurable future benefit realized as of December 31, Taking It Further: (a) (b) Current ratio Curr ent ratio = = $ 120,000 $ 80,000 $ 121,8 00 $ 95,00 0 = 1.50:1 = 1.28:1 As a result of the required adjustments, Kamloops current ratio is considerably worse as it has reduced by from the initial 1.5 to Since the adjustments that were required are in the same direction (reducing profit, decreasing current assets, and increasing current liabilities), there appears to be a bias in the errors made by Kamloops. On the other hand, without knowing the level of training and expertise of Alphonzo, the company s manager, who is the preparer of the financial statements, it is inappropriate to conclude if the errors were intentional