Intermediate Accounting

IFRS Edition-2nd
Questions & Solutions
Chapter 2

Conceptual
Framework for
Financial
Reporting

Donald E. Kieso
Jerry J. Weygandt
Terry D. Warfield
 BRIEF EXERCISES
4 BE2-1 Match the qualitative characteristics below with the following statements.
1. Relevance 5. Comparability
2. Faithful representation 6. Completeness
3. Predictive value 7. Neutrality
4. Confirmatory value 8. Timeliness
(a) Quality of information that permits users to identify similarities in and differences between
two sets of economic phenomena.
(b) Having information available to users before it loses its capacity to influence decisions.
(c) Information about an economic phenomenon that has value as an input to the processes
used by capital providers to form their own expectations about the future.
(d) Information that is capable of making a difference in the decisions of users in their capacity
as capital providers.
(e) Absence of bias intended to attain a predetermined result or to induce a particular behavior.
4 BE2-2 Match the qualitative characteristics below with the following statements.
1. Timeliness 5. Faithful representation
2. Completeness 6. Relevance
3. Free from error 7. Neutrality
4. Understandability 8. Confirmatory value
(a) Quality of information that assures users that information represents the economic phenom-
ena that it purports to represent.
(b) Information about an economic phenomenon that changes past or present expectations
based on previous evaluations.
(c) The extent to which information is accurate in representing the economic substance of a
transaction.
(d) Includes all the information that is necessary for a faithful representation of the economic
phenomena that it purports to represent.
(e) Quality of information that allows users to comprehend its meaning.
4 BE2-3 Discuss whether the changes described in each of the situations below require recognition in the
audit report as to consistency. (Assume that the amounts are material.)
(a) The company changed its inventory method to FIFO from weighted-average, which had been
used in prior years.
(b) The company disposed of one of the two subsidiaries that had been included in its consolidated
statements for prior years.
(c) The estimated remaining useful life of plant property was reduced because of obsolescence.
(d) The company is using an inventory valuation method that is different from those used by all
other companies in its industry.
 Brief Exercises 53

4 BE2-4 Identify which qualitative characteristic of accounting information is best described in each item
below. (Do not use relevance and faithful representation.)
(a) The annual reports of Best Buy Co. (USA) are audited by certified public accountants.
(b) Motorola (USA) and Nokia (FIN) both use the FIFO cost flow assumption.
(c) Starbucks Corporation (USA) has used straight-line depreciation since it began operations.
(d) Heineken Holdings (NLD) issues its quarterly reports immediately after each quarter ends.
5 BE2-5 Explain how you would decide whether to record each of the following expenditures as an asset or
an expense. Assume all items are material.
(a) Legal fees paid in connection with the purchase of land are €1,500.
(b) Eduardo, Inc. paves the driveway leading to the office building at a cost of €21,000.
(c) A meat market purchases a meat-grinding machine at a cost of €3,500.
(d) On June 30, Monroe and Meno, medical doctors, pay 6 months’ office rent to cover the month of
July and the next 5 months.
(e) Smith’s Hardware Company pays €9,000 in wages to laborers for construction on a building to
be used in the business.
(f) Alvarez’s Florists pays wages of €2,100 for November to an employee who serves as driver of
their delivery truck.
5 BE2-6 For each item below, indicate to which category of elements of financial statements it belongs.
(a) Retained earnings. (e) Depreciation. (h) Dividends.
(b) Sales. (f) Loss on sale of equipment. (i) Gain on sale of investment.
(c) Share Premium. (g) Interest payable. (j) Issuance of ordinary shares.
(d) Inventory.
6 BE2-7 If the going concern assumption is not made in accounting, discuss the differences in the amounts
shown in the financial statements for the following items.
(a) Land.
(b) Depreciation expense on equipment.
(c) Inventory.
(d) Prepaid insurance.
6 BE2-8 Identify which basic assumption of accounting is best described in each of the following items.
(a) The economic activities of FedEx Corporation (USA) are divided into 12-month periods for the
purpose of issuing annual reports.
(b) Total S.A. (FRA) does not adjust amounts in its financial statements for the effects of inflation.
(c) Barclays (GBR) reports current and non-current classifications in its statement of financial position.
(d) The economic activities of Tokai Rubber Industries (JPN) and its subsidiaries are merged for
accounting and reporting purposes.
7 BE2-9 Identify which basic principle of accounting is best described in each item below.
(a) Parmalat (ITA) reports revenue in its income statement when it delivers goods instead of when
the cash is collected.
(b) Google (USA) recognizes depreciation expense for a machine over the 2-year period during
which that machine helps the company earn revenue.
(c) Oracle Corporation (USA) reports information about pending lawsuits in the notes to its finan-
cial statements.
(d) Fuji Film (JPN) reports land on its statement of financial position at the amount paid to acquire
it, even though the estimated fair value is greater.
7 BE2-10 Vande Velde Company made three investments during 2015. (1) It purchased 1,000 shares of Sastre
Company, a start-up company. Vande Velde made the investment based on valuation estimates from an
internally developed model. (2) It purchased 2,000 shares of Fuji Film (JPN), which trades on the Nikkei.
(3) It invested $10,000 in local development authority bonds. Although these bonds do not trade on an ac-
tive market, their value closely tracks movements in U.S. Treasury bonds. Rank these three investments in
terms of the verifiability of fair value.
4 BE2-11 Presented below are three different transactions related to materiality. Explain whether you would
classify these transactions as material.
(a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it
reduces its bad debt expense to ensure another positive earnings year. The impact of this
adjustment is equal to 3% of net income.
54 Chapter 2 Conceptual Framework for Financial Reporting

(b) Hindi Co. has a gain of €3.1 million on the sale of plant assets and a €3.3 million loss on the sale
of investments. It decides to net the gain and loss because the net effect is considered immaterial.
Hindi Co.’s income for the current year was €10 million.
(c) Damon Co. expenses all capital equipment under €2,500 on the basis that it is immaterial. The
company has followed this practice for a number of years.
6 7 BE2-12 What accounting assumption, principle, or constraint would Marks and Spencer plc (M&S) (GBR)
8 use in each of the situations below?
(a) M&S records expenses when incurred, rather than when cash is paid.
(b) M&S was involved in litigation over the last year. This litigation is disclosed in the financial
statements.
(c) M&S allocates the cost of its depreciable assets over the life it expects to receive revenue from
these assets.
(d) M&S records the purchase of a new Lenovo (CHN) PC at its cash equivalent price.
3 4 BE2-13 Fill in the blanks related to the following statements.
8 1. Financial reporting imposes ______; the benefits of financial reporting should justify those _____.
2. The information provided by ______ ______ ______ ______ focuses on the needs of all capital
providers, not just the needs of a particular group.
3. A depiction of economic phenomena is ______ if it includes all the information that is necessary
for faithful representation of the economic phenomena that it purports to represent.
4. ______ is the quality of information that allows users to comprehend its meaning.
5. ______ is the quality of information that permits users to identify similarities in and differences
between two sets of economic phenomena.
6. Information about economic phenomena has _____ _____ if it confirms or changes past or present
expectations based on previous evaluations.

EXERCISES
1 3 E2-1 (Usefulness, Objective of Financial Reporting) Indicate whether the following statements about
the Conceptual Framework are true or false. If false, provide a brief explanation supporting your position.
(a) Accounting rule-making that relies on a body of concepts will result in useful and consistent
pronouncements.
(b) General-purpose financial reports are most useful to company insiders in making strategic busi-
ness decisions.
(c) Accounting standards based on individual conceptual frameworks generally will result in consis-
tent and comparable accounting reports.
(d) Capital providers are the only users who benefit from general-purpose financial reporting.
(e) Accounting reports should be developed so that users without knowledge of economics and busi-
ness can become informed about the financial results of a company.
(f) The objective of financial reporting is the foundation from which the other aspects of the frame-
work logically result.
1 3 E2-2 (Usefulness, Objective of Financial Reporting, Qualitative Characteristics) Indicate whether the
4 following statements about the Conceptual Framework are true or false. If false, provide a brief explana-
tion supporting your position.
(a) The fundamental qualitative characteristics that make accounting information useful are relevance
and verifiability.
(b) Relevant information has predictive value, confirmatory value, or both.
(c) Conservatism, a prudent reaction to uncertainty, is considered a constraint of financial reporting.
(d) Information that is a faithful representation is characterized as having predictive or confirmatory
value.
(e) Comparability pertains only to the reporting of information in a similar manner for different
companies.
(f) Verifiability is solely an enhancing characteristic for faithful representation.
(g) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge
of business and economic activities.
 Exercises 55

4 8 E2-3 (Qualitative Characteristics) The Conceptual Framework identifies the qualitative characteristics
that make accounting information useful. Presented below are a number of questions related to these qual-
itative characteristics and underlying constraint.
(a) What is the quality of information that enables users to confirm or correct prior expectations?
(b) Identify the overall or pervasive constraint developed in the Conceptual Framework.
(c) A noted accountant once remarked, “If it becomes accepted or expected that accounting principles
are determined or modified in order to secure purposes other than economic measurement, we
assume a grave risk that confidence in the credibility of our financial information system will be
undermined.” Which qualitative characteristic of accounting information should ensure that such
a situation will not occur? (Do not use faithful representation.)
(d) Muruyama Group switches from FIFO to average-cost and then back to FIFO over a 2-year period.
Which qualitative characteristic of accounting information is not followed?
(e) Assume that the profession permits the savings and loan industry to defer losses on investments
it sells, because immediate recognition of the loss may have adverse economic consequences on
the industry. Which qualitative characteristic of accounting information is not followed? (Do not
use relevance or faithful representation.)
(f) What are the two fundamental qualities that make accounting information useful for decision-making?
(g) Watteau Inc. does not issue its first-quarter report until after the second quarter’s results are re-
ported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.)
(h) Predictive value is an ingredient of which of the two fundamental qualities that make accounting
information useful for decision-making purposes?
(i) Duggan, Inc. is the only company in its industry to depreciate its plant assets on a straight-line
basis. Which qualitative characteristic of accounting information may not be present?
(j) Nadal Company has attempted to determine the replacement cost of its inventory. Three different
appraisers arrive at substantially different amounts for this value. The president, nevertheless,
decides to report the middle value for external reporting purposes. Which qualitative characteris-
tic of information is lacking in these data? (Do not use reliability or representational faithfulness.)
4 E2-4 (Qualitative Characteristics) The qualitative characteristics that make accounting information
useful for decision-making purposes are as follows.
Relevance Neutrality Verifiability
Faithful representation Completeness Understandability
Predictive value Timeliness Comparability
Confirmatory value Materiality Free from error
Instructions
Identify the appropriate qualitative characteristic(s) to be used given the information provided below.
(a) Qualitative characteristic being displayed when companies in the same industry are using the
same accounting principles.
(b) Quality of information that confirms users’ earlier expectations.
(c) Imperative for providing comparisons of a company from period to period.
(d) Ignores the economic consequences of a standard or rule.
(e) Requires a high degree of consensus among individuals on a given measurement.
(f) Predictive value is an ingredient of this fundamental quality of information.
(g) Four qualitative characteristics that enhance both relevance and faithful representation.
(h) An item is not reported because its effect on income would not change a decision.
(i) Neutrality is a key ingredient of this fundamental quality of accounting information.
(j) Two fundamental qualities that make accounting information useful for decision-making purposes.
(k) Issuance of interim reports is an example of what enhancing ingredient?
5 E2-5 (Elements of Financial Statements) Five interrelated elements that are most directly related to
measuring the performance and financial status of an enterprise are provided below.
Assets Income
Liabilities Expenses
Equity
Instructions
Identify the element or elements associated with the following nine items.
(a) Obligation to transfer resources arising from a past transaction.
(b) Increases ownership interest by issuance of shares.
(c) Declares and pays cash dividends to owners.
(d) Increases in net assets in a period from non-owner sources.
56 Chapter 2 Conceptual Framework for Financial Reporting

(e) Items characterized by service potential or future economic benefit.

(f) Equals increase in assets less liabilities during the year, after adding distributions to owners and
subtracting investments by owners.
(g) Residual interest in the assets of the enterprise after deducting its liabilities.
(h) Increases assets during a period through sale of product.
(i) Decreases assets during the period by purchasing the company’s own shares.
6 7 E2-6 (Assumptions, Principles, and Constraint) Presented below are the assumptions, principles, and
8 constraint used in this chapter.
1. Economic entity assumption 6. Historical cost principle 10. Revenue recognition
2. Going concern assumption 7. Fair value principle principle

3. Monetary unit assumption 8. Expense recognition principle 11. Cost constraint

4. Periodicity assumption 9. Full disclosure principle
5. Accrual-basis assumption
Instructions
Identify by number the accounting assumption, principle, or constraint that describes each situation below.
Do not use a number more than once.
(a) Allocates expenses to revenues in the proper period.
(b) Indicates that fair value changes subsequent to purchase are not recorded in the accounts. (Do not
use revenue recognition principle.)
(c) Ensures that all relevant financial information is reported.
(d) Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.)
(e) Generally records revenue at the point of sale.
(f) Indicates that personal and business record keeping should be separately maintained.
(g) Separates financial information into time periods for reporting purposes.
(h) Permits the use of fair value valuation in certain situations.
(i) Assumes that the yen is the “measuring stick” used to report on financial performance of a Japanese
company.
6 7 E2-7 (Assumptions, Principles, and Constraint) Presented below are a number of operational guidelines
8 and practices that have developed over time.
Instructions
Select the assumption, principle, or constraint that most appropriately justifies these procedures and prac-
tices. (Do not use qualitative characteristics.)
(a) Fair value changes are not recognized in the accounting records.
(b) Accounts receivable are recorded for sales on account rather than waiting until cash is received.
(c) Financial information is presented so that investors will not be misled.
(d) Intangible assets are capitalized and amortized over periods benefited.
(e) Brokerage companies use fair value for purposes of valuing financial securities.
(f) Each enterprise is kept as a unit distinct from its owner or owners.
(g) All significant post-statement of financial position events are reported.
(h) Revenue is recorded at point of sale.
(i) All important aspects of bond indentures are presented in financial statements.
(j) Rationale for accrual accounting.
(k) The use of consolidated statements is justified.
(l) Reporting must be done at defined time intervals.
(m) An allowance for doubtful accounts is established.
(n) All payments out of petty cash are charged to Miscellaneous Expense.
(o) Goodwill is recorded only at time of purchase.
(p) Cash received and paid is not the basis used to recognize revenues and expenses.
(q) A company charges its sales commission costs to expense.
7 E2-8 (Full Disclosure Principle) The following facts relate to Weller, Inc. Assume that no mention of these
facts was made in the financial statements and the related notes.
Instructions
Assume that you are the auditor of Weller, Inc. and that you have been asked to explain the appropriate
accounting and related disclosure necessary for each of these items.
(a) The company decided that, for the sake of conciseness, only net income should be reported on the
income statement. Details as to revenues, cost of goods sold, and expenses were omitted.
 Exercises 57

(b) Equipment purchases of €170,000 were partly financed during the year through the issuance of a
€110,000 notes payable. The company offset the equipment against the notes payable and reported
plant assets at €60,000.
(c) Weller has reported its ending inventory at €2,100,000 in the financial statements. No other infor-
mation related to inventories is presented in the financial statements and related notes.
(d) The company changed its method of valuing inventories from weighted-average to FIFO. No
mention of this change was made in the financial statements.
7 E2-9 (Accounting Principles—Comprehensive) Presented below are a number of business transactions
that occurred during the current year for Gonzales, Inc.

Instructions
In each of the situations, discuss the appropriateness of the journal entries.
(a) The president of Gonzales, Inc. used his expense account to purchase a new Suburban solely for
personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000
(b) Merchandise inventory that cost €620,000 is reported on the statement of financial position at
€690,000, the expected selling price less estimated selling costs. The following entry was made to
record this increase in value.
Inventory 70,000
Sales Revenue 70,000
(c) The company is being sued for €500,000 by a customer who claims damages for personal injury
apparently caused by a defective product. Company attorneys feel extremely confident that the
company will have no liability for damages resulting from the situation. Nevertheless, the com-
pany decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
(d) Because the general level of prices increased during the current year, Gonzales, Inc. determined
that there was a €16,000 understatement of depreciation expense on its equipment and decided to
record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation—Equipment 16,000
(e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of
liquidation. As a consequence, goodwill arising from a purchase transaction during the current
year and recorded at €800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f) Because of a “fire sale,” equipment obviously worth €200,000 was acquired at a cost of €155,000.
The following entry was made.
Equipment 200,000
Cash 155,000
Sales Revenue 45,000

7 E2-10 (Accounting Principles—Comprehensive) The following information relates to Wang Group.

Instructions
Comment on the appropriateness of the accounting procedures followed by Wang Group.
(a) Depreciation expense on the building for the year was ¥60,000. Because the building was increas-
ing in value during the year, the controller decided to charge the depreciation expense to retained
earnings instead of to net income. The following entry is recorded.
Retained Earnings 60,000
Accumulated Depreciation—Buildings 60,000
(b) Materials were purchased on January 1, 2015, for ¥120,000 and this amount was entered in the
Materials account. On December 31, 2015, the materials would have cost ¥141,000, so the following
entry is made.
Inventory 21,000
Gain on Inventories 21,000
58 Chapter 2 Conceptual Framework for Financial Reporting

(c) During the year, the company purchased equipment through the issuance of ordinary shares. The
shares had a par value of ¥135,000 and a fair value of ¥450,000. The fair value of the equipment was
not easily determinable. The company recorded this transaction as follows.
Equipment 135,000
Share Capital 135,000
(d) During the year, the company sold certain equipment for ¥285,000, recognizing a gain of ¥69,000.
Because the controller believed that new equipment would be needed in the near future, she de-
cided to defer the gain and amortize it over the life of any new equipment purchased.
(e) An order for ¥61,500 has been received from a customer for products on hand. This order was
shipped on January 9, 2015. The company made the following entry in 2014.
Accounts Receivable 61,500
Sales Revenue 61,500

C O N C E P T S F O R A N A LY S I S
CA2-1 (Conceptual Framework—General) Wayne Cooper has some questions regarding the theoretical
framework in which IFRS is established. He knows that the IASB has attempted to develop a conceptual
framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theo-
retical 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 a conceptual framework.
(b) Identify the benefits that arise from a conceptual framework.
CA2-2 (Conceptual Framework—General) The IASB’s Conceptual Framework for Financial Reporting
sets forth the objective and fundamentals that will be the basis for developing financial accounting and
reporting standards. The objective identifies the purpose 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 characteristics or qualities of information discussed in the Conceptual Framework are the con-
cepts 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 Conceptual Frame-
work.
(b) What is the most important quality for accounting information as identified in the Conceptual
Framework? Explain why it is the most important.
(c) Briefly discuss the importance of any three of the fundamental characteristics or enhancing quali-
ties of accounting information.
CA2-3 (Objective of Financial Reporting) Homer Winslow and Jane Alexander are discussing various
aspects of the Conceptual Framework. Homer indicates that this pronouncement provides little, if any,
guidance to the practicing professional in resolving accounting controversies. He believes that the Concep-
tual Framework provides such broad guidelines that it would be impossible to apply the objective(s) to
present-day reporting problems. Jane concedes this point but indicates that objective(s) are still needed to
provide a starting point for the IASB 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 IASB needs a starting point to
resolve accounting controversies about how to improve financial reporting?
 Concepts for Analysis 59

CA2-4 (Qualitative Characteristics) Accounting information provides useful information about business
transactions and events. Those who provide and use financial reports must often select and evaluate ac-
counting alternatives. The Conceptual Framework examines the characteristics of accounting information
that make it useful for decision-making. It also points out that various limitations inherent in the measure-
ment 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 (consistency).
(2) Faithful representation. (5) Neutrality.
(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 ex-
presses surprise that the income statement assumes that an equal proportion of the revenue is earned with
the publication of every issue of the company’s magazine. She feels that the “crucial event” in the process
of recognizing 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 sale.
Instructions
Discuss the propriety of timing the recognition of revenue in Piper Publishing Company’s accounts with
respect to the following.
(a) The cash sale of the magazine subscription.
(b) The publication of the magazine every month.
(c) Both events, by recognizing a portion of the revenue with the cash sale of the magazine subscrip-
tion and a portion of the revenue with the publication of the magazine every month.
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 de-
pendent on the proper recognition, in general, of revenue and expense 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 in-
stead 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.
CA2-7 (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 lum-
ber, roofing, doors, windows, and similar materials necessary to complete a shell house. Upon com-
mencing operations in a new area, Barenboim buys or leases land as a site for his 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.
60 Chapter 2 Conceptual Framework for Financial Reporting

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 pas-
sage of time or (2) the number of shell houses sold? Explain.

CA2-8 (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 pur-
chasing 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 Neville that, unless you can take a look at its 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 state-
ments which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse
these statements, and they are quite impressive. The statement of financial position 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 ad-
dition, 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 a faithful representation.

CA2-9 (Expense Recognition Principle) Anderson Nuclear Power Plant will be “mothballed” at
the end of its useful life (approximately 20 years) at great expense. 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?

CA2-10 (Cost Constraint) A 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 com-
pany’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 manage-
ment agree they should be reported—a concept of flexible reporting.
6. Companies should not have to report forward-looking information unless there are effec-
tive 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.
 SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 2-1

(a) Comparability
(b) Timeliness
(c) Predictive value
(d) Relevance
(e) Neutrality

BRIEF EXERCISE 2-2

(a) Faithful representation

(b) Confirmatory value
(c) Free from error
(d) Completeness
(e) Understandability

BRIEF EXERCISE 2-3

(a) If the company changed its method for inventory valuation, the consis-
tency, and therefore the comparability, of the financial statements have
been affected by a change in the method of applying the accounting
principles employed. The change would require comment in the auditor’s
report in an explanatory paragraph.

(b) If the company disposed of one of its two subsidiaries that had been
included in its consolidated statements for prior years, no comment as
to consistency needs to be made in the auditor’s report. The compara-
bility of the financial statements has been affected by a business trans-
action, but there has been no change in any accounting principle
employed or in the method of its application. (The transaction would
probably require informative disclosure in the financial statements.)

(c) If the company reduced the estimated remaining useful life of plant
property because of obsolescence, the comparability of the financial
statements has been affected. The change is a matter of consistency;
it is a change in accounting estimate which leads to a change in
accounting principles employed or in their method of application. The
change would require comment in the auditor’s report in an explanatory
paragraph.

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BRIEF EXERCISE 2-3 (Continued)

(d) If the company is using a different inventory valuation method from

all other companies in its industry, no comment as to consistency
need be made in the CPA’s audit report. Consistency refers to a
given company following consistent accounting principles from one
period to another; it does not company following the same accounting
principles as other companies in the same industry.

BRIEF EXERCISE 2-4

(a) Verifiability
(b) Comparability
(c) Consistency
(d) Timeliness

BRIEF EXERCISE 2-5

(a) Should be debited to the Land account, as it is a cost incurred in

acquiring land.

(b) As an asset, preferably to a Land Improvements account. The driveway

will last for many years, and therefore it should be capitalized and
depreciated.

(c) Probably an asset, as it will last for a number of years and therefore
will contribute to operations of those years.

(d) If the fiscal year ends December 31, this will all be an expense of the
current year that can be charged to an expense account. If statements
are to be prepared on some date before December 31, part of this cost
would be expense and part asset. Depending upon the circumstances,
the original entry as well as the adjusting entry for statement purposes
should take the statement date into account.

(e) Should be debited to the building account; depreciation expense

during the life of building will include these costs.

(f) As an expense, as the service has already been received; the contri-
bution to operations occurred in this period.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-11
BRIEF EXERCISE 2-6
(a) Equity
(b) Income
(c) Equity
(d) Assets
(e) Expenses
(f) Expenses
(g) Liabilities
(h) Equity
(i) Income
(j) Equity

BRIEF EXERCISE 2-7

(a) Fair value, or net realizable value, if the land was sold.

(b) Would not be disclosed. Depreciation would be inappropriate if the

going concern assumption no longer applies.

(c) Fair value, or selling price less costs to complete.

(d) Fair value (i.e., redeemable value), if the insurance coverage was
transferred to another party.

Note: In each of these cases, historical cost or fair value valuation might be
abandoned if it can not be assumed that the company will not continue
on indefinitely.

BRIEF EXERCISE 2-8

(a) Periodicity
(b) Monetary unit
(c) Going concern
(d) Economic entity

BRIEF EXERCISE 2-9

(a) Revenue recognition

(b) Expense recognition
(c) Full disclosure
(d) Historical cost principle

2-12 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
BRIEF EXERCISE 2-10

Investment 1—Least verifiable.

Investment 2—Most verifiable.
Investment 3—Intermediate verifiability

BRIEF EXERCISE 2-11

(a) Material; although amount is small the change affects the trend.
(b) Material; netting obsures the information on the gain and loss.
(c) Likely not material; the amount of depreciation expense, if capitalized
would not have a significant impact on income.

BRIEF EXERCISE 2-12

(a) Accrual basis

(b) Full disclosure
(c) Expense recognition principle
(d) Historical cost principle

BRIEF EXERCISE 2-13

1. Costs; costs
2. General purpose financial reporting
3. Complete
4. Understandability
5. Comparability
6. Confirmatory value

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-13
 SOLUTIONS TO EXERCISES

EXERCISE 2-1 (10–15 minutes)

(a) True

(b) False. General purpose financial reporting helps users who lack the
ability to demand all the financial information they need from an entity
and therefore must rely, at least partly, on the information provided in
financial reports. Managers and company insiders generally do not
meet these criteria.

(c) False. Accounting standards based on individual conceptual frameworks

generally will not result in consistent and comparable accounting
reports. Rather, standard-setting that is based on personal conceptual
frameworks will lead to different conclusions about identical or similar
issues than it did previously. As a result, standards will not be con-
sistent with one another and past decisions may not be indicative of
future ones.

(d) False. The objective of general purpose financial reporting is to

provide financial information about the reporting entity that is useful to
present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers. However, that
information may also be useful to other users of financial reporting
who are not capital providers.

(e) False. An implicit assumption is that users need reasonable knowledge

of business and financial accounting matters to understand the
information contained in financial statements. This point is important.
It means that financial statement preparers assume a level of com-
petence on the part of users. This assumption impacts the way and the
extent to which companies report information.

(f) True.

2-14 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
EXERCISE 2-2 (10–15 minutes)

(a) False. The fundamental qualitative characteristics that make accounting

information useful are relevance and faithful representation.

(b) True.

(c) False. The Framework does not include prudence or conservatism as

desirable qualities of financial reporting information. The framework
indicates that prudence or conservatism generally is in conflict with
the quality of neutrality. This is because by being prudent or con-
servative likely leads to a bias in the reported financial position and
financial performance. In fact, introducing biased understatement of
assets (or overstatement of liabilities) in one period frequently leads to
overstating financial performance in later periods—a result that cannot
be described as prudent. This is inconsistent with neutrality, which
encompasses freedom from bias.

(d) False. To be a faithful representation, information must be complete,

neutral, and free of material error.

(e) False. While comparability does pertain to the reporting of information in

a similar manner for different companies, it also refers to the consistency
of information, which is present when a company applies the same
accounting treatment to similar events, from period to period. Through
such application the company shows consistent use of accounting
standards and this permits valid comparisons from one period to
the next.

(f) False. Verifiability is an enhancing characteristic for both relevance

and faithful representation. Verifiability occurs when independent
measurers, using the same methods obtain similar results.

(g) True.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-15
EXERCISE 2-3 (15–20 minutes)

(a) Confirmatory Value. (e) Neutrality.

(b) Cost Constraint. (f) Relevance and Faithful Representation.
(c) Neutrality. (g) Timeliness.
(d) Consistency (note the overall (h) Relevance.
qualitative characteristic is (i) Comparability.
comparability; consistency is (j) Verifiability.
considered part of
comparability).

EXERCISE 2-4 (15–20 minutes)

(a) Comparability. (g) Comparability (Consistency),

(b) Confirmatory Value. Verifiability, Timeliness, and
(c) Comparability (Consistency). Understandability.
(d) Neutrality. (h) Materiality
(e) Verifiability. (i) Faithful Representation.
(f) Relevance. (j) Relevance and Faithful Representation.
(k) Timeliness.

EXERCISE 2-5 (10–15 minutes)

(a) Liabilities.
(b) Equity.
(c) Equity.
(d) Income.
(e) Assets.
(f) Income.
(g) Equity.
(h) Income.
(i) Equity.

2-16 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
EXERCISE 2-6 (15–20 minutes)

(a) 8. Expense recognition principle.

(b) 6. Historical cost principle.
(c) 9. Full disclosure principle.
(d) 2. Going concern assumption.
(e) 10. Revenue recognition principle.
(f) 1. Economic entity assumption.
(g) 4. Periodicity assumption.
(h) 7. Fair value principle.
(I) 3. Monetary unit assumption.

EXERCISE 2-7 (20–25 minutes)

(a) Historical cost principle. (j) Revenue and expense recogni-

(b) Accrual-basis assumption. tion principles.
(c) Full disclosure principle. (k) Economic entity assumption.
(d) Expense recognition principle. (l) Periodicity assumption.
(e) Fair value principle. (m) Expense recognition principle.
(f) Economic entity assumption. (n) Cost constraint.
(g) Full disclosure principle. (o) Historical cost principle.
(h) Revenue recognition principle. (p) Accrual-basis assumption.
(i) Full disclosure principle. (q) Expense recognition principle.

EXERCISE 2-8

(a) It is well established in accounting that revenues, cost of goods sold

and expenses must be disclosed in an income statement. It might be
noted to students that such was not always the case. At one time, only
net income was reported but over time we have evolved to the present
reporting format.

(b) The proper accounting for this situation is to report the equipment as
an asset and the notes payable as a liability on the statement of
financial position. Offsetting is permitted in only limited situations
where certain assets are contractually committed to pay off liabilities,
or when a government grant is involved.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-17
EXERCISE 2-8 (Continued)

(c) The basis upon which inventory amounts are stated (net realizable value)
and the method used in determining cost (Weighted Average, FIFO, etc.)
should also be reported. The disclosure requirement related to the
method used in determining cost should be emphasized, indicating that
where possible alternatives exist in financial reporting, disclosure in some
format is required.

(d) Comparability requires that disclosure of changes in accounting princi-

ples be made in the financial statements. To do otherwise would result
in financial statements that are misleading. Financial statements are
more useful if they can be compared with similar reports for prior years.

EXERCISE 2-9

(a) This entry violates the economic entity assumption. This assumption
in accounting indicates that economic activity can be identified with a
particular unit of accountability. In this situation, the company erred
by charging this cost to the wrong economic entity.
(b) The historical cost principle indicates that assets and liabilities are
accounted for on the basis of cost. If we were to select sales value,
for example, we would have an extremely difficult time in attempting
to establish a sales value for a given item without selling it. It should
further be noted that the revenue recognition principle provides the
answer to when revenue should be recognized. Revenue should
be recognized when it is probable that future economic benefits will flow
to the entity and reliable measurement of the amount of revenue is
possible. In this situation, an earnings process has definitely not taken
place.

(c) Probably the company should not record this loss. The expense
recognition principle indicates that expenses should be allocated to the
appropriate periods involved. In this case, there appears to be a high
uncertainty that the company will have to pay. IAS 37 requires that a
loss should be accrued only (1) when it is probable that the company
would lose the suit and (2) the amount of the loss can be reasonably
estimated. (Note to instructor: The student will probably be unfamiliar
with this standard. The purpose of this question is to develop some
decision framework when the probability of a future event must be
assumed.)

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EXERCISE 2-9 (Continued)

(d) At the present time, accountants generally do not recognize price-

level adjustments in the accounts. Hence, it is misleading to deviate
from the cost principle because conjecture or opinion can take place.
It should also be noted that depreciation is not so much a matter of
valuation as it is a means of cost allocation. Assets are not depreciated
on the basis of a decline in their fair value, but are depreciated on the
basis of systematic charges of expired costs against revenues.

(e) Most accounting methods are based on the assumption that the busi-
ness enterprise will have a long life. Acceptance of this assumption
provides credibility to the historical cost principle, which would be of
limited usefulness if liquidation were assumed. Only if we assume some
permanence to the enterprise is the use of depreciation and amortization
policies justifiable and appropriate. Therefore, it is incorrect to assume
liquidation as Gonzales, Inc. has done in this situation. It should be
noted that only where liquidation appears imminent is the going concern
assumption inapplicable.

(f) The answer to this situation is the same as (b).

EXERCISE 2-10

(a) Depreciation is an allocation of cost, not an attempt to value assets.

As a consequence, even if the value of the building is increasing,
costs related to this building should be matched with revenues on the
income statement, not as a charge against retained earnings.

(b) A gain should not be recognized until the inventory is sold. Accoun-
tants follow the cost approach and write-ups of assets are not
permitted. It should also be noted that the revenue recognition
principle states that revenue should not be recognized until the
benefits will flow to the company and can be measured reliably.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-19
EXERCISE 2-10 (Continued)

(c) Assets should be recorded at the fair value of what is given up or the
fair value of what is received, whichever is more clearly evident. It
should be emphasized that it is not a violation of the historical cost
principle to use the fair value of the shares. Recording the asset at the
par value of the shares has no conceptual validity. Par value is merely
an arbitrary amount usually set at the date of incorporation.

(d) The gain should be recognized at the point of sale. Deferral of the
gain should not be permitted. Revenue should be recognized when
it is probable that future economic benefits will flow to the entity
and reliable measurement of the revenue is possible. To explore this
question at greater length, one might ask what justification other than
the controller’s might be used to justify the deferral of the gain. For
example, the rationale provided in IFRS, noncompletion of the earnings
process, might be discussed.

(e) It appears from the information that the sale should be recorded in
2015 instead of 2014. Regardless of whether the terms are f.o.b.
shipping point or f.o.b. destination, the point is that the inventory was
sold in 2015. 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 is also necessary in 2015.

2-20 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
 SOLUTIONS TO CONCEPTS FOR ANALYSIS

CA 2-1
(a) A conceptual framework establishes the concepts that underlie financial reporting. A conceptual
framework is a coherent system of concepts that flow from an objective. The objective indentifies
the purpose of financial reporting. The other concepts provide guidance on (1) identifying the
boundaries of financial reporting (2) selecting the transactions, other events, and circumstances to
be represented. (3) how they should be recognized and measured, and (4) how they should be
summarized and reported.

A conceptual framework is necessary so that standard setting is useful, i.e., standard setting
should build on and relate to an established body of concepts and objectives. A well-developed
conceptual framework should enable the IASB to issue more useful and consistent standards in
the future.

(b) Specific benefits that may arise are:

(1) A coherent set of standards and rules should result.
(2) New and emerging practical problems should be more quickly solved by reference to an
existing framework.
(3) It should increase financial statement users’ understanding of and confidence in financial reporting.
(4) It should enhance comparability among companies’ financial statements.
(5) It should help determine the bounds for judgment in preparing financial statements.
(6) It should provide guidance to the body responsible for establishing accounting standards.

CA 2-2
(a) The Conceptual Framework should provide benefits to the accounting community such as:
(1) guiding the IASB in establishing accounting standards on a consistent basis.
(2) determining bounds for judgment in preparing financial statements by prescribing the nature,
functions and limits of financial accounting and reporting.
(3) increasing users’ understanding of and confidence in financial reporting.

(b) The Conceptual Framework identifies the most important quality for accounting information as
usefulness for decision making. Relevance and faithful representation are the fundamental 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.

(c) The qualitative characteristics can be distinguished as fundamental or enhancing characteristics,

depending on how they affect the usefulness of information. Each quality is described briefly below.

Fundamental Qualities
Relevance To be relevant, accounting information must be capable of making a difference in a
decision. Information with no bearing on a decision is irrelevant. Financial information is capable of
making a difference when it has predictive value, confirmatory value, or both.

Faithful Representation For accounting information to be useful, it must be a faithful represen-

tation of the real-world phenomenon that it purports to represent. Faithful representation is a
necessity because most users have neither the time nor the expertise to evaluate the factual
content of the information. To be a faithful representation, information must be complete, neutral,
and free of material error.

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CA 2-2 (Continued)
Enhancing Qualities
Comparability. Information that is measured and reported in a similar manner for different
companies is considered comparable. Comparability enables users to identify the real similarities
and differences in economic events between companies. Another type of comparability, consistency,
is present when a company applies the same accounting treatment to similar events, from period
to period, the company shows consistent use of accounting standards.

Verifiability. Occurs when independent measurers, using the same methods obtain similar results.

Timeliness. Timeliness means having information available to decision makers before it loses its
capacity to influence decisions. Having relevant information available sooner can enhance its
capacity to influence decisions, and a lack of timeliness can rob information of its usefulness.

Understandability. Decision makers vary widely in the types of decisions they make, how they
make decisions, the information they already possess or can obtain from other sources, and their
ability to process the information. For information to be useful there must be a connection (linkage)
between these users and the decisions they make. This link, understandability, is the quality of
information that lets reasonably informed users see its significance. Understandability is enhanced
when information is classified, characterized, and presented clearly and concisely. Comparability
also can enhance understandability.

CA 2-3
(a) The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders, and other
creditors in making decisions in their capacity as capital providers. Information that is
decision useful to capital providers may also be useful to other users of financial reporting who are
not capital providers. However, an implicit assumption is that users need reasonable knowledge of
business and financial accounting matters to understand the information contained in financial
statements. This point is important. It means that financial statement preparers assume a level
of competence on the part of users. This assumption impacts the way and the extent to which
companies report information.

(b) The purpose of the Conceptual Framework is to set forth fundamentals on which financial
accounting and reporting standards may be based. Without an objective that everyone can agree
to, inconsistent standards will be developed. For example, some believe that accountability should
be the primary objective of financial reporting. Others argue that prediction of future cash flows is
more important. It follows that individuals who believe that accountability is the primary objective may
arrive at different financial reporting standards than others who argue for prediction of cash flow.
Only by establishing some consistent starting point can accounting ever achieve some underlying
consistency in establishing accounting principles.

It should be emphasized to the students that the Board itself is likely to be the major user and thus
the most direct beneficiary of the guidance provided by this pronouncement. However, knowledge
of the objectives and concepts the Board uses should enable all who are affected by or interested
in financial accounting standards to better understand the content and limitations of information
provided by financial accounting and reporting, thereby furthering their ability to use that informa-
tion effectively and enhancing confidence in financial accounting and reporting. That knowledge, if
used with care, may also provide guidance in resolving new or emerging problems of financial
accounting and reporting in the absence of applicable authoritative pronouncements.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-23
CA 2-4
(a) (1) Relevance is one of the two fundamental decision-specific characteristics of useful
accounting information. Relevant information is capable of making a difference in a decision.
Relevant information helps users to make predictions about the outcomes of past, present,
and future events, or to confirm or correct prior expectations.

(2) Faithful representation is one of the two fundamental decision-specific characteristics of

useful accounting information. Faithfully represented information can be depended upon to
represent the conditions and events that it is intended to represent. Faithful representation
stems from completeness, neutrality, and lack of error.

(3) Understandability is an enhancing characteristic of information. Information is understandable

when it permits reasonably informed users to perceive its significance. Understandability is a
link between users, who vary widely in their capacity to comprehend or utilize the information,
and the decision-specific qualities of information.

(4) Comparability means that information about companies has been prepared and presented in a
similar manner. Comparability enhances comparisons between information about two different
companies at a particular point in time.

(5) Neutrality means that a company cannot select information to favor one set of parties over
another. Reporting unbiased information must be the overriding consideration. If financial
reporting is biased, financial reports will lose their credibility.

(b) (Note to instructor: There are a multitude of answers possible here. The suggestions below are
intended to serve as examples.)
(1) Forecasts of future operating results and projections of future cash flows may be highly relevant
to some decision makers. However, they would not be as representationally faithful as historical
cost information about past transactions.
(2) Proposed new accounting methods may be more relevant to many decision makers than exist-
ing methods. However, if adopted, they would impair consistency and make trend comparisons
of an company’s results over time difficult or impossible.
(3) There presently exists much diversity among acceptable accounting methods and procedures.
In order to facilitate comparability between companies, the use of only one accepted account-
ing method for a particular type of transaction could be required. However, consistency would
be impaired for those firms changing to the new required methods.
(4) Occasionally, relevant information is exceedingly complex. Judgment is required in determining
the optimum trade-off between relevance and understandability. Information about the impact of
general and specific price changes may be highly relevant but not understandable by all users.

(c) Although trade-offs result in the sacrifice of some desirable quality of information, the overall result
should be information that is more useful for decision making.

CA 2-5
(a) The “crucial event” in determining when revenue is recognized is when a performance obligation
is satisfied. In the case of subscriptions, the performance obligation is met when the magazines
are delivered (including ads contained therein). The new director suggests that this principle does
not apply in the magazine business and that revenue from subscription sales and advertising
should be recognized in the accounts when the difficult task of selling is accomplished and not
when the magazines are published and delivered to fill the subscriptions or to carry the
advertising.

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CA 2-5 (Continued)
The director’s view that there is a single crucial event in the process of earning revenue in the
magazine business is questionable even though the amount of revenue is determinable when the
subscription is sold. Although the firm cannot prosper without good advertising contracts and while
advertising rates depend substantially on magazine sales, it also is true that readers will not renew
their subscriptions unless the content of the magazine pleases them. Unless subscriptions are
obtained at prices that provide for the recovery in the first subscription period of all costs of selling
and filling those subscriptions, the editorial and publishing activities are as crucial as the sale in the
earning of the revenue. Even if the subscription rate does provide for the recovery of all associated
costs within the first period, however, the editorial and publishing activities still would be important
since the firm has an obligation (in the amount of the present value of the costs expected to be
incurred in connection with the editorial and publication activities) to produce and deliver the
magazine. Not until this obligation is fulfilled should the revenue associated with it be recognized in
the accounts since the revenue is the result of delivering on a promise (selling and filling
subscriptions) and not just the first one. The director’s view also presumes that the cost of
publishing the magazines can be computed accurately at or close to the time of the subscription
sale despite uncertainty about possible changes in the prices of the factors of production and
variations in efficiency. Hence, only a portion–not most–of the revenue should be recognized in the
accounts at the time the subscription is sold.

(b) Recognizing in the accounts all the revenue in equal portions with the publication of the magazine
every month is subject to some of the same criticism from the standpoint of theory as the
suggestion that all or most of the revenue be recognized in the accounts at the time the
subscription is sold. Although the journalistic efforts of the magazine are important in the process
of earning revenue, the firm could not prosper without magazine sales and the advertising that
results from paid circulation. Hence, some revenue could be recognized in the accounts at the
time of the subscription sale, to the extent that part of the performance obligation to the subscriber
and advertisers has been met. That is, the ads are in the public domain.

This approach requires the magazine to allocate the proportion of the revenue related to
advertising from that related to subscriptions. For this reason, and because the task of estimating
the amount of revenue associated with the subscription sale often has been considered
subjective, recognizing revenue in the accounts with the monthly publication of the magazine has
received support even though it does not meet the tests of revenue recognition as well as the next
alternative.

(c) Recognizing in the accounts a portion of the revenue at the time a cash subscription is obtained
and a portion each time an issue is published meets the tests of revenue recognition better than
the other two alternatives. A portion of the net income is recognized in the accounts at the time of
each major or crucial event – that is, when a performance obligation has been met. Each crucial
event is clearly discernible and is a time of interaction between the publisher and subscriber. A
legal sale is transacted before any revenue is recognized in the accounts. Prior to the time the
revenue is recognized in the accounts, it already has been received in distributable form. Finally,
the total revenue is measurable with more than the usual certainty, and the revenue attributable to
each crucial event is determinable using reasonable (although sometimes conceptually
unsatisfactory) assumptions about the relationship between revenue and costs when the costs
are indirect.

(Note to instructor: CA 2-5 might also be assigned in conjunction with Chapter 18.)

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CA 2-6
(a) Some costs are recognized as expenses on the basis of a presumed direct association with
specific revenue. This presumed direct association has been identified as the expense recognition
principle, or in this case as “associating cause and effect” (“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 expense recognition principle requires that the revenue
recognized and the expenses incurred to produce the revenue be given concurrent periodic recog-
nition in the accounting records. Only if effort is properly related to accomplishment will the results,
called earnings, have useful significance concerning the efficient utilization of business resources.
Thus, applying the expense recognition 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.

(b) Some costs are assigned as expenses to the current accounting period because
(1) their incurrence during the period provides no discernible future benefits;
(2) they are measures of assets recorded in previous periods from which no future benefits are
expected or can be discerned;
(3) they must be incurred each accounting year, and no build-up of expected future benefits occurs;
(4) by their nature they relate to current revenues even though they cannot be directly associated
with any specific revenues;
(5) 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;
(6) and 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 with 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.
(c) A cost should be capitalized, that is, treated as a measure of an asset when it is expected that the
asset will produce benefits in future periods. The important concept here is that the incurrence of
the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred
that resulted in the acquisition of an asset from which benefits are not expected beyond the current
period, the cost may be expensed as a measure of the service potential that expired in producing
the current period’s revenues. Not only should the incurrence of the cost result in the acquisition of
an asset from which future benefits are expected, but also the cost should be measurable with a
reasonable degree of objectivity, and there should be reasonable grounds for associating it with
the asset acquired. Examples of costs that should be treated as measures of assets are the costs
of merchandise on hand at the end of an accounting period, costs of insurance coverage relating
to future periods, and the cost of self-constructed plant or equipment.

(d) 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.

2-26 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
CA 2-6 (Continued)
(e) A cost should be treated as a loss when no revenue results. The matching of losses to specific
revenue should not be attempted because, by definition, they are expired service potentials not
related to revenue produced. That is, losses result from events that are not anticipated as
necessary in the process of producing revenue.

There is no simple way of identifying a loss because ascertaining whether a cost should be a loss
is often a matter of judgment. The accounting distinction between an asset, expense, loss, and
prior period adjustment is not clear-cut. For example, an expense is usually voluntary, planned,
and expected as necessary in the generation of revenue. But a loss is a measure of the service
potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecur-
ring and is usually not taken into direct consideration in planning the size of the revenue stream.

CA 2-7
(a) The preferable treatment of the costs of the sample display houses is expensing them over more
than one period. These sample display houses are assets because they represent rights to future
service potentials or economic benefits.

According to the expense recognition principle, the costs of service potentials should be amortized
as the benefits are received. Thus, costs of the sample display houses should be matched with the
revenue from the sale of the houses which is receivable over a period of more than one year. As
the sample houses are left on display for three to seven years, Daniel Barenboim apparently
expects to benefit from the displays for at least that length of time.

The alternative of expensing the costs of sample display houses in the period in which the
expenditure is made is based primarily upon the uncertainty of measurement. These costs are of a
promotional nature. Promotional costs often are considered expenses of the period in which the
expenditures occur due to the uncertainty in determining the time periods benefited. It is likely that
no decision is made concerning the life of a sample display house at the time it is erected. Past
experience may provide some guidance in determining the probable life. A decision to tear down
or alter a house probably is made when sales begin to lag or when a new model with greater
potential becomes available.

There is uncertainty not only as to the life of a sample display house but also as to whether a
sample display house will be torn down or altered. If it is altered rather than torn down, a portion of
the cost of the original house may be attributable to the new model.

(b) If all of the shell houses are to be sold at the same price, it may be appropriate to allocate the
costs of the display houses on the basis of the number of shell houses sold. This allocation would
be similar to the units-of-production method of depreciation and would result in a good matching of
costs with revenues. On the other hand, if the shell houses are to be sold at different prices, it may
be preferable to allocate costs on the basis of the revenue contribution of the shell houses sold.
There is uncertainty regarding the number of homes of a particular model which will be sold as a
result of the display sample. The success of this amortization method is dependent upon accurate
estimates of the number and selling price of shell houses to be sold. The estimate of the number
of units of a particular model which will be sold as a result of a display model should include
not only units sold while the model is on display but also units sold after the display house is torn
down or altered.

Cost amortization solely on the basis of time may be preferable when the life of the models can be
estimated with a great deal more accuracy than can the number of units which will be sold. If unit
sales and selling prices are uniform over the life of the sample, a satisfactory matching of costs
and revenues may be achieved if the straight-line amortization procedure is used.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-27
CA 2-8
Date

Dear Uncle Carlos,

I received the information on Neville Corp. and appreciate your interest in sharing this venture with me.
However, I think that basing an investment decision on these financial statements would be unwise
because they are neither relevant nor a faithful presentation.

One of the most important characteristics of accounting information is that it is relevant, i.e., it will make
a difference in my decision. To be relevant, this information must have predictive value, confirmatory
value, or both. Being timely is also important. Because Neville’s financial statements are a year old,
they have lost their ability to influence my decision: a lot could have changed in that one year.

As indicated, one element of relevance is predictive value. Neville’s accounting information proves
irrelevant. Shown without reference to other years’ profitability, it cannot help me predict future profit-
ability because I cannot see any trends developing. Closely related to predictive value is confirmatory
value. These financial statements do not provide feedback on any strategies which the company may
have used to increase profits.

These financial statements also are not faithfully presented. In order to be so, their assertions must be
verifiable by several independent parties. Because no independent auditor has verified these amounts,
there is no way of knowing whether or not they are represented faithfully. For instance, I would like to
believe that this company earned €2,424,240, and that it had a very favorable debt-to-equity ratio.
However, unaudited financial statements do not give me any reasonable assurance about these claims.

Finally, the fact that Mrs. Neville herself prepared these statements indicates a lack of neutrality.
Because she is not a disinterested third party, I cannot be sure that she did not prepare the financial
statements in favor of her husband’s business.

I do appreciate the trouble you went through to get me this information. Under the circumstances,
however, I do not wish to invest in the Neville bonds and would caution you against doing so. Before
you make a decision in this matter, please call me.

Sincerely,

Your Nephew

2-28 Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only)
CA 2-9
(a) The stakeholders are investors, creditors, etc.; i.e., users of financial statements, current and future.

(b) Honesty and integrity of financial reporting, job protection, profit.

(c) Applying the expense recognition principle and recording expense during the plant’s life, or not
applying it. That is, record the mothball costs in the future.

(d) The major question may be whether or not the expense of mothballing can be estimated properly
so that the integrity of financial reporting is maintained. Applying the expense recognition principle
will result in lower profits and possibly higher rates for consumers. Could this cost anyone his or
her job? Will investors and creditors have more useful information? On the other hand, failure to
apply the matching principle means higher profits, lower rates, and greater potential job security.

(e) Students’ recommendations will vary.

Note: Other stakeholders possibly affected are present and future consumers of electric power.
Delay in allocating the expense will benefit today’s consumers of electric power at the expense of
future consumers.

CA 2-10
1. Information about competitors might be useful for benchmarking the company’s results but if
management does have expertise in providing the information, it could lack reliability. In addition, it is
likely very costly for management to gather sufficiently reliable information of this nature.

2. While users of financial statements might benefit from receiving internal information, such as
company plans and budgets, competitors might also be able to use this information to gain a
competitive advantage relative to the disclosing company.

3. In order to produce forecasted financial statements, management would have to make numerous
assumptions and estimates, which would be costly in terms of time and data collection. Because of
the subjectivity involved, the forecasted statements would lack reliability, thereby detracting from
any potential benefits. In addition, while management’s forecasts of future profitability or statement
of financial position amounts could be of benefit, companies could be subject to shareholder
lawsuits, if the amounts in the forecasted statements are not realized.

4. It would be excessively costly for companies to gather and report information that is not used in
managing the business.

5. Flexible reporting allows companies to “fine-tune” their financial reporting to meet the information
needs of its varied users. In this way, they can avoid the cost of providing information that is not
demanded by its users.

6. Similar to number 3, concerning forecasted financial statements, if managers report forward-

looking information, the company could be exposed to liability if investors unduly rely on the
information in making investment decisions. Thus, if companies get protection from unwarranted
lawsuits (called a safe harbor), then they might be willing to provide potentially beneficial forward-
looking information.

Copyright © 2014 John Wiley & Sons, Inc. Kieso, IFRS, 2/e, Solutions Manual (For Instructor Use Only) 2-29