CHAPTER 11

Accounting principles

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: AN = Analysis AP = Application C = Comprehension E = Evaluation

summary of questions by Level of difficulty (LOD)

Note: E = Easy M = Medium H=Hard

CHAPTER STUDY OBJECTIVES

1. Explain the importance of having a conceptual framework of accounting, and list the key components. The conceptual framework ensures that there is a consistent and coherent set of accounting standards. Key components of the conceptual framework are the: (1) objective of financial reporting; (2) underlying assumption; (3) cost constraint; (4) elements of financial statements; (5) qualitative characteristics of accounting information; and (6) recognition and measurement criteria.

2. Identify and apply the objective of financial reporting, as well as the underlying assumption and cost constraint used by accountants. The objective of financial reporting is to provide useful information for investors and creditors in making decisions in their capacity as capital providers. The underlying assumption is that, unless otherwise stated, the financial statements have been prepared using the going concern assumption. The cost constraint exists to ensure the value of the information provided is more than the cost of preparing it.

3. Describe the fundamental and enhancing qualitative characteristics of financial reporting. The fundamental qualitative characteristics are relevance and faithful representation. Accounting information has relevance if it makes a difference in a decision. Materiality is an important component of relevance. An item is material when it is likely to influence the decision of a reasonably careful investor or creditor. Information is faithfully represented when it shows the economic reality and is complete, neutral, and free from material error.

The enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability. Comparability enables users to identify the similarities and differences between companies. The consistent use of accounting policies from year to year is part of the comparability characteristic. Information is verifiable if two knowledgeable and independent people would generally agree that it faithfully represents the economic reality. Timeliness means that accounting information is provided when it is still highly useful for decision-making. Understandability enables reasonably informed users to interpret and comprehend the meaning of the information provided in the financial statements.

4. Identify and apply the basic recognition and measurement concepts of accounting. The revenue recognition criteria require that revenue be recognized when assets have increased or liabilities have decreased as a result of a transaction with a customer. Expenses are recognized when there is a decrease in an asset or increase in a liability, excluding transactions with owners, which result in a decrease in owners’ equity. Three measurements used in accounting are cost, fair value, and amortized cost. Incorrect application of the basic recognition and measurement concepts can lead to material misstatements in the financial statements. Incorrect application can be due to error or intentional misstatement.

Exercises

Exercise 1

The CICA's conceptual framework discusses the following:

Code:

A Objective of Financial Reporting

B Qualitative Characteristics of Accounting Information

C Elements of Financial Statements

Instructions

For each item below, indicate the area of the conceptual framework that pertains to that item by selecting the appropriate code.

Example:

C Asset (An asset is an element of financial statements.)

____ 1. Information that is helpful in assessing management’s performance

____ 2. Owners' equity

____ 3. Timeliness

____ 4. Neutral

____ 5. Expense

____ 6. Confirmatory value

____ 7 Faithful representation

____ 8 Comparability-consistency

____ 9. Information that is useful in making resource allocation decisions

____ 10 Full disclosure principle

Exercise 2

For each of the independent situations described below, list the assumption, characteristic, concept, or constraint that has been violated, if any. List only one term for each case.

1. McHale Company reports only current assets and current liabilities on its balance sheet. Intangible assets and a 20-year mortgage payable are reported as a current asset and a current liability, respectively. Liquidation of the company is unlikely.

2. Fizzard Company is in its third year of operation and has yet to issue financial statements. (Do not use full disclosure principle.)

3. Harris Company is carrying inventory at its net realizable value of $110,000. The inventory had an original cost of $135,000.

4. Martin Company expenses some office equipment that is inexpensive even though it has useful life that exceeds 1 year.

5. Singh Corporation has selected FIFO as its inventory cost flow formula during the current year. Next year it plans to change to the weighted average cost formula.

Exercise 3

Presented below are some business transactions that occurred during 2013 for Cahill Company:

1. A heavy duty stapler costing $25 is being depreciated over 5 years. The following entry was made:

Depreciation Expense—Stapler 5

Accumulated Depreciation—Stapler 5

2. An owner of Cahill Company took a vacation to France and charged the travel expenses to the company. The following entry was made:

Travel Expense 4,000

Cash 4,000

3. An account receivable has been deemed a bad debt. The following entry was made:

Allowance for Doubtful Accounts 9,000

Accounts Receivable 9,000

4. Merchandise Inventory with a cost of $420,000 is reported at its fair value of $510,000. The following entry was made:

Merchandise Inventory 90,000

Gain on Fair Value Adjustment of Inventory 90,000

5. Equipment worth $75,000 was acquired at a cost of $60,000 from a company that was going out of business. The following entry was made:

Equipment 75,000

Cash 60,000

Gain from on Fair Value Adjustment on Equipment 15,000

Instructions

For each situation above, identify the assumption, concept, or constraint that has been violated, if any. If the entry is incorrect, prepare the entry that should have been made, if any.

Exercise 4

A beginning accountant for Davis Company recorded the following transactions in the records of the company for the year ended December 31, 2013. The controller has questioned the appropriateness of the entries since she thinks that they have not been recorded in accordance with generally accepted accounting principles. Profit for the year, including the entries described below, is $200,000.

1. On January 1, the company president, an owner of the company, took a personal vacation trip to the Gaspé. The trip cost $3,000. The accountant recorded the entry as follows:

Travel Expense 3,000

Accounts Payable 3,000

2. The company purchased on account a wastebasket on December 31 at a cost of $20. The accountant made the following entry:

Office Equipment 20

Accounts Payable 20

3. Merchandise inventory which cost $14,000 had a current net replacement value of $22,000. The accountant made the following entry as a result:

Merchandise Inventory 8,000

Gain on fair value adjustment 8,000

4. Equipment with a fair market value of $15,000 was acquired in a liquidation sale for cash at a cost of $10,000. The accountant recorded the transaction as follows:

Equipment 15,000

Cash 10,000

Gain on fair value adjustments 5,000

5. A customer's account receivable for $17,000 was uncollectible and the following entry was made:

Bad Debts Expense 17,000

Accounts Receivable 17,000

Instructions

a. For each of the above entries, indicate the concept or constraint that was violated.

b. Determine the correct profit for 2013.

Exercise 5

The following are independent situations observed by General Company’s senior accountant at December 31, 2014, the company’s year end. General Company has not adopted the revaluation model for accounting for long-lived assets.

1. General purchased land in February at a cost of $60,000 for the purpose of expanding the size of their parking lot, although this project has not yet been started at year end. Due to increases in real estate values, this land has a value of $100,000 by year end. An entry to record this increase in value has been recorded, crediting “Gain on Land”.

2. One of the items making up General’s total current assets of $354,000 is an amount of $1,400 for Supplies. The Company owner asks one of the accounting staff whether she thinks this balance is correct. The staff person takes two days of work time to count the actual supplies on hand and another day to research the exact cost of the items, and subsequently adjusts the balance of Supplies to its exact balance of $1,425. As a result of this task, the month-end financial statements are submitted to the company’s lender two days after the reporting deadline.

3. A $96,300 payment for a 12 month insurance policy effective March 1 had been debited to the Insurance Expense Account.

4. Included in Accrued Interest Payable is interest on a $200,000, 3% note payable. Interest has been paid to the end of December 2, 2014. Accrued interest payable was calculated and recorded as $500 by applying the following formula: $200,000 x 3% x 1÷12. However the accountant was concerned because part of December’s interest has already been paid and the formula included a full month’s accrual. He therefore reduces the accrued interest payable by $33 ($200,000 x 3% x 2÷365).

5. On January 15, 2015, before the financial statement preparation for December 31, 2014 had been completed, a fire destroyed General’s warehouse, which had a carrying value of $1,500,000, and inventory with a cost of $900,000. The lost assets are insured, but will result in a 6 month interruption in business while being reconstructed. No mention of this occurrence is found in the financial statements.

6. The company completed its year end inventory count and the controller noticed that obsolete inventory had been included in the physical count and that it was valued at its original cost less an obsolescent factor of 10%. When the controller asked how long the inventory had been on hand, he was told that it was 4 years old; most of their inventory is 6 months old.

Instructions

For each of the events, indicate the accounting assumption, concept, or constraint that has been violated and provide your reason. Prepare the correcting entry required, or if no entry is required, explain what other change, if any, should be made to ensure that General’s financial statements comply with GAAP.

Exercise 6

Generally accepted accounting principles include the following assumptions, concepts, and constraints:

A Going concern assumption

B Economic entity concept

C Revenue recognition criteria

D Matching

E Full disclosure

F Cost concept

G Cost constraint

H Materiality constraint

The following independent situations occurred in different companies:

1. One third of the company's sales were made to a related party and this fact is disclosed in the financial statements.

2. The company's inventory's cost is $50,000, its retail value is $120,000, and if liquidated could be sold at auction for $30,000. The inventory is reported at $50,000 on the company's balance sheet.

3. A company's accountant notices that the petty cash account was not adjusted prior to preparing the year end financial statements and the account balance is incorrect by $13.52. However, the accountant decides to release the financial statements without making the correction.

4. The proprietor of an unincorporated business maintains two bank accounts and two sets of accounting records - one for household expenses, and the other for business purposes.

5. The company records revenue when services are provided, not when the customers pay for the service.

6. The company has a large number of accounts receivable which individually have small balances. In order to determine the allowance for doubtful accounts, the company uses an estimate based on past experience rather than taking the time to evaluate the collectability of individual accounts.

7. Insurance expense is recorded each month, although the insurance policy covers a full year and is paid annually.

8. A patent with an indefinite life has an original cost of $12,500 although the company was recently offered $1,000,000 by another company who wants to buy it.

9. Interest expense is payable semi-annually and is recorded only when paid, with no adjustment at year end even though payment dates do not coincide with year end date.

10. A former employee has sued the company for a large amount, but no mention is made of this case in the financial statements.

11. After obtaining an independent appraisal which indicated a significant increase in value over original cost, the company restated its land at the higher amount. The company has not adopted the revaluation model for accounting for long-lived assets.

12. The company accountant recently spent two days calculating the accrued utilities expense on 130 individual apartments for the last few days of the year. In the past, the amounts were estimated.

13. The company's sales are made on credit, but to keep accounting costs down, sales are recorded when the customer accounts are paid.

14. When preparing financial statements, the company's policy is to record all correcting entries, whether the correction is for $200,000 or $2.

15. The proprietor's babysitting costs are recorded in the company expense accounts.

16. All assets are restated at their liquidation values.

Instructions

For each of the situations, identify the assumption, concept, constraint or recognition criteria that provides the best explanation by selecting the appropriate code. Each code will be used more than once; however each situation only has one correct answer.

Exercise 7

A number of unrelated transactions recorded by National Company are as follows:

1. At year end the Depreciation expense is calculated as $10,000, which results in a net book value that is $14,000 greater than the equipment’s liquidation value:

Loss on fair value adjustment 14,000

Depreciation Expense 10,000

Accumulated Depreciation 24,000

2. The proprietor of National paid for her household cleaning costs out of the business bank account:

Cleaning Expense 140

Cash 140

3. A customer pays for November services in October. The October entry is:

Cash 525

Service Revenue 525

4. National guaranteed the loan of a related party, Provincial Corp, and Provincial defaulted on its loan. In December, the bank demanded payment of $100,000 from National, who negotiated to make the payments in 4 equal monthly instalments, the first of which was made in December. The following entry was recorded by National when the December payment was made. No further information was provided in its financial statements because it is probable that Provincial will be able to make the remainder of the payments.

Loss on Loan Guarantee 25,000

Cash 25,000

Instructions

For each of the above situations, identify the accounting assumption, concept, constraint or recognition criteria that have been violated. Prepare the correct journal entry as it should have been made. If no entry should have been made, or if additional financial statement disclosure is required, explain.

Exercise 8

For each of the independent situations described below, list the assumption, concept, constraint or recognition criteria that have been violated, if any. List only one term for each case.

1. Mark McDougal, MD, had the clinic accountant prepare his personal tax return. He paid the accountant using clinic funds and debited the clinic's "Professional Fees" account.

2. Won Company does not use an account for allowance for doubtful accounts. Instead, accounts receivable are written off directly to Bad Debt Expense if they remain unpaid after 24 months.

3. Equipment is carried at its fair value on the Fontaine Company balance sheet, which is $25,000 higher than cost. Fontaine Company has not adopted the revaluation model for accounting for long-lived assets.

4. Depreciation Expense for the Sobowski Company is $15,000. The company will have a net loss of $12,000 if the Depreciation is recorded, but a Profit of $3,000 if Depreciation is deferred a year. The decision is made to defer the Depreciation to next year which is expected to be more profitable.

5. The land of Krypto Company is appraised at $200,000 more than its cost. The new accountant for the company recommends booking the appraised value and showing a "Gain from Revaluation" on the Income Statement. Krypto Company has not adopted the revaluation model for accounting for long-lived assets.

Exercise 9

The following are independent situations observed by Mersey’s senior accountant at December 31, 2014, the company’s year end. Mersey has not adopted the revaluation model for accounting for long-lived assets.

1. The draft financial statements include an item listed under non-current assets “Human resources” but there is no financial amount included.

2. Mersey’s employees are paid a bonus based on profit. Mersey’s management would like to minimize the amount of bonus paid, and so they instructed a junior accountant to write down inventory by $1,000,000 and record a Loss on Inventory. Their argument is that the “fire sale” value of the inventory would be lower than recorded cost by this amount. Mersey has no intention of liquidating the inventory under such circumstances, but expects to sell the inventory in the normal course of business at amounts significantly above cost.

3. A building being constructed for a customer was 90% complete, and accordingly 90% of the related revenue had been correctly included in sales for the year. The total projected cost of construction is $600,000. Of the $540,000 cost of the project incurred to date, $200,000 has been expensed.

4. Mersey owns 5% of the shares of Liverpool Investments. A note to Liverpool’s financial statements describes a valuable new patent registered by Liverpool and the anticipated profits that are expected to result. A junior accountant at Mersey recorded an entry “Debit Intangible Assets; Credit Gain on Patent Registration” in the amount of $220,000, which is 5% of the amount at which Liverpool has recorded the cost of the patent.

5. In November, Mersey entered into a service contract to provide maintenance services to a client for a fee of $20,000 per month. On signing the contract, the client paid Mersey a $40,000 deposit on services to be provided. The term of the contract is from December 15, 2014 through December 15, 2015. The $40,000 deposit was recorded as Service Revenue.

Instructions

For each of the events, indicate an accounting assumption, concept, constraint or recognition criteria that have been violated and provide your reason. Prepare the correcting entry required, or if no entry is required, explain what other change, if any, should be made to ensure that Mersey’s financial statements comply with GAAP.

Exercise 10

The following are independent situations observed by Kola Industrial’s senior accountant at December 31, 2014, the company’s year end.

1. Kola has parts inventory for use in its construction department (not for resale). The inventory includes over 1,500 different items, with between 10 and 100 of each item in stock. The cost of the individual items ranges from $0.30 to $1.50. In the past, the inventory quantities have been estimated by weighing the parts bins. This year, the accountant had the individual items counted and priced to provide more precise information. The total estimated value of the items is $45,000, which is material in total. It took four staff a full day to count the inventory at a cost of $1,000 in labour costs, and it would have taken two staff a half day to complete the estimate by weighing at a cost of $250. After the count, an entry of $27 was needed to reduce the inventory balance to actual. The entry was debited to Construction Supplies Expenses.

2. Goods with a sales price of $55,000 were shipped to a customer FOB shipping point. The goods were picked up by the shipping company on December 31, and delivered to the customer on January 2. The customer’s invoice was prepared and recorded in January.

3. Prepaid expenses include $12,000 in prepaid rent related to the long term lease of a branch office. When the lease was signed 4 years ago, Kola had to pay a $6,000 deposit which comprises the final month’s rent. Rental rates have since doubled in that location, so an entry has been recorded to reflect this value as follows: “Debit Prepaid Rent $6,000; Credit Rent Expense $6,000”. The junior accountant’s argument for making this entry is that the company has benefited from the long term lease and the financial statements should reflect this benefit.

4. One of the owners of Kola purchased a vacation property for $190,000 with company funds. The transaction was recorded as a debit to Property, Plant, and Equipment, and a credit to Cash.

Instructions

For each of the events, indicate the accounting assumption, concept, constraint, or recognition criteria that have been violated and provide your reason. Prepare the correcting entry required, or if no entry is required, explain what other change, if any, should be made to ensure that Kola’s financial statements comply with GAAP.

Exercise 11

A number of unrelated transactions recorded by Provincial Company are as follows:

1. At the end of the month, the obsolete inventory was valued at $17,000. No entry was made.

2. Provincial, which owns an art gallery, purchases a valuable painting for $40,000 in November, and sells it in January, which is after the company’s year end. The entry made when the painting is purchased is:

Cost of Goods Sold 40,000

Cash 40,000

3. Equipment was purchased for $8,000 from a store that is going out of business. The equipment was appraised at $10,000.

Equipment 10,000

Cash 8,000

Retained Earnings 2,000

Instructions

For each of the above situations, identify the accounting assumption, concept, constraint or recognition criteria that have been violated. Prepare the correct journal entry as it should have been made. If no entry should have been made, or if additional financial statement disclosure is required, explain.

Exercise 12

Match the following qualitative characteristics of financial statements to the appropriate code:

Code:

A Faithful representation

B Timeliness

C Neutral

D Verifiable

E Relevance

F Complete

1. Information is available to decision makers before the information loses its ability to influence decision.
2. Accounting information reports the economic reality of a transaction, not its legal form.
3. All of the information necessary to show the economic reality of transactions is provided.
4. Information makes a difference in a decision.
5. Users are assured that the financial information shows the economic reality of the transaction.
6. Information is free from bias that is intended to attain a predetermined result.

Exercise 13

The following transactions occurred during 2014:

1. A television set is delivered to the customer in August. Six instalment payments of $200 per month begin the following January. Ignore interest considerations.

2. Goods are sold FOB shipping point. An item with a retail value of $10,000 is loaded onto the truck on May 31, but not unloaded until June 3 because the recipient delayed paying the freight bill until then. The vendor prepares and mails the invoice to the customer on June 10.

3. A computer network system and related cables are delivered to the customer's premises on March 31. Installation is completed by April 30, after which the system is ready for use. The vendor provides monthly support and upgrades for 4 months following the month of installation (through August). The value of the system and cables is $50,000, the value of the installation services is $22,000 and the value of the monthly support totals $6,000.

4. Goods are sold FOB destination. An order with an invoice total of $3,500 is loaded onto the truck January 31 and delivered on February 1.

5. A customer prepays for 10 oil changes for a total of $300. During December, two oil changes are completed for this customer.

Instructions

Identify in which month revenue should be recognized in each situation. If revenue should be recognized in more than one month, calculate the amounts that apply to each relevant month.

Exercise 14

Shediac Marine Supplies is a marine supplier of tugboat engines. As part of the selling process, the company will install the tugboat engine, conduct sea trials on the engine, provide any servicing required on the engine for the first year of operation and not require a payment from the client until 60 days after the client’s acceptance of the engine. The engine will remain property of Shediac until the first payment is made, even though the boat is not the property of Shediac. The company’s customers frequently ask Shediac to customize the engines to suit their needs. This customization changes can be extensive and may take several months.

Instructions

Comment on when you think that Shediac should recognize revenue.

Exercise 15

Shediac Bay Sailing Inc. sold $175,500 of boat parts on credit in the month of September to customers. 30% of the goods were shipped FOB destination and 70% were shipping FOB shipping point. At September 30, $25,000 of the goods that were FOB destination, were in transit. During September the company collected $100,000 cash from its customers. The company estimates that about 2% of the sales will become uncollectible and that about 8% of the sales will be returned by the customer. How much revenue should the company recognize for the month of September?

Exercise 16

In the following transactions, indicate when revenue should be recognized:

1. In September, Mount Allison University collects tuition revenue for the term from students. The term runs from September through December.

2. Grinstone Island Company sells merchandise with terms of 2/10, n/30, FOB destination.

3. The Ottawa Senators sell season tickets to games in ScotiaBank Place. Fans can purchase the tickets at any time, although the season doesn’t officially begin until September. It runs from September through May.

4. Porter Airline sells you a refundable airline ticket in September for your flight home at Christmas.

5. The University Bookstore has the following return policy for textbook sales: “Textbooks (new and used) may be returned for seven calendar days from the start of classes. After that time, textbooks (new and used) may be returned within 48 hours of purchase.”

Instructions

Identify when revenue should be recognized in each of the above situations.