Instant Download with all chapters and Answers
*you will get solution manuals in PDF in best viewable format after buy*
Underlying Financial Accounting
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
1. Conceptual framework–
2. Objectives of financial
3. Qualitative characteristics
3, 4, 6, 24 1, 2 1, 2, 3
4. Elements of financial
7, 8, 9 3, 10 4
5. Basic assumptions. 10, 11, 12 4 7, 8
6. Basic principles:
a. Historical cost.
b. Revenue recognition.
c. Expense matching.
d. Full disclosure.
13, 14, 15
16, 17, 18
5 7, 8
5, 6, 7, 8
7, 8, 9
7. Accounting principles–
8. Constraints. 23, 24, 25, 26 6, 7, 9 1, 7, 8
9. Comprehensive assignments on assumptions,
principles, and constraints.
8 7, 8, 10, 11
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Brief Exercises Exercises
1. Describe the usefulness of a conceptual frame work.
2. Describe the FASB’s efforts to construct a conceptual
3. Understand the objectives of financial reporting.
4. Identify the qualitative characteristics of accounting
1, 2 1, 2, 3
5. Define the basic elements of financial statements. 3, 10 4
6. Describe the basic assumptions of accounting. 4, 8, 9 7, 8
7. Explain the application of the basic principles of
5, 9 5, 6, 7, 8, 9,
8. Describe the impact that constraints have on reporting
6, 7, 9 1, 3, 7, 8
ASSIGNMENT CHARACTERISTICS TABLE
E2-1 Qualitative characteristics. Moderate 25–30
E2-2 Qualitative characteristics. Simple 15–20
E2-3 Qualitative characteristics. Moderate 30–35
E2-4 Elements of financial statements. Simple 15–20
E2-5 Revenue recognition and matching principle. Moderate 30–35
E2-6 Matching principle. Moderate 20–30
E2-7 Assumptions, principles, and constraints. Simple 15–20
E2-8 Assumptions, principles, and constraints. Moderate 20–25
E2-9 Full disclosure principle. Complex 20–25
E2-10 Accounting principles–comprehensive. Moderate 20–25
E2-11 Accounting principles–comprehensive. Moderate 20–25
ANSWERS TO QUESTIONS
1. A conceptual framework is a coherent system of interrelated objectives and fundamentals that can
lead to consistent standards and that prescribes the nature, function, and limits of financial
accounting and financial statements. A conceptual framework is necessary in financial accounting
for the following reasons:
1. It will enable the FASB to issue more useful and consistent standards in the future.
2. New issues will be more quickly soluble by reference to an existing framework of basic theory.
3. It will increase financial statement users’ understanding of and confidence in financial reporting.
4. It will enhance comparability among companies’ financial statements.
2. The primary objectives of financial reporting are as follows:
1. Provide information useful in investment and credit decisions for individuals who have a
reasonable understanding of business.
2. Provide information useful in assessing future cash flows.
3. Provide information about enterprise resources, claims to these resources, and changes in them.
3. “Qualitative characteristics of accounting information” are those characteristics which contribute
to the quality or value of the information. The overriding qualitative characteristic of accounting
information is usefulness for decision making.
4. Relevance and reliability are the two primary qualities of useful accounting information. For
information to be relevant, it should have predictive value or feedback value, and it must be
presented on a timely basis. Relevant information has a bearing on a decision and is capable of
making a difference in the decision. Relevant information helps users to make predictions about
the outcomes of past, present, and future events, or to confirm or correct prior expectations.
Reliable information can be depended upon to represent the conditions and events that it is
intended to represent. Reliability stems from representational faithfulness, neutrality, and
5. In providing information to users of financial statements, the accounting profession relies on
general-purpose financial statements. The intent of such statements is to provide the most useful
information possible at minimal cost to various user groups. Underlying these objectives is the
notion 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
in the preparation of financial statements a level of reasonable competence can be assumed; this
has an impact on the way and the extent to which information is reported.
6. Comparability facilitates comparisons between information about two different enterprises at a
particular point in time. Consistency facilitates comparisons between information about the same
enterprise at two different points in time.
7. At present, the accounting literature contains many terms that have peculiar and specific
meanings. Some of these terms have been in use for a long period of time, and their meanings
have changed over time. Since the elements of financial statements are the building blocks with
which the statements are constructed, it is necessary to develop a basic definitional framework for
8. Distributions to owners differ from expenses and losses in that they represent transfers to owners,
and they do not arise from activities intended to produce income. Expenses differ from losses in
that they arise from the entity’s ongoing major or central operations. Losses arise from peripheral
or incidental transactions.
Questions Chapter 2 (Continued)
9. Investments by owners differ from revenues and gains in that they represent transfers by owners
to the entity, and they do not arise from activities intended to produce income. Revenues differ
from gains in that they arise from the entity’s ongoing major or central operations. Gains arise
from peripheral or incidental transactions.
10. The four basic assumptions that underlie the financial accounting structure are:
1. An economic entity assumption.
2. A going concern assumption.
3. A monetary unit assumption.
4. A periodicity assumption.
11. (a) In accounting it is generally agreed that any measures of the success of an enterprise for
periods less than its total life are at best provisional in nature and subject to correction.
Measurement of progress and status for arbitrary time periods is a practical necessity to serve
those who must make decisions. It is not the result of postulating specific time periods as
measurable segments of total life.
(b) The practice of periodic measurement has led to many of the most difficult accounting
problems such as inventory pricing, depreciation of long-term assets, and the necessity for
revenue recognition tests. The accrual system calls for associating related revenues and
expenses. This becomes very difficult for an arbitrary time period with incomplete transactions
in process at both the beginning and the end of the period. A number of accounting practices
such as adjusting entries or the reporting of corrections of prior periods result directly from
efforts to make each period’s calculations as accurate as possible and yet recognizing that
they are only provisional in nature.
12. The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably
stable so that dollars of different years can be added without any adjustment. When the value of
the dollar fluctuates greatly over time, the monetary unit assumption loses its validity.
The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation
to be used to measure items recognized in financial statements. Only if circumstances change
dramatically will the Board consider a more stable measurement unit.
13. Some of the arguments which might be used are outlined below:
1. Cost is definite and reliable; other values would have to be determined somewhat arbitrarily
and there would be considerable disagreement as to the amounts to be used.
2. Amounts determined by other bases would have to be revised frequently.
3. Comparison with other companies is aided if cost is employed.
4. The costs of obtaining replacement values could outweigh the benefits derived.
14. Revenue is generally recognized when (1) realized or realizable, and (2) earned.
The adoption of the sale basis is the accountant’s practical solution to the extremely difficult
problem of measuring revenue under conditions of uncertainty as to the future. The revenue is
equal to the amount of cash that will be received due to the operations of the current accounting
period, but this amount will not be definitely known until such cash is collected. The accountant,
under these circumstances, insists on having “objective evidence,” that is, evidence external to
the firm itself, on which to base an estimate of the amount of cash that will be received. The sale is
considered to be the earliest point at which this evidence is available in the usual case. Until the sale is
made, any estimate of the value of inventory is based entirely on the opinion of the management of
the firm. When the sale is made, however, an outsider, the buyer, has corroborated the estimate
of management and a value can now be assigned based on this transaction. The sale also leads
Questions Chapter 2 (Continued)
to a valid claim against the buyer and gives the seller the full support of the law in enforcing collection.
In a highly developed economy where the probability of collection is high, this gives additional weight
to the sale in the determination of the amount to be collected. Ordinarily there is a transfer of control as
well as title at the sales point. This not only serves as additional objective evidence but necessitates
the recognition of a change in the nature of assets. Usually the change is for an amount which
differs from the costs assigned to the item being sold. The sale, then, has been adopted because it
provides the accountant with objective evidence as to the amount of revenue that will be collected,
subject of course to the bad debts estimated to determine ultimate collectibility.
15. Revenues should be recognized when they are realized or realizable and earned. The most
common time at which these two conditions are met is when the product or merchandise is
delivered or services are rendered to customers. Therefore, revenue for Magnus Eatery should be
recognized at the time the luncheon is served.
16. Revenues are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues are realizable when related assets received or held
are readily convertible to known amounts of cash or claims to cash. Readily convertible assets
have (1) interchangeable (fungible) units and (2) quoted prices available in an active market that
can rapidly absorb the quantity held by the entity without significantly affecting the price.
17. Each deviation depends on either the existence of earlier objective evidence other than the sale or
insufficient evidence of sale. Objective evidence is the key.
(a) In the case of installment sales the probability of uncollectibility may be great due to the nature
of the collection terms. The sale itself, therefore, does not give an accurate basis on which to
estimate the amount of cash that will be collected. It is necessary to adopt a basis which will
give a reasonably accurate estimate. The installment sales method is a modified cash basis;
income is recognized as cash is collected. A cash basis is preferable when no earlier estimate
of revenue is sufficiently accurate.
(b) The opposite is true in the case of certain agricultural products. Since there is a ready buyer
and a quoted price, a sale is not necessary to establish the amount of revenue to be received.
In fact, the sale is an insignificant part of the whole operation. As soon as it is harvested, the
crop can be valued at its selling price less the cost of transportation to the market and this
valuation gives an extremely accurate measure of the amount of revenue for the period without
the need of waiting until the sale has been made to measure it. In other words, the sale
proceeds are readily realizable and earned, so revenue recognition should occur.
(c) In the case of long-term contracts, the use of the “sales basis” would result in a distortion
of the periodic income figures. A shift to a “percentage of completion basis” is warranted if objective evidence of the amount of revenue earned in the periods prior to completion is available.
The accountant finds such evidence in the existence of a firm contract, from which the ultimate
realization can be determined, and estimates of total cost which can be compared with cost
incurred to estimate percentage-of-completion for revenue measurement purposes. In general,
when estimates of costs to complete and extent of progress toward completion of long-term
contracts are reasonably dependable, the percentage-of-completion method is preferable to
the completed-contract method.
18. The president means that the “gain” should be recorded in the books. This item should not be
entered in the accounts, however, because it has not been realized.
19. The cause and effect relationship can seldom be conclusively demonstrated, but many costs
appear to be related to particular revenues and recognizing them as expenses accompanies
recognition of the revenue. Examples of expenses that are recognized by associating cause and
effect are sales commissions and cost of products sold or services provided.
Questions Chapter 2 (Continued)
Systematic and rational allocation means that in the absence of a direct means of associating
cause and effect, and where the asset provides benefits for several periods, its cost should be
allocated to the periods in a systematic and rational manner. Examples of expenses that are
recognized in a systematic and rational manner are depreciation of plant assets, amortization of
intangible assets, and allocation of rent and insurance.
Some costs are immediately expensed because the costs have no discernible future benefits or
the allocation among several accounting periods is not considered to serve any useful purpose.
Examples include officers’ salaries, most selling costs, amounts paid to settle lawsuits, and costs
of resources used in unsuccessful efforts.
20. The characteristics are:
1. Definitions—The item meets the definition of an element of financial statements.
2 Measurability—It has a relevant attribute measurable with sufficient reliability.
Reference to SFAC No. 5 indicates two additional factors:
3. Relevance—The information is capable of making a difference in user decisions.
4. Reliability—The information is representationally faithful, verifiable, and neutral.
21. (a) To be recognized in the main body of financial statements, an item must meet the definition of
an element. In addition the item must have been measured, recorded in the books, and
passed through the double-entry system of accounting.
(b) Information provided in the notes to the financial statements amplifies or explains the items
presented in the main body of the statements and is essential to an understanding of the
performance and position of the enterprise. Information in the notes does not have to be
quantifiable, nor does it need to qualify as an element.
(c) Supplementary information includes information that presents a different perspective from that
adopted in the financial statements. It also includes management’s explanation of the
financial information and a discussion of the significance of that information.
22. The general guide followed with regard to the full disclosure principle is to disclose in the financial
statements any facts of sufficient importance to influence the judgment of an informed reader. The
fact that the amount of outstanding common stock doubled in January of the subsequent reporting
period probably should be disclosed because such a situation is of importance to present
stockholders. Even though the event occurred after December 31, 2007, it should be disclosed on
the balance sheet as of December 31, 2007, in order to make adequate disclosure. (The major
point that should be emphasized throughout the entire discussion on full disclosure is that there is
normally no “black” or “white” but varying shades of grey and it takes experience and good
judgment to arrive at an appropriate answer.)
23. Accounting information is subject to two constraints: cost/benefit considerations, and materiality.
Information is not worth providing unless the benefits it provides exceed the costs of preparing it.
Information that is immaterial is irrelevant, and consequently, not useful. If its inclusion or omission
would have no impact on a decision maker, the information is immaterial.
24. The costs of providing accounting information are paid primarily to highly trained accountants who
design and implement information systems, retrieve and analyze large amounts of data, prepare
financial statements in accordance with authoritative pronouncements, and audit the information
presented. These activities are time-consuming and costly. The benefits of providing accounting
information are experienced by society in general, since informed financial decisions help allocate
scarce resources to the most effective enterprises. Occasionally new accounting standards require
presentation of information that is not readily assembled by the accounting systems of most
companies. A determination should be made as to whether the incremental or additional costs of
providing the proposed information exceed the incremental benefits to be obtained. This
determination requires careful judgment since the benefits of the proposed information may not be
Questions Chapter 2 (Continued)
25. The concept of materiality refers to the relative significance of an amount, activity, or item to
informative disclosure and a proper presentation of financial position and the results of operations.
Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size
enter into its evaluation.
An accounting misstatement is said to be material if knowledge of the misstatement will affect the
decisions of the average informed reader of the financial statements. Financial statements are
misleading if they omit a material fact or include so many immaterial matters as to be confusing. In
the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative
risk and disregards immaterial items.
The relevant criteria for assessing materiality will depend upon the circumstances and the nature
of the item and will vary greatly among companies. For example, an error in current assets or
current liabilities will be more important for a company with a working capital problem than for one
with adequate working capital.
The effect upon net income (or earnings per share) is the most commonly used measure of
materiality. This reflects the prime importance attached to net income by investors and other users
of the statements. The effects upon assets and equities are also important as are misstatements
of individual accounts and subtotals included in the financial statements. The auditor will note the
effects of misstatements on key ratios such as gross profit, the current ratio, or the debt/equity
ratio and will consider such special circumstances as the effects on debt agreement covenants
and the legality of dividend payments.
There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality
has been variously estimated at 5% of net income, but the determination will vary based upon the
individual case and might not fall within these limits. Certain items, such as a questionable loan to
a company officer, may be considered material even when minor amounts are involved. In contrast a
large misclassification among expense accounts may not be deemed material if there is no misstatement
of net income.
26. (a) To the extent that warranty costs can be estimated accurately, they should be matched against
the related sales revenue. Acceptable if reasonably accurate estimation is possible.
(b) Not acceptable. Most accounts are collectible or the company will be out of business very soon.
Hence sales can be recorded when made. Also, other companies record sales when made
rather than when collected, so if accounts for Joan Osborne Co. are to be compared with other
companies, they must be kept on a comparable basis. However, estimates for uncollectible
accounts should be recorded if there is a reasonably accurate basis for estimating bad debts.
(c) Not acceptable. A provision for the possible loss can be made through an appropriation of
retained earnings but until judgment has been rendered on the suit or it is otherwise settled,
entry of the loss usually represents anticipation. Recording it earlier is probably an unwise legal
strategy as well. For the loss to be recognized at this point, the loss would have to be probable
and reasonably estimable. (See FASB No. 5 for additional discussion if desired.) Note disclosure
is required if the loss is not recorded.
(d) Acceptable because lower of cost or market is in accordance with generally accepted accounting
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 2-1
(a) If the company changed its inventory method from the weighted average
to the LIFO method, the consistency, 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
(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 need be made in the CPA’s audit report. The comparability of the financial statements has been affected by a business
transaction, 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 not a matter of consistency;
it is a change in accounting estimate required by altered conditions
and involves no change in accounting principles employed or in their
method of application. The change would probably be disclosed by a
note in the financial statements; if commented upon in the CPA’s
report, it would be as a matter of disclosure rather than consistency.
(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 refer to a company following the same accounting
principles as other companies in the same industry.
BRIEF EXERCISE 2-2
BRIEF EXERCISE 2
) Distributions to owners
) Investments by owners
BRIEF EXERCISE 2
) Monetary unit
) Going concern
) Economic entity
BRIEF EXERCISE 2
) Revenue recognition
) Full disclosure
) Historical cost
BRIEF EXERCISE 2
) Industry practices
BRIEF EXERCISE 2-7
Companies and their auditors for the most part have adopted the general
rule of thumb that anything under 5% of net income is considered not
material. Recently, the SEC has indicated that it is okay to use this
percentage for the initial assessment of materiality, but other factors must
be considered. For example, companies can no longer fail to record items
in order to meet consensus analysts’ earnings numbers; preserve a positive
earnings trend; convert a loss to a profit or vice versa; increase management
compensation, or hide an illegal transaction like a bribe. In other words,
both quantitative and qualitative factors must be considered in determining
when an item is material.
(a) Because the change was used to create a positive trend in earnings,
the change is considered material.
(b) Each item must be considered separately and not netted. Therefore
each transaction is considered material.
(c) In general, companies that follow an ―expense all capital items below
a certain amount‖ policy are not in violation of the materiality concept.
Because the same practice is followed from year to year, and the
amounts are small, it is unlikely that the aggregate of these amounts
would be material.
BRIEF EXERCISE 2-8
(a) Net realizable value.
(b) Would not be disclosed. Liabilities would be disclosed in the order to
(c) Would not be disclosed. Depreciation would be inappropriate if the
going concern assumption no longer applies.
(d) Net realizable value.
(e) Net realizable value (i.e. redeemable value).
BRIEF EXERCISE 2-9
(b) Full disclosure
(c) Matching principle
(d) Historical cost
BRIEF EXERCISE 2-10
(a) Should be debited to the Land account, as it is a cost incurred in
(b) As an asset, preferably to a Land Improvements account. The driveway
will last for many years, and therefore it should be capitalized and
(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, as it is a part of the cost of
that plant asset which will contribute to operations for many years.
(f) As an expense, as the service has already been received; the contribution
to operations occurred in this period.
SOLUTIONS TO EXERCISES
EXERCISE 2-1 (20–30 minutes)
(a) Feedback Value. (f) Relevance and Reliability.
(b) Cost/Benefit and Materiality. (g) Timeliness.
(c) Neutrality. (h) Relevance.
(d) Consistency. (i) Comparability.
(e) Neutrality. (j) Verifiability.
EXERCISE 2-2 (15–20 minutes)
(a) Comparability. (f) Relevance.
(b) Feedback Value. (g) Comparability and Consistency.
(c) Consistency. (h) Reliability.
(d) Neutrality. (i) Relevance and Reliability.
(e) Verifiability. (j) Timeliness.
EXERCISE 2-3 (30–35 minutes)
(a) (1) Relevance is one of the two primary 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. Information
must also be timely in order to be considered relevant.
(2) Reliability is one of the two primary decision-specific characteristics
of useful accounting information. Reliable information can be depended
upon to represent the conditions and events that it is intended to
represent. Reliability stems from representational faithfulness and
verifiability. Representational faithfulness is correspondence or agreement between accounting information and the economic phenomena
it is intended to represent. Verifiability provides assurance that the
information is free from bias.
EXERCISE 2-3 (Continued)
(3) Understandability is a user-specific 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 enterprises has been
prepared and presented in a similar manner. Comparability enhances
comparisons between information about two different enterprises at
a particular point in time.
(5) Consistency means that unchanging policies and procedures have
been used by an enterprise from one period to another. Consistency
enhances comparisons between information about the same enterprise at two different points in time.
(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 reliable as historical cost information about
(2) Proposed new accounting methods may be more relevant to many
decision makers than existing methods. However, if adopted, they
would impair consistency and make trend comparisons of an enterprise’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
enterprises, the use of only one accepted accounting method for a
particular type of transaction could be required. However, consistency would be impaired for those firms changing to the new required
(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.
EXERCISE 2-4 (15–20 minutes)
(a) Gains, losses.
(c) Investments by owners, comprehensive income.
(also possible would be revenues and gains).
(d) Distributions to owners.
(Note to instructor: net effect is to reduce equity and assets).
(e) Comprehensive income
(also possible would be revenues and gains).
(g) Comprehensive income.
(h) Revenues, expenses.
(k) Distributions to owners.
(l) Comprehensive income.
EXERCISE 2-5 (30–35 minutes)
(a) The economist views business income in terms of wealth of the entity
as a whole resulting from an accretion attributable to the whole process
of business activity. The accountant must measure the ―wealth‖ of the
entity in terms of its component parts, that is, individual assets and
liabilities. The events must be identified which cause changes in financial
condition of the entity and the resulting changes should be assigned to
specific accounting periods. To achieve this identification of such events,
accountants employ the revenue recognition principle in the measurement
of periodic income.
(b) Revenue recognition results from the accomplishment of economic
activity involving the transfer of goods and services giving rise to a
claim. To warrant recognition there must be a change in assets that is
capable of being objectively measured and that involves an exchange
transaction. This refers to the presence of an arm’s-length transaction
with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice,
or may be stipulated in a contract. Note that an item should meet four
fundamental recognition criteria to be recognized. Those criteria are:
1. Definitions—The item meets the definition of an element of financial
2. Measurability—It has a relevant attribute measurable with sufficient
EXERCISE 2-5 (Continued)
3. Relevance—The information is capable of making a difference in user
4. Reliability—The information is representationally faithful, verifiable,
In the context of revenue recognition, recognition involves consideration
of two factors, (a) being realized or realizable and (b) being earned, with
sometimes one and sometimes the other being the more important
Events that can give rise to recognition of revenue are: the completion
of a sale; the performance of a service; the production of a standard
interchangeable good with a guaranteed market, a determinable market
value and only minor costs of marketing, such as precious metals and
certain agricultural commodities; and the progress of a construction
project, as in shipbuilding. The passing of time may be the ―event‖ that
establishes the recognition of revenue, as in the case of interest revenue
or rental income.
As a practical consideration, there must be a reasonable degree of
certainty in measuring the amount of revenue recognized. Problems of
measurement may arise in estimating the degree of completion of a
contract, the net realizable value of a receivable or the value of a
nonmonetary asset received in an exchange transaction. In some cases,
while the revenue may be readily measured, it may be impossible to
estimate reasonably the related expenses. In such instances revenue
recognition must be deferred until proper periodic income measurement
can be achieved through the matching process.
(c) No. The factor apparently relied upon by Sulu Associates is that revenue
is recognized as the services giving rise to it are performed. The firm
has completed the construction of the building, obtained financing for
the project, and secured tenants for most of the space. Management of
the project is yet to be rendered and Sulu did not accrue revenue for
this service. However, another factor must be considered. Since the fee
for Sulu’s services has as its source the future profits of the project, on
May 31, 2008, there is no way to measure objectively the amount of the
fee. Setting the amount at the commercial value of the services might
be a reasonable approach were it not for the contingent nature of the
source of the fees. That an asset, contracts receivable, exists as a
EXERCISE 2-5 (Continued)
result of this activity is outweighed by the inability to measure it
objectively. Revenue recognition at this time is unwarranted because of
the contingent nature of the revenue and the likelihood of overstating
the assets. Thus, revenue recognition at this point would not be in
accordance with generally accepted accounting principles.
Because revenue cannot be recognized, the related expenses should be
deferred so that they can be amortized over the respective periods of
revenue recognition. With a reasonable expectation of future benefit,
the deferred costs conform to the accounting concept of assets.
EXERCISE 2-6 (20–30 minutes)
(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 matching concept, 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, Carlos Rodriguez 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
concept of conservatism. 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.