Chapter

 2  Exercise  Solutions  
 
EXERCISE 2-3
(a) Comparability
(b) Feedback value
(c) Consistency
(d) Neutrality
(e) Verifiability
(f) Relevance
(g) 1. Comparability
2. Verifiability
3. Timeliness
4. Understandability
(h) Representational faithfulness
(i) Relevance and Representational faithfulness
(j) Timeliness
 
EXERCISE 2-11

(a)
The financial statements are a formalized, structured way of
communicating financial information. The full disclosure
principle requires that information that is required for fair
presentation that is relevant to decisions should be included in
the financial statements, including the related notes. The notes
are not only helpful to understanding the enterprise’s
performance and position—they are a required component of
the financial statements. The full-disclosure principle recognizes
that the nature and amount of information included in financial
reports reflects a series of judgmental trade-offs. These trade-
offs aim for information that is:
• detailed enough to disclose matters that make a difference to
users, but
• condensed enough to make the information understandable,
and also appropriate in terms of the costs of preparing and
using it.
More information is not always better. Too much information
may result in a situation where the user is unable to digest or
process the information.

Information about a company’s financial position, income, cash

flows, and investments can be found in one of three places:

1. in the main body of financial statements

2. in the notes to the financial statements
3. in supplementary information, including the Management
Discussion and Analysis (MD&A)
EXERCISE 2-11 (CONTINUED)

(a) (continued)

Some important points to remember:

1. Disclosure is not a substitute for proper accounting.

2. The notes to financial statements generally amplify or explain
the items presented in the main body of the statements.
3. Information in the notes does not have to be quantifiable, nor
does it need to qualify as an element. Notes can be partially
or totally narrative. Examples of notes are:

• descriptions of the accounting policies and methods used

in measuring the elements reported in the statements
• explanations of uncertainties and contingencies
• statistics and details that are too voluminous to include in
the statements

4. Supplementary information may include details or amounts

that present a different perspective from what appears in
the financial statements. They may include quantifiable
information that is high in relevance but low in reliability, or
information that is helpful but not essential.

(b)
1. It is well established in accounting that revenues and
expenses, including the cost of goods sold (or raw
materials/consumables used), must be disclosed in the
income statement. Disclosure of specific items such as
interest expense and depreciation expense is mandatory
under GAAP. Showing additional details also meets the
objectives of financial statements for relevance: the
classifications on the income statement help in providing
predictive and feedback information. It also separates
major categories of elements such as revenues from gains,
and expenses from losses.
EXERCISE 2-11 (CONTINUED)

(a) (continued)

2. The proper accounting for this situation is to report the full

cost of the equipment as an asset and the note payable as
a liability on the balance sheet. Offsetting is permitted in
only limited situations where certain assets are
contractually committed to pay off specific liabilities. Not
showing the items separately would mean that certain
elements of the financial statements would be missing and
some key ratios would be affected. This also violates the
cost principle since the equipment would not be shown at
its acquisition cost.

3. One might argue that this event need not be disclosed in

the financial statements since the amount of money
involved is relatively small (i.e. not material) in relation to
the net income of the business and should not affect the
fairness of the presentation of the financial statements.
Having said that, investors and other users might find this
information material regardless of the size and the loss
should therefore be reported, even if not separately
identified as a line item on the statement.

4. According to GAAP, the basis upon which inventory

amounts are stated (lower of cost and net realizable value)
and the method used in determining cost (FIFO, average
cost, 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. Assuming the categories of inventory
are material, disclosure of the amounts of raw materials,
goods in process, and finished goods would also be
reported, likely in a note that is cross-referenced to the
balance sheet.
EXERCISE 2-11 (CONTINUED)

(b) (continued)

5. A change in depreciation method is considered to be a

change in estimate of the pattern in which the entity
receives benefits from the asset. Therefore, it is accounted
for prospectively; i.e., in the current and future periods
only. Estimates are a fundamental part of accounting and
to constantly go back and restate previous statements
every time management changes its estimates would
actually work against the idea of comparability. However, if
the change in estimate has a significant effect on current
or future periods, the change in estimate should be
disclosed. This is consistent with the full disclosure
principle.

EXERCISE 2-13

(a) Under the ASPE, revenue is recorded when:

• Risks and rewards have passed
• Revenue is measurable; and,
• Collectability is reasonably assured

1. Since the sales effort (i.e. passing of risks and rewards) is

not complete until the flight actually occurs, revenue
should not be recognized until December.

2. If collection can be reasonably assured and an estimate of

uncollectible amounts can be made, then revenue can be
recognized at the point of sale when the risks and rewards
transfer to the purchaser. If an estimate for uncollectible
amounts cannot be made, accounting reverts to a cash
basis, and the sale is not recorded until payment is
received (further discussed in chapter 6).

3. Revenue should be recognized on a per game basis over

the season from April to October.
 4. Revenue should be recorded at the time the sweater is
shipped to the customer and charged to her credit card.
Companies selling using on-line catalogues usually
estimate a returns allowance, a contra account to sales
revenue for expected returns, all based on prior
experience or industry norms. The company would also
use their past experience in estimating bad debt expense
and an allowance for doubtful accounts. The usual
treatment, therefore, is to recognize revenue when the
goods are shipped, and to estimate any future charges
that may arise in connection with that revenue.  
 
(b) Using the new IFRS 15 model, a five step approach would be
used in determining when revenue is recognized:

1. Identify the contract with the customer,

2. Identify the performance obligations in the contract (promises
to transfer goods and/or services that are distinct),
3. Determine the transaction price,
4. Allocate the transaction price to each performance obligation,
and finally
5. Recognize revenue as each performance obligation is
satisfied.

For all 4 transactions given in the exercise, the timing of the

revenue recognition will be the same as was given for ASPE
as the critical event used to trigger revenue corresponds to
the timing for satisfaction of the performance obligation.

These models will be further discussed in Chapter 6.

 PROBLEM 2-5

1. Agree. This is a change in how Sheridan does business. The revenue

recognition principle requires that the risks and rewards of ownership
(control) be transferred to the purchaser in order for the sale to be
recognized. That is when the performance obligation is satisfied. While the
shipping terms have been changed, further investigation should be
undertaken to ensure that customer business practices are aligned with this
changed policy. For example, if the company will continue to replace items
lost or damaged in transit, the risks have not passed, irrespective of the
change in shipping terms, and the timing of revenue recognition should not
change (further discussed in Chapter 6).

2. Agree. Depreciation is a means of cost allocation on a systematic charge

against revenues. As it is based on best estimates, the useful life, and
resulting depreciation expense, should be revised when economic or
business events dictate that an asset will remain useful for a longer period.
While comparability is impaired, changes in estimates are accounted for
prospectively. Restatement would not provide decision useful information,
since depreciation in the prior periods was determined with the best
estimates available at the time. All estimates and judgements used to
prepare the financial information should be free from bias, error, or omission.
The change is acceptable as long as it is supported by evidence that the
equipment is likely to last longer and is not a change simply to reduce
annual depreciation expense and thereby increase income.

3. Agree. The full disclosure principle recognizes that reasonable condensation

and summarization of the details of a corporation's operations and financial
position are essential to readability and comprehension. Thus, in
determining full disclosure, the accountant makes decisions on the basis of
whether omission will cause a misleading inference by the reader of the
financial statements. Only the total amount of cash is generally presented on
a balance sheet, unless some special circumstance is involved such as a
possible restriction on the use of the cash. In most cases, however, the
company's presentation would be considered appropriate and in accordance
with the full disclosure principle. Showing the additional detail on the balance
sheet would not be relevant to the reader.
PROBLEM 2-5 (CONTINUED)

4. Disagree. 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 establishing an appraisal
value for the given item without selling it, and verifiability would be violated.
It should further be noted that the revenue recognition principle provides
guidance as to when revenue should be recognized. In this case, the
revenue was not earned because the transfer of risks and rewards based on
a sale of the developed land had not occurred. In addition the development
costs of subdividing the land should be included in inventory cost of the lots
and appear on the balance sheet, and not as expenses of the period. These
costs are associated with the land, which is an economic resource, not with
an expense that is associated with the revenue producing activities for the
year.

NOTE: IFRS allows investment property to be measured at fair value. Land

to be developed and sold does not qualify as investment property, so this
standard does not apply (IFRS 40.08 and .09). The company could use the
revaluation model as an accounting policy choice under IAS 16. (This will be
covered in Chapter10).

1. From the facts it is difficult to determine whether to agree or disagree with

the president. Comparability requires similar transactions be given the same
accounting treatment from period to period for a given business enterprise.
The choice of accounting policy should not be made based on the impact on
net income but rather on the method that provides the most relevant
information. The information should be neutrality and free from bias. It might
be useful for Sheridan report on a moving average basis as it would make
the statements more comparable across other companies in the same
industry

2. Disagree. While there is an economic burden as a result of the new

legislation, this is not a present obligation since the new law cannot be
enforced until 2022. A liability does not exist in fiscal 2017.

7. Disagree. The voluntary recall establishes an unconditional economic burden

for Sheridan. This is a present obligation that is legally enforceable based on
Sheridan’s recall announcement. A liability should be provided at the time
the recall is made.