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Solutions Manual

to accompany

Financial
Accounting:
Reporting, Analysis
and Decision Making
Fifth Edition

Prepared by

Rosina Mladenovic-McAlpine

John Wiley & Sons Australia, Ltd 2016


Chapter 13: Analysing and integrating GAAP

CHAPTER 13 – ANALYSING AND INTEGRATING GAAP

ASSIGNMENT CLASSIFICATION TABLE

Brief
Learning Objectives Exercises Exercises Problems
1. Explain and apply the concepts and 1, 2, 3 1, 2, 3, 4, 5 1A, 2A
principles underlying the recording of
accounting information.

2. Describe the Conceptual Framework 2 3A


for Financial Reporting
(the Conceptual Framework).

3. Explain the objective of general 4A, 5A


purpose financial reporting.

4. Identify the primary and other users, 5, 6


and their uses of
financial reports.

5. Explain the nature of a reporting 7 6A, 9A


entity.

6. Identify and apply the qualitative 9 3, 4, 5 2A, 7A


characteristics and constraint on
financial reporting.

7. Define assets, liabilities, equity, 10 3, 4, 5, 6, 2A, 8A, 9A


income and expenses and apply 7, 8, 9, 10,
recognition criteria. 11, 12, 13

8. Integrate principles, concepts, 10A


standards and the
Conceptual Framework.

9. Appreciate, at an introductory level,


various future developments in
financial reporting.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

CHAPTER 13 – ANALYSING AND INTEGRATING GAAP

Note to Instructors

Students are invited to discuss their own views in the questions throughout the end of chapter
activities. For example, question 4 requires students discuss the advantages of a conceptual
framework. The question also asks students to discuss if they believe these advantages can
actually be achieved. As there are no correct or recommended answers for these types of
questions, the solution manual states “student’s personal views and discussion required” in these
instances.

ANSWERS TO QUESTIONS

1. There are 2 concepts and 4 principles that underlie the recording of accounting information.
In many cases, more than one principle or concept can apply to each transaction. For
example, the monetary principle requires that only those things that can be expressed in
monetary terms be included in the accounting records. Hence, all accounting transactions
will be based on the monetary principle, but may also be based on others.

Accounting Entity Concept


This concept states that every entity can be separately identified and accounted for.

Accounting Period Concept


The accounting period concept states that the life of a business entity can be divided into
artificial periods and that useful reports covering those periods can be prepared for the
entity.

Monetary Principle
This principle requires that the items included in the accounting records must be able to be
expressed in monetary terms.

Going Concern Principle


This principle states that financial statements are prepared on a going concern basis unless
management either intends to or must liquidate the business or cease trading.

Cost Principle
The cost principle states that all assets are initially recorded in the accounts at their
purchase price or cost. This is applied not only at the time the asset is purchased but also
over the time the asset is held.

Full Disclosure Principle


The full disclosure principle requires that all circumstances and events that could make a
difference to the decisions financial statement users might make should be disclosed in the
financial statements.

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Chapter 13: Analysing and integrating GAAP
2. Accounting concepts, principles and recognition criteria are interrelated and provide
guidance when recording certain transactions. An example is the best way to illustrate this
point. Consider the payment of a 2 year insurance policy for $24,000 on 1 January 2016.
The initial recording and subsequent adjustments related to this transaction are informed by
both the accounting period concept and recognition criteria. The accounting period concept
states that the life of a business entity can be divided into artificial periods and that useful
reports covering those periods can be prepared for the entity. The recognition criteria inform
when a transaction is to be recorded – that is when it is probable and can be reliably
measured. On January 1, the payment can be recorded as:

Dr Prepaid Insurance $24,000


Cr Cash $24,000

If the year-end is 30 June 2016, in order to provide useful information to our users about the
accounting period, we can use the expense recognition criteria and the period assumption to
inform the following adjusting entry:

Dr Insurance Expense $6,000


Cr Prepaid Insurance $6,000

That is $6,000 of future economic benefits in relation to insurance have expired and are
recorded as an expense in the period in which it expired.

3. A conceptual framework consists of a set of concepts defining the nature, purpose and
content of general purpose financial reporting to be followed by preparers of general
purpose financial reports and standard setters.

In Australia, the conceptual framework has 4 main components: [1] the objective of general
purpose financial reporting, [2] the reporting entity (SAC 1), [3] the qualitative characteristics
[4] and the definition of elements in financial statements.

4. A conceptual framework consists of a set of concepts defining the nature, purpose and
content of general purpose financial reporting to be followed by preparers of general
purpose financial reports and standard setters. The advantages or benefits of a conceptual
framework are that it improves the standard setting process and consistency in accounting
practice. To illustrate, prior to the late 1970s there was no generally accepted theory of
financial accounting. This meant that the development of accounting standards for financial
accounting practice was piecemeal as the standards were not based on any particular
theory. This resulted in some inconsistencies between standards and therefore
inconsistencies in accounting practice. The development of a conceptual framework in
relation to financial reporting is beneficial in that it outlines the objectives of financial
reporting, the required qualitative characteristics for financial information and to provide
clear guidance on how to measure and account for economic events when recording
transactions and preparing financial information.

Question part 2 – do you believe that these benefits can actually be achieved?

Student’s personal views and discussion required.


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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

5. As defined in Paragraph 2 “a reporting entity is a circumscribed area of economic activities


whose financial information has the potential to be useful to existing and potential equity
investors, lenders and other creditors who cannot directly obtain they information they need
in making decisions about providing resources to the entity in assessing whether
management and the governing board of that entity have made efficient and effective use of
the resources provided.” This definition is consistent with the definition in the Framework and
is linked to the objective of general purpose financial reporting in the Conceptual
Framework.

The exposure draft identifies the three features as necessary but not always sufficient
conditions to identify a reporting entity. First, a reporting entity conducts, has conducted or
will conduct economic activities. Second the economic activities can be distinguished from
other entities and the economic environment. Third, linking back to the objective of financial
reporting, financial information about the economic entities will be useful in making decisions
about providing resources to the entity and in assessing the efficiency and effectiveness of
management and the governing board.

A related concept to the reporting entity is the accounting entity concept. While the
accounting entity concept applies to all accounting entities, not all entities are reporting
entities. The Accounting Entity Concept states that every entity can be separately identified
and accounted for. In particular for sole traders and partnerships, it is extremely important
that the owners do not confuse the entity’s transactions with their personal transactions, or
the transactions of any other entity. Accounting entity must be identified and reported as
separate from its owners.

Question part 2 - Do you believe the accounting entity concept is helpful?

Once the entity concept is explained as above, then student’s personal views and
discussion required.

6. The different categories of entities include:


 profit companies and entities,
 public sector entities and
 not-for-profit entities.

The Australian and New Zealand reporting requirements for each of these entities is
provided below.

Australia
AASB 1053 Application of Tiers of Australian Accounting Standards establishes a differential
financial reporting framework consisting of two tiers of reporting requirements for preparing
general purpose financial reports.

Tier 1
Tier 1, are required apply the full AASB standards. Tier 1 entities are for-profit entities in the
private sector that have public accountability and the Australian Government and State,
Territory and Local Governments entities.

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Chapter 13: Analysing and integrating GAAP

Tiers 2
Tiers 2 entities are: for-profit private sector entities that do not have public accountability; all
not-for-profit private sector entities; and public sector entities other than the Australian
Government and State, Territory and Local Governments. Tier 2 entities are required to
apply the full recognition, measurement and presentation requirements of IFRSs, but have
substantially reduced disclosure requirements. The disclosures required by Tier 2 and the
disclosures required by the IASB’s, IFRS for SMEs, are similar. However, the IFRS for
SMEs do not include all the recognition and measurement requirements corresponding to
those in IFRSs.

New Zealand
In 2011, the New Zealand government announced changes to the financial reporting
requirements for New Zealand entities. These changes are enacted in the Financial
Reporting Act 2013. The main change is that many small and medium sized New Zealand
companies will no longer need to prepare accounting reports using New Zealand generally
accepted accounting practice (GAAP). Complementary to this, the External Reporting Board
(XRB) announced that, for financial reporting, New Zealand would change from a single set
of sector neutral accounting standards to a multi-sector and standards approach. The full
effect of these changes will take effect in 2016.

Now, New Zealand is similar to the international standards where the for-profit publicly
accountable entities will use New Zealand equivalents to the International Financial
Reporting Standards (NZ IFRS) and public benefit entities (not-for-profit and government
sector) will report using PBE standards, which are based primarily on International Public
Sector Accounting Standards (IPSAS), modified as necessary for the New Zealand
environment by the XRB. Also within the two-sector reporting regime there are four tiers.
Tier one in both sectors will use the full standards with fewer requirements as the tiers go
down.

7. The Conceptual Framework identifies the objective of general purpose financial reporting as
the provision of financial information about the reporting entity that is useful to existing and
potential equity investors, lenders and other creditors in making their decisions about
providing resources to the entity.

Why is it necessary to have an objective? This is best explained with reference to the
building analogy given in the text on p 775. We see that understanding who the primary
users of a building are, as well as details of their needs would more likely result in a building
that would satisfy their needs and achieve the purpose the building was constructed to fulfil.
The same is true for financial reporting – if we know the objective of financial reporting is the
provision of information to users for decision making and we know who the users are and
their decision making needs – the reports are more likely to fulfil their purpose!

Furthermore we can also consider how that objective is best served and in what format the
financial information should be presented to meet the objectives. These issues are
addressed by chapter 3 of the Conceptual Framework. The Conceptual Framework provides
guidance on the qualitative characteristics that information contained in general purpose
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financial reports should have to achieve the objective of providing useful information for
decision making. That is, the qualitative characteristics are the attributes that make the
information in financial statements useful.

8. Figure 13.3 sets out the primary users of the general purpose financial reports being those
users who provide resources to the entity and therefore require information to make
decisions concerning the provision of those resources. (1) Equity investors provide
resources to an entity usually by investing cash for the purpose of receiving a return and
include shareholders, holders of partnership interests and other equity owners. (2) Lenders
provide resources to an entity by lending cash for the purpose of receiving a return in the
form of interest. (3) Other creditors including employees, suppliers and customers (but only
in their capacity to provide resources to the entity are they considered primary users).

Some questions that may be asked by investors and lenders about a company include:
 Is the company earning satisfactory profit?
 How does the company compare in size and profitability with its competitors?
 Will the company be able to pay its debts as they fall due?
 Is the company paying regular dividends to its shareholders?
 What is the company’s potential for generating future cash flows?
 Should I invest in the company?
 Should I lend funds to this company?

9. The conceptual framework sets out both the primary and other users. The primary users of
the general purpose financial reports being those users who provide resources to the entity
and therefore require information to make decisions concerning the provision of those
resources. (1) Equity investors provide resources to an entity usually by investing cash for
the purpose of receiving a return and include shareholders, holders of partnership interests
and other equity owners. (2) Lenders provide resources to an entity by lending cash for the
purpose of receiving a return in the form of interest. (3) Other creditors including employees,
suppliers and customers (but only in their capacity to provide resources to the entity are they
considered primary users). Suppliers are considered to be other creditors when they extend
credit to facilitate a sale, employees are considered to be other creditors when they provide
their services (human resources) in exchange for remuneration and customers are
considered to be other creditors when they prepay for goods or services which are to be
provided in the future. These parties are only considered resource providers to the extent
that they provide the entity with resources in the form of credit or services, and they make
decisions based on providing such resources. When they are not in this capacity they are
referred to as other users. Figure 13.3 summarises the three main categories of users.

In addition to ‘primary users’ there are also ‘other users’.

Other users include government agencies, members of the public as well as suppliers,
customers and employees (when not resource providers as explained above). The
information needs and questions of other users vary considerably. For example, taxation
authorities such as the ATO want to know whether the entity complies with the tax laws.
Regulatory agencies such as the Australian Securities and Investments Commission (ASIC)

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Chapter 13: Analysing and integrating GAAP
or the Australian Competition and Consumer Commission (ACCC) want to know whether the
entity is operating within prescribed rules.

While these other users have specialised information needs, they may find the financial
information that meets the needs of resource providers useful. Like the primary users, the
common information needs of other users include an assessment of the entity’s future cash
flows (amount, timing and uncertainty) and evidence that management has discharged its
responsibilities to use the entity’s resources efficiently and effectively. However, it is made
clear that financial reporting is not primarily directed to other users but rather to equity
investors, lenders and other creditors.

10. According to the Conceptual Framework, the qualitative characteristics are classified as
either fundamental or enhancing depending on how they affect the usefulness of financial
information. Enhancing qualitative characteristics and fundamental qualitative characteristics
are complementary.

Fundamental qualitative characteristics


For the information in general purpose financial reports to be useful, it must be relevant and
provide a faithful representation of the economic phenomena it represents. Relevance and
faithful representation are therefore classified as fundamental qualitative characteristics.

Relevance
Information is considered relevant if it is capable of making a difference in the decisions
made by users. Information that has predictive value and/or confirmatory value is considered
to be relevant.

Faithful representation
Information is a faithful representation of the economic phenomena it purports to represent if
it is complete, neutral and free from material error.

Relevance and faithful representation work together in enhancing the decision usefulness of
information. Relevance is applied to determine which economic phenomena to represent
and then faithful representation is applied to determine which depictions best represent the
underlying economic phenomena.

Enhancing qualitative characteristics


Enhancing qualitative characteristics include comparability, verifiability, timeliness and
understandability. These characteristics are called enhancing characteristics as they
enhance the decision usefulness of relevant information faithfully represented in financial
statements. The enhancing qualitative characteristics are summarised in Figure 13.4

Comparability
Information that is comparable facilitates users identifying similarities and differences
between different economic phenomena. Consistency refers to the use of the same
accounting policies between entities, at the same point in time, or the same entity over time.
Consistency supports the achievement of comparability.

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Verifiability
Information is verifiable if it faithfully represents the economic phenomena it is meant to
represent. Verifiability means that independent observers could reach a consensus – but
not necessarily one hundred percent agreement- that a particular depiction is a faithful
representation. Direct verification is through direct observation like counting cash to verify
cash balance reported on the statement of financial position or counting inventory to
determine quantities in stock. Indirect verification is where techniques or calculations are
used to check the representation. For example verifying the ending inventory balance in the
statement of financial position by checking quantities and costs using the same cost flow
assumption. See chapter 5 for more information on calculating ending inventory using
different cost flow assumptions.

Timeliness
Timeliness is measured by whether the information is available to users before it ceases to
be relevant; that is, the information is received while it is still capable of influencing the
decisions users make based on the information. Financial information may lose its relevance

Understandability
Understandability is the last of the enhancing qualitative characteristics and relates to the
quality of information that assists users to understand the meaning of the information
provided

Constraint on financial reporting


There is only one constraint on financial reporting namely cost.
Providing decision-useful information imposes costs, and the benefits of providing the
information should outweigh the costs. Costs can include those associated with collecting,
processing, verifying and disseminating information. Assessing whether benefits outweigh
costs is usually more qualitative than quantitative and is often incomplete. In an attempt to
ensure benefits outweigh costs, it is important to consider whether one or more enhancing
qualitative characteristics may be sacrificed to reduce costs.

Figure 13.5 summarises the fundamental and enhancing qualitative characteristics of


financial information and the constraint of providing financial information as outlined in the in
the Conceptual Framework.

11. Accounting information is deemed to be relevant if it would make a difference in a business


decision. Users of financial information need to make many decisions based on the
information contained in general purpose financial reports. Decisions such as “shall I invest
in this entity?” or “should I lend money to this entity?” require information on the entity’s
future profitability and ability to pay its debts as they fall due. It seems then that, for
information to be relevant, it must have predictive value, to help users make predictions
about the future, or provide feedback, to help users assess the accuracy of their past
predictions and decisions.

Information is a faithful representation of the economic phenomena it purports to represent if


it is complete, neutral and free from material error. It is important that the information depicts
the economic substance of the transactions, events or circumstances.
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Chapter 13: Analysing and integrating GAAP
At times, economic substance may not be the same as the legal form. To be complete, all of
the information needed to represent the economic phenomena faithfully is included
and there is no omission which could make the information misleading. Hence, like
relevance, faithful representation is also linked to the full disclosure principle.

Question part 2 – Discuss whether you believe one is more important than the other, or if
they are equally important?

Student’s personal views and discussion required.

Relevance and faithful representation are both important however, they can involve some
trade-offs. For example, information about future profits is very relevant. However, as we are
unable to tell the future with certainty, such information may not be faithful represented.

While they are both important to answer which one is more important in a particular instance
it is helpful to consider the information needs of the user. For example, if the user is a capital
provider then relevance and faithful representation could be considered equally important.
However, if the user is a government agency performing a review or oversight function,
faithful representation could be considered more important than relevance if relevance
relates to future information, rather than relevance of the information to the oversight
function.

12. Information is a faithful representation of the economic phenomena it purports to represent if


it is complete, neutral and free from material error. To be complete, all of the information
needed to represent the economic phenomena faithfully is included and there is no omission
that could make the information misleading. Information that is considered to be neutral is
free from bias. Information is biased if it is intended to attain or induce a particular behaviour
or result. Some of the information in general purpose financial reports is measured using
estimates in conditions of uncertainty.

Question part 2 – Do you believe that financial information can, in reality, be neutral and
representationally faithful? Explain your answer.

Student’s personal views and discussion required.

Ruth Hines explores this very question in R. Hines 1991, ‘The FASB’s Conceptual
framework, financial accounting and the maintenance of the social world’, Accounting
Organizations and Society, vol. 16, no. 4, pp. 313–2.

Some time ago in this journal article she wrote about the FASB’s conceptual framework. She
suggested that it appears that the ‘assumption underpinning the Conceptual Framework is
that the relationship between financial accounting and economic reality is a unidirectional,
reflecting or faithfully reproducing relationship: economic reality exists objectively,
intersubjectively, concretely and independent of financial accounting practices; financial
accounting reflects, mirrors, represents or measures the pre-existent reality’. This is an
objectivist’s view of the world.

If this was our world view then we would answer the question by stating “Yes it is possible
for information to be represented faithfully and neutral.”

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

On the other hand, if we held a subjectivists view of the world, we would assume there is no
such phenomena as an economic reality to be measured objectively that exists independent
of people’s perceptions. That is, reality is subjective and the result of personal interpretation.
Based on this assumption, accounting information is subjective and it requires judgements,
estimates and interpretations and must, therefore, be biased and cannot be
representationally faithful.

13. Cost is a constraint that limits the information provided by financial reporting.

Cost

Preparers and standard setters seek to ascertain that the costs of preparing certain financial
information are not greater than the benefits to be derived from using that information. The
costs and particularly the benefits of financial information are difficult to measure;
consequently, it is a subjective measure. Assessing whether benefits outweigh costs is
usually more qualitative than quantitative and is often incomplete. In an attempt to ensure
benefits outweigh costs, it is important to consider whether one or more enhancing
qualitative characteristics may be sacrificed to reduce costs.

14. General purpose financial statements of an entity can provide valuable information about an
entity. However, this information is more meaningful if it is supplemented with additional
information including general economic conditions, political climate, industry trends or
averages, information from directors’ reports and media releases. For example, in times of
increasing interest rates, pressures on the housing markets have affected the demand for
other sales such as building materials and furniture sales. These general economic
conditions make it more difficult for entities to increase their prices without potentially losing
sales to competitors and might explain decreases in sales for the period. Investing in a
government project in a country which is politically unstable might explain financial losses if
the government has changed. Industry averages or competitors’ ratios for a variety of ratios
– e.g. return on assets, debt to equity, dividend payout etc…allow us to determine how
effective a particular entity is in relation to its competitors.

15. General purpose financial reports should be seen more as models of transactions rather
than exact depictions of transactions and events given the information contained in general
purpose financial reports is, to a significant extent, based on estimates and judgements.
Many types of judgements have been explored throughout the book. For example, we
calculated estimates to accrue expenses in chapter 3, estimates for bad and doubtful debts
in chapter 7, and estimates for warranties in chapter 9. The Conceptual Framework outlines
the concepts that underlie the estimates and judgements necessary for financial reports. For
this reason, general purpose financial reports can be seen as models of the transactions
and events that have occurred in relation to an entity rather than an exact depiction.

16. The conceptual framework identifies qualitative characteristics as either fundamental or


enhancing depending on how they affect the usefulness of financial information.

Fundamental qualitative characteristics

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Chapter 13: Analysing and integrating GAAP
For the information in general purpose financial reports to be useful, it must be relevant and
provide a faithful representation of the economic phenomena it represents. Relevance and
faithful representation are therefore classified as fundamental qualitative characteristics.

Information is considered relevant if it is capable of making a difference in the decisions


made by users as capital providers.

Information that has predictive value and/or confirmatory value is considered to be relevant.
Information is considered to have predictive value if it can be used by capital providers to
develop their expectations for the future. Information is considered to have confirmatory
value if it confirms or disconfirms users’ past or present expectations. Information is a faithful
representation of the economic phenomena it purports to represent if it is complete, neutral
and free from material error. It is important that the information depicts the economic
substance of the transactions, events or circumstances.

To be complete, all of the information needed to represent the economic phenomena


faithfully is included and there is no omission that could make the information misleading.
Hence, faithful representation is linked to the full disclosure principle. Information that is
considered to be neutral is free from bias. Information is biased if it is intended to attain or
induce a particular behaviour or result. Some of the information in general purpose financial
reports is measured using estimates in conditions of uncertainty. Hence, it is not reasonable
to expect that reports will be completely error free. However, despite this limitation, faithful
representation is achieved when the inputs used to make the judgements and estimate
reflect the best available information at the time.

Relevance and faithful representation work together in enhancing the decision usefulness of
information as follows. First, relevance is applied to determine which economic phenomena
to represent. Then, faithful representation is applied to determine which depictions best
represent the underlying economic phenomena. Enhancing qualitative characteristics and
fundamental qualitative characteristics are complementary.

Enhancing qualitative characteristics

Enhancing qualitative characteristics include comparability, verifiability, timeliness and


understandability, and are used to distinguish more useful information from less useful
information. They are called enhancing characteristics as they enhance the decision-
usefulness of relevant information faithfully represented in financial reports. Information that
is comparable facilitates users’ identification of similarities and differences between different
economic phenomena. Consistency refers to the use of the same accounting policies
between entities, at the same point in time, or by the same entity over time. Consistency
supports the achievement of comparability.

Information is verifiable if the information presented represents the economic phenomena


without bias or material error and has been prepared with appropriate recognition and
measurement methods.

Timeliness is measured by whether the information is available to users before it ceases to


be relevant; that is, the information is received while it is still capable of influencing the
decisions that users make.

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Understandability is the last of the enhancing qualitative characteristics and relates to the
quality of information that facilitates users to comprehend the meaning of the information
provided. It is important to recognise that it is highly dependent upon the capabilities of
users of financial reports and that users are assumed to have a reasonable knowledge of
business activities and economic phenomena. However, classifying, characterising and
presenting comparable information clearly and concisely will enhance understandability.

What makes a qualitative characteristic fundamental or enhancing depends on how it affects


the usefulness of financial information. Given the aim of general purpose financial reports is
to be useful, it must therefore be relevant and provide a faithful representation of the
economic phenomena it represents. Relevance and faithful representation are therefore
classified as fundamental qualitative characteristics. While enhancing qualitative
characteristics improve the usefulness of financial information and should be maximised
where possible, they cannot make information decision useful if the information is irrelevant
or not faithfully represented.

Question part 2 - What makes a qualitative characteristic fundamental or enhancing?

For the information in general purpose financial reports to be useful, it must be relevant and
provide a faithful representation of the economic phenomena it represents. Relevance and
faithful representation are therefore classified as fundamental qualitative characteristics.

Enhancing qualitative characteristics include comparability, verifiability, timeliness and


understandability, and are used to distinguish more useful information from less useful
information. They are called enhancing characteristics as they enhance the decision-
usefulness of relevant information faithfully represented in financial reports.

Question part 3 – Do you believe this is an important distinction?

Student’s personal views and discussion required

17. Cost is the constraint that limits the information provided by financial reporting.

Providing decision-useful information imposes costs, and the benefits of providing the
information should outweigh the costs. Costs can include the costs of collecting, processing,
verifying and disseminating information. Assessment of benefits and costs is usually more
qualitative than quantitative and is often incomplete. When attempting to ensure that the
benefits of providing the information outweigh the costs, it may be necessary to sacrifice one
or more enhancing (rather than fundamental) qualitative characteristics in order to reduce
costs.

This is justified by the fact that for the information in general purpose financial reports to be
useful, it must be relevant and provide a faithful representation of the economic phenomena
it represents. Therefore, relevance and faithful representation cannot be compromised to
save costs.

Enhancing qualitative characteristics on the other hand are used to distinguish more useful
information from less useful information. Given they are only ‘enhancing’ characteristics as

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Chapter 13: Analysing and integrating GAAP
they enhance the decision-usefulness of relevant information they can be sacrificed and
users can still have faithfully represented and relevant information in financial reports.

18. A liability is defined in the Conceptual Framework as ‘a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits’ (paragraph 4.4b).

Recognition criteria

As outlined in the Conceptual Framework, a liability is recognised in the statement of


financial position when:

(a) it is probable that an outflow of resources embodying economic benefits will result from
the settlement of a present obligation

(b) the amount at which the settlement will take place can be measured reliably
( paragraph 4.46).

19. Income is defined in the Conceptual Framework as ‘increases in economic benefits during
the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants’(paragraph 4.25a). It is important to note that, like the definition of equity,
the definition of income is linked to the definitions of assets and liabilities.

As defined in the Conceptual Framework expenses are ‘decreases in economic benefits


during the accounting period in the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity, other than those relating to distributions to equity
participants’(paragraph 4.25b). It is important to note that, like the definitions of equity and
income, the definition of expenses is linked to the definitions of assets and liabilities.

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20. Assets are defined in the Conceptual Framework as “a resource controlled by the entity as a
result of past events and from which future economic benefits are expected to flow to the
entity.” (para 4.4a). First, the entity must have control over the asset. While control often
means ownership of the asset, ownership is not an essential characteristic.

A second essential characteristic is that the control of the future economic benefits must be
as a result of a past transaction or event. Generally, this is after the purchase of the asset
has taken place. It is important to note that resources to be purchased in the future are not
considered an asset of the entity until the exchange takes place. However, to further
complicate matters, payment is not an essential characteristic of an asset; a donated
resource, once the entity has control of the future economic benefits, meets the definition of
an asset as well.

Finally, the resource must be able to provide future economic benefits or service potential,
such that it can contribute directly or indirectly to the future cash flows or cash equivalents of
the entity. The definition of an asset identifies its essential features but does not attempt to
specify the criteria that need to be met before it can be recognised in the statement of
financial position. Hence, it is not sufficient to record assets based only upon the definition of
assets. We also need the recognition criteria.

Recognition is the process of recording in the financial statements any item that meets the
definition of an element and satisfies the criteria for recognition.

Assets that satisfy the recognition criteria should be incorporated in the statement of
financial position when: [1] it is probable that the future economic benefits will flow to the
entity, and [2] the asset has a cost or value that can be measured with reliability.

The first recognition criterion results from the fact that business entities operate in uncertain
environments. We use the concept of probability to refer to the degree of uncertainty that
surrounds whether the future economic benefits will flow to or from the entity in relation to a
transaction or event. To assess the degree of probability of the future economic benefits, all
of evidence available when the financial statements are prepared is used. For example,
when it was probable that a receivable would be collected, it was recognised as an asset.
When it was probable that a receivable would not be collected, we incurred doubtful debts
expense. The second recognition criterion requires that each item possesses a cost or
value that can be measured with reliability. Some items are recorded at cost and very
straight forward. Some items such as provision for warranties must be estimated. Items that
cannot be reasonably estimated are not recognised in the financial statements.

21. Equity is defined in the Conceptual Framework as “the residual interest in the assets of the
entity after deducting all its liabilities.” Equity is what remains when we subtract liabilities
from assets. The accounting equation can be restated from:

Assets = Liabilities + Equity

to:

Equity = Assets – Liabilities.

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Chapter 13: Analysing and integrating GAAP
The above equation shows that equity cannot be defined independently of the other
elements in the statement of financial position. Equity is the residual.

Examples of transactions that affect equity are sale of equipment that results in gain or loss,
capital injection into a business or withdrawals by owners, and asset valuations.

Examples of transactions that do not affect equity are purchase of equipment, payment of
debts, purchase of an insurance policy and receipt of cash for existing receivables.

22. Income is recognised when income definition and income recognition criteria are met.
Income is defined in the Conceptual Framework as “increase in economic benefits during
the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.” Income is recognised in the statement of profit or loss “when an
increase in future economic benefits related to an increase in an asset or a decrease of a
liability has arisen that can be measured reliably.” That is, the recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in liabilities. To
illustrate, a sale of goods on credit results in an increase in Accounts Receivable (asset) and
a corresponding increase in Sales Revenue (income). Another illustration, the provision of
goods or services in relation to a customer who has paid in advance would be recorded as a
decrease in Revenue Received in Advance (liability) and an increase in Revenue (income).

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been
provided.

23. The 2 basic common recognition criteria that are applied to assets, liabilities, revenues and
expenses are:

[1] Increase or decrease in economic benefits is probable, and

[2]The amount of assets, liabilities, revenues or expenses can be measured reliably.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

24. The four bases of measurement as outlined in the Conceptual Framework are:

[1] Historical Cost

Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire them at the time of their acquisition. Liabilities are recorded at
the amount of proceeds received in exchange for the obligation, or in some circumstances
(for example, income taxes), at the amounts of cash or cash equivalents expected to be paid
to satisfy the liability in the normal course of business.

[2] Current Cost

Assets are carried at the amount of cash or cash equivalents that would have to be paid if
the same or an equivalent asset was acquired currently. Liabilities are carried at the
undiscounted amount of cash or cash equivalents that would be required to settle the
obligation currently.

[3] Realisable (Settlement) Value

Assets are carried at the amount of cash or cash equivalents that could currently be
obtained by selling the asset in orderly disposal. Liabilities are carried at their settlement
values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to
satisfy the liabilities in the normal course of business.

[4] Present Value

Assets are carried at the present discounted value of the future net cash inflows that the
item is expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of the future net cash outflows that are expected to be required to
settle the liabilities in the normal course of business.

There are some common alternative measurement bases that can be found in general
purpose financial reports. Some assets that are originally recorded at cost are reported on a
revalued basis in statement of financial position. This means the assets were revalued either
upward or downward to their fair value. Fair value is a subset of the realisable (settlement)
value in the Conceptual Framework. Another alternative measurement base is the fair value
less any costs incurred in selling the asset. For example, inventories are usually reported at
the lower of cost and net realisable value.

25. GAAP consists of accounting standards, underlying accounting concepts and principles and
the Conceptual Framework.

The Conceptual Framework defines which entities are required to prepare general purpose
financial reports, explains the objective of general purpose financial reports, outlines what is
reported in general purpose financial reports, and provides guidance on how items are
reported.

In addition to the Conceptual Framework, other aspects of GAAP outline what is reported in
general purpose financial reports as well as how those items are reported in general
purpose financial reports. The various other aspects include the concepts and principles, the

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Chapter 13: Analysing and integrating GAAP
accounting standards backed by legislation, as well as the measurement rules as outlined in
the standards and the Conceptual Framework.

After the Corporations Act, accounting standards are the first point of guidance for
preparers. Accounting standards and authoritative interpretations of accounting standards
must be followed as they have legislative backing. If the standards are silent on an
accounting issue, preparers can seek guidance from the conceptual framework (the
Conceptual Framework plus SAC 1 and SAC 2). The concepts and principles that
traditionally underlie accounting are applied where there is no guidance on an issue in the
conceptual framework. To summarise, GAAP is applied as follows: first the Corporations
Act, then accounting standards and interpretations are consulted, then the conceptual
framework and finally the underlying concepts and principles.

26. Three future developments in financial reporting are:

[1] International Accounting Standards Board (IASB) and the US Financial Accounting
Standards Board (FASB) are currently conducting a joint project to develop the Conceptual
Framework. This will impact financial reporting in many ways including what transactions
and events will be reported and how. As this is a comprehensive project, it has been divided
into eight phases that will take many years to complete and will involve consultation with
many and varied stakeholders at all stages of the project.

[2] Sustainability Reporting: Mining, deforestation, toxic wastes in river and oceans, and
natural resource consumption are some of many negative impacts that businesses all
around the world have on natural environment. Currently, many companies disclose
information on the impact of their businesses on the environment, however these social and
environmental disclosures are voluntary. There are increasing pressures on companies from
shareholders and other stakeholders to measure, report on and reduce their environmental
impact. [3] Business entities use their accounting information systems to record, analyse
and communicate the economic transactions of a business. While businesses collect similar
information in the main, they can vary widely in the format and level of detail of the
information they collect. These differences make it difficult for organisations to share
information reliably or cost effectively. To further complicate matters, elements of financial
information can be defined differently, different accounting methods can be used, and in
different countries reporting requirements can vary. This creates difficulties for multinational
companies that operate and report all over the world. There is something called eXtensible
Business Reporting Language (XBRL) which can help solving these problems.

XBRL is a language for describing exactly which information is included in a report. It can
even take into account differences in definitions and measurements of elements in other
countries. The goal of XBRL is to make the analysis and reporting financial information more
consistent and reliable, and easier to facilitate. The financial information based on XBRL can
be used to report to shareholders, banks, regulators and other parties. To report financial
information in a consistent form, the creators of XBRL have developed a taxonomy or
vocabulary that can affect the format of financial information throughout the complete life
cycle of that information. XBRL will also facilitate the completion of reports required by
regulatory agencies and the preparation of financial reports.
SOLUTIONS TO BRIEF EXERCISES

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 13.1

(a) False

The accounting period concept states that the life of a business entity can be divided into artificial
periods and that useful reports covering those periods can be prepared for the entity. This concept
does not include “smoothing out seasonal fluctuations between periods”.

(b) False

The cost principle states that all assets are initially recorded in the accounts at their purchase price
or cost. This is applied not only at the time the asset is purchased but also over the time the asset is
held.

(c) False

The going concern principle states that financial statements are prepared on a going concern basis
unless management either intends to or must liquidate the business or cease trading. Following
that, the going concern assumption is that the business will remain in operation for the foreseeable
future.

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Chapter 13: Analysing and integrating GAAP

BRIEF EXERCISE 13.2

(a) In this case the accounting entity concept has been incorrectly applied. This concept states
that every entity can be separately identified and accounted for. The owner’s personal
transactions should not be recorded as part of the business transactions and they should be
kept separate. Hence, recording personal vehicle expenses in the entity’s statement of profit
or loss is a violation of accounting entity concept.

(b) In this case, no amount would be reported in the financial statements but would be disclosed
in the notes, as a law suit of this nature is classified as a contingent liability. Contingent
liabilities are liabilities for which the amount of the future sacrifice is so uncertain that it
cannot be measured reliably, that do not satisfy the probability criterion, or are dependent
upon the occurrence of an uncertain future event outside the control of the entity. Contingent
liabilities are not recognised in the financial statements. However, information about
contingent liabilities must be disclosed in the notes to the financial statements if they are
material. If the children’s toy manufacturer does not disclose the lawsuit and probable loss,
there is a violation of full disclosure principle. The full disclosure principle requires that all
circumstances and events that could make a difference to the decisions financial statement
users might make should be disclosed in the financial statements.

(c) The cost principle states that all assets are initially recorded in the accounts at their cost.
This is applied not only at the time the asset is purchased but also over the time the asset is
held. The going concern principle states that financial statements are prepared on a going
concern basis unless management either intends to or must liquidate the business or cease
trading. So, unless the business is to cease trading or is to be liquidated, recording land and
buildings at their estimated selling price is a deviation from the cost principle.

BRIEF EXERCISE 13.3

(a) The going concern principle states that financial statements are prepared on a going
concern basis unless management either intends to or must liquidate the business or cease
trading.

(b) The full disclosure principle requires that all circumstances and events that could make a
difference to the decisions financial statement users might make should be disclosed in the
financial statements.

(c) The accounting entity concept states that states that every entity can be separately identified
and accounted for. Under this concept, the personal transactions of the owners (regardless
of entity form i.e. sole trader, partnership or company) should be accounted for separately
from the entity’s transactions.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BRIEF EXERCISE 13.4

(a) True. Prior to 1970 there was no generally accepted theory of accounting.

(b) False. While there are many financial accounting theories with a variety of aims, the capitalist
theory is not one of them.

(c) True. Prior to the late 1970s there was no generally accepted theory of financial accounting.
This meant that the development of accounting standards for financial accounting practice
was piecemeal as the standards were not based on any particular theory. This resulted in
some inconsistencies between standards and therefore inconsistencies in accounting
practice.

(d) True. In Australia, the conceptual framework (the Framework) consists of a set of concepts
defining the nature, purpose and content of general purpose financial reporting to be followed
by preparers of general purpose financial reports and standard setters.

(e) False. Currently, the authoritative status of the Conceptual Framework is that entities that
prepare financial statements in accordance with IFRSs are required to consider the
Conceptual Framework when there is no particular standard or interpretation that applies to a
transaction or event. The IASB and FASB have not decided upon the authoritative status of
the proposed improved conceptual framework; however, it will not have the same status as
financial reporting standards, nor will it override standards.

BRIEF EXERCISE 13.5

User Category Primary users Other users


Potential equity X
investors
Regulators X
Existing equity X
investors
Lenders X
Members of the public X
Other creditors X*
Financial advisers X
Customers X** X

 Include employees, suppliers and **customers in their capacity as resource providers


otherwise they are not considered primary users

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Chapter 13: Analysing and integrating GAAP

BRIEF EXERCISE 13.6

Users Information needs

1. Managers 6. Information to calculate the amount of tax owing


and whether the entity complies with tax laws

2. Investors 4. Information on whether an entity will continue to


honour product warranties and support its product
lines

3. Creditors 7. Information to determine whether the entity is


operating within prescribed rules

4. Customers 5. Information on whether the entity has the ability to


pay increased wages and benefits, and offer job
security

5. Employees and trade unions 3. Information to determine whether to grant credit


based on risks and ability of the entity to repay debts

6. Government authorities 2. Information to determine whether to invest based


on future profitability, return on capital growth

7. Regulatory agencies 1. Information to plan, organise and run a business

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BRIEF EXERCISE 13.7

There are three main indicators used to decide whether a business organisation is a reporting
entity. An entity is more likely to be classified as a reporting entity if:

 the entity is managed by individuals who are not owners of the entity;

 the entity is politically or economically important; and

 the entity is considered large when measured in terms of sales, assets, borrowings,
customers and employees.

Based on these criteria, reporting entities include public companies and some large private
companies as well as government authorities, as these entities have external users with a
significant stake or interest in the organisation but are unable to command the preparation of
specialised reports to satisfy their information needs. Hence:

(a) Less likely


(b) More likely
(c) Not clear…need more information (if it had a small customer base it is less likely than if it
has a large customer base, regardless of satisfaction)
(d) More likely
(e) Less likely
(f) More likely

BRIEF EXERCISE 13.8

(a) Constraint
(b) Neither constraint nor qualitative characteristic
(c) Qualitative characteristic
(d) Qualitative characteristic
(e) Neither constraint nor qualitative characteristic
(f) Neither constraint nor qualitative characteristic
(g) Qualitative characteristic
(h) Qualitative characteristic

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Chapter 13: Analysing and integrating GAAP

BRIEF EXERCISE 13.9

(a) Fundamental
(b) Neither fundamental or enhancing *
(c) Enhancing
(d) Enhancing
(e) Neither fundamental or enhancing but a constraint
(f) Enhancing
(g) Neither fundamental or enhancing
(h) Fundamental
(i) Enhancing

* While materiality is not explicitly mentioned as a fundamental or enhancing characteristic - the


relevance of the information is affected by its materiality. Information is material if its omission or
misstatement could affect users’ decisions.

BRIEF EXERCISE 13.10

(a) Assets are defined in the Conceptual Framework as a resource controlled by the entity as a
result of past events and from which ‘future economic benefits’ (not resources) are expected to
flow ‘to’ (not ‘from’) the entity.

(b) Expenses are defined in the Conceptual Framework as ‘decreases’ (not ‘increases’) in
economic benefits during the accounting period in the form of outflows or depletions of assets
or incurrence of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

(c) Equity is defined in the Conceptual Framework as the residual interest in the ‘assets’ (not
‘equity’) of the entity after deducting all its liabilities.

(d) Income is defined in the Conceptual Framework as increases in economic benefits during the
accounting period in the form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity, ‘other than those relating to’ contributions from equity
participants (not ‘as well as’ contributions from equity participants).

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

SOLUTIONS TO EXERCISES

EXERCISE 13.1

Accounting Entity Concept:

Tony is the sole owner of Tony’s Pizza Palace. Recently, he purchased a bicycle for his own
personal use from his business bank account. He never delivers pizza using the bicycle. At the time
of purchase, Tony recorded the transaction in his business accounts as:

Dr Withdrawals
Cr Bank

Accounting Period Concept:

A company with a December year end purchased a 1-year fire insurance policy for $12,000 on
October 1, 2017. In order to report the correct income and asset figures in the financial statements
ending December 2017, the transaction was recorded as:

Dr Prepaid Insurance $9,000


Dr Insurance Expense $3,000
Cr Cash $12,000
This transaction recognises a $3000 expense in period one and a 9,000 expense in the following
accounting period. Alternatively the $12,000 could have been initially recorded using either the
asset method or the expense method and then adjusted at year end. Note that asset and expense
definitions and recognition criteria are also relevant and related.

Going Concern Principle:

Company A purchased equipment for $1 million. A year later, the equipment is still reported at its
book value (purchase price minus accumulated depreciation), not liquidation value.

Cost Principle:

Company A purchased a piece of land for $ 1,000,000 after obtaining a loan. At the time of
purchase, the company was considered to be a going concern and the land was recorded in the
statement of financial position at $ 1,000,000.

Dr Land $ 1,000,000
Bank Loan $ 1,000,000
In the next reporting period, the land will still be recorded at $1,000,000 under the cost principle,
although the price of the land may have increased to $1,200,000.

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Chapter 13: Analysing and integrating GAAP
Full Disclosure Principle:

Company A was sued for defective products that resulted in customer injuries. The legal
representation for the company assessed that the company is likely to lose the case and will be
required to pay a large amount of money as compensation. While the payment is probable, however
at this stage it cannot be reliably estimated. While no amount is recorded in the financial
statements, Company A discloses information about the law suit and likely losses in its notes to the
financial statements.

EXERCISE 13.2
SALAMI 4 U
(a)

(i) The purchase of motor vehicle transaction was recorded incorrectly. The purchase of
plant and equipment was recorded correctly.

(ii)The entry for the purchase of motor vehicle was incorrectly recorded as it violates the
accounting entity concept. The accounting entity concept states that every entity can be
separately identified and accounted for. In this case the personal transactions of the owner
were not recorded separately from the transactions of the entity. The purchase of the motor
vehicle for personal use out of company funds should be recorded as a withdrawal of
capital.

(iii)
Correcting entry:
Drawings $20,000
Motor Vehicles $20,000

Correct entry that should have been recorded in the first instance:
Drawings $20,000
Cash $20,000

(b) If the car were to be used for business purposes, then the initial entry of debit to Motor
Vehicles and credit Cash would have been correct. If the vehicle is purchased solely for
business use, it is correct to report the vehicle as a company asset and accounting entity
concept is not violated.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

EXERCISE 13.3

(a) 7. (Going Concern Principle) This principle states that financial statements are prepared on
a going concern basis unless management either intends to or must liquidate the business
or cease trading.

(b) 1. (Accounting Entity Concept) This concept states that every entity can be separately
identified and accounted for.

(c) 6. (Full Disclosure Principle) The full disclosure principle requires that all circumstances and
events that could make a difference to the decisions financial statement users might make
should be disclosed in the financial statements.

(d) 2. (Monetary Principle) This principle requires that the items included in the accounting
records must be able to be expressed in monetary terms.

(e) 5. (Materiality) The relevance of information is affected by its materiality. Information is


material if its omission or misstatement could affect users’ decisions.

(f) 3. (Accounting Period Concept) The accounting period concept states that the life of a
business entity can be divided into artificial periods and that useful reports covering those
periods can be prepared for the entity.

(g) 9. (Expense recognition criteria) The Conceptual Framework provides expense recognition
criteria. Expenses should be recognised when ‘a decrease in future economic benefits
related to a decrease in an asset or an increase of a liability has arisen that can be
measured reliably’ (paragraph 94).

(h) 4. (Cost Principle) The cost principle states that all assets are initially recorded in the
accounts at their purchase price or cost. This is applied not only at the time the asset is
purchased but also over the time the asset is held.

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Chapter 13: Analysing and integrating GAAP

EXERCISE 13.4

(a) A violation of revenue recognition criteria has occurred. AASB 118 and NZ IAS 18 ‘Revenue’
prescribe principles for the recognition of revenue for the sale of goods. As explained in
chapter 3, IAS 18 Revenue prescribes five principles for the recognition of revenue from the
sale of goods and four principles for the recognition of revenue from the provision of
services.

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been
provided.

In this case no sale has occurred however, revenue has been recognised. Normally, the
transfer of significant risks and rewards of ownership occurs when legal title passes to the
buyer. Further, as outlined in the Conceptual Framework, income (which includes revenues
and gains) is recognised in the statement of profit or loss ‘when an increase in future
economic benefits related to an increase in an asset or a decrease of a liability has
arisen that can be measured reliably’. in the question we are also told that the amount
cannot be reliably measured at this stage – a further violation of the recognition criteria.

(b) A violation of Accounting Period Concept has occurred. The accounting period concept
states that the life of a business entity can be divided into artificial periods and that useful
reports covering those periods can be prepared for the entity. In this case no reports have
been prepared.

(c) In this case no violation is evident as the inventory is being carried at the lower of cost or net
realisable value. Although the cost principle states that assets are to be recorded at their
cost, AASB 102 Inventories mandates that ‘inventories shall be measured at the lower of
cost and net realisable value’ (para.9). Furthermore, the Conceptual Framework also
provides expense recognition criteria. Expenses should be recognised when ‘a decrease in
future economic benefits related to a decrease in an asset or an increase of a liability has
arisen that can be measured reliably’ (paragraph 94). In this case the net realisable value is
lower than the cost of inventory so there has been a decrease in an asset (inventory) and an
increase in an expense (inventory write-down expense).

(d) A violation of going concern principle is evident in this case. The going concern principle
states that financial statements are prepared on a going basis unless management either
intends to or must liquidate the business or cease trading. In this case, liquidation is unlikely,
so property plant and equipment should not be reported at the amount for which it could be

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

sold at short notice, but either cost or revalued basis. In addition, property, plant and
equipment and bills payable also need to be classified as non-current assets and liabilities
respectively.

(e) A violation of cost principle in this case. The cost principle states that all assets are initially
recorded in the accounts at their purchase price or cost. This is applied not only at the time
the asset is purchased, but also over the time the asset is held. If the net realisable value is
lower than cost, then Surf’s Up Ltd should report the inventory at net realisable value.

(f) A violation of accounting entity concept is evident in this case. This concept states that every
entity can be separately identified and accounted for. In other words, owner’s personal
transactions must be clearly separated from the entity’s transactions. Hence a computer that
is purchased for personal use should not be included in the company records.

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Chapter 13: Analysing and integrating GAAP

EXERCISE 13.5

(1) Drawings 3,000


Cash 3,000

(Purchase of a computer from entity funds for personal use)

Accounting Entity Concept states that every entity can be separately identified and
accounted for. Hence personal transactions of the owner should be recorded separately
from the transactions of the entity. Therefore, the purchase of computer for personal use
using company funds is recorded as a withdrawal of capital rather than an asset of the
entity.

(2) Paintings 50,000


Cash 50,000

(Purchased paintings for $50,000 in cash)

The monetary principle requires that the items included in the accounting records must be
able to be expressed in monetary terms. This principle underlies all recorded transactions.
Hence the purchase of paintings for use within the business is recorded in monetary terms
at cost as indicated above.

(3) 1 Jan 2017


Dr Prepaid Insurance 24,000
Cr Cash 24,000
(Company purchased a 1-year insurance policy for $24,000 on 1 January 2017)

The accounting period concept states that the life of a business entity can be divided into
artificial periods and that useful reports covering those periods can be prepared for the
entity. If the company’s year-end is 30 June, in order to provide useful reports at the end of
each accounting period, the company must make adjusting entries to ensure assets,
liabilities, revenues and expenses are reported correctly.

The adjusting entry is:

30 June 2017
Insurance Expense 12,000
Prepaid Insurance 12,000

(Adjusting entry for Insurance)

(4) Building 1,000,000


Cash 1,000,000

(Purchased a building for $1,000,000)

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

Cost principle states that all assets are initially recorded in the accounts at their purchase
price or cost. In the above example, the company recorded the purchase of its new building
at cost.

(5) Notes to the financial statements:


Our company is currently involved in a law suit in relation to damages caused by one of our
products. While the exact amount of the possible payout is currently unknown, it is expected
that a payout will be awarded and could be in the vicinity of $500,000 to $1,000,000.

In this case, no amount would be reported in the financial statements but would be disclosed
in the notes as shown above, as a law suit of this nature is classified as a contingent liability.
Contingent liabilities are liabilities for which the amount of the future sacrifice is so uncertain
that it cannot be measured reliably, that do not satisfy the probability criterion, or are
dependent upon the occurrence of an uncertain future event outside the control of the entity.
Contingent liabilities are not recognised in the financial statements. However, information
about contingent liabilities must be disclosed in the notes to the financial statements if they
are material. If this company did not disclose the lawsuit and probable loss, there is a
violation of full disclosure principle. The full disclosure principle requires that all
circumstances and events that could make a difference to the decisions financial statement
users might make should be disclosed in the financial statements.

(6) 31 December 2016


Depreciation Expense 20,000
Accumulated Depreciation – Building 20,000

(Depreciation expense for the year - Cost $1,000,000 / 50 years no residual value =
$20,000)

On January 1 2016, Dido Ltd purchased a building for $1,000,000. The building is to be
depreciated with straight line method over 50 years with no residual value. On December 31
2016, the company recorded the above journal entry. Dido Ltd is in a strong financial
position and has no liquidation plans.

The going concern principle states that financial statements are prepared on going concern
basis unless management either intends to or must liquidate the business or cease trading.
As the company is a going concern the building is not reported at liquidation value. The
above journal entry records the annual depreciation charge. The building cost $1,000,000
less the accumulated depreciation charge $20,000 will be reported in the statement of
financial position in the non-current asset section.

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Chapter 13: Analysing and integrating GAAP
(7) 25 June 20015
Accounts Receivable 1,000
Service Revenue 1,000

(Billed customer for services performed)

Income is recognised when income definition and income recognition criteria are met.
Income is defined in the Conceptual Framework as “increase in economic benefits during
the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.” Income is recognised in the statement of profit or loss “when an
increase in future economic benefits related to an increase in an asset or a decrease of a
liability can be measured reliably.” That is, the recognition of income occurs simultaneously
with the recognition of increases in assets or decreases in liabilities.
Revenue is a subset of income. To illustrate, a sale of goods on credit results in an increase
in Accounts Receivable (asset) and a corresponding increase in Sales Revenue (income).
Another illustration, the provision of goods or services in relation to a customer who has paid
in advance would be recorded as a decrease in Revenue Received in Advance (liability) and
an increase in Revenue (income).

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been
provided.

Once the services have been performed, the inflow of economic benefits during the
accounting period in the form of inflows or enhancements of assets that result in increase in
equity, other than those relating to contributions from equity participants, is probable and can
be reliably measured.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(8) Dec 31 2017


Rent Expense 1,000
Prepaid Rent 1,000
(Year-end adjusting entry for rent expense)

Expenses are defined in the Conceptual Framework as ‘decreases’ in economic benefits


during the accounting period in the form of outflows or depletions of assets or incurrence of
liabilities that result in decreases in equity, other than those relating to distributions to equity
participants. The Conceptual Framework provides expense recognition criteria. Expenses
should be recognised when ‘a decrease in future economic benefits related to a decrease in
an asset or an increase of a liability has arisen that can be measured reliably’ (paragraph
94).

The 2 basic common recognition criteria that are applied to assets, liabilities, revenues and
expenses are:

[1] Increase or decrease in economic benefits is probable, and

[2]The amount of assets, liabilities, revenues or expenses can be measured reliably

In this case, the asset in the form of Prepaid Rent has expired as the service has been
provided. The depletion of assets has arisen and can be reliably measured.

The company paid $2,000 for 2 months’ rent in advance on 1 December 2017. The initial
entry was recorded as a debit to prepaid rent. The adjusting entry above was made on 31
December 2017 to recognise that an expense had been incurred based on the expense
recognition criteria, that is a decrease in assets that can be measured reliably.

© John Wiley and Sons Australia Ltd, 2016 13.32


Chapter 13: Analysing and integrating GAAP

EXERCISE 13.6

Provisions are defined as liabilities for which the amount of the future sacrifice is uncertain. That is,
whether a liability is a provision or some other type of liability (e.g. borrowings, trade creditors,
accruals) depends upon the extent of uncertainty associated with the amount of the future sacrifice.
For borrowings such as debentures, leases, unsecured notes and mortgages, the amount of the
future sacrifice (i.e. the repayment) can be predicted with a high level of certainty. Similarly, the
amount of the future sacrifice for trade creditors can be measured with a high level of certainty
because it is quantified on the supplier’s invoice. The uncertainty associated with the amounts of
future sacrifice varies along a continuum ranging from very low uncertainty to very high uncertainty.

Provisions are liabilities for which there is significant uncertainty about the amount of the future
sacrifice but which are considered able to be measured reliably by estimation. Examples include
provisions for warranties, and provisions for employee entitlements such as long service leave. A
warranty is an obligation of the supplier of goods or services to the purchaser that the product will
be functional or that the work performed will remain satisfactory for a stated period after the sale of
goods or the provision of services. There is significant uncertainty in the measurement of the future
sacrifices that will be needed to satisfy existing warranties. This is due to two reasons:

1. The future sacrifice is conditional upon the customer making a claim.

2. The costs of satisfying claims vary with the nature of the fault. Some warranty claims may require
the replacement of a small part, while other warranty claims may require replacement of the goods
sold to the customer.

There is significant uncertainty about the future sacrifice required for employee entitlements, such
as long service leave, because the amount payable is affected by the following:
• whether employees stay with the employer long enough to become entitled to long service leave
• when employees take long service leave
• the extent to which the employee is promoted before taking long service leave
• increases in general salaries between the time the liability is recorded and when it is paid.

Other liabilities such as accruals are liabilities to pay for goods or services that have been
provided but for which a supplier’s invoice has not yet been recorded as an account payable.
Accruals often involve estimation, such as the amount of the next electricity bill or telephone
account. Although higher than borrowings and trade creditors, the level of uncertainty of accruals is
typically low because they are often for recurring services such as telephone connections, electricity
usage and interest.

© John Wiley and Sons Australia Ltd, 2016 13.33


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

Contingent liabilities are liabilities for which the amount of the future sacrifice is so uncertain that it
cannot be measured reliably. Liabilities are also classified as contingent if they do not satisfy the
probability criterion, or if they are dependent upon the occurrence of an uncertain future event
outside the control of the entity. Examples include an unresolved lawsuit brought against the entity
and the potential liability resulting from a tax audit in progress. Contingent liabilities are not
recognised because they are not probable or are unable to be measured reliably, or both, i.e. they
do not satisfy the probability criterion and the measurement criterion for the recognition of liabilities.

Based on these definitions, the liabilities are classified as follows:

(a) Contingent liabilities


(b) Other liabilities
(c) Other liabilities
(d) Provisions
(e) Other liabilities
(f) Provisions
(g) Other liabilities
(h) Other liabilities
(i) Contingent liabilities

© John Wiley and Sons Australia Ltd, 2016 13.34


Chapter 13: Analysing and integrating GAAP

EXERCISE 13.7
COMPUTER GAMES LTD

(1) Revenue recognition criteria were not followed.

Income is defined in the Conceptual Framework as “increase in economic benefits during


the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.”

Further, in the context of revenue recognition (income), as explained in chapter 3, IAS 18


Revenue prescribes principles for the recognition of revenue for the sale of goods. The
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered.

In this case part (a) has not been satisfied and revenue should not be recorded until the
computer games are delivered in March. The effect of this error is an overstatement of
revenue and hence an overstatement of profit and also an understatement of liabilities in the
form of Revenue Received in Advance by $20,000.

The correcting entry would be:


Dr Service Revenue 20,000
Cr Revenue Received in Advance 20,000
(To adjust the Service Revenue account for revenue received in advance)

(2) Expense recognition criteria were not followed.


Expenses are recorded when there is a decrease in future economic benefits related to a
decrease in an asset or an increase in liability. In this case there was no decrease in assets
as the advertising supplies (asset) were still on hand and have not been used.

The entry to correct this error:


Dr Supplies Inventory 2,300
Cr Supplies Expense 2,300
(To adjust the supplies expense account for supplies still on hand)
The effect of the error is an overstatement of the company’s expenses, an understatement
of the company’s assets and therefore an understatement of the company’s profit by $2,300.

© John Wiley and Sons Australia Ltd, 2016 13.35


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(3) Expenses are recorded when there is a decrease in future economic benefits related to a
decrease in an asset or an increase in liability. In this case the expense recognition criteria
were not followed as there was a decrease in assets (prepaid insurance which had expired)
which could be reliably measured. The prepaid insurance should amount to $9,000 as of 31
December 2016, hence the company should record an adjusting entry at year end to
account for the decline in the asset and increase in insurance expense.
The adjusting journal entry would be a debit of $3,000 for Insurance Expense and a credit of
$3,000 for Prepaid Insurance.
In this case the decrease in future economic benefits related to a decrease in an asset and
the amount of that decrease can be measured reliably, and so the expense must be
recorded. The effect of this error is an understatement of expenses, an overstatement of
assets and an overstatement of profit by $3,000.

(4) Expenses were not recorded correctly and the company did not follow expense recognition
criteria. In these cases there have been decreases in future economic benefits related to
increases in liabilities and the amounts can be measured reliably, and so the expenses must
be recorded.

The expenses should be recorded (accrued) as follows:

Dr Advertising Expense 2,500


Cr Advertising Payable 2,500
Dr Repairs Expense 2,000
Cr Repairs Payable 2,000
Dr Electricity Expense 800
Cr Electricity Payable 800

The effect of not recording the expenses correctly is an understatement of expenses and an
understatement of liabilities by $5,300. Therefore, profit is also overstated by $5,300.

(5) Expenses were not recorded correctly and the company did not follow expense recognition
criteria. In this case there has been a decrease in future economic benefits related to an
increase in liabilities and the amount can be measured reliably, and so the expense must be
recorded. Once employees have performed their duties, wages expenses have been
incurred. Therefore, the company must record the wages expenses and corresponding
liabilities.

In this case, the journal entry:


Dr Wages Expense 400
Cr Wages Payable 400
The impact of this error is an understatement of expenses and liabilities and an
overstatement of profit by $400.

© John Wiley and Sons Australia Ltd, 2016 13.36


Chapter 13: Analysing and integrating GAAP
(6) Expenses were not recorded correctly and the company did not follow expense recognition
criteria. In this case there has been a decrease in future economic benefits related to an
increase in liabilities and the amount can be measured reliably, and so the expense must be
recorded.

The interest for 1 year is $24,000. As the amount for December has not been recorded,
expenses and liabilities are understated and the profit is overstated by $2,000. The journal
entry to record the expense and corresponding liability is:
Interest Expense 2,000
Interest Payable 2,000

EXERCISE 13.8

(a)

(1) The correcting entry would be:


Dr Service Revenue 20,000
Cr Revenue Received in Advance 20,000
(To adjust the Service Revenue account for revenue received in advance)

(2) The entry to correct this error:


Dr Supplies Inventory 2,300
Cr Supplies Expense 2,300
(To adjust the supplies expense account for supplies still on hand)

(3) The adjusting entry is as follows:


Dr Insurance Expense $3,000
Cr Prepaid Insurance $3,000
(To adjust the prepaid insurance to recognise the amount expired)

(4) The adjusting entry would be:

Dr Advertising Expense 2,500


Cr Advertising Payable 2,500
Dr Repairs Expense 2,000
Cr Repairs Payable 2,000
Dr Electricity Expense 800
Cr Electricity Payable 800
(To record various accrued expenses)

(5) The adjusting entry would be:

Dr Wages Expense 400


Cr Wages Payable 400
(To recorded accrued wages)

© John Wiley and Sons Australia Ltd, 2016 13.37


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(6) The adjusting entry would be:

Dr Interest Expense 2,000


Cr Interest Payable 2,000
(To record accrued interest)

(b) Initial Reported Profit 50,560

Revenue that should have not been recorded (20,000)

Supplies expense that should have not been recorded 2,300

Insurance expense that was not recorded (3,000)

Advertising expense that was not recorded (2,500)

Repairs expense that was not recorded (2,000)

Electricity expense that was not recorded (800)

Wages expense that was not recorded (400)

Interest expense that was not recorded (2,000) (28,400)

Revised Profit 22,160

© John Wiley and Sons Australia Ltd, 2016 13.38


Chapter 13: Analysing and integrating GAAP

EXERCISE 13.9

(a) Income is defined in the Conceptual Framework as “increase in economic benefits during
the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.”

Further, in the context of revenue recognition (income), as explained in chapter 3, IAS 18


Revenue prescribes principles for the recognition of revenue for the sale of goods. The
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered.

In this case the entity has NOT transferred to the buyer the significant risks and rewards of
ownership of the goods (i.e. the tubing is yet to be manufactured and shipped), hence
revenue cannot be recognised.

As outlined in the Conceptual Framework, a liability is recognised in the statement of


financial position when:
(a) it is probable that an outflow of resources embodying economic benefits will result from
the settlement of a present obligation
(b) the amount at which the settlement will take place can be measured reliably (paragraph
91).

In this case there is a present obligation to manufacture and ship the machinery, and
therefore a liability should be recognised as follows:

Cash 200,000
Revenue Received in Advance 200,000
(To record revenue received in advance form a customer for goods to be shipped
in Feb 2017)

(b) Assets are defined in the Conceptual Framework as ‘a resource controlled by the
entity as a result
of past events and from which future economic benefits are expected to flow to the
entity’ (paragraph 49(a)). Assets that satisfy the recognition criteria should be incorporated
in the statement of financial position when:
(1) it is probable that the future economic benefits will flow to the entity
(2) the asset has a cost or value that can be measured with reliability (paragraph 89).

© John Wiley and Sons Australia Ltd, 2016 13.39


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

In this case, the equipment is a result of a past transaction (settlement for goods sold), is
controlled by Tough Tyres, and provides the business with future economic benefits (generating
revenue). Hence one asset account has increased (equipment) and another decreased
(accounts receivable).

Journal Entry:
Equipment 3,000
Accounts Receivables 3,000

As an asset account is increased by $3,000 and another asset account is decreased by $3,000,
the total amount of assets does not change.

(c) Contingent liabilities are liabilities for which the amount of the future sacrifice is so uncertain that
it cannot be measured reliably, that do not satisfy the probability criterion, or are dependent
upon the occurrence of an uncertain future event outside the control of the entity. Contingent
liabilities are not recognised in the financial statements. However, information about contingent
liabilities must be disclosed in the notes to the financial statements if they are material. In this
case the amount cannot be measured with reliability, and cannot be reported on the face of the
financial statements (no journal entry). However, while the amount is unknown a future
obligation is certain as the courts have ordered the repairs. Hence, this must be disclosed in the
notes to the financial statements as a contingent liability.

© John Wiley and Sons Australia Ltd, 2016 13.40


Chapter 13: Analysing and integrating GAAP

EXERCISE 13.10

Assets are defined in the Conceptual Framework as a resource controlled by the entity as a result
of past events and from which future economic benefits are expected to flow to the entity. Assets
that satisfy the recognition criteria should be incorporated in the statement of financial position when
[1] it is probable that the future economic benefits will flow to the entity and [2] the asset has a cost
or value that can be measured with reliability.

(a) Saleable inventory is an asset (as opposed to old and obsolete inventory which has no
expected future economic benefit). It is it is probable that the future economic benefits will
flow to the entity through the sale of inventory in the form of receivables and then cash and
this can be measured with reliability (i.e. known selling price and cost price).

(b) Not an asset. While the antique boot is an interesting talking point and meets some of the
elements in the definition and recognition criteria of an asset (e.g. it is controlled by the
entity), we are told that it has no commercial value (cannot provide future economic benefits
in the form of sale). An asset needs to provide a future economic benefit and a cost or value
that can be measured with reliability.

(c) Consignment stock is not an asset of Shiny Shoes (the consignee); it is an asset of the
consignor. Although Shiny Shoes has possession of the consigned shoes, it does not have
control of the shoes as the ownership still belongs to the consignor.

(d) While in colloquial terms we often hear ‘employees are the greatest assets of a company’, in
terms of the definition of an asset in accounting, staff members are not the company’s
assets. Shiny Shoes does not have control of the three staff members, which is essential to
the definition of an asset. While staff members may provide future economic benefits to the
company, they are not controlled by the company as they are able to resign anytime and
work elsewhere.

(e) Shelving to display shoes is an asset. It is controlled by the entity as a result of past events
(i.e. purchase transaction). It provides a probable future economic benefit in that displaying
shoes is likely to result in shoe sales or the shelves themselves can be sold for cash.
Shelves also have costs that can be measured with reliability (i.e. purchase price), and
therefore should be recognised in the financial statements.

© John Wiley and Sons Australia Ltd, 2016 13.41


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

EXERCISE 13.11

Liability is defined in the Conceptual Framework as a present obligation of the entity arising from
past events, the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits. A liability is recognised in the statement of financial position when [1]
it is probable that an outflow of resources embodying economic benefit will result from the
settlement of a present obligation, and [2] the amount at which the settlement will take place can be
measured reliably.

(a) The purchase of tyres, glass and steel on account should be recognised as a liability. Once
the goods are received, a present obligation of a-Forden and a-Holden Custom Cars (i.e.
obligation to pay for the materials) arising from past events (i.e. purchase transaction) exists,
the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits e.g. the payment of cash.

It is probable that an outflow of resources embodying economic benefit will result from the
settlement of the obligation, and the amount of the settlement can be measured reliably
through the purchase price.

The journal entry to recognise the liability is:


Manufacturing Materials X
Accounts Payable X

(b) The receipt of $100,000 as a deposit for cars to be built is recognised as a liability. The
deposit received, cannot be recorded as Revenue as the work to manufacture the car has
not been completed. Once the deposit is received, a present obligation of the company to
build homes for its clients has risen from a past event (i.e. receipt of the deposit). The
settlement of the obligation is expected to result in an outflow from the company of
resources embodying economic benefits e.g. resources used to build cars or the repayment
of the deposit.

The journal entry to recognise the liability is:


Cash 100,000
Revenue Received in Advance 100,000

It is probable that an outflow of resources embodying economic benefit will result from the
settlement of the obligation to build homes, and the amount of the settlement can be
measured reliably through the amount of deposit received.

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Chapter 13: Analysing and integrating GAAP

(c) An agreement to employ new staff is not recorded as liability as no present obligation exists
and there is no transaction from past event (the new staffs have not commenced working).
Once the new staff members start working, a present obligation to pay them will exist. The
journal entry to recognise the liability after the work has been completed will be:
Wages Expense X
Wages payable X

(d) No liability should be recorded, however in this case there may be a contingent liability.
Contingent liabilities are liabilities for which the amount of the future sacrifice is so uncertain
that it cannot be measured reliably, that do not satisfy the probability criterion, or are
dependent upon the occurrence of an uncertain future event outside the control of the entity.

Although the amount of the lawsuit can be measured reliably ($13,000), whether or not an
outflow of resources embodying economic benefit resulting from the settlement of the
lawsuit occurs would depend on the court’s decision, which is outside the control of a-
Forden and a-Holden Custom Cars. While the company believes that it might lose the case,
the result cannot be determined until court decisions are made. Given that the lawsuit does
not satisfy the probability criterion and are dependent upon the court’s decision, it should be
disclosed in the notes to the financial statements as a contingent liability.

(e) No liability recorded as the amount of damages cannot be measured reliably. However,
given that the company has been ordered by the court to pay damages even though the
amount is uncertain, it must be disclosed in the notes of the financial statement as a
contingent liability. Contingent liabilities are liabilities for which the amount of the future
sacrifice is so uncertain that it cannot be measured reliably, that do not satisfy the probability
criterion, or are dependent upon the occurrence of an uncertain future event outside the
control of the entity. In this case there is an obligation but the amount is uncertain.

© John Wiley and Sons Australia Ltd, 2016 13.43


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

EXERCISE 13.12

Revenue is a subset of income. Income is recognised when income definition and income
recognition criteria are met. Income is defined in the Conceptual Framework as “increase in
economic benefits during the accounting period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity, other than those relating to contributions
from equity participants.” Income is recognised in the statement of profit or loss “when an increase
in future economic benefits related to an increase in an asset or a decrease of a liability can be
measured reliably.” That is, the recognition of income occurs simultaneously with the recognition of
increases in assets or decreases in liabilities. To illustrate, a sale of goods on credit results in an
increase in Accounts Receivable (asset) and a corresponding increase in Sales Revenue (income).
Another illustration, the provision of goods or services in relation to a customer who has paid in
advance would be recorded as a decrease in Revenue Received in Advance (liability) and an
increase in Revenue (income).

Further, in the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is recognised on
the sale of goods when all of the following conditions are satisfied: the revenue and the associated
costs must be able to be reliably measured and it is probable the economic benefits, usually in the
form of cash inflows, will accrue to the seller. The seller must have transferred to the buyer the
effective control over the goods and not have any continuing managerial involvement, thereby
transferring the significant risks and rewards of ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered.

(a) Revenue is not recognised as the magazines have yet to be delivered, hence the
transaction doesn’t meet the revenue recognition criteria as the seller must have
transferred to the buyer the effective control over the goods and not have any continuing
managerial involvement, thereby transferring the significant risks and rewards of
ownership. .

Currently Surfin’ Magazines has an obligation to either refund the money or to deliver the
magazines, hence the $24,000 is recorded as a liability (Revenue Received in Advance)
and not a revenue. Revenue will be recognised once the magazines have been delivered
to subscribers.

(b) Dividend received is recognised as income because it is an increase in economic benefit


during the accounting period in the form of inflow or enhancement of assets (i.e. cash) that
results in increase in equity, other than those relating to contribution from equity
participants. Since the dividend has already been received, the economic benefits
associated with the transaction have flown to Surfin’ Magazines and the amount of
dividends can be measured reliably.

In this case the transaction would be recorded as follows:


Cash X
Dividend Income X

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Chapter 13: Analysing and integrating GAAP
(c) Payment of interest on a loan is not recognised as revenue. Rather, it is recognised as an
expense as it involves a decrease of future economic benefits in the form of outflows of
assets (cash).

The journal entry would be:


Interest expense X
Cash X

(d) Discount Received is recorded as revenue. Discount Received is revenue as the discount
represents a saving in outflows of economic resources - a consequential reduction in
liabilities and also an increase in equity other than those relating to contributions from
equity participants. Furthermore, the increase in future economic benefits related to the
decrease in liability (account payable) has arisen and can be measured reliably.

The journal entry should be:

Accounts Payable X
Cash X
Discount Received X

(e) Once the magazines are delivered, revenue can be recognised as Surfin’ Magazines has
fulfilled all of the recognition criteria including transfer of the significant risks and rewards of
ownership of the goods to the customers. The amount of revenue can be measured
reliably as reflected in the subscription price. Hence the amount previously recorded as
Revenue Received in Advance can now be recorded as Revenue.

The journal entry:

Revenue Received in Advance X


Revenue X

(f) Once the magazines are delivered, revenue can be recognised as Surfin’ Magazines has
fulfilled all of the recognition criteria including transfer of the significant risks and rewards of
ownership of the goods to the customers. Since the customers have not yet paid the
subscription fees, the revenue is recognised with a corresponding receivable account to
record payments owed by the customers.

The journal entry:

Accounts Receivable X
Revenue X

© John Wiley and Sons Australia Ltd, 2016 13.45


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

EXERCISE 13.13

NIGHT GOLF COURSE LTD

As defined in the Conceptual Framework expenses are decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result
in decreases in equity, other than those relating to distributions to equity participants. Expenses
should be recognised when a decrease in future economic benefits related to a decrease in an
asset or an increase of liability has arisen that can be measured reliably.

(a) A payment of public liability insurance 1 year in advance does not meet the definition criteria
of an expense. No expense is recognised because no depletion of assets or incurrence of
liabilities that result in decreases in equity has occurred. Instead, an asset account has
decreased (cash) and another asset account has increased (prepaid insurance) by the same
amount (hence there is no change in total assets). Insurance expense will start to be
recognised next month when the insurance fee for the 1st month expires.

The journal entry is:


Prepaid Insurance 240,000
Cash 240,000

(b) A payment of dividends is a distribution of profit and not an expense. Expenses are outflows
or depletions of assets (cash) or incurrence of liabilities that result in decreases in equity
other than those relating to distributions to equity participants. In this case the depletion of
assets relates to equity participants in the form of dividend payments.

(c) Interest payment is an expense. There is a decrease in economic benefit in the form of a
depletion of assets (cash) and the amount can be measured reliably.

The journal entry:


Interest Expense X
Cash X

(d) Discount allowed is recorded as an expense. There is a decrease in future economic benefit
in the form of depletion of assets (i.e. reduction in the amount of cash received from
customers) that result in decreases in equity. If no discount was allowed more cash would
have been received.

The journal entry:


Cash X
Discount Allowed 2000
Accounts Receivable XX

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Chapter 13: Analysing and integrating GAAP
(e) Fees paid in advance by members are not recorded as expenses. There has been no
decrease yet in economic benefit i.e. outflows or depletions of assets (cash) or incurrence of
liabilities that result in decreases in equity. Rather, Night Golf Course should recognise the
fees received in advance as a liability, because the fees have created a present obligation
for Night to provide facilities/services to its members, which will result in outflows of its
resources or future economic benefits.

The transaction should be recorded as:


Cash 3,000,000
Revenue Received in Advance 3,000,000
An asset account (cash) is increased by $3 million and a liability account (Revenue
Received in Advance) is increased by $3 million.

(f) The electricity bill is recorded as an accrued expense. The company has used the electricity
for the period and incurred a liability to pay for the electricity used that results in a decrease
in equity other than those relating to distributions to equity participants and the amount can
be measured reliably.

The journal entry:


Electricity Expense X
Electricity Payable X

© John Wiley and Sons Australia Ltd, 2016 13.47


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

SOLUTIONS TO PROBLEM
SET A

PROBLEM SET A 13.1

BEAUTIFUL WEDDING MEMORABILIA LTD

(a)
a) In this case reporting inventory at net realisable value is violation of cost principle.
b) In this case recording the computer as an asset of the business is a violation of
accounting entity concept.
c) In this case, including 2018 sales in the 2017 period to increase profit violates both the
accounting period concept and revenue recognition criteria.
d) In this case, excluding incurred yet not paid expenses to increase profit violates both the
accounting period concept and expense recognition criteria.
e) Non-disclosure of the law suit is a violation of the full disclosure principle and the
definition and recognition criteria for liabilities.
(b)
a) The cost principle states that all assets are initially recorded in the accounts at their
purchase price or cost. This is applied not only at the time the asset is purchased but
also over time the asset is held. Under the lower of cost or net realisable value rule,
inventory should be reported in the statement of financial position at cost, unless the net
realisable value is less than cost. Hence, merchandise inventory with a cost of $68,000
and a realisable value of $100,000 should not be recorded at its net realisable value but
at its cost.
b) Accounting Entity Concept states that every entity can be separately identified and
accounted for. Hence, the personal transactions of the owner should be recorded
separately from the transactions of the entity. The purchase of a computer for personal
use out of company funds should be recorded as a withdrawal of owner’s capital (i.e. a
debit to Drawings and a credit to Cash), not an increase in the company’s assets (i.e. a
debit to office equipment).
c) The accounting period concept states that the life of a business entity can be divided into
artificial periods and that useful reports covering those periods can be prepared for the
entity. This implies that only transactions that occur in one period can be included in the
report for that particular period. Therefore, the manager of Beautiful Wedding
Memorobilia should not include the sales figure for the first two days of 2018 in the 2017
statement of profit or loss.

Income (e.g. revenue) is recognised when income definition and income recognition
criteria are met. Income is defined in the Conceptual Framework as “increase in
economic benefits during the accounting period in the form of inflows or enhancements
of assets or decreases of liabilities that result in increases in equity, other than those
relating to contributions from equity participants”. Recognition criteria require the inflow
of resources to be probable and measured reliably. Revenue is recognised on the sale
of goods when a number of conditions are satisfied, including that the entity has

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Chapter 13: Analysing and integrating GAAP
transferred to the buyer the significant risks and rewards of ownership of the goods.
Clearly the sales made during the first two days of 2018 (when the goods were
delivered) must be excluded from 2017 revenue since the ownership of goods has not
yet been transferred to customers in 2017 and thus revenue should not be recognised at
that point.
d) The accounting period concept states that the life of a business entity can be divided into
artificial periods and that useful reports covering those periods can be prepared for the
entity. This implies that an interest payment incurred in 2017 should be recorded in 2017
period even though payment has not yet been made.

Expenses are defined in the Framework as decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets or incurrence of
liabilities that result in decreases in equity, other than those relating to distributions to
equity participants. The $13,000 interest payment incurred by Beautiful Wedding
Memorobilia in 2017 satisfies the definition of an expense, as there was a decrease in
economic benefits in the form of incurrence of a liability (i.e. interest payable) that result
in a decrease in equity other than those relating to distributions to equity participants. In
addition, the decrease in economic benefits was incurred in 2017 and can be measured
reliably. Hence, the manager should have recorded $13,000 interest expense during
2017.
e) The definition and recognition criteria for liabilities and the full disclosure principle are
relevant to this case. Full disclosure requires that all circumstances and events that
could make a difference to the decision financial statement users might make should be
disclosed in the financial statements. In this case there is a lawsuit for which there is a
probable payout. This circumstance could cause financial statement users to make a
different decision, for example by not investing as much to the company if they found out
about the lawsuit. Therefore, the accountant should disclose this information in the notes
to the financial statements.

In the case of Beautiful Wedding Memorobilia, although the lawsuit damages satisfies
the definition of liabilities, it fails the recognition criteria due to the uncertainty of the
amount to be paid. Following that, the damages is not a liability, but a contingent liability.
Contingent liabilities are liabilities for which the amount of the future sacrifice is so
uncertain that it cannot be measured reliably, that do not satisfy the probability criterion,
or are dependent upon the occurrence of an uncertain future event outside the control of
the entity. Contingent liabilities are not recognised in the financial statements. However,
information about contingent liabilities must be disclosed in the notes to the financial
statements if they are material. Hence, Beautiful Wedding Memorobilia must disclose
information about the lawsuit in the notes of financial statement so as to provide all the
relevant data needed for financial statement users in making decisions.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(c)
a) Statement of Financial Position
Current Assets:
Inventory 68,000

Inventory should be reported in the statement of financial position at cost as the net
realisable value is greater than cost.

b) The correct journal entry should be:


Drawings – Ima McBride 2,500
Cash 2,500

Given the computer was purchased for personal use, it should not be recorded as the
company’s transactions. Rather, the transaction should be recorded as a withdrawal of
Ima’s capital.

c) No sales occurred in 2018 should be recorded in the statement of profit or loss for the
year ending 2017.

For the statement of profit or loss for the year ending 2018, record the first two days
sales:
Accounts Receivable or Cash X
Sales X

d) Interest expense of $13,000 should be recorded in 2017 as follows:


Interest Expense 13,000
Interest Payable 13,000

Interest expense is recorded when there is as decrease in economic benefits during the
accounting period in the form of outflows or depletions of assets or incurrence of
liabilities (interest payable). Beautiful Wedding Memorobilia has incurred $13,000 of
interest expense in the year ended 31 December 2017.

e) No journal entry recorded since the amount of damages cannot be measured reliably.
However, given Beautiful Wedding Memorobilia is likely to pay damages, information
about the lawsuit must be disclosed in the notes to the financial statements as the
lawsuit could make a difference to the decisions made by financial statement users.

Notes to the financial statements:


Currently Beautiful Wedding Memorobilia is being sued by a customer in relation to one
of the company’s products. While the amount of damages to be paid is unknown at this
stage, it is expected that the company will have to pay damages in the vicinity of $XX-
$XX.

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Chapter 13: Analysing and integrating GAAP

PROBLEM SET A 13.2


MOO COW FARM LTD

Please note that under REQUIRED that part (j) refers to the cost principle and for part (h) cost
refers to the cost constraint on financial reporting.

(a) In this situation, the concept of materiality has been correctly applied. The relevance of
information is affected by its materiality. Information is material if its omission or
misstatement could affect users’ decisions. In this case, as the fence repair tools are
immaterial they are expensed immediately rather than being capitalised and depreciated
over the life of the asset.

(b) In this situation, the expense recognition criteria have been correctly applied. Expenses
should be recognised when a decrease in future economic benefit related to a decrease in
an asset or an increase of a liability has arisen that can be measured reliably. Clearly,
unpaid farm hand salaries are decreases in future economic benefits in the form of
incurrence of liabilities (i.e. salaries payable) that result in decreases in equity, other than
those relating to distributions to equity participants. The decrease in future economic
benefits has arisen when the workers complete their work, and the amount can be
measured reliably through the salary rate. Therefore, the salaries incurred but unpaid should
be recognised as expenses in the period when they were incurred.

(c) In this situation, the monetary principle has been correctly applied. The monetary principle
requires that the items included in the accounting records must be able to be expressed in
monetary terms, such as dollar, pound, or euro.

(d) In this situation, the accounting period concept has been correctly applied. The accounting
period concept states that the life of a business entity can be divided into artificial periods
and that useful reports covering those periods can be prepared for the entity. Consequently,
financial information must be separated into time periods for reporting purposes.

(e) In this situation, the cost principle has been correctly applied. The cost principle states all
assets are initially recorded in the accounts at their purchase price or cost. This can be
applied not only at the time the asset is purchased but also over the time the asset is held.
However, assets can be re-valued as appropriate.

(f) In this situation, the accounting entity concept has been correctly applied. This concept
states that every entity can be separately identified and accounted for. Therefore the
personal transactions of owners should be recorded separately from the transactions of the
business entity.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(g) In this situation, the full disclosure principle has been correctly applied. The full disclosure
principle requires that all circumstances and events that could make a difference to the
decision financial statement users might make should be disclosed in the financial
statements.

(h) In this situation, the revenue recognition criteria have been correctly applied. Revenue is
recognised in the statement of profit or loss when an increase in future economic benefit
related to an increase in an asset or a decrease of a liability has arisen that can be
measured reliably. The increase in asset or decrease in liability must result in increase in
equity, other than those relating to contributions from equity participants.

(i) This situation illustrates the cost versus benefits constraint. Preparers and standard setters
seek to ascertain that the costs of preparing certain financial information are not greater than
the benefits to be derived from using that information.

PROBLEM SET A 13.3

(a)
“The Conceptual Framework looks like a window that you can see the world through” (In the text
book, the analogy of the window is used to help students understand how the Conceptual
Framework works. That is, the Conceptual Framework is likened to a window because it allows
users, standard setters and preparers to view the economic world in a particular way. The
Conceptual Framework itself does not look like a window; this student has not understood or
discussed the analogy used in the book correctly).

“and has four sections”. (There are 4 sections in the Conceptual Framework. This is correctly
pointed out).

“It talks about accounting concepts”. (A conceptual framework indeed outlines accounting
concepts, so this is correct).

“It talks about what accounting is about”. (More specificity is required in the answer, the Conceptual
Framework identifies the objective of financial reporting rather than ‘what it is about’.)

“It tells accountants how to prepare financial statements”. (Correct, the Conceptual Framework.
provides guidance for standard setters and preparers).

“It is helpful to standard setters” (Correct, see comments above).

The four parts are:

(a) the accounting entity, which states that the transactions of the owners should be separate
from that of the business”. (Incorrect. The student should refer to “the reporting entity”, not
the accounting entity. The reporting entity is an entity in which it is reasonable to expect the
existence of users who depend on general purpose financial reports for information to
enable them to make economic decisions).

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Chapter 13: Analysing and integrating GAAP
(b) “the objective of businesses, which states the objective of a business, is to make profit to be
able to pay dividends to the owners”. (Incorrect. The Conceptual Framework explains “the
objective of general purpose financial reporting.” The objective of general purpose financial
reporting is to provide information to users that is useful for making and evaluating decisions
about the allocation of scarce resources).

(c) “the qualitative characteristics, which include the monetary principle, the accounting period
concept and the going concern and cost principles”. (Incorrect. According to the Conceptual
Framework, the qualitative characteristics are classified as either fundamental or enhancing
depending on how they affect the usefulness of financial information. Enhancing qualitative
characteristics and fundamental qualitative characteristics are complementary. Relevance
and faithful representation are therefore classified as fundamental qualitative characteristics.
Enhancing qualitative characteristics include comparability, verifiability, timeliness and
understandability).

(d) “the definition of elements in the financial statements, which is the last window. For example,
accounts receivable is defined as ‘the right to receive cash upon the sale of goods or
provision of services to a customer.’” (Incorrect. The Conceptual Framework defines the
major elements of general purpose financial reports namely assets, liabilities, equity, income
and expenses).

(b) A possible model or correct answer:

The conceptual framework consists of a set of concepts defining the nature, purpose and content of
general purpose financial reporting to be followed by preparers of general purpose financial reports
and standard setters.

The conceptual framework in Australia, also known as the Conceptual Framework, has 4 main
components:

[1] the reporting entity (SAC 1),

[2] the objective of general purpose financial reports

[3] the qualitative characteristics, and

[4] the definition of elements of financial statements.

The reporting entity is defined in the Conceptual Framework as an entity for which it is reasonable
to expect the existence of users who depend on general purpose financial reports for information to
enable them to make economic decisions (SAC 1).

The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential equity investors, lenders and other creditors in
making their decisions about providing resources to the entity. Decisions include: buying, selling or
retaining shares and providing loans or settling amounts owed to the entity. To make those
decisions, users need information to help them assess the prospects for future net cash inflows to
an entity. This will allow them to estimate the return they can expect from the resources they
provide to the entity.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

This definition highlights the primary users of general purpose financial reports to be existing and
potential investors, lenders and other creditors, however, these users cannot generally require a
reporting entity to provide information directly to them so they rely on general purpose financial
reports.

It is acknowledged that general purpose financial reports cannot provide all of the information that
each of the primary users may need, neither do they provide a valuation of an entity. However, they
seek to provide information set that will meet the needs of the maximum number of primary users.
Hence, financial reports, together with other sources of information such as general economic
conditions, political climate and industry conditions, allow primary users to estimate the value of the
reporting entity and assess the prospects for future net cash inflows to an entity.

It is, however, acknowledged that other groups may also be interested in the financial information.
For example, the management of the reporting entity is one such group but it was decided that
management does not need to rely on general purpose financial reports because managers can
obtain the financial information they needs internally. Other parties such as regulators and members
of the public may also find general purpose financial reports useful. However, it is made clear that
financial reporting is not primarily directed to other users but rather to equity investors, lenders and
other creditors.

According to the Conceptual Framework, the qualitative characteristics are classified as either
fundamental or enhancing depending on how they affect the usefulness of financial information.
Enhancing qualitative characteristics and fundamental qualitative characteristics are
complementary. Relevance and faithful representation are therefore classified as fundamental
qualitative characteristics. Relevance - information is considered relevant if it is capable of making
a difference in the decisions made by users. Information that has predictive value and/or
confirmatory value is considered to be relevant. Information is considered to have predictive value if
it can be used to develop expectations for the future. Information is considered to have confirmatory
value if it confirms or contests users’ past or present expectations. Information can often be both
predictive and confirmatory.

Information is a faithful representation of the economic phenomena it purports to represent if it is


complete, neutral and free from material error. It is important that the information depicts the
economic substance of the transactions, events or circumstances. At times, economic substance
may not be the same as the legal form. To be complete, all of the information needed to represent
the economic phenomena faithfully is included and there is no omission which could make the
information misleading. Hence, like relevance, faithful representation is also linked to the full
disclosure principle.

Enhancing qualitative characteristics include comparability, verifiability, timeliness and


understandability. These characteristics are called enhancing characteristics as they enhance the
decision usefulness of relevant information faithfully represented in financial statements.

Comparability Information that is comparable facilitates users identifying similarities and


differences between different economic phenomena. Consistency refers to the use of the same
accounting policies between entities, at the same point in time, or the same entity over time.
Consistency supports the achievement of comparability.

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Chapter 13: Analysing and integrating GAAP
Verifiability Information is verifiable if it faithfully represents the economic phenomena it is meant to
represent. Verifiability means that independent observers could reach a consensus - but not
necessarily one hundred percent agreement- that a particular depiction is a faithful representation.
Direct verification is through direct observation like counting cash to verify cash balance reported on
the balance sheet or counting inventory to determine quantities in stock. Indirect verification is
where techniques or calculations are used to check the representation.

Timeliness is measured by whether the information is available to users before it ceases to be


relevant; that is, the information is received while it is still capable of influencing the decisions users
make based on the information. Financial information may lose its relevance if it is not reported in a
timely manner, however, some information may remain timely even long after the reporting period
as the information is used to determine trends.

Application of timeliness means that the preparer should not take so long to collect and prepare
financial information that the reported information loses its relevance. Application of this principle
may mean that some transactions and events are reported before all the facts are known.

Understandability refers to the extent to which information can be understood by proficient users;
that is, users who have reasonable knowledge of accounting and business activities. It is not
practicable to require financial statements to be understandable to novices.

The definitions of asset, liability, equity, income and expense are also outlined in the Conceptual
Framework. Assets are defined in the Framework as ‘a resource controlled by the entity as a result
of past events and from which future economic benefits are expected to flow to the entity’
(paragraph 49(a)). A liability is defined in the Framework as ‘a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits’ (paragraph 49(b)). Equity is defined in the Framework as
‘the residual interest in the assets of the entity after deducting all its liabilities’ (paragraph 49(c)).
Income is defined in the Framework as ‘increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants’ (paragraph
70(a)). Finally, expenses are ‘decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants’ (paragraph 70(b)).

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

PROBLEM SET A 13.4


THRIFTY TYRES LTD

(a) A number of different objectives or purposes of financial reporting have been suggested, for
example, the stewardship or accountability objectives (or perspectives) of financial reporting.
These perspectives suggest that for entities where there is a separation of ownership from
control (e.g. in a company where shareholders do not manage the business), general
purpose financial reports can support the stewardship or accountability function. Managers
can use general purpose financial reports to show the owners they are fulfilling their
stewardship function effectively and that the resources are being managed effectively and
appropriately, and shareholders can use the reports to check on managers and make them
accountable. An alternative purpose or objective of financial reporting is the decision
usefulness perspective where the objective of general purpose financial reports is to provide
information to users that is useful for making and evaluating decisions about the allocation of
scarce resources.

(b) The Conceptual Framework states that the objective of general purpose financial reporting is
to provide financial information about the reporting entity that is useful to existing and
potential equity investors, lenders and other creditors in making their decisions about
providing resources to the entity. Decisions include: buying, selling or retaining shares and
providing loans or settling amounts owed to the entity. To make those decisions, users need
information to help them assess the prospects for future net cash inflows to an entity. This
will allow them to estimate the return they can expect from the resources they provide to the
entity.

(c) It is acknowledged that general purpose financial reports cannot provide all of the
information that each of the primary users may need, neither do they provide a valuation of
an entity. However, they seek to provide information set that will meet the needs of the
maximum number of primary users. Hence, financial reports, together with other sources of
information such as general economic conditions, political climate and industry conditions,
allow primary users to estimate the value of the reporting entity and assess the prospects for
future net cash inflows to an entity. Furthermore, financial information about the economic
entities will be useful in assessing the efficiency and effectiveness of management and the
governing board.

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Chapter 13: Analysing and integrating GAAP

PROBLEM SET A 13.5

(a) In the Conceptual Framework, the primary categories of users include:

- Equity investors:
 Shareholders
 Holders of partnership interests
 Other equity owners
- Lenders
 Lenders (e.g. banks)
 Purchasers of traded debt instruments (e.g. debentures)
- Other creditors
 Employees*
 Suppliers*
 Customers*
 Other groups*

*Only in their capacity as resource providers, otherwise they are not considered primary
users.

(b) Other users include government agencies, members of the public as well as suppliers,
customers and employees (when not resource providers as explained above). The
information needs and questions of other users vary considerably. For example, taxation
authorities, such as the Australian Taxation Office (ATO), want to know whether the entity
complies with taxation laws. Regulatory agencies, such as the Australian Securities and
Investments Commission (ASIC) or the Australian Competition and Consumer Commission
(ACCC), want to know whether the entity is operating within prescribed rules.

(c) The Conceptual Framework distinguishes between primary and other users because the
objective of general purpose financial reporting is to satisfy the needs of primary users – that
is to provide financial information about the reporting entity that is useful to existing and
potential equity investors, lenders and other creditors in making their decisions about
providing resources to the entity.

Given it is also acknowledged that other groups may also be interested in the financial
information such as government agencies, members of the public as well as suppliers,
customers and employees (when not resource providers as explained above). may also find
general purpose financial reports useful. Hence it is useful to distinguish who the primary and
other users are.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

PROBLEM SET A 13.6

(a) Accounting entity concept states that every entity can be separately identified and
accounted for. For example, if a sole trader purchased a car for personal use by obtaining
the funds from their personal bank account, the accounting entity concept implies that the
transaction should not be recorded in the accounts of the entity. However, if the owner
purchased a car from their personal bank account for use within the business, then, based
on the accounting entity concept, this transaction would be recorded as a debit to an asset
account (Motor Vehicles) and a credit to an equity account (Owner’s Capital).

(b) At the time of writing the book the section on the reporting entity was not available in
Conceptual framework. Hence, Australian business entities and standard setters use that
section form the previous conceptual framework known as the Framework. The Framework
(in SAC1) defines a reporting entity as “an entity in which it is reasonable to expect the
existence of users who depend on general purpose financial reports for information to
enable them to make economic decisions”.

(c) The statement “all accounting entities are reporting entities” is incorrect. The accounting
entity concept states that every entity can be separately identified and accounted for. This is
particularly important for sole proprietorships and partnerships as they are not separate legal
entities. It is important that the owners do not confuse the entity’s transactions with their
personal transactions, or the transactions of any other entity. There are many different forms
of business organisation, including the sole trader, partnerships, companies and not-for-
profit organisations. While each of these businesses records accounting transactions based
on the accounting entity concept and is likely to prepare financial information for a variety of
users, not all businesses are defined as reporting entities. Hence, while the accounting
entity concept applies to all entities, not all entities are reporting entities. The Framework
defines the reporting entity “as an entity in which it is reasonable to expect the existence of
users who depend on general purpose financial reports for information to enable them to
make economic decisions” (SAC 1). Based on this definition, there would be little point in
requiring a small business to prepare general purpose financial reports if the owner is also
the manager of the business and there are no external users who would be dependent on
the reports to make decisions. Therefore the statement is incorrect, as not all accounting
entities are reporting entities.

(d) A business organisation is more likely to be classified as a reporting entity if (1) the entity is
managed by individuals who are not owners of the entity, (2) the entity is politically or
economically important, and (3) the entity is considered large when measured in terms of
sales, assets, borrowings, customers and employees.

(e) Based on the indicators, publicly listed companies, some large private companies and
government authorities are generally classified as reporting entities.

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Chapter 13: Analysing and integrating GAAP
(f) It is important to link the definition of a reporting entity to the objective of financial reporting
because what classifies an entity as a reporting entity would be dependent on whether there
are users who rely on general purpose financial reports to make and evaluate decisions
about the allocation of scarce resources (which is the objective of financial reporting). In
other words, if there is no user who needs the report to make economic decisions, then most
likely the entity is not a reporting entity.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

PROBLEM SET A 13.7


BUSY B CLEANING LTD

(a) Relevance and faithful representation as defined in the Conceptual Framework:

Accounting information is deemed to be relevant if it would make a difference in a business


decision. Information is a faithful representation of the economic phenomena it purports to
represent if it is complete, neutral and free from material error.

(b) Relevance and reliability are both important qualitative characteristics of financial information.
Accounting information that is not relevant is not useful in decision making because it does not
help users to predict the future or assess the accuracy of their past predictions. Accounting
information that is not reliable is also not useful because users cannot depend on the
information to make decisions. Relevance and reliability can involve some trade-offs. For
example, information about future profits is very relevant. However, as we are unable to tell the
future with certainty, such information lacks reliability.

(c) Based on GAAP, the alternative ways land can be reported is at cost (based on the cost
principle) or at fair value. In chapter 8 we discussed the recording and reporting of non-current
assets. In that chapter, examples of asset revaluations were provided. Recall that after the
initial recognition of an asset at cost (which is its fair value at the time of acquisition), an entity
may choose to revalue its non-current assets to fair value. A revaluation is a reassessment of
the fair value of a non-current asset at a particular date. After the initial recognition of a
property, plant and equipment (PPE) asset at cost, AASB 116 requires each class of PPE to be
measured on either the cost basis or the revalued basis. Assets can be revalued upwards or
downwards as relevant. When the PPE asset is measured using the revaluation basis, any
impairment loss is treated as a revaluation decrement. You can review chapter 8 if you cannot
recall how to record non-current assets.

(d) Your recommendation as to the land should be reported, including justification for your answer.

The decision should be based on providing the information that will best serve the objective for
financial reporting – that is the objective of general purpose financial reporting is to satisfy the
needs of primary users – that is to provide financial information about the reporting entity that is
useful to existing and potential equity investors, lenders and other creditors in making their
decisions about providing resources to the entity.

Student’s personal views and discussion required

(e) Information is a faithful representation of the economic phenomena it purports to represent if it


is complete, neutral and free from material error. To be complete, all of the information needed
to represent the economic phenomena faithfully is included and there is no omission that could
make the information misleading. Information that is considered to be neutral is free from bias.
Information is biased if it is intended to attain or induce a particular behaviour or result. Some of
the information in general purpose financial reports is measured using estimates in conditions
of uncertainty.

Ruth Hines explores whether financial information can be neutral and representationally faithful
in R. Hines 1991, ‘The FASB’s Conceptual framework, financial accounting and the

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Chapter 13: Analysing and integrating GAAP
maintenance of the social world’, Accounting Organizations and Society, vol. 16, no. 4, pp.
313–2.

Some time ago in this journal article she wrote about the FASB’s conceptual framework. She
suggested that it appears that the ‘assumption underpinning the Conceptual Framework is that
the relationship between financial accounting and economic reality is a unidirectional, reflecting
or faithfully reproducing relationship: economic reality exists objectively, intersubjectively,
concretely and independent of financial accounting practices; financial accounting reflects,
mirrors, represents or measures the pre-existent reality’. This is an objectivist’s view of the
world.

From this world view “it is possible for information to be free from material error and neutral.”

On the other hand, if we held a subjectivists view of the world, we would assume there is no
such phenomena as an economic reality to be measured objectively that exists independent of
people’s perceptions. That is, reality is subjective and the result of personal interpretation.
Based on this assumption, accounting information is subjective and it requires judgements,
estimates and interpretations and must, therefore, be biased and cannot be representationally
faithful.

© John Wiley and Sons Australia Ltd, 2016 13.61


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

PROBLEM SET A 13.8


BRAIDWOOD HAIR LTD

Reporting assets - leased and purchased.

(a and b)

Assets are defined in the Conceptual Framework as “a resource controlled by the entity as a result
of past events and from which future economic benefits are expected to flow to the entity”
(paragraph 49(a)). The entity must have control over the asset. Ownership is not necessary. An
asset is recognised when it is probable that the future economic benefits will flow to the entity and
the asset has a cost or value that can be measured with reliability.

A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits. A liability
is recognised when it is probable that an outflow of resources embodying economic benefits will
result from the settlement of a present obligation and the amount at which the settlement will take
place can be measured reliably.

(c)

An operating lease is where the lessor effectively retains the risks and rewards of owning an asset
and, consequently, operating leases are reported in the statements of financial position of the
lessor. A finance lease is where the substantial risks and rewards of ownership of the asset are
effectively transferred to the lessee even though the ownership remains with the lessor. In essence,
a finance lease is simply another way to finance the purchase of an asset and hence, the asset and
the liability should be reported on the statement of financial position of the lessee as they would
have been if the entity had borrowed funds to finance the asset’s purchase. Consequently, finance
leases are reported on the lessee’s statement of financial position.

(d)

A finance lease meets the definition and recognition criteria for assets and liabilities. First, the
lessee has control over the asset as the lease contract transfers all the benefits and risks of
ownership to the lessee. The control is a result of past events, which is the lease agreement. The
leased asset also provides future economic benefits to the lessee, as the lessee is able to use the
asset to generate future income. In relation to the lessee’s liability, there is a present obligation to
make lease payments. The present obligation is a result of past events (i.e. the lease agreement)
and there will be outflows of resources embodying economic benefits (cash outlays for lease
payments).

In conclusion, Braidwood Hair Ltd would record asset and liability in its statement of financial
position if the assets are acquired under a finance lease. Under a finance lease, the substantial
risks and rewards of ownership of the asset are effectively transferred to the lessee; hence the
asset and liability must be recorded in the lessee’s statement of financial position.

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Chapter 13: Analysing and integrating GAAP

PROBLEM SET A 13.9


TRAVEL THE WORLD BAGS LTD

(a)

a) Income is recognised when income definition and income recognition criteria are met.
Income is defined in the Conceptual Framework as “increase in economic benefits during
the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.” Income is recognised in the statement of profit or loss “when an
increase in future economic benefits related to an increase in an asset or a decrease of a
liability can be measured reliably.” That is, the recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in liabilities. To
illustrate, a sale of goods on credit results in an increase in Accounts Receivable (asset)
and a corresponding increase in Sales Revenue (income). Another illustration, the
provision of goods or services in relation to a customer who has paid in advance would
be recorded as a decrease in Revenue Received in Advance (liability) and an increase in
Revenue (income).

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The
seller must have transferred to the buyer the effective control over the goods and not
have any continuing managerial involvement, thereby transferring the significant risks and
rewards of ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been
provided.

In the case of Travel the World Bags, revenue cannot be recognised on the sale of goods
as Travel the World Bags has not transferred to the buyer the significant risks and
rewards of ownership of the goods (i.e. the goods have not been delivered to the buyer).
Therefore, no revenue can be recorded. Instead, a liability is recorded (Revenue
Received in Advance) as Travel the World Bags has a present obligation to the buyer
resulting in an outflow of resources – either in the form of the good to be delivered or the
payment refunded. Once the goods are delivered, then sales revenue can be recognised.

b) In this case Travel the World Bags needs to record an expense. An expense should be
recognised when decreases in future economic benefits related to decreases in assets or
increases in liabilities have arisen that can be measured reliably. Based on past
experience, it is expected that $16,000 of the $400,000 recorded as accounts receivable
will not be collected, so there has been a decrease in future economic benefits for Travel
the World Bags in the form of forgone cash receipts from payments of receivables. The
amount of bad debts cab be measured reliably based on the receivable collection history
of the company. The expense is called bad debts expense. As Travel the World Bags
does not know which debts will go bad, it should credit an account called Allowance for

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

Doubtful Debts which is a contra asset account to account receivables and reduces the
net receivables reported in the statement of financial position.

c) Expense should be recognised when a decrease in future economic benefit related to a


decrease in an asset or an increase in a liability has arisen that can be measured reliably.
In this case, Travel the World Bags has $3,000 of inventory which is no longer saleable
as it had been damaged by water. There is a decrease in future economic benefits
related to the asset as the inventory can no longer be sold to generate income. The
amount of damaged inventory can be measured reliably during the stocktake. Travel the
World Bags must record an expense of $3,000 (Inventory Write-Down Expense) and a
decrease in Inventory of $3,000.

d) Assets are resources controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity. Travel the World Bags, the
consignee, has possession of goods on consignment. However, Travel the World Bags
does not have control of the assets, since the ownership of the assets still belongs to the
consignor. If Travel the World Bags does not sell the consigned goods within the agreed
consignment period, the goods will be returned to the consignor. Hence, the consigned
goods should not be included in the stocktake as inventory. The stocktake figures should
be adjusted to exclude the consignment stock to ensure the correct inventory figures are
reported in the statement of financial position.

e) Income is defined in the Conceptual Framework as “increase in economic benefits during


the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from
equity participants.” Income is recognised in the statement of profit or loss “when an
increase in future economic benefits related to an increase in an asset or a decrease of a
liability can be measured reliably.” In this case, Travel the World Bags should record a
Discount Received of $100. Discount Received is recorded by the buyer as income, as a
discount represents a saving in outflows and a consequential reduction in liabilities and
an increase in equity other than those relating to contributions from equity participants.

f) Liability is recognised in the statement of financial position when [1] it is probable that an
outflow of resources embodying economic benefits will result from the settlement of a
present obligation and [2] the amount at which the settlement will take place can be
measured reliably. It is probable that Travel the World Bags will need to pay for the
damages. However, as the amount is yet to be determined it cannot be measured
reliably. In this case, no amount would be reported in the financial statements but would
be disclosed in the notes to the financial statements. A lawsuit of this nature is classified
as a contingent liability. Contingent liabilities are liabilities for which the amount of the
future sacrifice is so uncertain that it cannot be measured reliably, that do not satisfy the
probability criterion, or are dependent upon the occurrence of an uncertain future event
outside the control of the entity. Contingent liabilities are not recognised in the financial
statements. However, information about contingent liabilities must be disclosed in the
notes to the financial statements if they are material. In this case, the estimated $500,000
is considered a material amount.

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Chapter 13: Analysing and integrating GAAP
g) Assets are resources controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity. On 1 November 2017, Travel
the World Bags purchased a one-year prepaid insurance of $12,000. This prepaid
insurance is recognised as an asset, because it is owned by Travel the World Bags as a
result of a past event (i.e. the purchase) and from which future economic benefits in the
form of payments for unexpected damages/losses are expected to flow to Travel the
World Bags. As of 31 December 2017, the value of the prepaid insurance is only $10,000
because the 2-month prepaid insurance for November and December has expired.
Expense should be recognised when a decrease in future economic benefit related to a
decrease in an asset or an increase in a liability has arisen that can be measured reliably.
Therefore, $2,000 worth of prepaid insurance that has expired should be recognised as
an expense, as there is a decrease in future economic benefit related to a decrease in
the prepaid insurance and the amount can be measured reliably. Travel the World Bags
must record an insurance expense of $2,000.

h) An expense should be recognised when a decrease in future economic benefit related to


a decrease in an asset or an increase in a liability has arisen that can be measured
reliably. Travel the World Bags has used the electricity for the period and a liability has
arisen to pay for the use of electricity to the electricity company, which can be measured
reliably based on the electricity bill. Therefore, Travel the World Bags must record $2,500
of Electricity Expense and $2,500 of Electricity Payable.

(b)

a) Cash 2,500
Revenue Received in Advance 2,500
b) At the time of sales, the journal entry is as follows:

Accounts Receivable 400,000


Revenue 400,000

The journal entry to record collection of receivables would be:

Cash 300,000
Accounts Receivable 300,000

The journal entry to record bad debt expense is:


Bad Debts Expense 16,000
Allowance for Doubtful Debts 16,000

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c) Inventory Write-down Expense 3,000


Inventory 3,000

d) No journal entry recorded if Travel the World Bags inventory has not been adjusted
to include the consignment stock. In that case the stocktake figures should be adjusted to
exclude the consignment stock to ensure the correct inventory figures are reported in the
statement of financial position.

e) Accounts Payable 10,000


Cash 9,900
Discount Received 100

f) No journal entry is recorded, but information about the contingent liability (lawsuit)
must be disclosed in the notes to the financial statements.

g) At the time of purchase of insurance, the journal entry is as follows:

Prepaid Insurance 12,000

Cash 12,000

At the end of year, the adjusting journal entry is as follows:

Insurance Expense 2,000

Prepaid Insurance 2,000

h) Electricity expense 2,500

Electricity Payable 2,500

(c) Travel the World Bags is considered to be a reporting entity if it is reasonable to expect the
existence of users who depend on general purpose financial reports for information to enable
them to make economic decisions. Using the indicators of a reporting entity, Travel the World
Bags would be classified as a reporting entity if:
 Travel the World Bags is managed by individuals who are not its owners;
 the company is politically or economically important; and
 the company is considered large when measured in terms of sales, assets,
borrowings, customers and employees.

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Chapter 13: Analysing and integrating GAAP

PROBLEM SET A 13.10

(a) GAAP consists of accounting standards, underlying accounting concepts and principles and
the Conceptual Framework.

In your notes you may like to use the summary table provided in Chapter 13. Figure 13.7.

The summary of the various aspects of GAAP is as follows:

GAAP
Reporting question Conceptual element of Source Authority
GAAP
Who is required to prepare Reporting entity Statement of Accounting
general purpose financial Concepts 1(The Australian
reports (preparers)? conceptual framework)
What is the purpose of Objective of financial Conceptual Framework
general purpose financial reporting
reporting?
Who uses general purpose Users of financial reports Conceptual Framework
financial reports
(recipients)?
What is reported in general Qualitative characteristics Conceptual Framework
purpose financial reports? and constraints
How are items reported in Definition of elements and Conceptual Framework
general purpose financial recognition criteria
reports? Concepts and principles Evolved over time,
Conceptual Framework ,
accounting standards
Rules Accounting standards,
Corporations Act
Measurement Conceptual Framework
accounting standards

GAAP consists of accounting standards, underlying accounting concepts and principles and
the Conceptual Framework .

The Conceptual Framework consists of a set of concepts defining the nature, purpose and
content of general purpose financial reporting to be followed by preparers of general
purpose financial reports and standard setters. The Conceptual Framework has 4 main
components:

[1] the reporting entity (SAC 1),


[2] the objective of general purpose financial reports and users
[3] the qualitative characteristics and
[4] the definition of elements in financial statements.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

The reporting entity is defined in the Framework as an entity for which it is reasonable to expect the
existence of users who depend on general purpose financial reports for information to enable them
to make economic decisions (SAC 1).

The reporting entity is defined in the Conceptual Framework as an entity for which it is reasonable
to expect the existence of users who depend on general purpose financial reports for information to
enable them to make economic decisions (SAC 1).

The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential equity investors, lenders and other creditors in
making their decisions about providing resources to the entity. Decisions include: buying, selling or
retaining shares and providing loans or settling amounts owed to the entity. To make those
decisions, users need information to help them assess the prospects for future net cash inflows to
an entity. This will allow them to estimate the return they can expect from the resources they
provide to the entity.

This definition highlights the primary users of general purpose financial reports to be existing and
potential investors, lenders and other creditors, however, these users cannot generally require a
reporting entity to provide information directly to them so they rely on general purpose financial
reports.

It is acknowledged that general purpose financial reports cannot provide all of the information that
each of the primary users may need, neither do they provide a valuation of an entity. However, they
seek to provide information set that will meet the needs of the maximum number of primary users.
Hence, financial reports, together with other sources of information such as general economic
conditions, political climate and industry conditions, allow primary users to estimate the value of the
reporting entity and assess the prospects for future net cash inflows to an entity.

It is, however, acknowledged that other groups may also be interested in the financial information.
For example, the management of the reporting entity is one such group but it was decided that
management does not need to rely on general purpose financial reports because managers can
obtain the financial information they needs internally. Other parties such as regulators and members
of the public may also find general purpose financial reports useful. However, it is made clear that
financial reporting is not primarily directed to other users but rather to equity investors, lenders and
other creditors.

According to the Conceptual Framework, the qualitative characteristics are classified as either
fundamental or enhancing depending on how they affect the usefulness of financial information.
Enhancing qualitative characteristics and fundamental qualitative characteristics are
complementary. Relevance and faithful representation are therefore classified as fundamental
qualitative characteristics. Relevance - information is considered relevant if it is capable of making a
difference in the decisions made by users. Information that has predictive value and/or confirmatory
value is considered to be relevant. Information is considered to have predictive value if it can be
used to develop expectations for the future. Information is considered to have confirmatory value if it
confirms or contests users’ past or present expectations. Information can often be both predictive
and confirmatory.

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Chapter 13: Analysing and integrating GAAP
Information is a faithful representation of the economic phenomena it purports to represent if it is
complete, neutral and free from material error. It is important that the information depicts the
economic substance of the transactions, events or circumstances. At times, economic substance
may not be the same as the legal form. To be complete, all of the information needed to represent
the economic phenomena faithfully is included and there is no omission which could make the
information misleading. Hence, like relevance, faithful representation is also linked to the full
disclosure principle.

Enhancing qualitative characteristics include comparability, verifiability, timeliness and


understandability. These characteristics are called enhancing characteristics as they enhance the
decision usefulness of relevant information faithfully represented in financial statements.
Comparability Information that is comparable facilitates users identifying similarities and differences
between different economic phenomena. Consistency refers to the use of the same accounting
policies between entities, at the same point in time, or the same entity over time. Consistency
supports the achievement of comparability.

Verifiability Information is verifiable if it faithfully represents the economic phenomena it is meant to


represent. Verifiability means that independent observers could reach a consensus - but not
necessarily one hundred percent agreement- that a particular depiction is a faithful representation.
Direct verification is through direct observation like counting cash to verify cash balance reported on
the balance sheet or counting inventory to determine quantities in stock. Indirect verification is
where techniques or calculations are used to check the representation.

Timeliness is measured by whether the information is available to users before it ceases to be


relevant; that is, the information is received while it is still capable of influencing the decisions users
make based on the information. Financial information may lose its relevance if it is not reported in a
timely manner, however, some information may remain timely even long after the reporting period
as the information is used to determine trends.

Application of timeliness means that the preparer should not take so long to collect and prepare
financial information that the reported information loses its relevance. Application of this principle
may mean that some transactions and events are reported before all the facts are known.

Understandability refers to the extent to which information can be understood by proficient users;
that is, users who have reasonable knowledge of accounting and business activities. It is not
practicable to require financial statements to be understandable to novices.

The definitions of asset, liability, equity, income and expense are also outlined in the Conceptual
Framework. Assets are defined in the Framework as ‘a resource controlled by the entity as a result
of past events and from which future economic benefits are expected to flow to the entity’
(paragraph 49(a)). A liability is defined in the Framework as ‘a present obligation of the entity arising
from past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits’ (paragraph 49(b)). Equity is defined in the Framework as
‘the residual interest in the assets of the entity after deducting all its liabilities’ (paragraph 49(c)).
Income is defined in the Framework as ‘increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants’ (paragraph
70(a)). Finally, expenses are ‘decreases in economic benefits during the accounting period in the

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form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants’ (paragraph 70(b)).

In addition to the Conceptual Framework, other aspects of GAAP include the corporations act,
accounting concepts and principles, accounting standards including the measurement rules as
outlined in the standards.

There are 2 concepts and 4 principles that underlie the recording of accounting information:

 Accounting Entity Concept: every entity can be separately identified and accounted for.

 Accounting Period Concept: the life of a business entity can be divided into artificial periods
and that useful reports covering those periods can be prepared for the entity.

 Monetary Principle: the items included in the accounting records must be able to be
expressed in monetary terms.

 Going Concern Principle: financial statements are prepared on a going concern basis unless
management either intends to or must liquidate the business or cease trading.

 Cost Principle: all assets are initially recorded in the accounts at their purchase price or cost.
This is applied not only at the time the asset is purchased but also over the time the asset is
held.
 Full Disclosure Principle: all circumstances and events that could make a difference to the
decisions financial statement users might make should be disclosed in the financial
statements.

It is important to identify the order in which the various aspects of GAAP must be applied. After the
Corporations Act accounting standards are the first point of guidance for preparers. Accounting
standards and authoritative interpretations of accounting standards must be followed as they have
legislative backing, which means they are required by law. If the standards are silent on an
accounting issue, preparers can seek guidance from the conceptual framework (the Conceptual
Framework plus SAC 1 from the Framework). The concepts and principles that traditionally underlie
accounting are applied where there is no guidance on an issue in the conceptual framework.
Further, if any conflicts arise between standards, the conceptual framework or concepts and
principles, the various aspects of GAAP are still applied in the order listed above. To summarise,
GAAP is applied as follows: first the Corporations Act, then accounting standards and
interpretations are consulted, then the conceptual framework and finally the underlying concepts
and principles.

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Chapter 13: Analysing and integrating GAAP
(b) The various aspects of GAAP do not operate in isolation, but are interrelated. Examples of the
interrelationships include:
 reporting entities are required to prepare general purpose financial reports and the
objective of general purpose financial reports is to provide decision-useful information to
users.
 the objective of general purpose financial reporting is to provide decision-useful
information to users and usefulness is dependent upon the information’s qualitative
characteristics.
 the accounting period concept and the revenue and expense recognition criteria are
interrelated. Revenue (expense) recognition criteria require that revenues (expenses)
are recognised in the period when the increase (decrease) in assets or decrease
(increase) in liabilities become probable and can be measured reliably. In other words,
only the increase/decrease in assets or liabilities that occur in a certain period can be
recognised as revenue or expense in that period. This is consistent with the accounting
period concept.

(c)

(i) The Global Reporting Initiative (GRI) is a network-based organization that pioneered
the world’s most widely used sustainability reporting framework. The Sustainability
Reporting Framework provides guidance on how organisations can disclose their
sustainability performance. It consists of the Sustainability Reporting Guidelines, Sector
Supplements and the Technical Protocol - Applying the Report Content Principles.

The Framework is applicable to organisations of any size or type, from any sector or
geographic region, and has been used by thousands of organisations worldwide as the
basis for producing their sustainability reports.

GRI is committed to the Framework’s continuous improvement and application worldwide.


GRI’s core goals include the mainstreaming of disclosure on environmental, social and
governance performance.

GRI's Reporting Framework is developed through a consensus-seeking, multi-


stakeholder process. Participants are drawn from global business, civil society, labour,
academic and professional institutions.

Sustainability reporting is a process for publicly disclosing an organisation’s economic,


environmental, and social performance. Many organisations find that financial reporting
alone no longer satisfies the needs of shareholders, customers, communities, and other
stakeholders for information about overall organisational performance.

The term “sustainability reporting” is synonymous with citizenship reporting, social reporting,
triple-bottom line reporting and other terms that encompass the economic, environmental,
and social aspects of an organisation’s performance.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

(ii) The benefits of GRI Reporting:

For reporting organisations, the GRI Reporting Framework provides tools for: management,
increased comparability and reduced costs of sustainability, brand and reputation
enhancement, differentiation in the marketplace, protection from brand erosion resulting
from the actions of suppliers or competitors, networking and communications.
For report users, the GRI Reporting Framework are a useful benchmarking tool, corporate
governance tool and an avenue for long term dialogue with reporting organisations.

GRI promotes a standardised approach to reporting to stimulate demand for sustainability


information – benefitting both reporting organisations and report users.
Sustainability reports based on the GRI Framework can be used to demonstrate
organisational commitment to sustainable development, to compare organisational
performance over time, and to measure organisational performance with respect to laws,
norms, standards and voluntary initiatives.

Other benefits include increased comparability. Companies follow a generally accepted


reporting framework for financial reporting. Without a similarly accepted framework for
sustainability reports, such reports could lack the features that could make them broadly
useful: credibility, consistency, and comparability. If the thousands of companies that
voluntarily disclose their sustainability impacts did not refer to a generally accepted reporting
framework, they would risk producing non-comparable reports, and/or reports which
inadequately address the full spectrum of stakeholder interests. A generally accepted
sustainability reporting framework also simplifies report preparation and assessment,
helping both reporters and report users gain greater value from sustainability reporting.
Because the development costs of the GRI framework is shared among multiple users, the
overall transaction cost for reporters is considerably lower than costs might be should a
company develop it’s ‘own company’ or ‘own sector’ reporting framework.

(iii) GRI Reporting Framework

The Reporting Framework sets out the principles and Performance Indicators that
organisations can use to measure and report their economic, environmental, and social
performance.

The cornerstone of the Framework is the Sustainability Reporting Guidelines. The third
version of the Guidelines – known as the G3 Guidelines - was published in 2006, and is a
free public document.

The Guidelines are the foundation of the Framework and are now in their third generation
(G3). They feature Performance Indicators and Management Disclosures that organisations
can adopt voluntarily, flexibly and incrementally, enabling them to be transparent about their
performance in key sustainability areas.

The G3.1 Guidelines are the latest and most complete version of GRI's G3 Sustainability
Reporting Guidelines. These Guidelines are based on G3 but contain expanded guidance
on local community impacts, human rights and gender. While G3-based reports are still
valid, GRI recommends that reporters use G3.1, the most comprehensive reporting
guidance available today.

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Chapter 13: Analysing and integrating GAAP

BUILDING BUSINESS SKILLS

FINANCIAL REPORTING AND ANALYSIS

BUILDING BUSINESS SKILLS 13.1 FINANCIAL REPORTING PROBLEM

DOMINOES

(a)

3.8 Revenue recognition

Revenue is measured at the fair value of the consideration received or receivable.

3.8.1 Sale of goods

Revenue from the sale of goods is recognised when the Consolidated entity has transferred
to the buyer the significant risks and rewards of ownership of the goods.

3.8.2 Franchise income

Franchise income is recognised on an accrual basis in accordance with the substance of the
relevant agreement.

3.8.3 Rendering of services

Service revenue relates primarily to store building services and is recognised by reference to
the stage of completion of the contract.

3.8.4 Royalties

Royalty revenue is recognised on an accrual basis in accordance with the substance of the

relevant agreement (provided that it is probable that the economic benefits will flow to the

Consolidated entity and the amount of revenue can be measured reliably). Royalties
determined on a time basis are recognised on a straightline basis over the period of the
agreement.

Royalty arrangements that are based on sales and other measures are recognised by
reference to the underlying arrangement.

3.8.5 Dividend and interest revenue

Dividend revenue from investments is recognised when the shareholder’s right to receive
payment has been established (provided that it is probable that the economic benefits will
flow to the Consolidated entity and the amount of revenue can be reliably measured).

Interest revenue is recognised when it is probable that the economic benefits will flow to the
consolidated entity and the amount of revenue can be measured reliably. Interest revenue is
accrued on a time basis, with reference to the principal outstanding and at the effective
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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

interest rate applicable, which is the rate that exactly discounts estimated future cash
receipts through the expected life of the financial asset to that asset’s net carrying amount
on initial recognition.

(b)

Income is recognised when income definition and income recognition criteria are met. Income is
defined in the Conceptual Framework as “increase in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.” Income is
recognised in the statement of profit or loss “when an increase in future economic benefits related
to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.” That
is, the recognition of income occurs simultaneously with the recognition of increases in assets or
decreases in liabilities.

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’ prescribes
principles for the recognition of revenue for the sale of goods. Revenue is recognised on the sale of
goods when all of the following conditions are satisfied: the revenue and the associated costs must
be able to be reliably measured and it is probable the economic benefits, usually in the form of cash
inflows, will accrue to the seller. The seller must have transferred to the buyer the effective control
over the goods and not have any continuing managerial involvement, thereby transferring the
significant risks and rewards of ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been provided.

Yes, Domino’s revenue recognition methods are consistent with the revenue recognition criteria
discussed in the chapter.

For example: Domino’s policy on the sale of goods corresponds with part (a) of AASB 118 and NZ
IAS 18 ‘Revenue’ for sale of goods the entity has transferred to the buyer the significant risks and
rewards of ownership of the goods;. DOMINO’S “Revenue from the sale of goods is recognised
when the Consolidated entity has transferred to the buyer the significant risks and rewards of
ownership of the goods”.

Royalty revenue is recognised as they accrue, in accordance with the relevant agreement and
effective yield on the financial asset. This implies that those revenues are recognised when the
increase in future economic benefits have arisen (accrued) and can be measured reliably using the
agreement and relevant yield, which is consistent with the income recognition criteria outlined in the
Conceptual Framework.

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Chapter 13: Analysing and integrating GAAP
(c)

3.7 Goods and services tax


Revenues, expenses and assets are recognised net of the amount of goods and services
tax (“GST”), except:
(i) where the amount of GST incurred is not recoverable from the taxation authority, it
is recognised as part of the cost of acquisition of an asset or as part of an item of
expense; or
(ii) for receivables and payables which are recognised inclusive of GST. The net
amount of GST recoverable from, or payable to, the taxation authority is included as part of
receivables or payables.
Cash flows are included in the cash flow statement on a gross basis. The GST component
of cash flows arising from investing and financing activities which is recoverable from, or
payable to, the taxation authority is classified within operating cash flows.

(d)

3.13 Inventories
Inventories are stated at the lower of cost and net realisable value. Costs, including an appropriate
portion of fixed and variable overhead expenses, are assigned to inventories by the method most
appropriate to each particular class of inventory, with the majority being valued on a first in first out
basis. Net realisable value represents the estimated selling price for inventories less all estimated
costs of completion and costs necessary to make the sale.

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Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BUILDING BUSINESS SKILLS 13.2 FINANCIAL ANALYSIS ON THE WEB

COCA-COLA AMATIL LTD

(b) Students are required to access the CCA 2013 annual report.

g) Revenue

Revenue is recognised and measured at the fair value of the consideration received or
receivable to the extent that it is probable that economic benefits will flow to the Group and
the revenue can be reliably measured. Revenue is recognised net of discounts, allowances
and applicable amounts of value added taxes such as the Australian goods and services
tax. The following specific recognition criteria must also be met before revenue is
recognised:

i) Sale of goods and materials


Revenue is recognised when the significant risks and rewards of ownership of the
goods have passed to the buyer and the amount of revenue can be measured
reliably;

ii) Rendering of services


Revenue from installation and maintenance of equipment is recognised when the
services have been performed and the amount can be measured reliably;

iii) Interest income


Interest income is recognised as the interest accrues, using the effective interest
method; and

iv) Rental income


Rental income arising from equipment hire is accounted for on a straight line basis
over the term of the rental contract.

(c) In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is probable
the economic benefits, usually in the form of cash inflows, will accrue to the seller. The seller
must have transferred to the buyer the effective control over the goods and not have any
continuing managerial involvement, thereby transferring the significant risks and rewards of
ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been
provided.

Yes, the company’s policies of revenue recognition are consistent with the revenue
recognition criteria discussed in the chapter.
© John Wiley and Sons Australia Ltd, 2016 13.76
Chapter 13: Analysing and integrating GAAP

For example: Coca-Cola Amatil Ltd’s policy on the sale of goods corresponds with AASB
118 and NZ IAS 18 ‘Revenue’ for sale of goods Revenue is recognised when the significant
risks and rewards of ownership of the goods have passed to the buyer and the amount of
revenue can be measured reliably . Similarly, Coca-Cola’s policy on the rendering of service
follows part (a) and (b) of AASB 118 and NZ IAS 18 ‘Revenue’ for rendering of services
Revenue from installation and maintenance of equipment is recognised when the services
have been performed and the amount can be measured reliably; . Furthermore, interest
income is recognised when it accrues. and the method of rental income arising from
equipment hire is accounted for on a straight line basis over the term of the rental contract.
This is consistent with the income recognition criteria as outlined in the Conceptual
Framework.

(d) Both company’s methods of revenue recognition are consistent with the revenue recognition
criteria discussed in the chapter. For example, for the sale of goods, they both recognise
revenue when significant risks and rewards of ownership of the goods have passed to the
buyer and the amount of revenue can be measured reliably with AASB 118 and NZ IAS 18
‘Revenue’ Both companies’ policies on recognising income from services are also consistent
with the AASB 118 and NZ IAS 18. In terms of interest, dividend, rent and royalty income,
both companies recognise the income when they accrue, which is when the increase in
economic benefits have arisen and can be measured reliably. In summary, both Domino
Pizza and Coca-Cola Amatil’s policies on revenue recognition comply with what outlines in
the Conceptual Framework.

© John Wiley and Sons Australia Ltd, 2016 13.77


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BUILDING BUSINESS SKILLS 13.3 A GLOBAL FOCUS

COCA-COLA AMATIL LTD

(a)

Excerpt from 10K

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery of products


has occurred, the sales price is fixed or determinable and collectability is reasonably assured. For
our Company, this generally means that we recognize revenue when title to our products is
transferred to our bottling partners, resellers or other customers. Title usually transfers upon
shipment to or receipt at our customers’ locations, as determined by the specific sales terms of
each transaction. Our sales terms do not allow for a right of return except for matters related to any
manufacturing defects on our part.

Our customers can earn certain incentives which are included in deductions from revenue, a
component of net operating revenues in our consolidated statements of income. These incentives
include, but are not limited to, cash discounts, funds for promotional and marketing activities,
volume-based incentive programs and support for infrastructure programs. Refer to Note 1 of Notes
to Consolidated Financial Statements. The aggregate deductions from revenue recorded by the
Company in relation to these programs, including amortization expense on infrastructure programs,
were $6.9 billion, $6.1 billion and $5.8 billion in 2013, 2012 and 2011, respectively. In preparing the
financial statements, management must make estimates related to the contractual terms, customer
performance and sales volume to determine the total amounts recorded as deductions from
revenue. Management also considers past results in making such estimates. The actual amounts
ultimately paid may be different from our estimates. Such differences are recorded once they have
been determined and have historically not been significant.

(b)

Income is recognised when income definition and income recognition criteria are met. Income is
defined in the Conceptual Framework as “increase in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.” Income is
recognised in the statement of profit or loss “when an increase in future economic benefits related
to an increase in an asset or a decrease of a liability can be measured reliably.” That is, the
recognition of income occurs simultaneously with the recognition of increases in assets or
decreases in liabilities.

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’ prescribes
principles for the recognition of revenue for the sale of goods. Revenue is recognised on the sale of
goods when all of the following conditions are satisfied: the revenue and the associated costs must

© John Wiley and Sons Australia Ltd, 2016 13.78


Chapter 13: Analysing and integrating GAAP
be able to be reliably measured and it is probable the economic benefits, usually in the form of cash
inflows, will accrue to the seller. The seller must have transferred to the buyer the effective control
over the goods and not have any continuing managerial involvement, thereby transferring the
significant risks and rewards of ownership.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been provided.

Yes, the company’s methods of revenue recognition are consistent with the revenue recognition
criteria discussed in the chapter. For example: Coca-Cola Company’s policy on the sale of goods
requires that the “delivery of products has occurred” for sales revenue to be recognised. This
corresponds with AASB 118 and NZ IAS 18 ‘Revenue’ that the entity has transferred to the buyer
the significant risks and rewards of ownership of the goods. Furthermore, the Coca-Cola
Company’s policy on the sale of goods requires that the “sales price charged is fixed or
determinable and collectability is reasonably assured”. This implies that for sales revenue to be
recognised, increase in future economic benefits in the form of cash receipts can be reliably
measured, which is consistent with the income recognition criteria outlined in the Conceptual
Framework.

© John Wiley and Sons Australia Ltd, 2016 13.79


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

CRITICAL THINKING

BUILDING BUSINESS SKILLS 13.4 GROUP DECISION CASE

VITA HEALTH LTD

(a) Correct statement of profit or loss:

Vita Health Ltd


Statement of Profit or Loss
For the year ended 31 March 2017

Revenues
Service revenue 151 200 (1)
Operating expenses
Advertising 12040 (2)
Wages 59640 (3)
Electricity 6580 (4)
Depreciation 1680
Repairs 8400 (5)
Insurance 11200 (6)
Supplies 10780 (7)
Interest 700(8)
Total operating expenses 111020 Profit
40180

Workings:
(1) 168000 - 16 800 =151 200
(2) 8540 + 3500 = 12040
(3) 59080 + 560 = 59640
(4) 5460 + 1120 = 6580
(5) 5600 + 2800 = 8400
(6) 22400/12 months * 6 months = 11200
(7) 14000 – 3220= 10780
(8) (28,000*0.1/12) * 3 = 700

(b) Revenue recognition criteria were not followed as revenue was recognised before Vita Health
has transferred to the buyer the significant risks and rewards of ownership of the goods. Hence the
$16800 advanced money should be recorded as a liability (Revenue Received in Advance). The
effect on the results of this error is that profit is overstated by $16800. The $16800 cash receipts will
be recognised as revenue once the goods have been delivered to the buyer.

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Chapter 13: Analysing and integrating GAAP
Expenses should be recognised when a decrease in future economic benefit related to a decrease
in an asset or an increase of a liability has arisen that can be measured reliably. Wang did not
follow the expense recognition criteria as he did not record some expenses which have been
incurred but not yet paid, such as advertising, electricity, repairs, wages, and interest. In addition, a
portion of prepaid expenses such as advertising supplies and insurance which have expired should
be recognised as expenses since the decrease in economic benefits have arisen. The effect of not
recognising expenses also results in an overstatement of profits. Overall profit was overstated by
$47460.

© John Wiley and Sons Australia Ltd, 2016 13.81


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BUILDING BUSINESS SKILLS 13.5 SUSTAINABILITY

COCA-COLA AMATIL LTD

(a) Students are required to access CCA 2013 sustainability report.

(b) CCA’s achievements in the areas of environment and community:

CCA has achieved many outcomes in the areas of environment and community. Key
Highlights in these areas 2011-2013 include:

ENVIRONMENT
 14,000 tonnes of rubbish removed from 5 Bali beaches since 2008
 the Coca-Cola company’s $1.24 million keep Australia beautiful recycling project -
1380 new bins recycling 274 tonnes of beverage containers
 water efficiency improved by 1.9%
 lighter glass bottles - 1500 tonnes of glass saved annually
 world’s most energy-efficient fridges - 60% lower emissions since 2009
 9,000 tonnes of pet resin saved
 65,000 truck kilometres reduced from supply chain

COMMUNITY
 7,000 children in 280 villages play coke kicks soccer program
 remote communities strategy 4.2% shift away from sugar sweetened drinks to water
and low or no-sugar drinks
 1,500 homes in Bali have clean water from the water for life program
 low and no-sugar beverages growing 2.5 x the rate of sugar beverages

© John Wiley and Sons Australia Ltd, 2016 13.82


Chapter 13: Analysing and integrating GAAP

BUILDING BUSINESS SKILLS 13.6 COMMUNICATION ACTIVITY

STATISTICS R US PTY LTD

To: Board of Directors, Statistics R Us Pty Ltd

From: Accountant

Subject: Accounting for Revenue

Income is recognised when income definition and income recognition criteria are met. Income is
defined in the Conceptual Framework as “increase in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants.” Income is
recognised in the statement of profit or loss “when an increase in future economic benefits related
to an increase in an asset or a decrease of a liability can be measured reliably.” That is, the
recognition of income occurs simultaneously with the recognition of increases in assets or
decreases in liabilities. To illustrate, a sale of goods (or the provision of services) on credit results in
an increase in Accounts Receivable (asset) and a corresponding increase in Sales (or Service)
Revenue (income). Another illustration, the provision of goods or services in relation to a customer
who has paid in advance would be recorded as a decrease in Revenue Received in Advance
(liability) and an increase in Revenue (income).

In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’ prescribes
principles for the recognition of revenue for the sale of goods. Revenue is recognised on the sale of
goods when all of the following conditions are satisfied: the revenue and the associated costs must
be able to be reliably measured and it is probable the economic benefits, usually in the form of cash
inflows, will accrue to the seller. The seller must have transferred to the buyer the effective control
over the goods and not have any continuing managerial involvement, thereby transferring the
significant risks and rewards of ownership. AASB 118 prescribes that in order to be recognised as
revenue, services must be performed, or the stage of completion at the reporting date can be
measured reliably.

Basically, for merchandising organisations revenue is recognised when the goods are
delivered. For service organisations revenue is recognised when the services have been provided.

© John Wiley and Sons Australia Ltd, 2016 13.83


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

In this case the facts are as follows:

13 June 2015 Contract signed for $ 1 million – no work has been completed by the year
ended 2015. Hence no revenue should be recognised.

Cash to be received: Year ended 2016 $600,000

Year ended 2017 $300,000

Year ended 2018 $100,000

Total $1,000,000

Work to be completed: Year ended 2016 50%

Year ended 2017 50%

AASB 118 prescribes that in order to be recognised as revenue, services must be performed, or the
stage of completion at the reporting date can be measured reliably. Therefore, Statistics R Us
should recognise service revenue when the research has been performed.

Details of the appropriate treatment of revenue each year are reported below.

June 13, 2015

No entry – there has not been an accounting transaction - no past transaction or event has
occurred. A contract has been signed but no work has been completed.

June 30, 2016

By June 2016, $600,000 cash will have been received, hence a debit of $600,000 to cash.
However, given only 50% of the work would have been completed, only 50% of the revenue should
be recognised (i.e. 50% of $1 million, or $500,000). The rest of the cash received ($100,000) should
be recorded as Revenue Received in Advance as the cash has been received in advance of the
service being performed. This is a liability account, as it represents a future obligation of Statistics R
Us to either provide the service or to pay back the cash.

The journal entry is as follows:

Cash 600,000

Service Revenue 500,000

Revenue Received in Advance 100,000

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Chapter 13: Analysing and integrating GAAP
June 30, 2017

By June 2017, a further $300,000 cash will have been received, hence a debit of $300,000 to cash.
Given the final 50% of the work would have been completed, then the final 50% of the revenue (i.e.
$500,000) should be recognised as income and be credited to service revenue account. The
$100,000 amount of revenue received in advance from the previous year can now be recognised as
revenue as the work has been completed. This is recorded as a debit of $100,000 to Revenue
Received in Advance. By this time, all research works would have been performed, however the
last $100,000 payment has not been received. Since the work has been completed, the $100,000
should be recognised as revenue and hence a debit to Accounts Receivable for $100,000 is made.

The journal entry is as follows:

Cash 300,000

Revenue Received in Advance 100,000

Accounts Receivable 100,000

Service Revenue 500,000

August 2017

At this stage, the amount owed for the work completed in June 2017 has now been received.
Hence, Accounts Receivable is credited for $100,000 to account for the collection.

The journal entry is as follows:

Cash 100,000

Accounts Receivable 100,000

I hope this report will be able to clarify your queries in regards to the appropriate treatment for the
revenue arising from the research contract. Please do not hesitate to contact me if you have further
questions.

Yours sincerely,

© John Wiley and Sons Australia Ltd, 2016 13.85


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

BUILDING BUSINESS SKILLS 13.7 ETHICS CASE

TOFFEE AND MORE LTD

(a) The stakeholders in this situation are:


 Sweet Tooth, the managing director
 creditors of Toffee and More
 shareholders of Toffee and More
 employees of Toffee and More
 potential investors of Toffee and More
 potential customers

(b) Many stakeholders could be potentially harmed by the non-disclosure. For example:
shareholders may lose their investment and/or receive decreased dividends if a large payout is
made. Potential investors may lose money if they have decided to invest in Toffee and More without
the knowledge of the lawsuit. Toffee and More’s ability to repay its creditors may also be affected if
it has to pay for large amount of damages. On the worst scenario, Toffee and More may declare
bankruptcy after paying the damages, which results in the employees losing their jobs and investors
their money. Potential customers may also be disadvantaged if they are not made aware of the
incident before they decide to buy the company’s products.

(c) The managing director’s actions are inappropriate as he does not follow generally accepted
accounting principles. The lawsuit is classified as a contingent liability. While it is not reported in the
financial statements because the amount is unknown and cannot be measured reliably, contingent
liabilities must be disclosed in the notes of financial statements. Given many stakeholders could be
harmed or disadvantaged by the non-disclosure, the managing director’s actions are unethical.

© John Wiley and Sons Australia Ltd, 2016 13.86


Chapter 13: Analysing and integrating GAAP

BUILDING BUSINESS SKILLS 13.8 ETHICS CASE

HEALTHY LIVING LTD

(a) The stakeholders in this situation include:


 Con Puter, the business information system manager
 Abit Crooked, the CFO
 Alot Crooked, the CEO
 shareholders of Healthy Living
 potential inventors of Healthy Living
 any reader of the press release.

(b) Financial information must be reported in a timely manner; otherwise it will lose its relevance. In
order to be timely, some estimates need to be made. For example, an estimated amount for
doubtful debts is calculated rather than waiting until the debt goes bad. Expenses are accrued,
e.g. for electricity and telephone expenses, if the expenses have been incurred but no invoice
has been received or paid by year end. However, while some estimates are consistent with the
timeliness constraint, it is not consistent with the timeliness constraint to estimate the revenue
on health cover contracts sold. This information needs to be accurate, not estimated. It is also
not consistent to estimate all other expenses if the data is not available due to a computer
error.

(c) No, the actions requested by Alot Crooked are not consistent with GAAP. The income and
expense recognition criteria require revenues and expenses to be recognised when the
increase or decrease in future economic benefits are probable and can be measured reliably.
Furthermore, one of the fundamental qualitative characteristics of financial information as
outlined in the Conceptual Framework is faithful representation. Information is a faithful
representation of the economic phenomena it purports to represent if it is complete, neutral and
free from material error. Without accurate computer records, the revenue and expense figures
cannot be measured faithfully. As a result, the estimated profit figure will not be complete or
free from material error.

(d) Faithful representation is only achieved when the inputs used to make the judgment and
estimate reflect the best available information at the time. In this case, reporting estimated
fictitious figures does not result in faithful representation of the economic reality of the business,
since the actual revenue and expense figures have been recorded. Further, given many
stakeholders could be harmed by the disclosure of estimated figures which could result in poor
information and hence poor decisions, the managing director’s action in reporting estimated
profit figure is unethical.

(e) A significant error in estimating profit can result in wrong decisions made by people who rely on
the information. For example, shareholders may lose their investment and/or receive less

© John Wiley and Sons Australia Ltd, 2016 13.87


Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e

dividends if the financial information is misrepresented in the form of an overstatement of profit.


Potential investors may lose money if they decide to invest in the organisation they believe is
more profitable than it actually is. Creditors may not be repaid as expected if they lend money
based on overstated profits. Overstatement of profit could result in employees and trade unions
trying to get higher wages and better working conditions. The general public could be harmed
by the overstatement of profits if they choose to invest or purchase products from the company
based on the incorrect figures. Errors and inappropriate behaviours in business decrease
people’s faith in accounting and the business world.

© John Wiley and Sons Australia Ltd, 2016 13.88