Brief Exercises

1. Why did the IASB develop a conceptual framework?

Solution:

Rule-making should build on and relate to an established body of concepts. Development of a conceptual
framework enables the IASB to issue more useful and consistent pronouncements over time. Also, the
profession should be able to more quickly solve new and emerging practical problems by referring to an
existing framework of basic theory. For these reasons, in 2018, the IASB published Conceptual Framework for
Financial Reporting (the Conceptual Framework).

2. What is the purpose of general purpose financial reporting?

Solution:

General-purpose financial reporting helps users who lack the ability to demand all the financial information they
need from an entity and therefore must rely, at least partly, on the information provided in financial reports.
However, an implicit assumption is that users need reasonable knowledge of business and financial
accounting matters to understand the information contained in financial statements.

3. Which of the attributes listed below are related to the fundamental quality of relevance?
(a) Predictive value
(b) Comparability
(c) Understandability
(d) Materiality
(e) Confirmatory value
(f) Free from error

Solution:

Both predictive value and confirmatory value are attributes that indicate that the financial information is capable
of making a difference in a decision (relevance). Materiality is a company-specific aspect of relevance.
Comparability is an enhancing quality of relevance and implies that material information is expected to have an
impact on a decision.

4. For each item below, indicate to which category of elements of financial statements it belongs, or which
category it affects.
(a) Dividends
(b) Interest receivable
(c) Issuance of preference shares
(d) Prepaid insurance
(e) Amortization
(f) Cost of goods sold
(g) Accounts payable
(h) Cash
(i) Equipment
(j) Gain on sale of equipment
Solution:
(a) Affects equity
(b) Assets
(c) Affects equity. May affect assets if issued for cash or other assets.
(d) Assets
(e) Expenses
(f) Expenses
(g) Liabilities
(h) Assets
(i) Assets
(j) Affects income

5. Identify which basic accounting assumption is best described in each item below.
(a) Ahold Delhaize prepares its financial statements in Euros.
(b) The financial statements of Aldi Einkauf GmbH & Co combine all of the activities of its subsidiaries.
(c) Schwarz Unternehmens Treuhand KG records depreciation on its equipment over its estimated
useful lives.

Solution:
(a) Monetary unit
(b) Economic entity
(c) Going concern

6. Asia Travel made three investments during 2022. (1) It purchased 5,000 shares of Rolls-Royce stock,
which trades on the London Stock Exchange. (2) The company purchased 500 shares of Antonia
Technical Company, a start-up company. Asia Travel used an internally developed model to evaluate
the amount of the investment. (3) It invested ¥10,000,000 in utility bonds of a small neighboring
community. Although these bonds do not trade on an active market, their value closely tracks
movements in Japanese government bonds.

Where will Asia Travel report these investments in the fair value hierarchy?

Solution:
Investment 1—Level 1
Investment 2—Level 3
Investment 3—Level 2

7. In developing accounting standards, the IASB attempts to determine that each proposed
pronouncement will fill a significant need and that the costs imposed to meet the rule are justified in
relation to overall benefits of the resulting information. What accounting assumption, principle, or
constraint is being illustrated?

Solution:
Cost constraint
Exercises

1. Indicate whether the following statements about the conceptual framework are true or false.
(a) In preparing financial reports, it is assumed that users of the reports have reasonable knowledge of
business and economic activities.
(b) The fundamental qualitative characteristics that make accounting information useful are relevance
and verifiability.
(c) Verifiability is an enhancing characteristic only for faithful representation.
(d) Relevant information only has predictive value, confirmatory value, or both.
(e) Comparability pertains to the reporting of information in a similar manner for different companies as
well as a company reporting under the same accounting policies over time.
(f) Information that is a faithful representation is characterized as having predictive or confirmatory
value.

Solution
(a) True – This captures the concept of understandability.
(b) False – The fundamental qualitative characteristics that make accounting information useful are
relevance and faithful representation.
(c) False – Enhancing characteristics relate to both relevance and faithful representation.
(d) False – Relevant information must also be material.
(e) True – Comparability refers to both comparisons across companies and for the same company
over time (consistency).
(f) False – Information that is relevant is characterized as having predictive or confirmatory value.

2. The IASB has identified the qualitative characteristics that make accounting information useful.
Presented below are a number of questions related to these qualitative characteristics and
underlying constraint.

Instructions

(a) Sicila Distributors. switches from FIFO to average-cost to FIFO over a 2-year period. Which
qualitative characteristic of accounting information is not followed?

(b) Assume that the profession permits the savings and loan industry to defer losses on investments it
sells because immediate recognition of the loss may have adverse economic consequences on the
industry. Which qualitative characteristic of accounting information is not followed? (Do not use
relevance or faithful representation.)

(c) A prominent business person at one time noted, “If it becomes accepted or expected that
accounting principles are determined or modified in order to secure purposes other than economic
measurement, we assume a grave risk that confidence in the credibility of our financial information
system will be undermined.” Which qualitative characteristic of accounting information should ensure
that such a situation will not occur? (Do not use faithful representation.)

(d) What are the two fundamental qualities that make accounting information useful for decision-
making?

(e) Davidson AG. does not issue its first-quarter report until after the second quarter's results are
reported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.)

(f) Identify the pervasive constraint developed in the conceptual framework.

(g) Predictive value is an ingredient of which of the two fundamental qualities that make accounting
information useful for decision-making purposes?
 (h) Rubin AG is the only company in its industry to depreciate its plant assets on a straight-line basis.
Which qualitative characteristic of accounting information may not be followed?

(i) What is the quality of information that enables users to confirm or correct prior expectations?

(j) Murray Company has attempted to determine the net realizable value of its inventory. Three
different appraisers arrive at substantially different amounts for this value. The president, nevertheless,
decides to report the middle value for external reporting purposes. Which qualitative characteristic of
information is lacking in these data? (Do not use relevance or faithful representation.)

Solution

(a) Comparability (Consistency.) (f) Cost.

3. (LO 3) Presented below are three different transactions related to materiality. Explain whether
you would classify these transactions as material.

Instructions

(a) Polley Industries has reported a positive trend in earnings over the last 4 years. In the current year, it
reduces its bad debt allowance to ensure another positive earnings year. The impact of this adjustment is
equal to 2% of net income.

(c) Linsmeier AG expenses all capital equipment under €18,000 on the basis that it is immaterial. The company
has followed this practice for a number of years.

(b) Carnall SpA has a gain of €3.1 million on the sale of plant assets and a €3.3 million loss on the sale of
investments. It decides to net the gain and loss because the net effect is considered immaterial. Carnall’s
income for the current year was €10 million.

Solution
Companies and their auditors for the most part have adopted the general rule of thumb that anything under 5%
of net income is considered not material. It is acceptable to use this percentage for the initial assessment of
materiality, but other factors must be considered. For example, companies can no longer fail to record items in
order to meet consensus analyst’s earnings numbers, preserve a positive earnings trend, convert a loss to a
profit or vice versa, increase management compensation, or hide an illegal transaction like a bribe. In other
words, both quantitative and qualitative factors must be considered in determining when an item is material.

(a) Because the change was used to create a positive trend in earnings, the change is considered material.

(b) In general, companies that follow an “expense all capital items below a certain amount” policy are not in
violation of the materiality concept. Because the same practice has been followed from year to year
(consistency), Linsmeier’s actions are acceptable. This situation is not considered to be material.

(c) Each item must be considered separately and not netted. Therefore each transaction is considered
material.
 4. (LO 3, 4, 5)) Presented below are a number of operational guidelines and practices that have
developed over time.

Instructions

Select the assumption, principle, or constraint that most appropriately justifies these procedures and practices.
(Do not use qualitative characteristics.)

(a) Intangible assets are capitalized and amortized over periods benefited.
(b) Repair tools with purchase prices below $1,000 are expensed when purchased.
(c) Brokerage firms use fair value for purposes of valuing investments.
(d) Each enterprise is kept as a unit distinct from its owner or owners.
(e) All significant subsequent events are reported.
(f) Fair value changes of fixed assets are not recognized in the accounting records.
(g) Supplemental information is presented so that investors will not be misled.
(h) Revenue is recorded when the performance obligation occurs.
(i) All important aspects of bond indentures are presented in financial statements.
(j) Rationale for accrual accounting.
(k) The use of consolidated statements is justified.
(l) Reporting must be done at defined time intervals.
(m) An allowance for doubtful accounts is established.
(n) Goodwill is recorded only at time of purchase.
(o) A company charges its sales commission costs to expense.

Solution
(a) Expense recognition principle. (i) Full disclosure principle.
(b) Materiality. (j) Expense recognition and revenue recognition
principles.
(c) Measurement (fair value) principle. (k) Economic entity assumption.
(d) Economic entity assumption. (l) Periodicity assumption.
(e) Full disclosure principle. (m) Measurement (fair value) and expense recognition
principles.
(f) Measurement (historical cost) principle. (n) Measurement (historical cost) principle.
(g) Full disclosure principle. (o) Expense recognition principle.
(h) Revenue recognition principle.