2.9 Exercises

Exercise 2.1

Describe the problem of information asymmetry and discuss the impact this problem has on the work of accountants.

Exercise 2.2

Discuss the reasons why Canada applies two different sets of accounting standards to profit-oriented companies. What are the benefits of having two sets of standards? What are the problems of maintaining two sets of standards?

Exercise 2.3

What is the conceptual framework? Why does the accounting profession need this framework?

Exercise 2.4

Describe the two fundamental qualitative characteristics of good accounting information. What problems do accountants face in trying to maximize these characteristics when producing accounting information?

Exercise 2.5

Describe the four enhancing qualitative characteristics and identify conflicts where possible trade-offs may occur in trying to maximize these characteristics.

Exercise 2.6

Identify which of the five financial statement elements applies to each item described below:

• A cash dividend is declared and paid to the shareholders.
• Cash is used to purchase a machine that will be used in the production process over the next five years.
• Products are sold to customers on 30-days’ credit
• Income taxes are calculated based on a company’s profit. The taxes will be paid next year.
• A customer makes a deposit on a special order that will not be manufactured until next year.
• A bill for electricity used in the current month is received but not payable until the following month.
• A shareholder invests money in a business in exchange for issued shares.
• A shareholder invests money in a business by making a loan with commercial terms to the business.
• An insurance settlement is received for a fully depreciated asset that was destroyed in a fire.
• An allowance for doubtful accounts is established based on estimates of future uncollectible accounts.

Exercise 2.7

Consider the following independent situations. For each of the situations described, discuss how the recognition criteria should be applied and suggest the appropriate accounting treatment.

• A publisher sells magazines on a two-year subscription. Customers are required to pay the full amount at the commencement of the subscription.
• A company is being sued by a customer group for losses sustained due to a faulty product design. The company’s lawyers feel the suit will likely succeed, but they cannot estimate the potential amount of damages that will be awarded.
• A company has completed a large infrastructure construction project as part of an economic development partnership with a foreign government. The invoice for the work has been issued, but due to a recent change in government, there is some doubt about whether payment will actually be received.
• A social media company has recorded an asset described as ”Goodwill” and an offsetting amount in its equity section. The amount was determined by comparing the current trading value of the company’s shares to the recorded value of the company’s shares on the balance sheet.
• A resource company is obligated by municipal regulations to clean up the site of an active drilling operation in 10 years’ time when the resource has been fully extracted. The company is in its first year of operations and has no previous experience in cleaning up drilling sites.

Exercise 2.8

Describe the four different measurement bases and discuss the relative strengths and weaknesses of each base.

Exercise 2.9

What are some of the difficulties in trying to determine the best concept of capital maintenance to apply to the development of accounting standards?

Exercise 2.10

Discuss the relative merits and weaknesses of principles-based and rules-based accounting systems.

Exercise 2.11

What are some of the motivations that managers may have for attempting to influence or bias reported financial results? What should the accountant do to deal with these possible attempts to affect the perceptions of the company’s results?

Exercise 2.12

You have just been appointed financial controller at Dril-Tex Inc., a manufacturer of specialized equipment used by various manufacturers of consumer products on their own production lines. Your immediate supervisor, the vice-president finance, has indicated that he will be retiring in six months and that you could be in line for his position if you do a good job managing the preparation of the year-end financial statements. He has provided you with the following comments for your consideration during the preparation of these statements:

• The company is currently being sued for breach-of-contract by one of our largest customers. This case has been ongoing for two years and will likely reach a conclusion next year. Our lawyers have now estimated that it is likely we will lose, and that the award will probably be in the range of $250,000 to $300,000. We have disclosed this previously in our notes, but have not accrued anything. Use the same treatment this year, as the case is not yet completed.
• We have changed our inventory costing method this year from weighted-average to FIFO. This has resulted in an increase in net income of $115,000. The new method should be identified in the accounting policy note.
• There are $50,000 worth of customer prepayments included in the Accounts Receivable sub-ledger. The customers have paid these amounts to guarantee their priority in our production cycle, but no work has yet been done on their special orders. We will just net these prepayments against the Accounts Receivable balance and report a single amount on the balance sheet.
• This year we hired a director of research and development. He has not yet produced any viable products or processes, but he was a top performer at his previous company. We have capitalized the cost of his salary and benefits, as we are confident he will soon be producing a breakthrough product for us.
• Our bank has put us on warning that our current ratio and debt-to-equity ratio are close to violation of the covenant conditions in our loan agreement. Violations will likely result in an increase in the interest rate the bank charges us. Keep this in mind as you prepare the year-end adjustments.

Comment on the accounting treatments proposed by the vice-president finance, supporting your discussion with any relevant components from the conceptual framework. Discuss the impact of item (e) on your work in preparing the year-end financial statements.