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Chapter 2: Q9CA (page 71)

Question: (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the 鈥済round floor鈥� of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.

You have told Uncle Carlos that, unless you can take a look at Neville鈥檚 financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville鈥檚 most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.

The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available.

Instructions

Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.

Short Answer

Expert verified

Answer

Date: XX/XX/XXX

To: Carlos

From: Mr. X

Subject: Why are financial statements are neither relevant nor represented faithfully

The financial statements are not relevant and are not faithfully represented because the methods used for calculating the value of inventory and depreciation are not disclosed. Also, it does not disclose any other relevant information necessary for increasing the transparency and relevancy of the financial statement

Step by step solution

01

Definition of Financial Statement

The financial statement can be defined as asummary report thatincludes all theinformation relating to the financial transactions. It includes reporting all the assets, liabilities, revenue, expenses, and cash inflows and outflows.

02

Non-relevancy of the financial statement

The financial statement is neither relevant nor representationally faithful because the business entity has not reflected the information relating to loan agreements, depreciation, and inventory valuation. It might be possible that the business entity depreciates its assets at lower rates to report the higher net income, the business entity is using the FIFO method for reporting higher net income and the business entity have loan agreements that are not reflected on the financial statement to reflect improved debt-to-equity ratio.

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Most popular questions from this chapter

E2-3 (L03,7) GROUPWORK (Qualitative Characteristics) SFAC No. 8 identifies the qualitative characteristics that make accounting information useful. Presented below are a number of questions related to these qualitative characteristics and underlying constraint.

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

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

(c) The chairman of the SEC at one time noted, 鈥淚f 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.鈥� Which qualitative characteristic of accounting information should ensure that such a situation will not occur? (Do not use faithful representation.)

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

(e) 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.)

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

(g) Watteau Inc. does not issue its first-quarter report until after the second quarter鈥檚 results are reported. Which qualitative characteristic of accounting is not followed? (Do not use relevance.)

(h) Predictive value is an ingredient of which of the two fundamental qualities that make accounting information useful for decision-making purposes?

(i) Duggan, Inc. 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?

(j) Roddick Company has attempted to determine the replacement cost 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.)

What is the primary objective of financial reporting?

Question: For each item below, indicate to which category of elements of financial statements it belongs.

(a) Retained earnings (f) Loss on sale of equipment

(b) Sales (g) Interest payable

(c) Additional paid-in capital (h) Dividends

(d) Inventory (i) Gain on sale of investment

(e) Depreciation (j) Issuance of common stock

Discuss whether the changes described in each of the cases below require recognition in the CPA鈥檚 audit report as to consistency. (Assume that the amounts are material).

  1. The company changed its inventory method to FIFO from weighted-average, which had been used in prior years.
  2. The company disposed of one of the two subsidiaries that had been included in its consolidated statements for prior years.
  3. The estimated remaining useful life of plant property was reduced because of obsolescence.

Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives. The FASB statement on qualitative characteristics of accounting information examines the characteristics of accounting information that make it useful for decision-making. It also points out that various limitations inherent in the measurement and reporting process may necessitate trade-offs or sacrifices among the characteristics of useful information.

Instructions

a) Describe briefly the following characteristics of useful accounting information.

1. Relevance (4) Comparability

2. Faithful representation (5) Consistency

3. Understandability

b)For each of the following pairs of information characteristics, give an example of a situation in which one of the characteristics may be sacrificed in return for a gain in the other.

1. Relevance and faithful representation.

2. Relevance and consistency.

3. Comparability and consistency.

4. Relevance and understandability.

c) What criterion should be used to evaluate trade-offs between information characteristics?

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