Book 1 - Chapter 18

The three objectives of financial reporting are to provide financial information that:

  • is useful in making good financial decisions.
  • helps understand cash flows.
  • identifies assets and claims on assets and the causes of changes in them.

Examples of decision making:

• Are we charging enough for our services?
• Are we controlling expenses?

Examples of cash flows:

• Why cash has been decreasing
• Determining if customers are paying on time

Examples of identifying assets and claims on assets and causes of changes:

  • The amount of inventory available
  • The amount of debts that are owed
  • The effect of business operations and owner investments and withdrawals.

The cost principle is the GAAP requirement for how to apply a value to a transaction. Follow
two rules:

  • The value to use when initially recording a transaction is the cash equivalent value agreed
      upon at the time of the transaction. AND
  • This value is to be permanently maintained in the accounting records unless another GAAP
      rule requires it to be changed.

The key advantage of the cost principle is reliability. Another advantage is that it reduces
confusion and does not create erratic gains and losses that result from changes in market value.
The key disadvantage of using historical cost is that the balance sheet often does not come close
to indicating the fair market value of assets and liabilities.

The equipment should be recorded at $900. This is the cash equivalent value that was agreed
upon at the time of the transaction (original transaction value). No other specific GAAP rule
supersedes this. The land donation is a more subjective value because it is not a “reciprocal”
transaction (property or services being both given and received). In this situation, the
corporation will have to obtain a reliable appraisal as the best alternative to record for the value
of the asset.

The revenue recognition principle is the GAAP guideline for determining how to record
revenue. The rule to apply is that revenue cannot be recorded (“recognized”) until it is earned.

  • Revenue has not been earned because you never asked for the service.
  • The equipment has not been delivered to you. I should not record the revenue yet.
  • My company should not record revenue for the sale because you cannot reasonably be expected to
     pay for it. There is a high probability that all or most of it will be returned. Note: In “real life” some
     companies estimate the amount of returns and reduce the net amount of recorded sales.
  • It does not appear that this transaction is really part of a genuine revenue-earning process.
     We are not really customers of each other. Revenue should not be recorded. Note: This is not
     to say that all “barter” transactions are not genuine. However, this example appears to simply
     be a manipulation in which the interest of each party is not to receive what the other party is
     selling, but rather to manipulate the amount of recorded revenue.

Reliability refers to the quality of information that makes it dependable. In other words, reliable
information is information that really represents what it claims to represent. If information is
reliable, it generally can be verified. For example, information that a sale was made for $500 is
reliable if the sale really occurred at that price. This can be verified by the sales invoice and the
collection from the customer. Relevance refers to the quality of information that makes the
information useful. Information that is relevant is useful. For example, knowing the cost of
paper clips is probably not relevant. Knowing the amount paid to employees is relevant.

Learning Goal 18, continued

SOLUTIONS

Section IV · The Essential Financial Statements

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Worthy & James Publishing is a provider of basic accounting books covering fundamental accounting principles, business accounting, and business math. Topics in financial accounting and business accounting covered include the balance sheet, the income statement, financial ratios, and bank reconciliation.