Budgeted Income
Topics 3 and 4
A.Demonstrate your ability to explain the objective of financial reporting and to apply the definitions of financial statement elements to identify events and transactions that businesses recognize in their accounting information systems. Limit the length of your response to a maximum of 150 words. Spell-check and grammar-and-style-check your completed response using MS Word’s tool for this purpose, being sure to correct any matters identified by these checking tools.
| Situation |
| During 20X1, Abacus Corp. received a Notice of Deficiency (NOD) from the IRS indicating the company owes a total of $5 million in additional income taxes for the three preceding taxable years of the company. The company has consulted its tax advisors and plans to defend vigorously the positions it has taken in the affected income tax returns. The company’s tax advisors have indicated that it is probable (i.e., more likely than not) that the company will lose on one of the matters that is at issue, which would result in the company paying additional taxes, penalties, and interest amounting to about $1.5 million. The dispute remained unresolved at the date Abacus issued its 20X1 financial statements. First, state whether the company should accrue an expense and accompanying liability related to the NOD in its 20X1 financial statements and, if so, the amount of such accrual. Then, provide your reasoning, by referring to the relevant: Definitions of financial statement elements, Basic principles of financial reporting, and theDesired qualitative characteristics of accounting information Each as discussed in the background paper, Financial Statement Concepts and Financial Reporting. |
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| Student’s response |
| 158 |
| The company should accrue the expenses and accompanying liability related to the NOD in its 2001 financial statement. The amount of the accrual will be $1.5 million. The remaining amount of $3.5 million should be kept under the contingent liabilities only. The definition of the financial statement elements that is relevant in this situation is the concept of conservatism. The conservatism standard states that the business must recognize certain contingent losses, but may not recognize contingent gains. In the present case, the amount of $1.5 million will be incurred as per the indication of the tax advisors. Hence, as per the conservatism standard, the loss should be recognized in the books. However, the remaining amount of $3.5 million is not certain, hence should be kept under contingent liabilities only. The accounting information thus will give a conservative, true, and fair view of the financial position of the company along with full disclosure. |
B. Demonstrate your ability to identify the basic assumptions, principles, and desired qualitative characteristics of financial reporting and accounting information. Listed below are the accounting assumptions, principles, and qualitative characteristics contained in the FASB’s Conceptual Framework for financial reporting.
| A | Periodicity assumption | E | Full disclosure principle | J | Representational faithfulness |
| B | Monetary unit assumption | F | Revenue recognition principle | K | Comparability (incl. Consistency) |
| C | Going concern assumption | G | Historical cost principle | L | Relevance |
| D | Economic entity assumption | H | Matching principle | M | Materiality |
| I | Timeliness | N | Conservatism |
Provide the letter corresponding to the SINGLE, PRIMARY assumption, principle, or qualitative characteristic that corresponds with each of the following statements. Hint: Use one of these concepts (letters) twice and leave one of these unused.
| J | 1. | A company transaction represents the completion of the earning process, and the related exchange amount is realized or realizable. |
| N | 2. | A company recognizes an accounts receivable allowance of $850,000 based on an analysis of existing accounts indicating that total uncollectible accounts will ultimately range from $750,000 and $850,000. |
| K | 3. | A company new in its industry adopts the “LIFO” inventory cost flow assumption after determining that the dominant firms in its industry have historically applied LIFO in their financial statements (FS). |
| G | 4. | In its FS, a company recognizes merchandise acquired for resale at amounts originally paid for it, unless market conditions indicate that expected selling prices will not be adequate to recover those costs. |
| I | 5. | Management issues a company’s FS within 30 days of the balance sheet date |
| B | 6. | A company’s functional currency is the appropriate means for measuring and reporting its economic affairs. |
| M | 7. | For expediency, a company’s records all purchases of office equipment costing less than $300 in the “office expense” account, rather than the “office equipment” account in its general ledger. |
| H | 8. | A company allocates the costs of equipment used in manufacturing goods it sells over the periods the company expects to use the equipment for this purpose, rather than expensing the costs immediately. |
| H | 9. | A company adopts an accelerated depreciation method because it better reflects the pattern of consumption of PP&E’s economic utility than does the straight-line depreciation method. |
| F | 10. | A company’s FS set forth the accounting policy that managers used for recognizing revenue. |
| C | 11. | Implicit in the company’s accounting policies and FS presentation is managers’ reasonable expectation that the company will continue to operate indefinitely. |
| A | 12. | A company issues FS quarterly, even though its operating cycle is about 270 days. |
| E | 13. | A company’s FS provide information about the bankruptcy of a significant customer that occurred after the date of the balance sheet but before managers issued the FS. |
| l | 14. | A company resold for $2 million treasury stock it previously acquired for $1 million and reported the sale as an increase in stockholder equity, rather than as a gain. |
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