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CA2-7 (Expense Recognition Principle) Accountants try to prepare income statements that are as accurate as possible. A basic requirement in preparing accurate income statements is to record costs and revenues properly. Proper recognition of costs and revenues requires that costs resulting from typical business operations be recognized in the period in which they expired.

Instructions

(a) List three criteria that can be used to determine whether such costs should appear as charges in the income statement for the current period

.(b) As generally presented in financial statements, the following items or procedures have been criticized as improperly recognizing costs. Briefly discuss each Item from the viewpoint of matching costs with revenues and suggest corrective or alternative means of presenting the financial information.

(1) Receiving and handling costs.

(2) Cash discounts on purchases.

Short Answer

Expert verified

Three criteria are matching principle, period costs and product costs. Receiving and handling cost and cash discount on purchases are shown in Step 3.

Step by step solution

01

Expense recognition principle

It is a concept of recognizing and reporting expenses when incurred/expensed, irrespective of the effect on cash.

02

Three criteria to classification of cost

(a) The three criteria that can be used to determine whether such costs should appear as charge in the income statement of the current period are as follows:

1. Matching Principle - The expenses should be properly matched with the revenues. If the connection between revenue and expenses cannot be determined clearly, the expenses will be charged in that current year.

2. Period costs –These are expenses such as administration expenses, officer’s salaries etc., which will be charged in the current period as these are not directly associated with the revenue of that period.

3. Product costs - These are expenses such as material, labour and overhead, which will be charged in the current year if the revenue of the product is associated only with the current year. These expenses are directly linked to revenue.

03

Receiving and handling cost and Cash discount on

(b) As per matching principle the viewpoints regarding different costs are as follows:

1. Receiving and handling cost

The cost associated with receiving the item and handling are the same. This cost is directly associated with the product, and hence it is a product cost. As per matching principle, the cost should follow the revenue. If the company is expecting the revenue from the product to flow in the future period too, the cost should also be deferred over the accounting periods.

2. Valuation of inventory at the lower of cost or market value

The valuation of closing stock can be done at eithercost or market value, whichever is lower. The cost associated with the inventory is directly linked to the production level. The closing stock of the product will be calculated as follows:

(Openingstockoftheproduct+Purchases-SalesoftheProduct).

The benefit/revenue of the products is likely to accruein the future; hence this cost will be reflected as a Current Asset and will be shown in the balance sheet.

3. Cash discounts on purchase

The cash discounts are those discounts which are given to the purchasers of the product by the seller, in order to encourage the purchaser to pay the amount early. These discounts are generally adjusted in the price of the purchases and the net amount (if payable) will be reflected as Current Liabilities in the balance sheet.

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Most popular questions from this chapter

According to the FASB conceptual framework, the objective of financial reporting for business enterprises is based on the needs of the users of financial statements. Explain the level of sophistication that the Board assumes about the users of financial statements.

Explain the revenue recognition principle.

(Elements of Financial Statements) Ten interrelated elements that are most directly related to measuring the performance and financial status of an enterprise are provided below.

Assets Distributions to owners Expenses Liabilities Comprehensive Income Gains Equity Revenues Losses Investments by owners

Instructions

Identify the element or elements associated with the 12 items below.(a) Arises from peripheral or incidental transactions.

(b) Obligation to transfer resources arising from a past transaction.

(c) Increases ownership interest.

(d) Declares and pays cash dividends to owners.

(e) Increases in net assets in a period from nonowner sources.

(f) Items characterized by service potential or future economic benefit.

(g) Equals increase in assets less liabilities during the year, after adding distributions to owners and subtracting investments by owners.

(h) Arises from income statement activities that constitute the entity’s ongoing major or central operations.

(i) Residual interest in the assets of the enterprise after deducting its liabilities.

(j) Increases assets during a period through sale of product.

(k) Decreases assets during the period by purchasing the company’s own stock.(l) Includes all changes in equity during the period, except those resulting from investments by owners and distributions to owners.

Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice.Instructions

(a) Help Wayne recognize the purpose of and benefit of a conceptual framework.

(b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.

(Usefulness, Objective of Financial Reporting) Indicate whether the following statements about the conceptual framework are true or false. If false, provide a brief explanation supporting your position.

  1. Accounting rule-making that relies on a body of concepts will result in useful and consistent pronouncements.
  2. General-purpose financial reports are most useful to company insiders in making strategic business decisions.
  3. Accounting standards based on individual conceptual frameworks generally will result in consistent and comparable accounting reports.
  4. Capital providers are the only users who benefit from general-purpose financial reporting.
  5. Accounting reports should be developed so that the users without knowledge of economics and business can become informed about the financial results of a company.
  6. The objective of financial reporting is the foundation from which the other aspects of the framework logically result.
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