Solutions for insertion in Beechy 3/c/e Study Guide

CHAPTER 1

Assignment1-6 WEB

1.Debt/equity ratio decreasesIncome and equity increase

Times-interest-earned ratio increasesIncome increases*

2.Debt/equity ratio increasesIncome and equity decrease

Times-interest-earned ratio decreasesIncome decreases*

3.Debt/equity ratio decreases marginallyLower discount amortization, lower debt

compared to effective interest method

Times-interest-earned ratio increasesIncome increases, interest expense decreases*

4.Debt/equity ratio increasesDebt increases

Times-interest-earned ratio decreases**

5.Debt/equity ratio increasesIncome and equity decline; warranty

liability increases

Times-interest-earned ratio decreasesIncome decreases*

6.Debt/equity ratio decreasesIncome and equity increases

Times-interest-earned ratio increasesIncome increases*

* Income effect is in the first or early years; later the difference would reverse and the effect would be the opposite.

** Dividends on shares are reclassified from the retained earnings statement to the income statement as “interest,” decreasing earnings and increasing “interest.”

Assignment 1-7 WEB

a)The term “accounting principles” in an auditors’ report includes not only “principles” but also the practices, procedures and methods used to apply those principles. GAAP rests upon fundamental accounting principles. GAAP is the body of practice that has been build up over a long period of time through use or pronouncement.

b)“Generally accepted” means that the accounting principles used are based upon:

  1. The official pronouncements of the AcSB, as documented in the CICA Handbook and other document issued by the AcSB.
  2. Professional judgment, consistent with recommendations in the CICA Handbook and other literature, including international standards, standards from other countries and current literature.
  3. Generally accepted accounting principles established through use in similar circumstances by a significant number of entities in Canada.

c)Diversity in accounting practice should always exist because no two businesses are alike and may well have different reporting objectives. Financial statements should reflect the uniqueness of a company, rather than a stereotype that is inflexible and unrealistic. The great diversity of businesses promotes accounting diversity. Statements can be tailored to meet user needs, as GAAP allows much flexibility in this regard.

Also, many transactions are unique, and it is impossible to set accounting standards for every conceivable transaction and event. Owners and managers should have reasonable discretion in revealing the financial affairs of a company.

Regardless of the extent of accounting rules, one cannot, and should not, disregard the fact that accrual-basis accounting requires unavoidable estimates and judgments. These estimates and judgements result in diversity of accounting practice.

Numerous ways of applying accounting principles (such as FIFO and LIFO) have been sanctioned by authoritative pronouncements and many more (not specified by those pronouncements) receive “general acceptance” through wide usage and common sense.

Finally, a cost-benefit constraint is necessary (exemplified by materiality), which causes diversity in accounting. Further, conservatism (e.g., in recognizing losses versus gains) promotes considerable diversity in accounting.

Arguments against diversity of accounting practice would hinge on the reduced usefulness of noncomparable financial statements. Because most investment decisions represent trade-offs between competing alternatives, some common basis of comparison across companies would seem desirable.

Assignment1-15 WEB

OrderDescription

4B

5A

2D

3F

1C

6E

Assignment 1-17 WEB

GAAP statements are general purpose financial statements meant to address the needs of investors, creditors and others making resource allocation decisions and/or assessing management stewardship. Furthermore, if a company wants or needs an audit report that states that the financial statements are fairly presented in accordance with GAAP, then obviously GAAP must be followed.

Generally, investors and creditors are well-served by GAAP, even though there is a lot of choice within GAAP. Securities commissions, that require copies of annual audited financial statements of public companies, take a dim view of non-GAAP statements that result in a less-than-clean audit report. Lenders often like to be able to do ratio analysis that permits comparison to similar companies. On the other hand, GAAP statements are sometimes of little use in special situations, like business valuations or when assessing the market value of assets pledged as security.

While GAAP is a norm, there are special circumstances in which other accounting principles are followed:

1.To meet the needs of special users.

2.To comply with regulated accounting policies (RAP).

For example; statements may be

  • non-consolidated, at the user’s request.
  • designed to value a company according to a purchase/sale agreement.
  • designed to allocate profits or ‘value’ to shareholders or partners using specific revenue recognition or valuation rules.
  • used to set (regulated) rates by a regulatory board.
  • used to evaluate cash flow, profitability or solvency by a lender using specific policies.

Private companies are free to use a disclosed basis of accounting (DBA) should they be more appropriate. Private companies may also choose to use differential reporting, if all shareholders consent. However, differential reporting is permitted by the CICA Handbook and therefore is not a departure from GAAP.