Question

Brenda Chan is the new accountant for a small private company called Ace Construction Limited. She has recently prepared the year-end financial statements for the company. Brenda's boss, Virginia Schwirtz, who is the chief executive officer (CEO), has asked her to make three changes to the financial statements as follows:

1. Remove an expense and its related liability that Brenda recorded for damages expected to be paid from a lawsuit due to a poorly done construction job a few months ago. Virginia believes that, although it is highly likely that Ace will have to pay for these damages, because a final agreement about the exact amount of these damages will not be agreed to until next month, nothing relating to this issue should be recorded in the financial statements or disclosed in the notes to the financial statements.

2. Just prior to the end of the year, Ace signed a contract to build a new arena for the city for a fixed fee of $80 million. As long as the company can build the facility for less than this amount, the company will make a profit. Since the value of the contract is fixed and because the city has always paid its bills on time, Virginia wants the revenue for this contract to be recorded in the current year because that was when the contract was signed.

3. The company has a chequing account that is allowed to go into an overdraft (negative) position. When the balance falls into an overdraft, the bank begins to charge interest on that amount as if it were a bank loan, which in essence it is. Since there is no due date on such a balance, Virginia would like the loan to be reported as a non-current liability.

a) What is the objective of financial reporting? Are Brenda's or Virginia's actions consistent with these objectives? Explain.

b) For each of the items covered above, determine if the proposed changes enhance or diminish the qualitative characteristics of the company's financial statements and whether the company is dealing with these items in a manner that is consistent with the definitions for elements of financial statements.

Answer 1

a. The primary objectives of financial reporting are :

1. Recording transactions and presenting financial information to users enabling to make decisions.

2. Financial reporting should provide information about the entity’s financial performance in a year, its sources of revenue application of funds in a true and fair view.

Brenda’s actions are not consistent with the above stated objectives of financial reporting. For thr first case , a company according to prudence concept has to recognise anticipated losses and outflow of cash as a provision for future expenses. In case the entity fails to it is showing higher profits than actual which presents an improper picture of the financial statements. In the second case , a company cannot recognise revenue until the ownership in an asset transferred. Although the company has previously built such projects, it is not a indication of the completion of the future project successfully. Therefore it should recognise the revenue of $80 million upfront based on past trends without actual transfer of ownership. This has overstated revenues than actual which shows an incorrect pricture for decision makers to take a decision. A chequeing account or bank overdraft is always treated as a current liability although there is no due date, the entity is ideally expected to pay back the overdraft balance in a operating cycle of 12 months. Hence, it is incorrect to improperly classify the liability as non current liability. This treatment doesnot meet the objective of propely classifying assets and liabilities of an entity.

b. The two major qualitative factors of financial reporting are relevance and reliability. All the three situations diminish the qualitative factors of financial reporting since neither the figures reported are relevant to the decision makers nor they present a reliable information.

For thr first case , a company according to prudence concept has to recognise anticipated losses and outflow of cash as a provision for future expenses. In the second case , a company cannot recognise revenue until the ownership in an asset transferred. Although the company has previously built such projects, it is not a indication of the completion of the future project successfully. Therefore it should recognise the revenue of $80 million upfront based on past trends without actual transfer of ownership. A chequeing account or bank overdraft is always treated as a current liability although there is no due date, the entity is ideally expected to pay back the overdraft balance in a operating cycle of 12 months.