Question

The following transactions fall somewhere in the continuum of choices in accounting decision-making.

1.		The company president approaches one of the company’s creditors to ask for a modification of the repayment terms so that they extend beyond the current year. This would make the liabilities long-term rather than short-term and would improve the company’s current ratio.
2.		The controller determines that significant amounts of capital assets are impaired and should be written off. Coincidentally, the company is currently showing lower levels of net income but expects better results in the following years.
3.		The company management decides to use FIFO as opposed to weighted average, since it more closely approximates the flow of costs.
4.		The vice-president of finance decides to capitalize interest during the self-construction of its properties. This policy will increase net income and several profitability ratios.
5.		The business owner enters into an arrangement with a business associate whereby they will buy each other’s merchandise before year end. The merchandise will then be shipped to customers after year end from the holding company’s warehouse.
6.		The assets and liabilities of an investment have been consolidated into Maher Company’s annual financial statements. Maher Company does not have the power to direct the investee’s activities.
7.		The corporate litigation lawyer representing the business in its defence against a patent infringement lawsuit is uncertain about the possible outcome of the case, as he has just recently been engaged in the matter. Although there is considerable work to be done to establish the merits of the case, management has decided to accrue in the current period half of the amount claimed under the lawsuit. Management is worried that the Board of Directors may declare dividends in the current year that will have to be reduced in a subsequent year, when the case is ultimately settled.

For each situation, state where it falls in the continuum of choices in decision-making.

Answer 1

The following transactions fall somewhere in the continuum of choices in accounting decision-making.

For each situation, state where it falls in the continuum of choices in decision-making:

Answer.

1. This transaction may be a bona fide business transaction but it is structured to minimize the impact on debt covenants. By modifying the payment terms (and with the creditors agreement), the company president will move the payable into long-term debt and improve the companys current ratio. Care should be taken to ensure all legal documentation is in place on a timely manner so that the financial statements reflect the true nature of the transaction.

2. This may be an aggressive interpretation of GAAP. Capital assets should be tested regularly for impairment and written down when their cost will not be recovered. The timing of the write-down to coincide with lower levels of net income indicates that the controller may be trying to show improved financial results in future years. The controller is taking advantage of current poor financial results to write down the capital assets, thereby improving future years results when those write-downs would have otherwise been recorded.

3. This is an example of a bona fide business transaction with no bias. Companies should select the inventory cost assumption that best approximates the cost flow. As well, under GAAP, this change in accounting policy would be accounted for retrospectively hence full disclosure would sufficiently inform the users.

4. Under IFRS, companies must capitalize interest on self-constructed assets; under ASPE, companies have an accounting policy choice. Since the policy is applied to only one property, this indicates that the policy may have been set with key financial ratios in mind. As such, this would mean that the sole purpose is to make the financial statements look better, which is not an acceptable approach to selecting policies.

5. This is an example of a business transaction entered into for the sole purpose of making the financial statements show revenue on merchandise where it is unlikely that the risks and rewards of ownership have, in fact, passed to the other party. What would happen if the business owners ultimate customer decided not to proceed with the purchase? Would the business owner have an agreement with the business associate that it would repurchase the goods? Who is insuring the goods? What is the nature of the holding company? Care should be taken to investigate whether all the revenue recognition criteria have actually been met.

6. This represents an error in the application of GAAP. Under the economic entity and control principles, Maher Company does not have control over the investee and as such its assets and liabilities are not part of Mahers economic resources and obligations and would not be consolidated.