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Chapter 2: Q9CA (page 71)

Question: (Qualitative Characteristics) Recently, your uncle, Carlos Beltran, who knows that you always have your eye out for a profitable investment, has discussed the possibility of your purchasing some corporate bonds. He suggests that you may wish to get in on the 鈥済round floor鈥� of this deal. The bonds being issued by Neville Corp. are 10-year debentures which promise a 40% rate of return. Neville manufactures novelty/party items.

You have told Uncle Carlos that, unless you can take a look at Neville鈥檚 financial statements, you would not feel comfortable about such an investment. Believing that this is the chance of a lifetime, Uncle Carlos has procured a copy of Neville鈥檚 most recent, unaudited financial statements which are a year old. These statements were prepared by Mrs. Andy Neville. You peruse these statements, and they are quite impressive. The balance sheet showed a debt-to-equity ratio of 0.10 and, for the year shown, the company reported net income of $2,424,240.

The financial statements are not shown in comparison with amounts from other years. In addition, no significant note disclosures about inventory valuation, depreciation methods, loan agreements, etc. are available.

Instructions

Write a letter to Uncle Carlos explaining why it would be unwise to base an investment decision on the financial statements that he has provided to you. Be sure to explain why these financial statements are neither relevant nor representationally faithful.

Short Answer

Expert verified

Answer

Date: XX/XX/XXX

To: Carlos

From: Mr. X

Subject: Why are financial statements are neither relevant nor represented faithfully

The financial statements are not relevant and are not faithfully represented because the methods used for calculating the value of inventory and depreciation are not disclosed. Also, it does not disclose any other relevant information necessary for increasing the transparency and relevancy of the financial statement

Step by step solution

01

Definition of Financial Statement

The financial statement can be defined as asummary report thatincludes all theinformation relating to the financial transactions. It includes reporting all the assets, liabilities, revenue, expenses, and cash inflows and outflows.

02

Non-relevancy of the financial statement

The financial statement is neither relevant nor representationally faithful because the business entity has not reflected the information relating to loan agreements, depreciation, and inventory valuation. It might be possible that the business entity depreciates its assets at lower rates to report the higher net income, the business entity is using the FIFO method for reporting higher net income and the business entity have loan agreements that are not reflected on the financial statement to reflect improved debt-to-equity ratio.

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Most popular questions from this chapter

Selane Eatery operates a catering service specializing in business luncheons for large corporations. Selane requires customers to place their orders 2 weeks in advance of the scheduled events. Selane bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, when should Selane recognize revenue related to its catering service

Question: William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2017. He invested \(20,000 of his own savings in the business. He paid \)6,000 cash to have a small building constructed to house the operations and spent \(800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land for \)1,000 per month. (He paid the first month鈥檚 rent in cash.) During the first month, advertising costs totaled \(750, of which \)150 was unpaid at the end of the month. Murray paid his three nephews \(400 for retrieving golf balls. He deposited in the company鈥檚 bank account all revenues from customers (\)4,700). On May 15, Murray withdrew \(800 in cash for personal use. On May 31, the company received a utility bill for \)100 but did not immediately pay it. On May 31, the balance in the company bank account was \(15,100.

Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of \)4,900 to a profit of \(1,650.

Accounting

Prepare a balance sheet at May 31, 2017. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of \)1,650? How could Murray conclude that the business operated at a loss of \(4,900?

Analysis

Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him \)10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain.

Principles

What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate?

Briefly describe the two fundamental qualities of useful accounting information.

What is the primary objective of financial reporting?

Question: The issues that the FASB and IASB must address in developing a conceptual framework include all of the following except:

(a) should the characteristic of relevance be traded-off in favor of information that is verifiable?

(b) should a single measurement method such as historical cost be used?

(c) what are the key elements of asset and liability definitions?

(d) should the role of financial reporting focus on internal decision-making as well as providing information to assist users in decision-making?
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