uired xplain to Maxie that the two companies do not have equal amoun nt to inclu
ID: 2331859 • Letter: U
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uired xplain to Maxie that the two companies do not have equal amoun nt to include in your discussion comments regarding the possibl , the impact of the historical cost concept on balance sheet information, ort paragraph, e equip You ma equipmen ct of different depreciation methods on book val imp arc6-5 Ethical Dilemma What's an expense? Saveral years ago, Wilson Blowhard founded a communications company. The company became suc- cesful and grew by expandi of its growth resulted from acquiring other companies. Mr. Blowhard is adamant about continuing the company's growth and increasing its net worth. To achieve these goals, the business's net income must continue to increase at a rapid pace ing its customer base and acquiring some of its competitors. In fact, most If the company's net worth continues to rise, Mr. Blowhard plans to sell the company and retire therefore, focused on improving the company's profit any way he can In the communications business, companies often use the lines of other communications compa- nies. This line usage is a significant operating expense for Mr. Blowhard's company. Generally ac cepted accounting principles require operating costs like line use to be expensed as they are incurred each year. Each dollar of line cost reduces net income by a dollar. After reviewing the company's operations, Mr. Blowhard concluded that the company did not cur rently need all of the line use it was paying for. It was really paying the owner of the lines now so that the line use would be available in the future for all of Mr. Blowhard's expected new customers. Mr. Blowhard instructed his accountant to capitalize all of the line cost charges and depreciate them over 10 years. The accountant reluctantly followed Mr. Blowhard's instructions and the company's net income for the cur rent year showed a significant increase over the prior year's net income. Mr. Blowhard had found a way to report continued growth in the co's net income and increase the value of the company Required a. How does Mr. Blowhard's scheme affeci the amount of income that the company would otherwise report in its financial statements and how does the scheme affect the company's balance sheet? Explain your answer. standards that were violated that are evident in this case. b. Review the AICPA's Articles of Professional Conduct (see Chapter 4) and comment on any of the c. Review the fraud triangle discussed in Chapter 4 and comment on the features of the fraud triangleExplanation / Answer
a.
Mr. Blowhard’s scheme adversely affects the amount of income that the company would otherwise report in its financial statements. The income statement is a financial statement designed to show a company’s net income (loss) over a certain period of time. If the accountant, at the direction of Mr. Blowhard, and how does the scheme affect the company’s balance sheet depreciates the capital expenditure for the use of communication lines, over the course of 10 years, then for the next 10 years, expenses will be understated and net income will be overstated. The effect of this action improves the appearance of the firm’s profitability at the expense of accurate financial reporting and violates the company’s fiduciary responsibility to its owners and creditors.
In addition, Mr. Blowhard’s scheme affects the company’s balance sheet by overstating assets (in this case cash and cash equivalents that would otherwise have been booked to show the payment of the capital expense for communication) and overstating equity (in this case retained earnings would be overstated because net income is overstated, where retained earnings is simply the accumulation of net income or loss over a firm’s going concern.
b.
According to the AICPA’ Articles of Professional Conduct, several standards were violated when the accountant decided to follow Mr. Blowhard’s schemata for revenue recognition. The standards that were violated include:
(1)Historical Cost Principle
Under this principle, which is a fundamental principle in accounting, all goods and services purchased are recorded at cost, where costs are measured on a cash or equivalent basis. If the consideration given for an asset or service is cash, cost is measured at the entire cash outlay made to secure the asset or the service. Otherwise, cost is measured at the cash equivalent value of the consideration given or the cash equivalent value of the thing received whichever is more clearly evident.
(2) Objectivity Principle
This principle requires that entries in the accounting records and data reported on financial statements be based on objectively determined evidence. This principle answers the question why assets and services are recorded at cost rather than some other amount such as estimated market value. As a rule, costs are objective since normally are established by buyers and sellers, each striking the best possible bargain for themselves. If this principle is not followed, the confidence of the many users of the financial statements could not be maintained. For example, objective evidence such as invoices and vouchers for purchases, bank statements for the amount of cash in bank, and physical counts for merchandise on hand supports much of the accounting. Such evidence is completely objective and can be verified.
(3) The Matching Principle
How well or bad the company is doing is reflected to users on the income statement prepared for a period of time. The income statement tries to measure the business’s earnings by comparing the revenue with expenses of that period which is covered by the income statement. The matching principle means that after the revenues for an accounting period have been determined, the costs associated with those revenues must be deducted in order to determine net income. The term matching refers to the close relationship that exists between certain costs and the revenue realized as a result of incurring those costs.
(4) Adequate Disclosure Principle
All financial statements and accompanying statements should include the necessary data that helps to facilitate the user’s understanding. Thus, all relevant information to the users must be disclosed. However, full disclosure does not mean that everything must be disclosed. That would be too costly. A balance must be maintained between the cost of disclosing information and its relevance to users. Basically, if the information will make a difference in investors’ or creditors’ decisions it should be disclosed. Therefore, the criterion for disclosure is based on value judgment rather than objective facts.
(5) The Conservatism Concept
Accountants follow methods and procedures that yield the lesser amount of net income or net asset value. Of an accountant faced two methods of handling a particular event, he /she tends to use the method which understate the net income or net asset. This is done to protect the firm from uncertain risk of loss. Thus, conservatism is usually expressed by the statement “anticipate no profit but provide for all losses”. Such an attitude of pessimism has been due in part to the need for an offset to the optimism of business management.
c.
Based on the Fraud Triangle, the features of this case are indicative of rationalization (the idea that misreporting net income by underreporting expenses is good for the company) and opportunity (the idea that misreporting net income will allow the company to be sold at a premium so that Mr. Blowhard can retire). In terms of rationalization, only a change in belief and boundary systems, colloquially referred to as a firm’s corporate culture and “tone at the top” respectively, can create a means by which an employee like the accountant would resist Mr. Blowhard’s insistence on understating expenses and overstating net income. In terms of opportunity, a strong system of internal controls coupled with a means by which an employee can report fraudulent actions, would act as a further deterrent to Mr. Blowhard’s insistence on amortizing a capital expense over a 10 year period.
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