E29 L06 GROUPwORK Accounting Principles and AssumptionsCompr

E2-9 (L06) GROUPwORK (Accounting Principles and Assumptions-Comprehensive) Presented below are a number of business transactions that occurred during the current year for Gonzales, Inc Instructions In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles (a) s expense account to purchase a new Suburban solely for p ersonal use. The fol- The president of Gonzales, Inc. used hi lowing journal entry was made Miscellaneous Expense 29,000 Cash 29,000 (b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less 70,000 (c) The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by estimated selling costs. The following entry was made to record this increase in value. Inventory Sales Revenue 70,000 a defective product. Company attorneys feel extremely confident that the company will have no liability for damages resulting from the situation. Nevertheless, the company decides to make the following entry Loss from Lawsuit 500,000 Liability for Lawsuit 500,000 (d) Because the general level of prices increased during the currentyear, Gonzales, Inc. determined that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made Depreciation Expense 16,000 Accumulated Depreciation-Equipment 16,000 (e) Gonzales, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a con sequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows. Retained Eamings 800,000 Goodwill 800,000 (f) Because of a \"fire sale,\" equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made Equipment 200,000 Cash Sales Revenue 155,000 45,000

Solution

ans)

a) This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.

b) The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.

c)  Probably the company is too conservative in its accounting for this transaction. The matching principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and

(2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.)

(d)       At the present time, accountants do not recognize price-level adjust-ments in the accounts. Hence, it is misleading to deviate from the cost principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of expired costs against revenues. (Note to instructor: It might be called to the students’ attention that the FASB does encourage supplemental disclosure of price-level information.)

(e)        Most accounting methods are based on the assumption that the busi-ness enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incor-rect to assume liquidation as Fresh Horses, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.

(f)        The answer to this situation is the same as (b).