E2-4 Assumptions, Principles and Constraints Presented below are the assumptions, principles, and constraints
1. Economic entity assumption
2. Going concern assumption
3.Monetary unit assumption
4. Periodicity assumption
5. Historical cost principle
6. Matching principle
7. Full disclosure principle
8. Cost-benefit relationship
10. Industry practices
Identify by number the accounting assumption, principle, or constraint that describes each situation.
Allocates expenses to revenues in the proper period.
Indicates that market value changes subsequent to purchase are not recorded in the accounts. (Do not use revenue recognition principle.)
Historical cost principle.
Ensures that all relevant financial information is reported.
Full disclosure principle.
Rationale why plant assets are not reported at liquidation value. (Do not use historical cost principle.)
Going concern assumption.
Anticipates all losses, but reports no gains.
Indicates that personal and business record keeping should be separately maintained.
Economic entity assumption.
Separates financial information into time periods for reporting purposes.
Permits the use of market value valuation in certain specific situations.
Requires that information significant enough to affect the decision of reasonably informed users should be disclosed. (Do not use full disclosure principle.)
Assumes that the dollar is the "measuring stick" used to report on financial performance.
Monetary unit assumption.
(Accounting Principles-Comprehensive) Presented below are a number of business transactions that occurred during the current year for Fresh Horses, Inc.
In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted accounting principles.
The president of Fresh Horses, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made.
Miscellaneous Expense 29,000
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.
Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs. The following entry was made to record this increase in value.
Merchandise Inventory 70,000
The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. Therefore inventory in the Balance sheet should be recorded at cost value. Revenue should be recorded only when it is realized but not when it is estimated.
The company is being sued for $500,000 by a customer who claims damages for personal injury apparently caused by 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
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.)
Because the general level of prices increased during the current year, Fresh Horses, 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 16,000
At the present time, accountants do not recognize price-level adjustments 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.)
Fresh Horses, Inc. has been concerned about whether intangible assets could generate cash in case of liquidation. As a consequence, goodwill arising from a purchase transaction during the current year and recorded at $800,000 was written off as follows.
Most accounting methods are based on the assumption that the business 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 incorrect 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.
1. Because of a "fire sale," equipment obviously worth $200,000 was acquired at a cost of $155,000. The following entry was made.
The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost.