understanding the basic accounting concepts_assumptions

Management Accounting- GMP 2012-13

Solution to Exercise 1: Applying the Basic ConceptsMatch each of the following statements with the appropriate accounting concept involved. Some concepts may be used more than once, while others may not be used at all. Use the notations shown to indicate the appropriate accounting concept.

Accounting Concept NotationAccounting period concept AAdequate disclosure concept DEntity concept BHistorical Cost concept CGoing concern concept GMatching concept MObjectivity concept OUnit of measure concept UPrudence concept PFair Value concept FMateriality concept Ma

Note: You have to only mention which accounting concept(s) is (are) involved and not the concepts that are violated.

Statements1. Assume that a business will continue forever.Which Concept(s) is (are) involved? Going Concern Concept: The going concern concept refers to the assumption that an entity will continue in business forever.

Which Concept(s) is (are) not involved? None of the other concept(s) are involved

Which Concept(s) is (are) violated?No concept is violated

2. Material litigation involving the corporation is described in a footnote.Which Concept(s) is (are) involved? Adequate Disclosure: Information relating to litigation is important for stakeholders to evaluate the financial performance of the entity. Following the adequate disclosure concept, the entity has disclosed this information in a footnote.Materiality: The concept of materiality requires that all items that could influence the economic decisions of stakeholders be disclosed in the financial statements (and not in the notes). Prudence: The concept of prudence requires that whenever estimates have to be made while preparing the financial statements, one should use the most pessimistic estimate. In arriving at the decision that the litigation is material, the corporation would have had to make an estimate of the possible settlement losses.

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Which Concept(s) is (are) not involved? None of the other concepts are involved.

Which Concept(s) is (are) violated?On the face of it, it appears that the company has violated the materiality concept. However, it cannot be definitively concluded that it has done so. As we have discussed, the application of the concept of prudence in practice suggests that when the likelihood of the event leading to a possible loss is very low, there is no requirement to present the item in the financial statements. Disclosing the item with the possibility in a note will suffice. Hence, in the absence of further information in the above statement, we can conclude that the company has not violated any of the accounting concepts. However, this situation highlights us to the importance of obtaining information on the likelihood of the possible losses to analyze the impact of the litigation on the financial performance and financial position of the company.

3. Monthly utilities costs are reported as expenses along with the monthly revenues.Which Concept(s) is (are) involved? Matching Concept: Monthly expenses are matched with the revenues earned during the month.

Which Concept(s) is (are) not involved? None of the other concepts are involved

Which Concept(s) is (are) violated?None of the concepts are violated

4. Personal transactions of owners are kept separate from the business.Which Concept(s) is (are) involved? Entity Concept: The entity concept implies that personal transactions of owners cannot be treated as transactions of the entity.



5. This concept supports relying on an independent actuary (statistician), rather than the chief operating officer of the corporation, to estimate a pension liability.

Which Concept(s) is (are) involved? Prudence: The company is using an estimate. Objectivity: The company is using an estimate as it is not possible to have objective verifiable evidence on the future pension liabilities. In situations where estimates are to be used, entities

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normally resort to using estimates provided by independent experts to provide a semblance of objectivity.Which Concept(s) is (are) not involved? None of the other concepts are involved


6. Changes in the use of accounting methods from one period to the next are described in the notes to the financial statements.

Which Concept(s) is (are) involved? Adequate Disclosure: The information that the entity has changed its accounting methods is important for stakeholders to evaluate its financial performance. In practice, the fact that there is a change in accounting method is indicated in the notes to the financial statements. The impact of such change on profits/values of assets and liabilities is also quantified and provided separately.

Materiality: The concept of materiality is indirectly involved in such situations. If the impact on profits/values of assets and liabilities is significant, then such impact should be shown in the financial statements rather than the notes to accounts. In practice, this is rarely done and hence one should be careful while analyzing the financial statements of an entity that has changed its accounting methods and/or policies.



7. Land worth $800,000 is reported at its original purchase price of $220,000. Which Concept(s) is (are) involved? Historical Cost Concept: The concept of historical cost suggests that assets are to be recorded at their original purchase price. Fair Value Concept: The fair value of the land is provided but the entity is not recording the land at fair value


Which Concept(s) is (are) violated?Fair Value Concept: The fair value concept and the historical cost concept are mirror images of each other. If one is followed, the other is violated.

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8. This concept justifies recording only transactions that are expressed in dollars.Which Concept(s) is (are) involved? Unit of Measure: The unit of measure concept suggests that all transactions (including barter transactions) must be recorded in terms of their monetary values. Similarly, it also states that financial statements must be presented in terms of a single currency.



9. If this concept was ignored, the confidence of users in the financial statements could not be maintained.Which Concept(s) is (are) involved? At the very basic level, this applies to all the basic accounting concepts. Violation of any of these would reduce the confidence of users in the financial statements. However, the objectivity concept is the most critical in maintaining the confidence of users in the financial statements. In case the objectivity concept is violated, the very basis of recording transactions is called into question. This in turn would lead users to doubt whether the other accounting principles are also being followed or not. For instance, if the objectivity principle is violated, one cannot place any confidence in the company recording only transactions relating to the business entity (e.g. whether directors/employees are using assets of the entity for their personal use). Similarly, if the objectivity principle is violated, one cannot be assured that the entity is providing all information useful to shareholders (adequate disclosure) or information that will influence their decision making (materiality) in the financial statements. This is because users will doubt the process by which the entity has arrived at the decision that the disclosure is adequate or that the information is material. You can similarly work out the arguments for other accounting concepts.At a very broad level, the accounting scandals at Adelphia, Enron, and AIG were violations of the objectivity principle as the transactions involved were not supported by adequate evidence as to their nature and amounts.1

Which Concept(s) is (are) not involved? All concepts are involved.

Which Concept(s) is (are) violated?Same as for concepts involved

1 The details of the accounting scandals noted in the class presentation will be uploaded in a separate document.

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10. The changes in financial condition are reported at the end of the month.Which Concept(s) is (are) involved? Accounting Period: The accounting period concept suggests that accounting statements are to be prepared at periodic intervals. The interval can be of any length of time and is normally determined either by regulatory requirements, industry practices, or by management.



11. Hansell Company recognizes revenue at the end of the production cycle but before the sale. The price of the product, as well as the amount that can be sold, is not certain.Which Concept(s) is (are) involved? Matching Concept: Revenues are to be recognized when they are earned.Prudence: As the company is recognizing revenues before the sale, it implies that the company is also making an estimate of the possible revenues.


Which Concept(s) is (are) violated?Matching Concept: The company is recognizing revenue before it has earned them.Prudence Concept: The concept of prudence requires that the entity take the most pessimistic value when it has to make an estimate. In the case of an ongoing business with a normal product (i.e. product that is not out of favor among customers), the most pessimistic value would be the cost of the product. Hence, by this argument, the company should have recorded revenue at the cost of the item. However, it would still have violated the matching concept.

12. Falk Company is in its fifth year of operation and has yet to issue financial statements.

Which Concept(s) is (are) involved? None of the accounting concepts are involved

Which Concept(s) is (are) not involved? None of the accounting concepts are involved. The accounting period concept does not specify the length of the period for which financial statements are to be issued. Similarly, without the financial statements being prepared, the concepts of adequate disclosure and materiality also do not apply. The concepts of matching and business entity deal with the recording of transactions. It cannot be presumed that because the company has not yet issued financial statements, it is not recording its transactions as well (though this is likely). Hence, from the given information, we cannot conclude that these concepts are being violated. Similarly, there is no information

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regarding the going concern assumption. Further, the going concern assumption influences the amounts at which various items are shown in the financial statements.

Which Concept(s) is (are) violated?None of the accounting concepts are violated. However, the company would be in violation of the taxation and corporate laws that require companies to prepare and present financial statements on an annual basis. If it were a listed company, then it would also violate the listing requirements and would most likely be delisted from the exchange. A large number of registered private limited companies in India do not prepare their financial statements for long periods of time.

13. Tavarez, Inc. Is carrying inventory at its current fair value of $100,000. Inventory had an original cost of $110,000.Which Concept(s) is (are) involved? Fair Value Concept: Inventory is being valued at fair valueHistorical Cost Concept: Historical cost concept is violated as the company is not recording inventory at cost.Prudence Concept: The company has to make an estimate of the future value of the inventory. For the purpose it has chosen the current fair value as the appropriate estimate.


Which Concept(s) is (are) violated?Historical Cost Concept: Historical cost concept is violated as the company is not recording inventory at cost.

14. Forgetta Hospital Supply Corporation reports only current assets and current liabilities on its balance sheet. Property, plant, and equipment and bonds payable are reported as current assets and current liabilities, respectively. Liquidation of the company is unlikely.Which Concept(s) is (are) involved? Going Concern Concept: As liquidation of the company is unlikely, it should report assets and liabilities at historical cost. However, the IFRS allows entities to choose the fair value standard for reporting assets and liabilities. Fair Value Concept: In practice, companies tend to report their current assets and current liabilities at fair value. By classifying these assets and liabilities as current, it appears that the company is reporting these at fair value as well. Historical Cost Concept: Fair value being followed implies violation of historical cost concept.


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Which Concept(s) is (are) violated?Historical Cost Concept: As these assets and liabilities are being valued at fair value.

Though the company is not violating any concept other than historical cost, it would be violating the regulations on presentation of financial statements as these regulations require companies to distinctly disclose fixed assets, long-term liabilities, current assets, current liabilities separately in the financial statements.

15. Kile Company has inventory on hand that cost $400,000. Kile reports inventory on its balance sheet at its current fair value of $425,000.Which Concept(s) is (are) involved? Historical Cost:Fair Value:Prudence:

Similar arguments as for case 13 above.

Which Concept(s) is (are) not involved? None of the other concepts.


Which Concept(s) is (are) violated?Historical Cost Concept: Historical cost concept is violated as the company is not recording inventory at cost.Prudence: The company is making an estimate of the future value of the inventory. As discussed in case 13, the most pessimistic estimate for a normal product is its cost. Hence, the company should have recorded inventory at cost. The company is resorting to the fair value concept to override the prudence concept. This is one of the shortcomings of the fair value concept.

16. Kim Farris, president of Classic Music Company, bought a computer for her personal use. She paid for the computer by using company funds and debited the "Computers" account. Which Concept(s) is (are) involved? Entity Concept: Personal expenses are treated as expense of the entity


Which Concept(s) is (are) violated?Entity Concept: Personal expenses are treated as expense of the entity

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17. The president of Fresh Horses, Inc. used his expense account to purchase a new car solely for personal use.Which Concept(s) is (are) involved? Entity Concept: Personal expenses are treated as expense of the entity


Which Concept(s) is (are) violated?Entity Concept: Personal expenses are treated as expense of the entity

18. Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected selling price less estimated selling costs.

Which Concept(s) is (are) involved? Historical Cost:Fair Value:Prudence:


Which Concept(s) is (are) not involved? None of the other concepts.


Which Concept(s) is (are) violated?Historical Cost Concept: Historical cost concept is violated as the company is not recording inventory at cost.Prudence: The company is making an estimate of the future value of the inventory. As discussed in case 13, the most pessimistic estimate for a normal product is its cost. Hence, the company should have recorded inventory at cost. The company is resorting to the fair value concept to override the prudence concept. This is one of the shortcomings of the fair value concept.

19. ABC 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.

Which Concept(s) is (are) involved? Adequate Disclosure: Information relating to litigation is important for stakeholders to evaluate the financial performance of the entity. Following the adequate disclosure concept, the entity has disclosed this information in a footnote.

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Prudence: The concept of prudence requires that whenever estimates have to be made while preparing the financial statements, one should use the most pessimistic estimate. In arriving at the decision that the litigation is material, the corporation would have had to make an estimate of the possible settlement losses.

Materiality: The concept of materiality requires that all items that could influence the economic decisions of stakeholders be disclosed in the financial statements (and not in the notes). Since the likelihood of losing the litigation is considered very low, the company is justified in providing information related to the litigation in a footnote.

Which Concept(s) is (are) not involved? None of the other concepts are involved.

Which Concept(s) is (are) violated?On the face of it, it appears that the company has violated the materiality concept. However, it cannot be definitively concluded that it has done so. As we have discussed, the application of the concept of prudence in practice suggests that when the likelihood of the event leading to a possible loss is very low, there is no requirement to present the item in the financial statements. Disclosing the item with the possibility in a note will suffice. Hence, in the absence of further information in the above statement, we can conclude that the company has not violated any of the accounting concepts. However, this situation highlights us to the importance of obtaining information on the likelihood of the possible losses to analyze the impact of the litigation on the financial performance and financial position of the company.

20. Because of a "fire sale," equipment obviously worth $200,000 was acquired at a cost of $155,000. Which Concept(s) is (are) involved? Fair Value Concept: The fair value concept would require that the equipment be recorded at a value of $200,000Historical Cost Concept: If the historical cost concept is followed, the equipment would be recorded at its cost of $155,000


Which Concept(s) is (are) violated?None of the concepts are violated as there is no information in the statement as to the amount at which the entity recorded the transaction. If it were given that the company recorded the equipment at fair value, it would be violating the historical cost concept and vice versa.

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21. A very large corporation's financial statements have the dollar amounts rounded to the nearest $1,000. Which Concept(s) is (are) involved? Materiality: The concept of materiality also allows entities to round off figures to the nearest thousands, lakhs, crores, millions, or billions depending on the size of the total assets/total revenues.



22. When the accountant has to choose between two acceptable alternatives, the accountant should select the alternative that will report less profit, less asset amount, or a greater liability amount. Which Concept(s) is (are) involved? Prudence: This is the implication of the concept of prudence



23. A large company purchases a $250 digital camera and expenses it immediately instead of recording it as an asset and depreciating it over its useful life. Which Concept(s) is (are) involved? Materiality: In those cases where the amount spent on acquiring an asset is insignificant relative to the size of total assets and total revenues it is a common practice to treat the amount spent as an expense. This is usually done because in such cases, the cost of maintaining the asset records over the lifetime of such items could be large relative to the amount spent in acquiring them.



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24. A company borrowed $100,000 in December and will make its only payment for interest when the note comes due six months later. The total interest for the six months will be $3,600. On the December income statement the accountant reported Interest Expense of $600. Which Concept(s) is (are) involved? Matching Concept: The income statement for the month of December records the interest expense for one month (i.e. 3,600/6).

Which Concept(s) is (are) not involved? None of the other concepts are involved. Prudence does not apply as the company is not making an estimate while arriving at the amount of interest on borrowings. The company is using the rate of interest as contracted in the borrowing arrangement.


25. Near the end of the current year, a company required a customer to pay $200,000 as an advance payment for goods to be delivered in the following year. At the end of the current year the company reported the $200,000 as a liability on its balance sheet.

Which Concept(s) is (are) involved? Matching Concept: The matching concept suggests that revenues are to be recognized in the accounting period in which they are earned. In this case, the payment has been received in advance, i.e. before the revenue has been earned and hence, the company is correct in not recognizing it as revenue.



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