Exercise 1
Presented below are a number of accounting procedures and
practices in Sanchez Corp. For each of these items, list the
assumption, principle, information characteristic, or modifying
convention that is violated.
1. Because the company's income is low this year, a switch from
accelerated depreciation to straight-line depreciation is made this
year.
2. The president of Sanchez Corp. believes it is foolish to report
financial information on a yearly basis. Instead, the president
believes that financial information should be disclosed only when
significant new information is available related to the company's
operations.
3. Sanchez Corp. decides to establish a large loss and related
liability this year because of the possibility that it may lose a
pending patent infringement lawsuit. The possibility of loss is
considered remote by its attorneys.
Answer of Exercise 1
1. Consistency
2. Periodicity
3. Matching (also conservatism)
Exercise 2
E.2-6, Presented below are a number of facts related to R. Kelly Inc.
Assume that no mention of these facts was made in the financial
statements and the related notes.
Instructions :
Assume that you are the auditor of R Kelly Inc, and that you have
been asked to explain the appropriate accounting and related
disclosure necessary for each of these items :
a. The company decided that, for the sake of conciseness, only net
income should be reported on the income statement. Details as
to revenues, cost of good sold, and expenses were omitted.
b. Equipment purchases of $ 170,000 were partly financed during
the year through the issuance of a $ 110,000 Notes Payable. The
company offset equipment against the Notes Payable and
reported plant asset as $ 60,000.
Exercise 2
c. During the year, an assistant controller for the
company embezzled $ 15,000. R Kelly’s net income for
the year was $ 2,300,000. Neither the assistant
controller nor the money have been found.
d. R Kelly has reported its ending inventory at $
2,100,000 in the financial statements. No other
information related to inventories is presented in the
financial statements and related notes.
e. The company changed its method of depreciating
equipment from the double declining balance to the
straight line method. No mention of this change was
made in the financial statements.
Answer of Exercise 2
a. It is well established in accounting that revenues and
cost of goods sold must be disclosed in the reporting
of an income statement. It might be noted to
students that such was not always the case. At one
time, only net income was reported but over time we
have evolved to the present reporting format.
b. The proper accounting for this situation is to report
the equipment as an asset and the notes payable as a
liability on the balance sheet. Offsetting is permitted
in only limited situations where certain assets are
contractually committed to pay off liabilities.
c. This event need not be disclosed in the financial
statements. The amount of monies involved is
relatively small in relation to the net income of the
business and should not affect the fairness of the
presentation of the financial statements.
Answer of Exercise 2
d. According to GAAP, the basis upon which inventory
amounts are stated (lower of cost or market) and the
method used in determining cost (LIFO, FIFO, average
cost, etc.) should also be reported. The disclosure
requirement related to the method used in
determining cost should be emphasized, indicating that
where possible alternatives exist in financial reporting,
disclosure in some format is required.
e. Consistency requires that disclosure of changes in
accounting principles be made in the financial
statements. To do otherwise would result in financial
statements that are misleading. Financial statements
are more useful if they can be compared with similar
reports for prior years.