Exercise-8: Accounting principles and appropriateness of journal entries

Abraham Inc. recorded the following business transactions during its most recent accounting period:

1. Inventories costing $430,000 were presented on the balance sheet at $490,000, the expected selling price less estimated selling expenses. To record this increase in value, the company debited the inventory by $60,000 and credited the sales revenue by the same amount.
2. Abraham Inc. was sued for $300,000 by a customer who claims damages for a personal injury caused by the use of a defective product sold by it. The company’s attorney is extremely confident that it will have no liability for damages arising from the situation. However, the company has decided to recognize it by debiting the loss from law suit by $300,000 and crediting the liability form law suit by the same amount.
3. The company acquired a processing plant worth $550,000 at a cost of $350,000 on a fire sale. This purchase was recorded by debiting equipment by $550,000, crediting cash by $350,000, and crediting sales revenue by $200,000.
4. Due to an increase in the general price level, the management of Abraham Inc. determined that there was an $8,000 understatement of depreciation on its plant and machinery. The company decided to record it by debiting depreciation expense by $8,000 and crediting accumulated depreciation – plant and machinery by the same amount.
5. The president of Abraham Inc. purchased a parcel of land in the countryside for $16,000 solely for his personal use, which was recorded by debiting miscellaneous expense and crediting cash.

Required: in each of the above situations, describe the appropriateness of journal entries in terms of GAAPs

Solution

1. The revenue recognition principle indicates when to recognize revenue in the accounting records. It states that revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, Abraham Inc. has definitely not completed the earning process. Further, the historical cost principle states that assets and liabilities must be recognized on the basis of their costs. If we were to use sales value, for example, we would have an extremely difficult time establishing the sales value of inventories without selling them.
2. In light of the expense recognition principle, expenses should be allocated to the appropriate periods involved. In this case, it looks highly uncertain that the company will have to pay damages to the claimant. FASB Statement No. 5 guides companies to accrue a loss only (1) when it is probable that the company would lose the suit and (2) when the amount of the loss can be reasonably estimated.
3. The answer to this situation is the same as (1).
4. Currently, companies do not recognize the adjustments in price levels because accounting for such changes leads to deviation from the historical cost principle. Further, a depreciation expense is recorded on the basis of a charge of expired costs against revenues, not a reduction in the fair market value of the asset. Therefore, it is widely said that depreciation is a process of cost allocation, not valuation. However, students should know that FASB encourages companies to provide supplemental information regarding changes in price levels.
5. This journal entry violates the economic (or separate) entity assumption, which states that economic activities can be identified with a particular unit of accountability. In this situation, Abraham Inc. erroneously charged the cost to the wrong economic entity.