Exercise-2: Accounting principles and the valuation of business assets

Learning objectives:
This exercise illustrates the use of accounting principles and assumptions in the valuation of business assets.

The following situations relate to the valuation of assets. Consider each situation independently.

Situation 1:
Eastern Corporation purchased a tract of land in 2012 for $28,000. In 2024, it purchased a similar tract of land for $42,000. The company reported these two tracts of land at a combined value of $70,000 in its 2024 balance sheet.

Situation 2:
On December 31, 2024, Moona Travels and Tours has unused office supplies costing $950. The supplier of these supplies does not give a cash refund. The company believes that it could sell these supplies for a maximum of $350. The management expects to consume these supplies in the next period and buy more when they are consumed. Mona presented the supplies at $350 on its balance sheet on December 31, 2024.

Situation 3:
On November 15, 2023, Dreams Inc. acquired a machine from a mail-order supplier for $6,500. According to the supplier, the retail value of the machine was $8,000. On February 2, 2024, the machine was stolen during a burglary. In its December 31, 2023, balance sheet, Inc. showed the machine at its cost of $6,500 without making any reference to its retail price or the burglary. This balance sheet was issued to shareholders on February 20, 2024.

Required: In each of the above situations, indicate the appropriate amount of the asset that should be reported on the balance sheet under generally accepted accounting principles (GAAPs). If you think the reported amount is appropriate or correct, mention the accounting principles that justify this treatment. If you think the reported amount is inappropriate or incorrect, identify the accounting principles that have been violated by the company.

Solution

Situation 1 – justification of reporting the tracts of land at their cost:

The reporting of two tracts of land at their combined amount of $70,000 illustrates the stable dollar value assumption and the cost principle. This treatment, therefore, conforms to generally accepted accounting principles (GAAPs).

Situation 2 – Violation of going concern, cost and objectivity principle:

Moona Travels and Tours should present its unused supplies at their cost, which is $950. Reporting the supplies at their estimated liquidation value violates the assumption that the company is a going concern and will consume these supplies in the forthcoming period(s) rather than sell them to someone on the open market. Moreover, reporting supplies on hand at $350 violates the cost principle and also the objectivity principle, as it is largely a matter of personal opinion.

Situation 3 – justification of reporting machine at its cost, violation of adequate disclosure principle:

The reporting of the machine conforms to generally accepted accounting principles (GAAPs) because it was reported at its cost of $6,500 and the company owned it on December 31, 2023, the balance sheet date. The retail value of the machine cannot be reported on the balance sheet as it does not represent the cost that the company actually incurred to acquire the asset. Moreover, the retail value is not an objective measurement of the asset’s value in this case.

However, in order to properly interpret the company’s balance sheet, investors and creditors may need to know that the machine no longer exists. Thus, the failure to disclose the loss of an asset subsequent to the balance sheet date may be a violation of the principle of adequate disclosure on the part of the company.

Whether the loss of an asset due to burglary is necessary to disclose depends on a number of issues. For example, is the amount of loss significant in relation to the company’s other assets and operations? Is the amount of loss large enough to impact investors’ decisions about the company? Was the asset in question insured?