Exercise-4: Identification of the violation of accounting principles

Learning objective:
This exercise illustrates the identification of violations of generally accepted accounting principles (GAAPs).

Consider the following three independent situations:

1. Southern Transport Company recognizes no depreciation on its trucks because they are regularly maintained and look like new ones.
2. Honeyhost Restaurant recognizes rental revenue on the day that a room reservation is received. For peak seasons, reservations are generally accepted six months in advance.
3. Fastmedia, a large advertising firm, depreciates a $15 wastebasket over a period of five years.
4. Alfred, a small manufacturing company, reports a parcel of land on its balance sheet at its current fair value of $28,000. This parcel of land was purchased for $9,000. The manager tries to justify this treatment by arguing that the land was acquired many years ago and therefore its cost is not as relevant for reporting purpose. He further adds that the current market value is more than three times its cost.

For each of the above situations, indicate the accounting principle that has been violated. Choose from the following principles:

• Realization or revenue recognition
• Matching
• Historical
• Materiality
• Objectivity

If you think that a practice does not violate any of the above accounting principles, answer “no violation” and defend your answer with a brief explanation.

Solution

1. By not recognizing the depreciation on its trucks, Southern Transport Company is violating the matching principle of accounting, which states that an expense should be recognized in the period in which it provides economic benefit in the course of generating revenue.
2. By recognizing the rental revenue at the time of receiving the reservation, Honeyhost Restaurant is violating the realization principle (also known as the revenue recognition principle). This principle states that revenue should be recognized when it is earned, i.e., when the performance obligations on the part of the service provider or the seller are satisfied.
3. No violation. Accounting for immaterial or insignificant items is not wrong. Therefore, Fastmedia has not violated any of the generally accepted accounting principles (GAAPs). However, it is a waste of time. The company’s bookkeeper is not taking advantage of the materiality concept. The materiality principle allows entities to charge an insignificant or immaterial cost directly to expense, thus eliminating the need to recognize depreciation expense in later periods.
4. By reporting land at its current market value, Alfred commits a violation of the historical cost principle of accounting, which states that assets should be reported at their original cost, i.e., the amount paid to initially acquire them. The company should present the land at $9,000, even though its fair value is $28,000, much higher than the amount paid to acquire it.