Exercise-7: Violation of adequate or full disclosure principle

Learning objective:
This exercise illustrates the violation of adequate or full disclosure principle of accounting.

Consider the following four independent items:

1. Emma Company reported only net income on its income statement for the year 2024. The details regarding revenues, expenses, and the cost of goods sold (COGS) were omitted. The management argues that this practice was adopted for the sake of conciseness.
2. Kiwi Company purchased a processing machine for $50,000. This purchase was partially financed through the issuance of a $20,000 note payable. The company offset the machine against the note and reported it at $30,000.
3. Best Buy Company presented its ending inventory at $1,500,000 on the balance sheet. It did not provide any details as to the valuation of inventory in the financial statements or related notes.
4. Roaster Company changed its inventory valuation method from weighted average to LIFO but did not disclose this change in its financial statements or related notes.

Required: Describe the appropriate accounting practice(s) and related disclosure necessary in each of the above situations.

Solution

1. According to the present format of the income statement, companies must report revenues and cost of goods sold (COGS) in the statement. Students might need to know that this has not always been the case. At one time, companies used to report only net income in their income statement. However, with the development of accounting practices, procedures, and guidelines over the course of many years, companies have evolved to the present format.
2. In this case, the company must have reported the machine as an asset and the note as a liability. The practice of offsetting assets against liabilities is allowed only when a particular asset is contractually committed to pay off a particular liability.
3. Generally accepted accounting principles (GAAPs) require companies to disclose the method used to determine the cost of their inventory (i.e., FIFO, LIFO, average cost, etc.) and the basis on which the amount of inventory is stated (i.e., lower of cost or market value). Therefore, Best Buy must have presented this information in its financial statements or related notes.
4. If a company changes its inventory valuation method, it must disclose it in its financial statements. The failure to disclose such a change may result in misleading information in the company’s financial statements and negatively impact investors’ decisions. A financial statement is more useful when it can be compared with the same statement from a previous period. In this case, Roaster not only violated the full disclosure principle but also the consistency principle of accounting.