E2-7 (Accounting Principles—Comprehensive) Presented below are a number of business transactions
that occurred during the current year for Fresh Horses, Inc.
Instructions
In each of the situations, discuss the appropriateness of the journal entries in terms of generally accepted
accounting principles.
(a) The president of Fresh Horses, Inc. used his expense account to purchase a new Suburban solely
for personal use. The following journal entry was made.
Miscellaneous Expense 29,000
Cash 29,000
(b) Merchandise inventory that cost $620,000 is reported on the balance sheet at $690,000, the expected
selling price less estimated selling costs. The following entry was made to record this increase
in value.
Merchandise Inventory 70,000
Revenue 70,000
(c) The company is being sued for $500,000 by a customer who claims damages for personal injury
apparently caused by a defective product. Company attorneys feel extremely confident that the
company will have no liability for damages resulting from the situation. Nevertheless, the company
decides to make the following entry.
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
(d) Because the general level of prices increased during the current year, Fresh Horses, Inc. determined
that there was a $16,000 understatement of depreciation expense on its equipment and decided to record it in its accounts. The following entry was made.
Depreciation Expense 16,000
Accumulated Depreciation 16,000
(e) Fresh Horses, Inc. has been concerned about whether intangible assets could generate cash in case
of liquidation. As a consequence, goodwill arising from a purchase transaction during the current
year and recorded at $800,000 was written off as follows.
Retained Earnings 800,000
Goodwill 800,000
(f) Because of a “fire sale,” equipment obviously worth $200,000 was acquired at a cost of $155,000.
The following entry was made.
Equipment 200,000
Cash 155,000
Revenue 45,000
(a)
Merchandise Inventory 70,000
Revenue 70,000
Discussion of appropriateness
This entry violates the economic entity assumption and according to assumption ,in the accounting indicates that economic activity should be identified with a particular unit of accountability.
In present situation, this company make error by charging this cost to the wrong entity.
(b)
Merchandise Inventory 70,000
Revenue 70,000
Discussion of appropriateness
According to historical cost principle, assets and liabilities should accounted for on the basis of cost. and revenue must be recognized when (1) realized or realizable and (2) earned. In present situation , earnings process has definitely not taken place.
(c)
Loss from Lawsuit 500,000
Liability for Lawsuit 500,000
Discussion of appropriateness
We could say that, company is conservative in its accounting for this particular transaction. According to the matching principles that expenses could be allocated to the appropriate periods involved. In this situation, It appears to be a high level of uncertainty that the company will have to pay. As per FASB Statement No. 5 says that a loss should be accrued only
(1) when it is probable that the company would lose the suit
(2) the amount of the loss can be reasonably estimated.
(d)
Depreciation Expense 16,000
Accumulated Depreciation 16,000
Discussion of appropriateness
Accountants does not considered the price-level adjust-ments in the accounting. So we could say that, it is misleading to deviate from the actual cost principle because opinion can take place.
We could also notice that, depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets should not be depreciated on decline in their fair market value
(e)
Retained Earnings 800,000
Goodwill 800,000
Discussion of appropriateness
Accounting methods are based on principal that , enterprise have a long life. It will be incorrect to considered the liquidation as Gonzals, Inc. has done in this particular situation. We could notice that only where liquidation appears and going concern inapplicable.
(f)
Equipment 200,000
Cash 155,000
Revenue 45,000
Discussion of appropriateness
The answer to this situation is the same as (b).
