Question

GROUPWORK (Accounting Principles and Assumptions—Comprehensive) Presented below are a number of business transactions that occurred during the current year for Gonzales, 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 Gonzales, Inc. used his expense account to purchase a new Suburban solely for personal use. The following journal entry was made.Miscellaneous Expense 29,000Cash 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.Inventory 70,000Sales 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 500,000Liability for lawsuit 500,000

(d) Because the general level of prices increased during the current year, Gonzales, 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 entryDepreciation Expense 16,000Accumulated Depreciation Equipment 16,000

(e) Gonzales, 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.

(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 2000Cash 155,000Sales Revenue 45,000

Short answer

All journal entry situation given in the question are incorrect in terms of generally accepted accounting principles.

Step-by-step solution

Generally Accepted Accounting Principles (GAAP)

The Generally Accepted Accounting Principles are the standards and guidelines for accounting and reporting of financial information. These are commonly followed principles that aim to ensure that the financial reporting is transparent, consistent, and comparable. They enhance the quality of the financial statements for their users.

Journal entry of miscellaneous expense

(a) As per GAAP, only those transactions that have economic substance or include an economic activity should be included in the books of accounts of the company. In the given transaction, the president bought a car for personal use. Such expenditure is not business expenditure.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.

Journal entry of inventory

(b) As per GAAP, the inventory must be recorded at lower of cost or net realizable value, whichever is lower. In this given case, the cost of the inventory is $620,000 and its net realizable value is $690,000. Thus, the inventory should be recorded at $620,000 which is lower.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.

Journal entry of loss from law suit

(c) As per GAAP, a contingent liability is only recorded when amount of the liability is ascertained, and the management is of the opinion that the liability will likely arise. Here, the amount of the contingent liability is ascertained, i.e., $500,000 but the company’s attorney is not of the opinion that they might lose the lawsuit. Therefore, the company should not record the liability, rather disclose it the notes to accounts of the financial statements.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.

Journal entry of depreciation expense

(d) As per GAAP, the depreciation expense is calculated on the historical cost or book value of the asset at which it is recorded. Any increase or decrease in the general price level does not affect the cost or book value of the asset. Therefore, the amount of depreciation shall also not change on account of any increase or decrease in the general price level.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.

Journal entry of Goodwill

(e) As per GAAP, the goodwill recorded in the books of a business entity arising from a purchase transaction is amortized over it’s an estimated useful life/economic life. Therefore, the company must not write-off all of the goodwill at once.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.

Journal entry of Equipment

(f) As per GAAP, any asset that is acquired/purchased by a business entity must be recorded at its cost. The cost of an asset comprises of its purchase price, custom duties, taxes, freight and transportation cost, and installation cost. The amount of discount availed on such purchase must be deducted from the total cost of the asset. Here, the purchase price of the asset is $155,000 and therefore, the cost of the asset shall be $155,000 only.

Hence, the journal entry is incorrect in terms of generally accepted accounting principles.