Describe the accounting concepts and principles that were violated in the case. Explain the correct method of accounting treatment that should be used, including the underlying concept or rationale.
Accounting is the providence financial statements to others. The information presented is in numeric figures stating the assets or liabilities owed by a business. Economic activities of the business are being processed into reports and make known to decision makers showing the financial position of an organisation and its profitability of its operation.
In business, numerous daily transactions happens between companies to companies, the accounting information which transacts through everyday requires it to be identified, measured and records into the bookkeeping. This involves making judgement about the values of asset or liabilities incurred by a business.
In Singapore accounting, a set of accounting principles known as GAAP (Generally Accepted Accounting Principles) sets a professional guide for accountants to follow. The guidelines provided are meant to be followed as closely as possible to avoid misrepresentation to the users of this information.
With regards to the case study, the following principle and concepts which are violated under GAAP are as follows;
Accrual Accounting (Charles T.Horngren, 2005, Financial Acccounting In Singapore and Malaysia, Pg 99) - “Businesses are required to us accrual accounting which records revenue when they are earned and expenses as they are incurred without presence of cash transactions. All types of transactions, including receivables, payables and depreciation are recorded and provide more complete information.”
Matching Principle (Charles T.Horngren, 2005, Financial Acccounting In Singapore and Malaysia, Pg 102) - “a basis for recording expenses which requires an accountant to identify all the expenses incurred during the accounting period and to measure the expenses and match it against the revenue earned.”
Disclosure Principle (Charles T.Horngren, 2005, Financial Acccounting In Singapore and Malaysia, Pg 257) - “Holds that a company's financial statements should report enough information for outsiders to make informed decisions about the company, the report should contain relevant, reliable and comparable information about itself.”
The request of delaying the purchase of inventories from December 2010 to January 2010 will actually help to keep the Cost Of Goods Sold (COGS) from growing too large and help to produce a higher net profit shown on the financial statements. It is a manager's decision to control the inventory level so as to stay on business. High inventory level are unhealthy to any business because as it may implies that low sales and represents lower net profit, it exposes the company to risks should the prices of inventory to fall and resulting a cash drain on the business.
However, the overstating of inventories violates the matching principle as the expense incurred does not match to the revenue earned. In addition to that, there will be an inventory error on the income statement. The effects of overstating inventory will actually cause the COGS understated and profits overstated this year (period 1). A misstatement which left unchanged, affects not only the current period, but also the next accounting year(period 2) as the first accounting period's ending inventory becomes the period 2's beginning inventory. This causes the COGS to be overstated and profits understated. Eventually, due to the inventory accounting error, the error is self corrected after 2 periods. The effects of overstating inventories are as follows.
Overstated by $10,000
Beginning Inventory Overstated by $10,000
Counter Balance Occurred
Cost Of Goods Sold
COG available for sale
bold wording marks the cause & effects of overstating in period 1 and period 2.
One could argue that inventory errors can be ignored because they counterbalance, however, the picture of operations is inaccurate it set users' thinking that the company is performing well this year hence increasing the chances of banks, investors into financing Alice's operations.
Creditors, management and investors base many decisions on the Alice's determination on net income. As disclosure principle requires businesses to disclose reliable, relevant and comparable information about the company, it is an obligation to make the net income statement to be as accurate as possible.
Next, to ignore the following adjusting entries on the prepaid insurance from July 2009 to December 2009 with the purchase recorded. Without adjusting the entries, the prepaid expenses will be recorded as an asset and forgoes the fact that the insurance coverage will diminished with time as it is used as expense for its operation. By not recognising the expense, this transaction will give rise to a $20,000 asset on the December 31, 2009 balance sheet. Think about it, an increase in asset and expenses reduced, increasing income and equity but leaving the balance sheet unbalanced hence violating the matching principle which requires an accountant to identify an expense though payment is not made at point of time.
The correct treatment should be monthly deduction of $1667 from the balance sheet and transferred to expense to account for insurance coverage from period July 2009 to Dec 2009. This is to correctly assign the appropriate amount of expense to the time period in question and hence leaving the remainder in a balance sheet account to carry over to the next time period(s). The adjustment of these entries will have to be made whenever financial statements are in preparation so as to ensure that the asset and expenses are pro-rated and reported correctly as of 31st Dec 2009.
Lastly, the commissions owed to employees for December 2009 to be pay out in Jan 2010 and not to be recorded in the journal entry. By not adjusting this entry, this will cause the expenses and liabilities understated, income and equity overstated hence producing a higher net profit as she had disregard the sales commission owed to an employee based on the amount of a sale. However, she expensed off the cost of inventory delivered to a customer when the sale is recognized. Under the matching principle, many costs can be directly involved to the revenue which is produced. For example, a commis