Assumptions of

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Chapter 1
Illustrated Solution Exercise 1-22
Assumptions of Financial Reporting
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Background Information

• In each of the following independent situations,
  an example is given involving the five
  traditional assumptions of the accounting model.
  
• For each situation, identify the assumption
  involved.

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Part 1

• Situation
• A subsidiary of Parent Inc. was exhibiting poor
  earnings performance for the year. In an effort
  to increase the subsidiarys reported earnings,
  Parent Inc. purchased products from the
  subsidiary at twice the normal markup.

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Part 1

• Situation
• A subsidiary of Parent Inc. was exhibiting poor
  earnings performance for the year. In an effort
  to increase the subsidiarys reported earnings,
  Parent Inc. purchased products from the
  subsidiary at twice the normal markup.

Solution Arms-Length Assumption By selling
inventory to the parent company at a price other
than the market price, the transaction between
the parent and its subsidiary violated the
arms-length assumption.
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Part 2

• Situation
• When preparing the financial statements for
  MacNeil Sons, the accountant included certain
  personal assets of MacNeil and his sons.

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Part 2

• Situation
• When preparing the financial statements for
  MacNeil Sons, the accountant included certain
  personal assets of MacNeil and his sons.

Solution Specific Economic Entity The assets of
owners of a company are not to be included when
disclosing the assets of the company itself.
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Part 3

• Situation
• The operations of Uintah Savings Loan are being
  evaluated by the federal government. During
  their investigations, government officials have
  determined that numerous loans made by top
  management were unwise and have seriously
  endangered the future existence of the savings
  and loan.

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Part 3

• Situation
• The operations of Uintah Savings Loan are being
  evaluated by the federal government. During
  their investigations, government officials have
  determined that numerous loans made by top
  management were unwise and have seriously
  endangered the future existence of the savings
  and loan.

Solution Going Concern An assumption made when
preparing financial statements is that the
company will continue into the foreseeable
future. In this example, the continued existence
of the savings and loan is in doubt.
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Part 4

• Situation
• Pine Valley Ski Resort has experienced a drastic
  reduction in revenues because of light snowfall
  for the year. Rather than produce financial
  statements at the end of the fiscal year, as is
  traditionally done, management has elected to
  wait until next year and present results for a
  two-year period.

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Part 4

• Situation
• Pine Valley Ski Resort has experienced a drastic
  reduction in revenues because of light snowfall
  for the year. Rather than produce financial
  statements at the end of the fiscal year, as is
  traditionally done, management has elected to
  wait until next year and present results for a
  two-year period.

Solution Specific Accounting Periods To enhance
comparability and consistency as well as to
provide periodic financial statement information,
the economic life of a company is partitioned
into specific accounting periods. By producing
financial statements at two-year intervals,
instead of annually, this assumption is violated.
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Part 5

• Situation
• Colobri Inc. has equipment that was purchased in
  1996 at a cost of 150,000. Because of
  inflation, that same equipment, if purchased
  today, would cost 225,000. Management would
  like to report the asset on the balance sheet at
  its current value.

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Part 5

• Situation
• Colobri Inc. has equipment that was purchased in
  1996 at a cost of 150,000. Because of
  inflation, that same equipment, if purchased
  today, would cost 225,000. Management would
  like to report the asset on the balance sheet at
  its current value.

Solution Stable Monetary Units Financial
statements assume that the value of the dollar
remains the same over time. That is, a dollar can
buy just as much today as it can in one year.
This assumption ignores the effects of inflation.
It is, however, consistent with the historical
cost measurement attribute.
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End of Problem