Question

Red Squirrel Ltd. provides audited financial statements to its creditors and is required to maintain certain covenants based on its debt to equity ratio and return on assets. In addition, management at Red Squirrel Ltd. receive a bonus partially based on revenues for the year. Additional information related to Red Squirrel Ltd. is shown below: 1. Depreciation expense on the building for the year was $45,000. Since the building was increasing in value during the year, the controller decided not to record any depreciation expense in the current year. 2. An order for $61,500 was received from a customer on December 29, 2020 for products on hand. This order was shipped f.o.b. shipping point on January 3rd, 2021. The company made the following entry in December (prior to yearend of 2020): Accounts Receivable 61,500 Sales Revenue 61,500 Please comment on the appropriateness of Red Squirrel’s accounting procedures and their impact on the company’s financial statement users for both scenarios, applying the conceptual framework.

Answer 1

1. Depreciation is an expense which is charged for the continuous and gradual fall in the life of an asset. An asset is acquired to be used in business and hence it is subject to wear and tear as time passes. The asset cost is charged to income statement based on life of asset or any other appropriate method of depreciation which resembles its usage in business for example: units of activity method. Depreciation is an expense in the period and it is in accordance with the matching principle since it helps in generation of revenue through assets deployed in the business. As per matching principle all expenses incurred in generation of revenue should be charged to the income statement.

Accordingly increase in market value does not mean depreciation expense need not be recorded since it will violate the accounting principle. Charging depreciation gives the true and fair view of the financial statements of the firm. The net income of the firm will be overstated for the year if depreciation expense is not recorded on buildings.

2. As per Revenue recognition concept revenue should be recognised in books of account based on when the goods are delivered or when service obligation is performed. In case of FOB shipping the goods belong to the buyer only when it is available for FOB shipping that is January 3^rd. Receipt of order does not amount to delivery of order and revenue should not be recognised since there is no delivery of goods. The revenues are overstated due to improper recording of sales for the year ended December 2020.