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Application of Auditing Assumptions and Principles

You have several new hires beginning work on Monday at Auditing Accountants of Alabama. Not everyone will have an accounting background; therefore, you have been asked to prepare a presentation to provide an overview of the concepts underlying accounting and financial reporting along with the four basic assumptions and four basic principles. In your presentation, identify the assumptions and principles and briefly define them in your own words.


Your auditing firm, Auditing Accountants of Alabama (AAA), has been hired to audit the books of BC Corporation. Prior to the start of the audit you ascertain the following from discussions with management:

Sally, the president, and Ed, the vice president, both have a small side business, One-Hundred-Percent Vitamin Co. As a convenience, they have been paying the bills and depositing the cash receipts from both business ventures into BC's accounts. No theft was intended as they reimbursed BC for any expenses. This method was just more convenient.
One of BC's divisions, Lackluster Sponge Company, may be going out of business next month. Bookkeeping has not been done over the past year.

Another BC division, Canadian Ice Company, has been consolidated into BC's financial statements in Canadian dollars.
BC's nonprofit division, My Second-Handed Clothes Rack, is another small endeavor. Accounting for this company has only been done every 5 years, and these results have been included in this year's BC books.

BC has performed positively over the last year. Management has taken the excess cash and invested it by purchasing common stock in a company listed on the New York Stock Exchange on a monthly basis. To date, the stock has risen by 30%. To account for each purchase, an entry debiting investment and crediting retained earnings is made on BC company books.

Another division of BC, Outer Space Satellite Company, has a 3-year contract to build a satellite. When BC was awarded the contract, they recorded the full amount of the contract in sales and accounts receivable although the satellite will not be delivered until 2007.

Two months ago, one of BC's warehouses was destroyed by fire. The warehouse was covered by insurance, so Sally does not want to disclose the fire in the company's financial statements.

Solution Preview

First, let's review the four basic assumptions and four basic principles and then define them by application to issues with our current audit client.

The four basic assumptions include the economic entity, 'going concern', the monetary unit, and periodicity.

The four basic principles include the use of historical cost, revenue recognition, matching and full disclosure.

Members of the audit team will have to resolve issues with BC Corporation as they apply to the very basic accounting assumptions and principles as follows:

1. Running transactions through BC for another entity violates the entity assumption. BC is a corporation separate from the owners, and any of their other business or personal transactions. The owners must be advised to discontinue that practice, and the audit team will have to search out all such transactions to determine that no effects not included in either revenue or expense of BC. All the items should be treated as shareholder amounts on the balance sheet.

2. Regardless of the appearance of a jumbled set of records with many divisions, investments, and subsidiaries, the ...

Solution Summary

The 734 word solution lists the four basic accounting assumptions and the four basic accounting principles, then applies them to the problem. Each issue in the problem is explained as it relates to an audit issue, and which of the assumptions and/or principles apply to the situation.