On a Corporation's balance sheet, a large tract of company-owned land is reported at its original cost of $50,000. The owner of the company is upset, because he thinks the land's true value is ten times that amount. He fears the low-cost figure may hurt the company as it tries to raise additional capital in the future.
The owner understands that generally accepted accounting principles (GAAP) require land to be recorded at the amount paid to purchase the land. Therefore, he hatches a plan to sell the land to his wife for $50,000, and then, six months later, have her give it back to the company in exchange for $500,000 of company stock. In this way, the land will be reported on the balance sheet at the higher figure of $500,000.
Based on this information, answer the following:
Describes the owner's plan, in terms of the ten accounting concepts that have been presented earlier in chapter 1, of your Financial Accounting as a Second Language text. Which concepts apply to this scenario?
Should the owner proceed with the plan?
Why or why not?
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The owner's plan involves manipulating the accounting treatment of the company-owned land to inflate its reported value on the balance sheet. This plan is not in line with the generally accepted accounting principles (GAAP) and violates several accounting concepts, as follows:
1. Economic Entity Concept: The owner is treating the land and the company as separate entities, but in reality, they are the same, and transactions between them should not be used to manipulate values.
2. Historical Cost Concept: GAAP requires assets, including land, to be recorded at their original cost. The owner's plan seeks to ignore the historical cost and overstate the land's value.
3. Reliability Concept: The plan undermines the reliability of the financial statements by distorting the true value of the land.
4. Going Concern Concept: The plan does not reflect the assumption that the company will continue operating in the foreseeable future. It is a short-term manipulation to deceive potential investors.
5. Matching Concept: The plan does not align expenses (purchase of stock) with the revenues generated from the land.
6. Materiality Concept: The plan involves a significant distortion of the reported value of the land, which is material to the financial statements.
7. Consistency Concept: The plan violates consistency as it seeks to change the accounting treatment of the land solely to misrepresent its value.
8. Full Disclosure Concept: The owner's plan tries to hide the true value of the land from potential investors and other stakeholders.
9. Objectivity Concept: The plan lacks objectivity by intentionally misstating the value of the land.
10. Substance Over Form Concept: The plan prioritizes the form of the transaction (selling and repurchasing the land) rather than its true substance, which is to overstate the land's value.
The owner should not proceed with this plan. The plan is unethical, violates several accounting principles, and can lead to serious consequences. It can damage the company's reputation, lead to legal issues, and negatively impact the trust of investors and other stakeholders. It is essential to adhere to GAAP principles and ensure financial statements accurately represent the financial position and performance of the company.