The accrual basis of accounting implicitly assumes that the firm will continue to operate well into the future such that the result of incomplete transactions will be completed or concluded. This assumption is called the “going-concern assumption.” Because of this assumption we can use the historical cost basis of valuing most of the accounts on the balance sheet. The opposite of the going-concern assumption is the notion that the firm is or will soon be bankrupt, and therefore no longer continues to operate.
Required:
a. How does the going-concern assumption relate to the valuation of property, plant, and equipment (PPE) on the balance sheet? Why is this assumption essential to the use of depreciation methods for PPE?
b. If the going-concern assumption is no longer valid, how should assets be valued?
c. A company purchased a machine for $10,000,000 on January 1, 2010. The machine has a 10-year estimated useful life and an estimated residual value of $1,000,000. The company uses the straight-line depreciation method. During 2012 the company experiences significant and unexpected financial difficulty such that it goes into bankruptcy on December 31, 2012. At this time, the machine has a resale value in an auction for $5,500,000. How much is depreciation expense for 2010 and 2011?
Should depreciation expense for 2012 be the same as for 2011? Why?
What should be the value of the machine on the balance sheet on December 31, 2012?
What should be the adjustment to the carrying value of the machine in 2012?
d. A company has prepaid rent of $100,000 on December 31, 2012. If the company is a going concern, how should this amount be valued? If the company were not a going concern, how should it value the prepaid rent?
e. How should inventory be valued if a company goes into bankruptcy? Can the company use first-in, first-out, or average cost?