Question

Lynne Jamison was recording the daily transactions of Liberty Physical Therapy, Inc., into the accounting records so she could prepare financial statements and apply for a bank loan. Some of the business expenses were higher than she expected, and Lynne was worried about the effect of these expenses on net income. Lynne was recording a $3,800 payment for legal fees incurred by the business by debiting Legal Expense and crediting Cash to properly record the journal entry. She then thought that, rather than debiting the expense account for the $3,800 payment, she could debit the Dividends account, which also had a normal debit balance. Lynne knew that debits had to equal credits, so debiting the Dividends account instead of the Le- gal Expense account would not affect the trial balance. Further, the net income would be $3,800 higher because now no legal expense would be recorded. She thought that either way the retained earnings would be lower, and besides, it really didn’t matter how the $3,800 payment was shown as long as she showed it somewhere.

Questions:

• Should Lynne debit the Dividends account rather than the Legal Expense account?
• Do you agree with her that it really doesn’t matter how the $3,800 payment is shown, as long as it is shown somewhere?
• Considering that Lynne owns all of the Liberty Physical Therapy, Inc., com- mon stock, does she have any ethical responsibilities to properly record each business transaction?

Answer 1

1. No Lyne should not debit the Dividend account instead of the Legal expenses. When the dividend is declared , The  dividend (Proposed Dividend Account ) will be credited  and Retained Earning will be debited . When the dividend is paid, the Dividend will be debited and Cash will be credited . Normally dividend will not be paid in advance and possibility of a debit balance is only exceptional.  

2. No , The legal expenses is a charge to the profit and dividend payment is an appropriation of the profit. The profitability of the company is analysed by using the Net income and if the legal expenses is debited to Dividend account , the profit is not correctly measured . It can not be judged as the accounting is correct if the Debit and credit sides of the Trial Balance are equal. The  transactions recorded in the financial statements must reflect their economic substance ie. economic reality of the particular transaction.

3.Even though    Lynne is the sole owner of the company, she have the ethical responsibility to properly record the business transaction. Lynne does have an ethical responsibility to accurately record the transactions as she is providing financial statements to the bank. Since the bank is relying on the accuracy of the financial statements, Bank is accepting the public deposits and so the public money is indirectly flowing in to the company if the bank grands loan to the company. Lynne has the ethical responsibility to record the business transactions as per the applicable accounting standards and present them in such a way that users can use the Financial statement to judge correctly  the profitability, Liquidity and solvency of the company.