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4 (a) The ASB’s Statement of Principles for Financial Reporting requires financial statements to be prepared on the
basis that they comply with certain accounting concepts, underlying assumptions and (qualitative)
characteristics. Five of these are:
Matching/accruals
Substance over form
Prudence
Comparability
Materiality
Required:
Briefly explain the meaning of each of the above principles/concepts. (5 marks)
(b) For most entities, applying the appropriate concepts/assumptions in accounting for stock is an important element
in preparing their financial statements.
Required:
Illustrate with examples how each of the principles/concepts in (a) may be applied to accounting for stock.
(10 marks)
(15 marks)

4 (a) The accruals basis requires transactions (or events) to be recognised when they occur (rather than on a cash flow basis).
Revenue is recognised when it is earned (rather than when it is received) and expenses are recognised when they are incurred
(i.e. when the entity has received the benefit from them), rather than when they are paid.
Recording the substance of transactions (and other events) requires them to be treated in accordance with economic reality
or their commercial intent rather than in accordance with the way they may be legally constructed. This is an important
element of faithful representation.
Prudence is used where there are elements of uncertainty surrounding transactions or events. Prudence requires the exercise
of a degree of caution when making judgements or estimates under conditions of uncertainty. Thus when estimating the
expected life of a newly acquired asset, if we have past experience of the use of similar assets and they had had lives of (say)
between five and eight years, it would be prudent to use an estimated life of five years for the new asset.
Comparability is fundamental to assessing the performance of an entity by using its financial statements. Assessing the
performance of an entity over time (trend analysis) requires that the financial statements used have been prepared on a
comparable (consistent) basis. Generally this can be interpreted as using consistent accounting policies (unless a change is
required to show a fairer presentation). A similar principle is relevant to comparing one entity with another; however it is more
difficult to achieve consistent accounting policies across entities.
Information is material if its omission or misstatement could influence (economic) decisions of users based on the reported
financial statements. Clearly an important aspect of materiality is the (monetary) size of a transaction, but in addition the
nature of the item can also determine that it is material. For example the monetary results of a new activity may be small,
but reporting them could be material to any assessment of what it may achieve in the future. Materiality is considered to be
a threshold quality, meaning that information should only be reported if it is considered material. Too much detailed (and
implicitly immaterial) reporting of (small) items may confuse or distract users.

(b) Accounting for stock, by adjusting purchases for opening and closing stocks is a classic example of the application of the
accruals principle whereby revenues earned are matched with costs incurred. Closing stock is by definition an example of
goods that have been purchased, but not yet consumed. In other words the entity has not yet had the ‘benefit’ (i.e. the sales
revenue they will generate) from the closing stock; therefore the cost of the closing stock should not be charged to the current
year’s profit and loss account.
Consignment stock is where goods are supplied (usually by a manufacturer) to a retailer under terms which mean the legal
title to the goods remains with the supplier until a specified event (say payment in three months time). Once the goods have
been transferred to the retailer, normally the risks and rewards relating to those goods then lie with the retailer. Where this is
the case then (in substance) the consignment stock meets the definition of an asset and the goods should appear as such
(stock) on the retailer’s balance sheet (along with the associated liability to pay for them) rather than on the balance sheet of
the manufacturer.
At the year end, the value of an entity’s closing stock is, by its nature, uncertain. In the next accounting period it may be sold
at a profit or a loss. Accounting standards require stock to be valued at the lower of cost and net realisable value. This is the
application of prudence. If the stock is expected to sell at a profit, the profit is deferred (by valuing stock at cost) until it is
actually sold. However, if the goods are expected to sell for a (net) loss, then that loss must be recognised immediately by
valuing the stock at its net realisable value.
There are many acceptable ways of valuing stock (e.g. average cost or FIFO). In order to meet the requirement of
comparability, an entity should decide on the most appropriate valuation method for its stock and then be consistent in the
use of that method. Any change in the method of valuing (or accounting for) stock would break the principle of comparability.
For most businesses stock is a material item. An error (omission or misstatement) in the value or treatment of stock has the
potential to affect decisions users may make in relation to financial statements. Therefore (correctly) accounting for stock is
a material event. Conversely there are occasions where, on the grounds of immateriality, certain ‘stocks’ are not (strictly)
accounted for correctly. For example, at the year end a company may have an unused supply of stationery. Technically this
is stock, but in most cases companies would charge this ‘stock’ of stationery to the profit and loss account of the year in which
it was purchased rather than show it as an asset.
Note: other suitable examples would be acceptable.

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