The concept of prudence, correction of errors

Question 1

what does prudence mean?

Answer 1

“The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated.”

acting cautiously

Question 2

what does prudence do?

Answer 2

Financial reporting involves judgements and estimates and management may tend to be optimistic so, prudence acts as a balance.

Question 3

what does prudence involve?

Answer 3

prudence would involve recording the minimum possible profit/cash flows and asset values and maximum liabilities (the worst-case scenario)

Question 4

Prudence concept: Advantages

Answer 4

Helps in the minimisation of losses;

Ensures that the financial statement presents a realistic and fair picture of a company’s revenue and liabilities

Makes the company of financial information possible

Helps in not overestimating as well as not underestimating the financial risk of a company.

Question 5

What happens if an asset suddenly loses value?
E.g. through damage or becoming obsolete.

Answer 5

IAS 16 Property, plant and equipment
Recognise an impairment

Question 6

When to test for impairment

Answer 6

At each year’s end

Question 7

External indicators that there is impairment are..

Answer 7

Observable indications eg market prices.

Significant changes with an adverse effect on the technological, market, economic or legal environment.

Increase in the discount rate – affects value in use.

Net assets of the entity exceed market capitalisation.

Question 8

Internal indicators that there is impairment are…

Answer 8

Physical damage or obsolescence.

Significant changes in the business affect how the asset is to be used.

Poor economic performance.

Question 9

what do do once finding if theres an Impairment ?

Answer 9

need to calculate impairment loss

Question 10

how to find recoverable amount

Answer 10

what ever is higher between
fair value less costs to sell
and
value in use

if these are higher than the book value of an asset then theres no impairment

Question 11

what is value in use? (NPV)

Answer 11

it is the present value of future cash flows expected to be derived from an asset

1. first estimate future cash inflows and outflows from point to the end of assets life
2. then select an estimated discount rate

Question 12

what is fair value less costs to sell?

Answer 12

The price at which a knowledgeable buyer would sell the asset, minus the costs to sell it. This is an objective value based on market price

Question 13

how to calculate impairment loss

Answer 13

1. find recoverable amount

2.compare net book value and recoverable amount and take which ones lower which shows revised net book value

3. impairment = net book value - revised net book value

recorded as expenses

Question 14

what happened to prudence in 2010 and 2018

Answer 14

it was removed from ifrs in 2010 as it conflicted with neutrality but got reintroduced in 2018

Question 15

The Conceptual Framework for Financial Reporting, para 6.7:

Answer 15

The historical cost of an asset is updated over time to depict, if applicable:
the consumption of part or all of the economic resource that constitutes the asset (depreciation or amortisation);
payments received that extinguish part or all of the asset;
the effect of events that cause part or all of the historical cost of the asset to be no longer recoverable (impairment); and
accrual of interest to reflect any financing component of the asset..’

Question 16

Net realizable value (NRV)

Answer 16

NRV is the estimated selling price of an item in the ordinary course of business, minus any costs necessary to complete and sell the item (such as shipping or repair costs). In simpler terms, it’s the amount a company expects to receive from selling inventory after accounting for any costs involved in making the sale.

Question 17

NRV Calculation

Answer 17

Net realizable value (NRV) = Selling price - Costs to complete - Costs to sell

Question 18

what could cause a loss if value of inventory

Answer 18

Becoming obsolete, out of date or damaged beyond repair: NRV = 0

End of line, close to best before date, damaged but still saleable: NRV = discounted selling price

Requiring remedial work and/or completion before it can be sold: NRV = selling price less costs to complete and/ or repair

Question 19

what happens if Book Value of inventory ˃ Net Realisable Value

Answer 19

1)Book Value of inventory should be reduced to the Net Realisable Value;

2) Inventory loss will be taken as a higher cost-of-sales

Question 20

What happens if Book Value of inventory ≤ Net Realisable Value

Answer 20

Book Value of inventory are left unchanged

Question 21

When do you apply NRV in stock take?

Answer 21

During a stock take, the value of inventory on hand may be affected by conditions such as obsolescence, damage, or a decline in market value. The principle of NRV ensures that inventory is not overstated in the financial statements.

Question 22

Stock Take

Answer 22

A stock take is the process of physically counting inventory to verify the quantities and condition of items held by a business. This is typically done periodically, such as at year-end or quarterly, to ensure that the financial records match the actual stock on hand.

Question 23

Inventory Valuation under NRV

Answer 23

According to accounting standards (e.g., IFRS, GAAP), inventory should be reported at the lower of cost or NRV. This means if the cost of the inventory is higher than its NRV, the inventory should be written down to its NRV.

For example:

If a company bought an item for $100, but due to market conditions, the item can only be sold for $70, the inventory would be written down to $70, reflecting the lower NRV.

Question 24

Scenario: NRV is Lower than Cost how to account for this

Answer 24

Accounting Treatment:
1. Initial Purchase (Inventory Purchase) (same as before)

The company still purchases the laptops for $800 each.
Journal Entry (at the time of purchase):

Dr. Inventory 80,000 (100 units * $800 each)
Cr. Accounts Payable 80,000 (liability for the purchase)

2. Write-down to NRV (Inventory Adjustment)

Since the NRV is now lower than the cost, the company must adjust the inventory value to $600 per unit. This means the inventory must be written down by $200 per unit ($800 cost - $600 NRV).

For 100 units, the total write-down is $20,000 ($200 per unit * 100 units).

Journal Entry (to adjust inventory to NRV):

Dr. Loss on Inventory Write-Down 20,000
Cr. Inventory 20,000

Dr. Loss on Inventory Write-Down: This is an expense account that reflects the loss due to the decline in inventory value. It’s reported on the income statement.

Cr. Inventory: This reduces the value of the inventory asset on the balance sheet.

Question 25

What is Book Value of an Asset?

Answer 25

This refers to the value of an individual asset after deducting accumulated depreciation, amortization, or impairment. For tangible assets like machinery or buildings, the book value is calculated by:

BookValue = OriginalCost − AccumulatedDepreciation(orAmortization)

Example: A company buys a piece of equipment for $50,000. Over the course of 5 years, the equipment depreciates by $10,000 per year. After 3 years, the accumulated depreciation would be $30,000. The book value of the asset at the end of Year 3 would be:

BookValue = 50,000 − 30,000 = 20,000

BookValue=50,000−30,000=20,000

This means that, based on the company’s records, the asset is worth $20,000.