The concept of prudence, correction of errors Flashcards
what does prudence mean?
“The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated.”
acting cautiously
what does prudence do?
Financial reporting involves judgements and estimates and management may tend to be optimistic so, prudence acts as a balance.
what does prudence involve?
prudence would involve recording the minimum possible profit/cash flows and asset values and maximum liabilities (the worst-case scenario)
Prudence concept: Advantages
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.
What happens if an asset suddenly loses value?
E.g. through damage or becoming obsolete.
IAS 16 Property, plant and equipment
Recognise an impairment
When to test for impairment
At each year’s end
External indicators that there is impairment are..
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.
Internal indicators that there is impairment are…
Physical damage or obsolescence.
Significant changes in the business affect how the asset is to be used.
Poor economic performance.
what do do once finding if theres an Impairment ?
need to calculate impairment loss
how to find recoverable amount
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
what is value in use? (NPV)
it is the present value of future cash flows expected to be derived from an asset
- first estimate future cash inflows and outflows from point to the end of assets life
- then select an estimated discount rate
what is fair value less costs to sell?
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
how to calculate impairment loss
- find recoverable amount
2.compare net book value and recoverable amount and take which ones lower which shows revised net book value
- impairment = net book value - revised net book value
recorded as expenses
what happened to prudence in 2010 and 2018
it was removed from ifrs in 2010 as it conflicted with neutrality but got reintroduced in 2018
The Conceptual Framework for Financial Reporting, para 6.7:
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..’
Net realizable value (NRV)
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.
NRV Calculation
Net realizable value (NRV) = Selling price - Costs to complete - Costs to sell
what could cause a loss if value of inventory
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
what happens if Book Value of inventory ˃ Net Realisable Value
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
What happens if Book Value of inventory ≤ Net Realisable Value
Book Value of inventory are left unchanged
When do you apply NRV in stock take?
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.
Stock Take
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.
Inventory Valuation under NRV
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.
Scenario: NRV is Lower than Cost how to account for this
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)
- 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.
