7.1 Accounting principles (3)
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1.
A business uses the FIFO (First-In, First-Out) method for valuing its inventory in 2023. In 2024, the business decides to change to the weighted average cost method. Explain why it is important for a business to maintain consistency in its accounting methods from one year to the next.
Maintaining consistency in accounting methods is crucial for several reasons:
- Comparability: Consistent methods allow for meaningful comparisons of financial statements across different periods. This makes it easier to assess the business's performance trend over time. If the method changes, comparisons become unreliable.
- Accuracy: Consistency reduces the risk of errors arising from changes in accounting policies. A change in method could introduce new errors or mask existing ones.
- Credibility: Consistent application of accounting methods enhances the credibility of the financial statements. Stakeholders (investors, creditors, etc.) are more likely to trust financial information presented using a consistent approach.
- Regulatory Requirements: Accounting standards often require consistency unless a change is justified and properly disclosed.
In the example provided, changing from FIFO to weighted average in 2024 would make it difficult to compare the 2023 and 2024 inventory valuations. The change would require careful explanation and justification in the financial statements.
2.
Question 3: Explain how a finance director might use materiality when deciding whether to correct an error in a company's financial statements. (4 marks)
A finance director uses materiality to weigh the cost and benefit of correcting an error. They consider the following:
- Cost of Correction: How much will it cost to correct the error? This includes time, resources, and potential legal costs.
- Impact on Financial Statements: How much will the error affect the financial statements? Is it material to users of the statements?
- Users of the Financial Statements: Who are the users of the financial statements (e.g., investors, creditors, regulators)? What information do they need?
- Regulatory Requirements: Are there any legal or regulatory requirements that dictate how errors must be treated?
If the error is immaterial, the finance director may choose not to correct it, as the cost of correction outweighs the benefit. However, if the error is material, the finance director must ensure it is corrected in accordance with accounting standards (e.g., FRS 102) and any relevant regulations. This might involve adjusting the financial statements or providing additional disclosure in the notes to the accounts.
3.
Question 2: Describe how matching is applied in the context of depreciation. Explain why it's important to match depreciation expense with the revenue generated by the asset over its useful life.
In the context of depreciation, matching is applied by spreading the cost of a long-term asset (like machinery or a vehicle) over its useful life. Depreciation expense is recognized in each period the asset is used to generate revenue.
It's important to match depreciation expense with the revenue generated by the asset because the asset is used to help generate that revenue. This provides a more realistic representation of profitability. If the entire cost of the asset was expensed in the year it was purchased, it would significantly reduce reported profits in that year, even though the asset is contributing to revenue generation over multiple years. Matching ensures that the expense is recognized when the benefit is received.