7.2 Accounting policies (3)
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1.
Question 3: Explain the importance of disclosure in ensuring the comparability of financial statements. Provide two examples of information that should be disclosed to enhance comparability.
Disclosure is vital for ensuring the comparability of financial statements because it provides users with the necessary context to understand the accounting policies and methods used by a company. Without adequate disclosure, users may not be able to accurately compare financial figures across different companies or over time. Disclosure helps to remove potential distortions caused by differing accounting choices.
Two examples of information that should be disclosed to enhance comparability are:
- Changes in accounting policies: Any changes in accounting policies (e.g., change in inventory valuation method, change in depreciation method) should be disclosed, along with the reason for the change and the impact on the financial statements. This allows users to adjust for the changes and make meaningful comparisons.
- Significant accounting estimates: Disclosures about significant accounting estimates (e.g., allowance for doubtful debts, provisions for warranties) are important. This includes explaining the assumptions made and the potential impact of these estimates on the financial statements. Consistent assumptions help improve comparability.
2.
Question 1: A business has the following transactions in January:
- Received £5,000 cash from a customer for services provided.
- Paid £1,200 for office supplies.
- Received £2,000 on credit from a customer.
- Paid £800 for advertising.
- Made a cash payment of £300 for bank charges.
Required: Prepare a simple accrual accounting entry for the advertising expense.
Answer:
An accrual accounting entry is required because the advertising expense was incurred in January but the cash payment wasn't made until later. The entry is as follows:
| Debit: Advertising Expense £800 | Credit: Cash £800 |
Explanation:
- Debit Advertising Expense: This increases the expense account, reflecting the cost of the advertising incurred.
- Credit Cash: This decreases the cash account, reflecting the cash payment made for advertising.
3.
Question 2: A company has recorded £5,000 as revenue in a particular accounting period. However, there is evidence that this revenue was not actually earned until the *following* accounting period. Explain the potential impact of this error on the reliability of the company's financial statements. What steps should the accountant take to correct this error?
This error significantly undermines the reliability of the company's financial statements. Recording revenue in the wrong accounting period misrepresents the company's profitability and financial position. Specifically, it overstates the company's profit for the period in which the revenue was incorrectly recorded and understates the profit for the subsequent period. This can lead to misleading conclusions by stakeholders.
To correct this error, the accountant should take the following steps:
- Adjust the financial statements: The revenue should be reclassified from the current period to the correct subsequent period. This will involve preparing an adjusted profit and loss account.
- Prepare a prior period adjustment: A prior period adjustment should be made to the balance sheet to reflect the correct level of retained earnings. This adjustment will increase retained earnings by the amount of the revenue that should have been recognized in the previous period.
- Disclose the error: The error should be disclosed in the notes to the financial statements, explaining the nature of the error and its impact on the financial statements. This ensures transparency and allows stakeholders to make informed decisions.