Question

 The idea that inventory should be included in accounts at the lower of historical cost and net realisable value follows the prudence convention but not the consistency convention.'

Required:

(a) Do you agree with the quotation?

(b) Explain, with reasons, whether you think this idea (that inventory should be included in accounts at the lower of historical cost and net realisable value) is a useful one. Refer to at least two classes of user of financial accounting reports in your answer

Answer 1

(a) Yes agree with the quotation .

The quotation is based on Conservatism (Prudence) Convention.

Prudence Convention: It says that anticipated profit are not to be recorded in the books of accounts whereas anticipated losses are to be recorded even if there is remote chance of it . So by doing this, profit will be not be overstated.

Another example of Prudence Convention is Bad Debts Reserve or Provision for Doubtful Debts

Consistency Convention : It states that the method used for recording the books of accounts should be same over the period of the time. For example method used for depreciation should be same every year.

For example Firm can’t use the straight line method for one year and fro second year written down value method . If firm keeps changing the method of depreciation then the profit figure will not be accurate and comparison will be difficult.

Another example will be the method used for the valuation of stock i.e. LIFO, FIFO or Weighted Average Method.

(b) Yes the idea of writing the stock less than the historical cost and net realisable value is useful. As this is based on Prudence (Conservatism ) Convention , where profit are not overstated . Profit are shown at conservative manner by taking into consideration all anticipated future losses .

Users of financial accounting reports are divided into two categories i.e. internal users and external users

Two users of financial accounting report is Investor and Creditor.

Investor would be looking for the amount of investment made by them will be giving good return or not. They are looking for return on investment and safety of their investment.

Creditors are those who have given goods on credit to the firm and they are looking whether the firm has enough creditability or not in order to repay their dues.

Both of the classes of users would be able to take better decision by looking at the financial report of firm as report would be showing true and fair image of the organisation prepared based on conservatism convention.

Note:

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