A range of accounting concepts, principles and assumptions that guide the preparation of financial statements. Discuss the following situations related to a recently established small business that sells homewares, and justify which concept, principle or assumption has been breached. For any that you did not select, explain them and create an illustration to support your explanation. (a) The business purchases inventory from a range of suppliers. The most recent purchase cost $52,000 and was recorded in the balance sheet at its estimated retail value of $95,000. (b) The business owner purchased a laptop specifically for personal use but recorded the laptop in the business records. (c) The business has been operating for three years, but is yet to prepare financial statements. (d) The owner is not experienced in accounting and has recorded assets at their market value (representing what the assets might be sold for at short notice).
Question
A range of accounting concepts, principles and assumptions that guide the preparation of financial statements. Discuss the following situations related to a recently established small business that sells homewares, and justify which concept, principle or assumption has been breached. For any that you did not select, explain them and create an illustration to support your explanation. (a) The business purchases inventory from a range of suppliers. The most recent purchase cost 95,000.
(b) The business owner purchased a laptop specifically for personal use but recorded the laptop in the business records.
(c) The business has been operating for three years, but is yet to prepare financial statements.
(d) The owner is not experienced in accounting and has recorded assets at their market value (representing what the assets might be sold for at short notice).
Solution
(a) The situation breaches the Cost Principle. According to this principle, assets should be recorded at their original cost to the company, not at their current market value. In this case, the inventory should have been recorded at its purchase cost of 95,000.
For example, if a business purchases a machine for 10,000 in its financial statements, regardless of whether its market value increases or decreases in the future.
(b) This situation breaches the Business Entity Concept. According to this concept, the business and the owner are separate entities. Therefore, personal transactions of the owner should not be recorded in the business records. In this case, the purchase of the laptop for personal use should not have been recorded in the business records.
For instance, if the owner of a business buys a car for personal use, this transaction should not be recorded in the business's financial records as it is not a business transaction.
(c) This situation breaches the Periodicity Assumption. According to this assumption, the life of a business is divided into regular intervals of time for the purpose of issuing financial statements. In this case, the business should have prepared financial statements for each of the three years it has been operating.
For example, a business should prepare financial statements for each fiscal year to provide information about its financial position and performance.
(d) This situation breaches the Cost Principle again. As mentioned earlier, assets should be recorded at their original cost to the company, not at their current market value. In this case, the owner should have recorded the assets at their purchase cost, not their market value.
For instance, if a business purchases a building for 500,000 in its financial statements, regardless of whether its market value increases or decreases in the future.
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