The Prudence Theory: The Conservatism Concept

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Register to read the introduction… For example: * That accounts recognise expected future losses immediately, subject to the test that this results in reporting a more reliable figure for profit. * That whenever there are alternative procedures or values, the accountant will choose the one that results in a lower profit, a lower asset value and a higher liability value.
For example, if a firm knows that some stock with a cost of £4,000 is worth £3,000 due to obsolescence or damage, it should charge £1,000 to the income statement immediately rather than wait until the sale to recognise this loss. On the other hand, if a firm is involved in a legal litigation, which it is expected to succumb after the year end, an item called provision must be reported in the balance sheet among the liabilities, to indicate that a liability will most likely arise in the future. However, the value of the provision will not reflect the worst case scenario, but the most likely one; because the principle of reliability prevails on that of
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Interest income, other income, etc. * You should never compare ratios across industries. * Why? * Because not only do industries differ in operations, they have different revenue recognition policies! * Ratios are only comparable when the underlying accounting policies are comparable. * Mostly not in such blatant form, because auditors tend to only allow common industry practices in accounting policy. * But it can happen. Then the “revenue recognition policy” must be clearly explained in the footnotes. Auditors can be ok under full disclosure. * Then, the footnotes will be crucial in understanding the ratio analysis. Ask: * Why is this company doing this? Is this standard with others in the industry? * What effect does this have on the main statements and the ratios?

Cash Flow Statement:
Cashflow (from Prepaid Expense) = Expense + Ending Balance – Beginning Balance
Or Cashflow = Expense + Change in Balance
Cashflow (from Postpaid Expense) = Expense + Beginning Balance – Ending Balance
Or Cashflow = Expense – Change in Balance
Things that do not wear out are not depreciated. Notably

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