Question

1. As a business owner, I fail to see why an adjusting entry for insurance is necessary. Why can I not just expense the entire amount when paid and forget about the other months? Would this make a difference if it was a cash-based business rather than accrual?

2. The concept of materiality is one of the most basic principles underlying financial accounting. Why is the materiality of a transaction or an event a matter of professional judgment? What criteria should accountants consider in determining whether a transaction or an event is material? Does the concept of materiality mean that financial statements are not precise, down to the last dollar? Does this concept make financial statements less useful to most users?

Answer 1

1. I cannot say that adjusing entry is always requireed for insurance. For eample,if insurance is taken only for a period of 6 mnths i.e, for suppose from the month of april to septmber in a financial year, no need f any adjustment entry to insurance, as the whole expense pertains to the same financial year. Hece, the gist of the matter is only when the Insurance paid covers two or more number of financial years, adjustment entries need to be passed. This is because the benefit from the amount paid spreads through out the period and it is unfair to write it off in the single year as it leads to over booking of expense in that financial year and less booking of expense in the subsequent years, as per the principal of accrual.

Yes, it makes a diference if it is the cash based businees , since cash based system gives more importance to cash inflows and outflows. even ifthe benefit is spreaded to next financial years, the cash is going out in the current year. hence in cash based system, the entire amount paid for insurance is expensed off. But it is against the principal o accrua and doesnot show the true picture of the business. Hence not suggestable.

2. Materiality refers to the misstatement or ommission of any information which influences the decissions of users of financials statements. Materiality is a subjective concept which changes from circumstance to circumstance. For Example, Embezzelement of cash of 1 lakh rupees in a company having turnover of even 10 crores become material because the nature of event is such kind that it brings a question of internal controls of the entity and thereby influences the decissions taken by the users of financial statements. Proessional judgement comes into picture to decide whether that particular event or transaction effects the decisisons taken by the users of financial statements. Even though it is a professional judgement, some guidelines are given by the auditing standards how to decide on materiality or how to implement professional judgement. Even though guide lines are given, since all the cases are not predictable, profesional judgement plays an important role.

The criteria for deciding on materiality can be described as follows:

1. Whether the trnsaction or event has its effect on ovreall financial statement level or a account balance level.

2. Whether the event or transaction or information is qualitative or quantitative in nature.

3.Whether the misstatements individually not material but aggregatively material.

The concept of materiality doesnot mean that financial statements are correct down to last dollar, but it ensures that there are no material misstatments in the financial statements. Even after application of materiality on financial statements, there is a chance that misstatements might exist but their effect would be minimal on the decissions taken by users of financial statements.