Question

Question 3

A company buys new computer equipment for 10 000 pounds. At the same time it buys 3 pens for 40 pence each. Define the following accounting conventions and explain how they would affect the recording of these transactions?

1. Historic cost convention

2. Materiality convention

There are 10 marks available for this question: 2 for each definition and 3 for each explanation

Answer 1

a) Historical cost Convention :-

Historical cost refers to the cost at the time of aquisition. Since accounting is basically the recording of past happenings, accountants use the acquisition price as the most objective measurement in as much as the evidence of a transaction supports it. It is fundamental concept of accounting ,which is based on a historical record of the transactions, i.e., an asset will ordinarily be recorded at its cost and this cost will be the basis for all subsequent accounting for the assets. if a plot of land is purchased , say for rs. 10000 pounds. I will appear in the books at that figure without considering the market value of the asset at any other point of time. It follows , from this concept that if nothing is paid for acquiring an assets , it will not be recorded at all. This concept is modified in practice by applying the concept of conservatism (valuing closing stock at cost or market value whichever is less).When the real worth of an assets changes with the passage of time , for various reasons, accounting records are changed to reflect changes in market value by revaluation of assets.

b) Materiality convention:-

The concept of Materiality isthe threshold for recognition of a transaction in accounting process. Since materiality is primarily related to relevence, this concept deals with the relative importance of economic data. Thus accountant do not record those transactions, which are insignificant. Again as no benefit is gained from excessive precision , accounting statements are not made complicated by including trivial matters - only a reasonable approximation is considered acceptable.

for example,

a brand new pencil is an asset of the business unit. Anyone the pencil is used, a part of the asset is used-up. Although the pencil is still in use at the year end,its original cost is so insignificant that it would be a waste of time to value that and reflect its value in balance sheet. Instead, the entire cost is charged to revenue in the period it was purchased.

• in Historic cost convention the affect of the recording of these transactions:-

the cost of computer equipment 10000 pounds and whatever the market value is present here, at the time of preparing final accounts the computer equipment value is recorded only for 10000 pounds. Thus the balance sheet does not indicate the price at which the computer equipment could be sold for.

• in Materiality convention the affect of the recording of these transactions:-

A company buys new computer equipment for 10 000 pounds. Anytime the computer equipment is used, a part of the asset is used-up. Although the computer equipment is still in use at the year end,its original cost is so insignificant that it would be a waste of time to value that and reflect its value in balance sheet. Instead, the entire cost is charged to revenue in the period it was purchased of computer equipment.