1Describe the four components of an accounting policy Illustrate your answer

1describe the four components of an accounting policy

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CQ2.1Describe the four components of an accounting policy. Illustrate your answer with examples . Accounting policies involve the following four components: Definition – does the transaction or event give rise to an item that meets the definition of one of the elements of financial statements? e.g., whether expenditure on building improvements gives rise to an asset. Recognition – when does the item satisfy the recognition criteria? e.g., recognising cost of goods sold as an expense when goods are delivered to the customer. Measurement – how should it be measured on initial recognition and, in the case of an asset or a liability, how should it be measured subsequent to initial recognition? e.g., whether to measure property, plant and equipment at cost or fair value, and how to measure depreciation. Disclosure – how should information be presented and disclosed? e.g., how much detail should be included about the calculation of depreciation, should an item be presented in the financial statement or in the notes? CQ2.2 Differentiate normative accounting theory from positive accounting theory. Provide an example of each. A normative theory prescribes what should be done based on a specific goal or objective. The outcome of a normative theory is derived from logical development based upon a stated objective; e.g., the Conceptual Framework prescribes principles, such as recognition criteria for elements of financial statements, based upon an explicit objective of financial reporting. In contrast, the role of a positive theory is to describe, explain or predict. For example, agency theory is a positive theory because it is used to explain why managers prefer accounting policies that increase profit in certain situations, such as when there is a bonus plan linked to accounting profit.
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CQ 2.4 What is an agency relationship? Explain how monitoring costs, bonding costs and residual loss arise in agency relationships. An agency relationship occurs when one party, who is referred to as the principal, employs another party, the agent, to undertake some activity on their behalf. Costs incurred by the principal to observe, evaluate and control the agent’s behaviour are referred to as monitoring costs. Examples of monitoring activities incurred by shareholders to monitor management include having the financial statements audited. Bonding costs are those costs incurred by the agents to provide assurance to the principal that they are acting in the principal’s best interests. The time and effort expended in producing and providing quarterly accounting reports to lenders is an example of bonding costs. Residual loss is the reduction in value of the firm that results from the separation of ownership of control, when the marginal cost of additional monitoring or bonding exceeds the expected benefit.
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