"Suppose you are working as an accountant and the president of your firm Mr. Ali has a little back ground of accounting. This morning, he approached you and said:
"Last year we purchased a piece of land for Rs. 200,000. During this, the inflation has driven prices up by 12 %, and an expert has also just told me that we can sell this land for Rs. 300,000 whereas our balance sheet still shows the land at Rs. 200,000. It should be valued at Rs. 300,000 or at least at Rs. 224,000 (after the effect of 12% inflation)".
Identify accounting principle(s) (GAAP) applicable to this situation which negates Mr. Ali's Claim. "
Solution:
Prudence principle: when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked
Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
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