chapter 2 accounting concepts and principles

7/28/2019 Chapter 2 Accounting Concepts and Principles

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CHAPTER 2

Accounting concepts andprinciples1 A conceptual framework of accounting 1.1 The meaning of accounting concepts

Accounting concepts (also called accounting principles or accounting conventions) are thebasic ideas underlying the preparation of financial statements. They may take the form ofstated principles or be generally accepted rules in accounting for transactions. These ruleshave evolved over time reflecting the needs of both users and preparers of financialstatements.

1.2 The IASC s wo rk It is clearly best if financial statements are drawn up in accordance with a set of concepts thatare logically consistent and universally agreed. Such a set of concepts is called a conceptualframework. In 1989 the IASC issued its Framework for the Preparation and Presentation ofFinancial Statements as its conceptual framework underpinning the issue of IASs. Thisdocument (known as the Framework) is not an IAS itself, so is not mandatory in its application,but it sets out best practice in the accounting concepts to be applied.

1.3 The need for an agreed conceptual framework

Many IASs deal with controversial areas of accounting, that can have a significant effect on theamount of profit or loss that a business reports, so IASs can be unpopular in their impact. Thehope is that, if we can all agree on the accounting concepts to be followed, then IASs can bedeveloped on the basis of these concepts and there will be far less criticism of the IASsthemselves.

2 Accounting conventions 2.1 Possible conventions

There are many accounting conventions that the IASC could have adopted. In the Frameworkthe IASC highlighted two as being of fundamental importance:

the accrual basisthe going concern assumption.

IAS 1 Presentation of Financial Statements identifies six conventions that financial statementsshould follow if they are to present fairly the results of the period:

going concernthe accrual basisconsistencymateriality and aggregationoffsettingcomparative information

There are other important conventions that you must also be able to describe:


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prudencebusiness entitymoney measurementdualityhistorical costrealisationtime interval

2.2 The going concern concept

The going concern concept assumes that a business will continue in operational existence forthe foreseeable future. Unless there is evidence to the contrary it is assumed that the businesswill go on more or less indefinitely (ie there are no plans to liquidate or reduce the size of thebusiness operation).

Certain circumstances may make the going concern assumption invalid. For example, sale ofpart of the business may be necessary owing to a lack of financing. If this is the case thefinancial statements should be prepared on a basis which takes this into account.

2.3 The accruals (or matching) concept

Revenues and costs are

matched

with one another in the period to which they relate. Revenues are included in the period in which the sale takes place rather than when cash isreceived. It is therefore appropriate to match the costs or expenses incurred in generating thisincome in the same period.

For example, cost of goods sold is included in the income statement in the same year that thesale of the goods generates income.

$

Sale made 28 December 20X8 5,000Money received from customer 1 February 20X9 5,000Cost of goods sold 3,300

For the year ended 31 December 20X8 the income statement extract would be as follows.

$

Sales revenue 5,000Cost of sales (3,300)

Although the cash is received the following year the actual sale took place in the year ended31 December 20X8 and is recognised in the income statement for that year. In accordancewith the accruals concept the cost of those goods must also be included in that year.

Although in the main the accruals concept is easy to apply there are circumstances whichcause problems, the most common being the purchase of non-current assets.

A non-current asset will incur a cost in one year, the year of purchase, but will generate incomeover many years. The solution is to spread the cost over the period the asset will generateincome, so matching income and expense.

The method used to achieve this is depreciation. This will be looked at in more detail in a laterchapter.

2.4 The consistency concept

There may be more than one accepted method of accounting for specific items. This meansthat different enterprises will treat similar items in different ways.


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The consistency concept states that a business should treat like items in a similar mannerwithin each accounting period and from one period to the next.

For example, depreciation must be calculated in a way which is appropriate to the way in whichthe non-current asset is used and how it generates income. This means that the same assetcould be depreciated differently by two different organisations.

The main consideration is that once a method of depreciation has been chosen for a particulartype of asset it must be consistently applied for all such assets throughout the period and fromone period to the next.

It is possible for a business to change its policy for depreciation but there would need to be agood reason for doing so (eg changing to a more appropriate method considering the usage ofthe asset and the way it generates income). However, the financial effect of changing thedepreciation policy would need to be quantified and, if material, reported to the shareholders.


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2.5 Materiality and aggregation

The purpose of preparing financial statements is to provide financial information to the users ofthe statements. In order to be useful, all material (ie significant in size) items should bepresented separately in the financial statements so that the users can appreciate them.Immaterial amounts should be aggregated with other amounts of a similar nature and need notbe presented separately.

2.6 Offsetting

Assets and liabilities should not be offset against each other in the balance sheet. Income andexpenses should not be offset against each other in the income statement. The gross itemsshould be presented as they offer the greater information to the users of the financialstatements.

For example, if a company borrows $100,000 to enable it to buy a building for $120,000, thebuilding should be shown in non-current assets and the loan in liabilities. It would not becorrect to omit the loan and include the building at its net amount of $20,000.

2.7 Comparative information

Comparative information should be disclosed in respect of the previous period for all numerical

information in the financial statements. This will be achieved in practice by having two columnsof figures, one for this year s numbers, and one for the previous year s, for comparisonpurposes. The user will be able to identify large differences between the figures and carry outfurther investigations if they wish.

2.8 The prudence concept

Revenues and profits are not recognised and reported until they are actually realised butprovision is made for losses and liabilities immediately even if the loss will not occur until thefuture.

For example, suppose that a sale of $1,000 is made to a credit customer on 1 December 20X8,who is given three months credit, so that he is due to pay his debt on 1 March 20X9. The salewill be recognised in the usual way in the income statement for the year ending 31 December20X8.

But if the debtor goes bankrupt on 15 December 20X8 so that he will now be unable to pay hisdebt at all, a bad debt will be recognised in 20X8, regardless of the fact that the money was notdue to be received until 20X9. (You will study the accounting for bad and doubtful debts indetail later in this text.)

2.9 Business entity

The information contained in the financial statements relates to the business entity alone. Thefinancial statements do not include transactions entered into by the proprietors in their personalcapacity.

The business is considered to be a completely separate entity from the proprietor. Thisdistinction is both for accounting purposes and legally for a company, whereas for a sole trader

the distinction is purely for accounting purposes (there is no legal distinction between a soletrader as an individual and the business he runs). Hence, the different terminology forcashflows between business and proprietors, sole traders and partnerships.


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Sole trader (or partnership)

Company

2.10 Money measurement

Only items which have a monetary value attributed to them will be recorded in the accounts.

Although all items have a value the problem comes in defining the monetary value. Valuation ofless tangible items (for example, scientific know-how) may be impossible.

2.11 Duality Every transaction has two effects.

This concept is applied throughout the double entry system. Every debit has an equal andopposite credit. You will study this in detail later.

2.12 Historical cost

This is dealt with in more detail below.

2.13 Realisation

Transactions are normally recorded when there is a legal requirement to accept liability forthem; that is, when the legal title is transferred.

This means that a transaction may be included in an earlier accounting period than the one inwhich cash is eventually exchanged. As we have already seen, it is normal to include a sale inthe accounting period when it is made, because at that point the customer is legally bound tocomplete the transaction. Actual completion when the customer pays us for the goods maynot occur until a later accounting period, but this is irrelevant.

2.14 Time interval

Accounts are prepared for a stated period of time. This is generally a calendar year butcircumstances may cause it to be for a period other than a year.

3 Accounting bases and accounting policies

3.1 Meaning of bases and policies Accounting bases are the various possible methods developed for applying the accountingconcepts to financial transactions and items, for the purpose of preparing financial accounts.

In order to decide in which periods revenue and expenditure will be brought into the incomestatement and the amounts at which items should be shown in the balance sheet, businessenterprises will select specific accounting bases most appropriate to their circumstances andadopt them.

The specific bases adopted by a particular business are referred to as the accounting policies of that business. These are the specific accounting bases judged by the business enterprise to

Entity

Drawings

Capital/loansSole trader

Entity

Dividends

Share issue proceedsShareholders


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be most appropriate to their circumstances and adopted by them for the purpose of preparingtheir financial accounts.

As an example, consider non-current assets and depreciation. Possible bases for depreciatinga machine might be in equal instalments over five years, in equal instalments over ten years, orin reducing instalments over ten years. The directors of the business must choose theaccounting basis that they believe is most appropriate, say to depreciate in equal instalmentsover ten years. This then becomes the accounting policy for machines of that type.

Since depreciation should be allocated so as to charge a fair proportion of the cost or valuationof the asset to each accounting period expected to benefit from its use, it is an example ofinvoking the accruals concept.

3.2 Disclosure of accounting policies

The accounting policies followed for dealing with items which are judged material or critical indetermining the profit or loss for the year and in stating the financial position should bedisclosed by way of notes to the accounts. The explanation should be clear, fair and as brief aspossible.

3.3 The conflict between accruals and prudence concepts

In certain cases, there may be a conflict between the accruals concept and the prudenceconcept. In other words, the prudence concepts suggests that a particular accounting treatmentshould be adopted in respect of some item in the financial statements, whereas the accrualsconcept suggests a different treatment.

The general rule in these cases is that the prudence concept should be followed. The prudenceconcept generally prevails over the accruals concept in cases where they conflict.

As an example, if the cost of inventory on hand at the end of the accounting period is $12,000,the accruals concept suggests that we carry the inventory as an asset in the balance sheet,valued at $12,000. However, if for some reason it is believed that the inventory will only sell for$8,000 (perhaps because it has deteriorated) then the prudence concept insists that this lowervalue is used in both the balance sheet and the income statement.

4 Qualitative characteristics of financial statements 4.1 Introduction

Qualitative characteristics are the attributes that make the information provided in financialstatements useful to users. The IASC Framework identifies four principal qualitativecharacteristics:

understandabilityrelevancereliabilitycomparability

4.2 Understandability

Information can only be useful if it is understandable by the users. Users can be assumed tohave a reasonable knowledge of business matters but cannot all be assumed to be experts.

4.3 Relevance

The overall message that the financial statements are trying to relay may be obscured if toomuch information is presented.


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4.7 True and fair presentation

An objective of the IASC in drawing up its Framework and IASs is to enable financialstatements to be prepared that present a true and fair view. In some jurisdictions, eg the UK, itis an overriding requirement by law that financial statements must present a true and fair view.The requirement in the US is similar, that financial statements must give a fair presentation inaccordance with GAAP.

Although the Framework does not explicitly require a true and fair view, the application of thequalitative characteristics listed above, together with compliance with IASs, should enablefinancial statements to give a true and fair view, or a fair presentation.

5 IAS 18: Revenue 5.1 Introduction

You have already seen that a business s revenue (normally the proceeds from selling goodsand services) is the first figure at the top of the income statement. IAS 18 explains theappropriate principles for deciding when revenue can be recognised in the income statement.

For example, if a sale is made on credit on 10 December 20X2, so that the money is not due tobe received until 10 January 20X3, should this sales revenue be recognised in an income

statement drawn up for the year ending 31 December 20X2? (If you remember the descriptionof the accruals concept given earlier in this chapter, you will already know that the answer tothis question is yes .)

5.2 Definition of revenue

Revenue is the gross inflow of economic benefits during the period arising in the course of theordinary trading activities of an enterprise.

For example, if goods are sold for $1,000 cash, then the revenue arising on the transaction is$1,000. If a business advisor sends out an invoice of $5,000 to charge for advice she hasgiven, then the revenue she should recognise is $5,000.

5.3 Recognition of revenue

Revenue should be recognised in the income statement when all of the following conditions aresatisfied:

(a) The seller has transferred to the buyer the risks and rewards of ownership of the goods.

(b) The seller no longer controls the goods.

(c) The amount of revenue can be measured reliably.

(d) It is probable that the seller will receive the economic benefits associated with thetransaction.

(e) Any costs incurred in the transaction can be measured reliably.

5.4 Commentary on IAS 18 IAS 18 is useful in laying down the circumstances when it is appropriate to recognise revenuein the income statement. As long as a genuine sale has taken place, and the seller expects toreceive the agreed proceeds of the sale, it is appropriate for the seller to recognise the revenuefrom the sale on the date of the sale.

6 Methods of valuing assets


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6.1 Historical cost convention

This is the generally accepted method of accounting for non-current assets where the originalcost is treated as the basis for their value in the balance sheet.

Advantages

Well understood due to the length of its use.

Certainty of the cost figure. The invoice amount is not open to any subjectivity.Simple and cheap to operate.

Disadvantages

Can bear very little relation to the actual current value of the asset.

Where prices are rising:

- depreciation charges are understated- profit is overstated.

Can distort performance ratios by understating capital employed, ie the amount of assetsless liabilities in the balance sheet.

6.2 Alternative methods As a result of the disadvantages of the historical cost convention, alternative methods havebeen developed.

Current cost

The cost of replacing an asset with a close as possible identical asset, ie same condition, ageand capacity.

Market value

The amount at which the asset could be sold on the open market.

Economic value (also called present value, or value in use)

The value of an asset s future earnings or the extra income the business will receive as a resultof owning the asset.

7 Accounting for the effects of changing prices 7.1 Introduction

The traditional method of accounting is historical cost accounting, where assets are stated inthe balance sheet at their historical costs, less amounts written off (for depreciation,impairment, or to bring damaged inventories down to their net realisable value).

Some businesses use the modified historical cost convention, where selected non-currentassets (usually properties) are revalued to market value, but traditional historical cost accountsare still the most common basis for preparing financial statements.

You must be aware of the weaknesses of historical cost accounting in a time of changing pricelevels.

7.2 Disadvantages of historical cost accounting

Accounts prepared using historical cost (HC) principles have serious weaknesses in times ofinflation or other price changes.


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CPP adjusts the HC accounts for the effects of general changes in prices, ie it is a method ofinflation accounting. All amounts are shown in CPP financial statements based on currencyunits at the year end.

7.6 Example

AB Ltd bought a machine for $2,000 on 1 January 20X1. It is expected to have a ten year life

and a nil scrap value at the end of that life. General inflation (as measured by the Retail PricesIndex) was 5% during 20X1. How would this machine be shown in a CPP balance sheet as at31 December 20X1?

7.7 Solution

In a HC balance sheet the machine would be shown at:

$

Cost 2,000Less: Accumulated depreciation (10%) (200)

_____ Net book value 1,800

_____ In a CPP balance sheet the machine would be shown at:

$Cost (2,000 1.05) 2,100Less: Accum depn (10%) (210)


_____

7.8 Current cost accounting (CCA)

CCA adjusts the HC accounts for the effects of specific changes in prices. Each asset must berevalued to its current value at the balance sheet date.

7.9 Example

Consider again AB Ltd, which bought a machine for $2,000 on 1 January 20X1. The machinehas a ten year life and a nil residual value. The specific index for the cost of this type ofmachine rose 4% during 20X1. How would this machine be shown in a CCA balance sheet asat 31 December 20X1?

7.10 Solution

In a CCA balance sheet the machine would be shown at:

$Cost (2,000 1.04) 2,080Less: Accumulated depreciation (10%) (208)


_____

7.11 Commentary on CPP and CCA

CPP is simple to apply, since it uses the same index (the RPI) to restate all items to year-endvalues. However the values at which assets are stated are not particularly useful, since theyare not the current values of the assets.

CCA has the advantage that assets are shown in the balance sheet at their current values,which is useful information to the users of the financial statements. However CCA is time-consuming and subjective, since each asset must be revalued at each balance sheet date.


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