Chapter 2 Accounting Concepts and Principles

CHAPTER 2

Accounting concepts and principles 1

A conceptual framework of accounting

1.1

The meaning of accounting concepts

Accounting concepts (also called accounting principles or accounting conventions) are the basic ideas underlying the preparation of financial statements. They may take the form of stated principles or be generally accepted rules in accounting for transactions. These rules have evolved over time reflecting the needs of both users and preparers of financial statements. 1.2

The IASC’s work

It is clearly best if financial statements are drawn up in accordance with a set of concepts that are logically consistent and universally agreed. Such a set of concepts is called a conceptual framework. In 1989 the IASC issued its ‘Framework for the Preparation and Presentation of Financial Statements’ as its conceptual framework underpinning the issue of IASs. This document (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 the amount of profit or loss that a business reports, so IASs can be unpopular in their impact. The hope is that, if we can all agree on the accounting concepts to be followed, then IASs can be developed on the basis of these concepts and there will be far less criticism of the IASs themselves.

2

Accounting conventions

2.1

Possible conventions

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

the accrual basis the going concern assumption.

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

going concern the accrual basis consistency materiality and aggregation offsetting comparative information

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

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       2.2

prudence business entity money measurement duality historical cost realisation time interval The going concern concept

The going concern concept assumes that a business will continue in operational existence for the foreseeable future. Unless there is evidence to the contrary it is assumed that the business will go on more or less indefinitely (ie there are no plans to liquidate or reduce the size of the business operation). Certain circumstances may make the going concern assumption invalid. For example, sale of part of the business may be necessary owing to a lack of financing. If this is the case the financial 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 is received. It is therefore appropriate to ‘match’ the costs or expenses incurred in generating this income in the same period. For example, cost of goods sold is included in the income statement in the same year that the sale of the goods generates income. $ Sale made 28 December 20X8 Money received from customer 1 February 20X9 Cost of goods sold

5,000 5,000 3,300

For the year ended 31 December 20X8 the income statement extract would be as follows. $ Sales revenue Cost of sales

5,000 (3,300)

Although the cash is received the following year the actual sale took place in the year ended 31 December 20X8 and is recognised in the income statement for that year. In accordance with 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 which cause 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 income over many years. The solution is to spread the cost over the period the asset will generate income, so matching income and expense. The method used to achieve this is depreciation. This will be looked at in more detail in a later chapter. 2.4

The consistency concept

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

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Chapter 2 Accounting concepts and principles

The consistency concept states that a business should treat like items in a similar manner within 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 which the non-current asset is used and how it generates income. This means that the same asset could be depreciated differently by two different organisations. The main consideration is that once a method of depreciation has been chosen for a particular type of asset it must be consistently applied for all such assets throughout the period and from one period to the next. It is possible for a business to change its policy for depreciation but there would need to be a good reason for doing so (eg changing to a more appropriate method considering the usage of the asset and the way it generates income). However, the financial effect of changing the depreciation 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 of the statements. In order to be useful, all material (ie significant in size) items should be presented 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 not be presented separately. 2.6

Offsetting

Assets and liabilities should not be offset against each other in the balance sheet. Income and expenses should not be offset against each other in the income statement. The gross items should be presented as they offer the greater information to the users of the financial statements. For example, if a company borrows $100,000 to enable it to buy a building for $120,000, the building should be shown in non-current assets and the loan in liabilities. It would not be correct 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 columns of figures, one for this year’s numbers, and one for the previous year’s, for comparison purposes. The user will be able to identify large differences between the figures and carry out further investigations if they wish. 2.8

The prudence concept

Revenues and profits are not recognised and reported until they are actually realised but provision is made for losses and liabilities immediately even if the loss will not occur until the future. 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 sale will be recognised in the usual way in the income statement for the year ending 31 December 20X8. But if the debtor goes bankrupt on 15 December 20X8 so that he will now be unable to pay his debt at all, a bad debt will be recognised in 20X8, regardless of the fact that the money was not due to be received until 20X9. (You will study the accounting for bad and doubtful debts in detail later in this text.) 2.9

Business entity

The information contained in the financial statements relates to the business entity alone. The financial statements do not include transactions entered into by the proprietors in their personal capacity. The business is considered to be a completely separate entity from the proprietor. This distinction 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 sole trader as an individual and the business he runs). Hence, the different terminology for cashflows between business and proprietors, sole traders and partnerships.

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Chapter 2 Accounting concepts and principles

Sole trader (or partnership) Drawings Sole trader

Entity Capital/loans

Company Dividends Shareholders

Entity Share issue proceeds

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 of less 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 and opposite 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 for them; that is, when the legal title is transferred. This means that a transaction may be included in an earlier accounting period than the one in which cash is eventually exchanged. As we have already seen, it is normal to include a sale in the accounting period when it is made, because at that point the customer is legally bound to complete the transaction. Actual completion – when the customer pays us for the goods – may not 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 but circumstances 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 accounting concepts 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 income statement and the amounts at which items should be shown in the balance sheet, business enterprises will select specific accounting bases most appropriate to their circumstances and adopt 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 19

be most appropriate to their circumstances and adopted by them for the purpose of preparing their financial accounts. As an example, consider non-current assets and depreciation. Possible bases for depreciating a machine might be in equal instalments over five years, in equal instalments over ten years, or in reducing instalments over ten years. The directors of the business must choose the accounting basis that they believe is most appropriate, say to depreciate in equal instalments over 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 valuation of the asset to each accounting period expected to benefit from its use, it is an example of invoking the accruals concept. 3.2

Disclosure of accounting policies

The accounting policies followed for dealing with items which are judged material or critical in determining the profit or loss for the year and in stating the financial position should be disclosed by way of notes to the accounts. The explanation should be clear, fair and as brief as possible. 3.3

The conflict between accruals and prudence concepts

In certain cases, there may be a conflict between the accruals concept and the prudence concept. In other words, the prudence concepts suggests that a particular accounting treatment should be adopted in respect of some item in the financial statements, whereas the accruals concept suggests a different treatment. The general rule in these cases is that the prudence concept should be followed. The prudence concept 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 lower value 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 financial statements useful to users. The IASC Framework identifies four principal qualitative characteristics:     4.2

understandability relevance reliability comparability Understandability

Information can only be useful if it is understandable by the users. Users can be assumed to have 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 too much information is presented.

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Chapter 2 Accounting concepts and principles

Accounting statements should contain only information that complies strictly with the specific requirements of the user, helping the user to evaluate the financial performance. Relevance is associated with materiality (described earlier). irrelevant to the user when making his decisions. 4.4

Immaterial transactions are

Reliability

Information is reliable when it is free from material error and bias and can be depended upon by users to represent faithfully what it purports to represent. The aspects of reliability are: 

faithful representation



substance over form – transactions and other events should be accounted for and presented in financial statements in accordance with their economic substance and financial reality and not merely with their legal form. For example, leasehold buildings are owned by the landlord rather than the occupier. But the occupier is using them for his business in the same way as if they were freehold. Thus it is appropriate to treat them as a non-current asset in the occupier’s balance sheet, provided that it is made clear that the premises are leasehold.



neutrality (also called objectivity) – the preparation of accounting statements involves a considerable amount of individual discretion. They should be prepared with the minimum amount of personal bias and the maximum amount of overall objectivity.



prudence (as explained earlier).



completeness – within the bounds of materiality and cost, the information in financial statements should be complete.

4.5

Comparability

Users must be able to compare the financial statements of an enterprise through time in order to identify trends. Hence comparability requires consistency of accounting practices (as described earlier) and the disclosure of comparative information for prior periods (also described earlier). 4.6

Constraints on relevance and reliability

There are certain inherent constraints on the relevance and reliability of financial information: 

timeliness – a long delay in issuing information may increase its reliability (since uncertainties will have been resolved so more accurate figures can be reported) but decrease its relevance (since the opportunity to take decisions promptly has passed).



balance between benefit and cost – all information should only be gathered and presented if the benefits from presenting it exceed the costs in gathering it. This principle is sound, however it is hard in practice to determine accurately the costs and benefits of the provision of particular information.

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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 financial statements to be prepared that present a true and fair view. In some jurisdictions, eg the UK, it is 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 in accordance with GAAP. Although the Framework does not explicitly require a true and fair view, the application of the qualitative characteristics listed above, together with compliance with IASs, should enable financial 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 goods and services) is the first figure at the top of the income statement. IAS 18 explains the appropriate 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 to be 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 description of the accruals concept given earlier in this chapter, you will already know that the answer to this question is ‘yes’.) 5.2

Definition of revenue

Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary 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 has given, 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 are satisfied: (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 the transaction.

(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 revenue in the income statement. As long as a genuine sale has taken place, and the seller expects to receive the agreed proceeds of the sale, it is appropriate for the seller to recognise the revenue from the sale on the date of the sale.

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Methods of valuing assets

Chapter 2 Accounting concepts and principles

6.1

Historical cost convention

This is the generally accepted method of accounting for non-current assets where the original cost 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: -



6.2

depreciation charges are understated profit is overstated.

Can distort performance ratios by understating capital employed, ie the amount of assets less liabilities in the balance sheet. Alternative methods

As a result of the disadvantages of the historical cost convention, alternative methods have been developed. Current cost The cost of replacing an asset with a close as possible identical asset, ie same condition, age and 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 result of 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 in the 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-current assets (usually properties) are revalued to market value, but traditional historical cost accounts are 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 price levels.

7.2

Disadvantages of historical cost accounting

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

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In a balance sheet, unexpired costs of assets purchased at different times with currency units of different purchasing power are summed to produce totals which are difficult to interpret. Amounts shown for assets such as plant and machinery or inventories do not represent any measure of the current value of such assets. In an income statement, out of date historical costs are deducted from current revenues to produce a profit figure that may not be useful. In addition, the prudence convention requires the application of an asymmetric test in determining whether or not profits or losses are to be recognised. Profits are recognised only when they have been realised, but provision is made for all foreseeable losses. This has the result that the profit for a year includes certain gains which relate to earlier periods but have been realised during this year, while it excludes certain gains which relate to the current year but have not been realised at the end of the year. Conversely, such a profit is reduced by all foreseeable losses, whether or not they have been realised in the current period. It is not surprising therefore, that the profit figure produced in HC accounts often proves to be useless for the purposes of decision-making that it was originally intended for. In an inflationary era it does not measure the increase in the owners’ wealth during a period, nor can it be used as a guide to the maximum amount which may be distributed. When the prices of its assets are rising, a firm which distributed the profit shown by the HC accounts would be unable to replace its assets without raising additional capital. 7.3

Advantages of historical cost accounting

Although we have identified the serious weaknesses of historical cost accounting in times of changing prices, there must be some advantages since HCA remains the most common method of accounting. These advantages are: (a)

Familiarity amongst users. Users of accounts are brought up with HCA, so are aware of the features of accounts drawn up in this way. For example they know that asset valuations do not represent the current values of assets, and know that not all HC profits should be paid out as dividends.

(b)

Limited subjectivity. The cost of an asset is a known objective fact which can be reported in HCA. If an alternative system wished to report the current value of an asset, there is much more subjectivity necessarily involved in identifying the value to be reported for each asset.

7.4

Alternatives to historical cost accounting

The main alternatives to strict HCA are: (a) (b) (c)

Modified HCA. Current purchasing power (CPP) accounting. Current cost accounting (CCA).

The modified historical cost convention has already been mentioned: this is exactly the same as strict HCA except that some non-current assets (normally only properties) are revalued to market value.

Modified HCA avoids the worst of the balance sheet problems of HCA, since properties are shown at their current values, but there are still problems with the balance sheet values of other non-current assets and inventories. These are shown on a modified HC balance sheet at their cost rather than their current value. 7.5

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Current purchasing power (CPP) accounting

Chapter 2 Accounting concepts and principles

CPP adjusts the HC accounts for the effects of general changes in prices, ie it is a method of inflation accounting. All amounts are shown in CPP financial statements based on currency units 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 Prices Index) was 5% during 20X1. How would this machine be shown in a CPP balance sheet as at 31 December 20X1? 7.7

Solution

In a HC balance sheet the machine would be shown at: $ Cost Less: Accumulated depreciation (10%) Net book value

2,000 (200) _____ 1,800 _____

In a CPP balance sheet the machine would be shown at: Cost (2,000  1.05) Less: Accum depn (10%) Net book value

7.8

$ 2,100 (210) _____ 1,890 _____

Current cost accounting (CCA)

CCA adjusts the HC accounts for the effects of specific changes in prices. Each asset must be revalued 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 machine has a ten year life and a nil residual value. The specific index for the cost of this type of machine rose 4% during 20X1. How would this machine be shown in a CCA balance sheet as at 31 December 20X1? 7.10

Solution

In a CCA balance sheet the machine would be shown at: Cost (2,000  1.04) Less: Accumulated depreciation (10%) Net book value

7.11

$ 2,080 (208) _____ 1,872 _____

Commentary on CPP and CCA

CPP is simple to apply, since it uses the same index (the RPI) to restate all items to year-end values. However the values at which assets are stated are not particularly useful, since they are 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 timeconsuming and subjective, since each asset must be revalued at each balance sheet date.

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Currently there is no international accounting standard requiring either CPP or CCA accounts to be prepared. Businesses present their financial statements using either strict HCA or modified HCA.

8

Summary

The IASC has issued a Framework document representing the conceptual framework underpinning the issue of IASs. The Framework identifies the accruals basis and the going concern assumption as being fundamental concepts. IAS 1 identifies six desirable accounting conventions:      

going concern accrual basis consistency materiality and aggregation offsetting comparative information.

A business should consider the possible accounting bases that could be used to apply the accounting concepts to transactions, and select its accounting policies as being the bases most appropriate in the circumstances. IAS 1 requires the accounting policies to be disclosed in a note to the financial statements. The Framework identifies four principal qualitative characteristics of financial statements:    

understandability relevance reliability comparability.

Financial statements are normally prepared using historical cost accounting (HCA), although this convention has serious problems in times of changing prices. Possible theoretical alternatives are:   

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modified historical cost accounting current purchasing power (CPP) accounting current cost accounting (CCA)