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Accounting is about the provision of figures to people about their resources (information) The owner of a business would like to know such things as: What they have got? What they used to have? The change in what they have got? What they may get in the future? How much profit or loss the business has made?
How much money the business has?
Will the business have sufficient funds to meet its commitments?
The emphasis has been on technical manipulation of numbers - writing up ledger accounts, preparing profit and loss account and balance sheet.
Accounting is not an exact science. There are many areas in which judgement must be exercised in attributing money values to items appearing in account. Certain procedures and principles have over the years been accepted as good accounting practice.
Accounting involves situations where numbers are not readily available or where a whole variety of numbers are available. How are you going to decide which figure to put in the records?
The figures which accountants should provide to people are the figures that they need to know about their own particular purpose.
Procedures in common use imply acceptance of certain underlying ideas which are taken for granted in preparing accounts. Accounting is based on a number of rules or conventions that have evolved over time. Many different words - Concepts, Conventions, Assumptions, Postulates have been used to describe the basic ideas underlying the accounting practice. Business Entity, Duality, Monetary Measurement, Cost, Accounting Period, Going Concern, Prudence, Consistency, Materiality, Objectivity, Realisation of Revenue, Matching.
They have evolved as attempts to deal with practical problems experienced by preparers and users rather than to reflect some theoretical ideal.
Some ideas are more fundamental (primary or basic) than others.
1 GOING CONCERN CONCEPT (Continuity)
Implies that the business will continue in operational existence for the foreseeable future
In the absence of evidence to the contrary it is assumed that the business will continue into the indefinite future
There is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations
This concept has a major influence on the valuation of items in the balance sheet
E.g. 1 - The convention allows us to assume that Inventory will be sold in the normal course of business, i.e. at normal selling prices.
E.g. 2 - It allows the principle of Depreciation, e.g. Plant depreciated over 10 years assumes that the plant will have a useful life of 10 years to the business
Assets of the business should not be valued at their break up value (the amount they would sell for if they are sold off piecemeal and the business were broken up.
Businessman acquires machine making shirts for $60,000. The machine is estimated to have a useful life of 6 years and will have no residual value thereafter.
Applying the Going Concern Concept, we assume that the business will continue operations and the asset will live out its full 6 years in use.
Depreciation of $10,000 will be provided each year
Value of asset = Cost less accumulated depreciation.
Question - show P & L and Balance Sheet for years 1 to 6
Assuming the asset has no other operational use outside the business, in a forced sale, the asset will be sold for scrap. After 1 year the scrap value is estimated to be $10,000.
The Net Book Value of the asset after 1 year will be $50,000; the immediate sell value will be $10,000
A retailer commences business on 1 January. He buys 20 printers at $100 each during the year. He sells 17 printers at $150 each.
How should the remaining printers be valued at 31 December if: -
He is forced to close down his business at the end of the year and the remaining printers will realize only $50 each in a forced sale?
He intends to continue his business into the next year?
If a business lacks working capital-
A sign of financial trouble
In such case better to draw up a statement of affairs, valuing assets on a break-up basis rather than reflecting the business as a going concern
Include other potential liabilities, e.g. redundancy payments, pensions accrued, liabilities arising because of non-completion of contracts
2 ACCRUAL CONCEPT (often referred to as the Matching Concept)
Income or profit determination is a process of matching against revenue the expenses incurred in earning that revenue
When an asset gets used, it becomes an expense.
At what point does the accountant regard an asset as being used? - When the related revenue is recognised.
The process of profit calculation can be summarised as follows:
Step 1 - Determine the point at which revenue is recognised - the time when the proceeds are made
Step 2 - Match the expense against the revenue - we regard the expense as occurring at the same time as the revenue
Revenue and Costs must be recognised as they are earned or incurred, not as money is received or paid (the cash basis)
Revenue and cost must be matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period to which they relate
Distinction is made between the receipt of cash and the right to receive cash, and between the payment of cash and the legal obligation to pay cash.
The accountant is required to include as expenses or income those sums which are due and payable.
If John makes 20 T-shirts at a cost of $100 and sells them for $200, he makes a profit of $100.
If he sold only 18 T-shirts ($180), it would be incorrect to charge the profit & loss account with the cost of 20 as there are 2 in stock.
It is assumed that he intends to sell them and make a profit on the sale
The cost of 18 T-shirts ($90) should be matched with the sales revenue ($180); profit = $90
The Balance Sheet would be:
Capital (profit for period) 90
If John decided to give up selling T-shirts, then the Going Concern Concept would no longer apply and the value of the 2 T-shirts in the balance sheet would be a breakup valuation rather than cost.
If the 2 unsold T-shirts were unlikely to be sold at more than their cost of $5 each (say because of damage or fall in demand), they would be recorded in the balance sheet at NET REALISABLE VALUE (i.e. the likely eventual sales price less any expenses incurred to make then saleable), rather than cost.
The accruals concept states that, in computing profit, revenue earned must be matched against the expenditure incurred in earning the revenue.
Companies Act 1985 states - "All income and charges relating to the financial year to which the accounts relate shall be taken into account, without regard to the date of receipt or payment"
This requires the business to take credit for sales and purchases when made, rather than when paid for and also to carry unsold stock forward in the balance sheet rather than to deduct its cost from profit for the period.
Receipt the receipt of cash or cheque by the business (for goods sold and services rendered)
Payment the payment of cash or cheque by the business in return for goods or services received
Revenue income the income which the business earns when it sells its goods; revenue is recognised when the goods pass to the customer, not when the customer pays
Expenses include all resources used up or incurred by a business during a financial period irrespective of when paid for
3 PRUDENCE CONCEPT (Conservatism)
Prudence is the inclusion of a degree of caution in the exercise of judgement needed in making the estimates required under conditions of uncertainty - gains and assets are not overstated; losses, liabilities and expenses are not understated. Caution in measuring profit and income
Accounts are in essence trying to give an indication of the current position (balance sheet) and of the degree of success achieved during the accounting period (profit and loss account).
The accounting practice of recognising all possible losses, but not anticipating possible gains. At the same time ensuring that the position or the degree of success is not overstated.
4 THE CONSISTENCY CONCEPT
One of the most useful concepts from the point of view of users who need to follow accounting statements from year to year
Involves the use of unvarying accounting treatment from one accounting period to the next
Can only identify a trend with certainty if accounts are consistent over long periods
In preparing accounts consistency should be observed in two respects:
Similar items within a single set of accounts should be given similar accounting treatment
The same treatment should be applied from one period to another in accounting for similar items.
This enables valid comparisons to be made from one period to the next (Comparability)
5 THE BUSINESS ENTITY CONCEPT
Accountants regard the business as a separate entity, distinct from its owner.
The concept applies whether the business is a limited company, a partnership or a sole trader.
The affairs of the business are distinguished from the personal affairs of the owner.
The records of the business are kept with a view to controlling and recording the affairs of the business and not for any benefit to the owner.
Transactions are recorded as they affect the business, not as they affect the owner.
If the owner of a sweet shop takes and eats a bar of chocolate or takes a few pence for some private purchase - such activities should be recorded.
Capital is -
the amount of wealth invested in the business by the owner
the amount of money borrowed by the business from the owner
the amount the business owes the owner
6 THE MATERIALITY CONCEPT
Accounting for every single item individually in the accounts of a multi-million pounds company would not be cost-effective.
Detailed treatment of insignificant items may well cause complication and confusion to the user of accounts - may involve time and effort and money for no useful purpose
Rounded figures give clarity to published statements (not much difference in showing property cost as $429,872 rather than $430,000) - accounts are therefore not strictly accurate
Only items material in amount or in their nature will affect the true and fair view given by a set of accounts.
An error which is too trivial to affect anyone's understanding of the accounts is referred to as immaterial.
Insignificant items are unlikely to influence decisions or provide useful information to decision makers.
Small items which fulfill the theoretical requirements of the definition of fixed assets, but cost below a defined minimum amount, as simple current expenses
7 THE DUALITY CONCEPT
Any economic event has two aspects - the giving and the receiving aspect
Double-entry book keeping requires each transaction to be entered twice in the books - as a debit (receiving aspect) and as a credit (giving aspect)
Debit - being an increase in the assets of the business or as an expense
Credit - being a reduction in the assets (cash balance to pay for an item) or an increase in the level of credit taken (debt)
The balance sheet shows the various resources of the business at a point in time (assets) and the claims on those resources (liabilities).
Assets of the business are shown in one section of a balance sheet and liabilities in another section
8 SUBSTANCE OVER FORM
Transactions should be accounted for and presented in accordance with their economic substance, not their legal form
Assets acquired on hire purchase - legally the purchaser does not own the asset until the final instalment has been paid - accounting treatment is to record a fixed asset in the accounts at the start of the agreement.
Same could be said for fixed assets acquired under long term leases (finance leases)
9 MONEY MEASUREMENT
Concept of a common unit - money is used as the unit of account to express information on a business
Dealing in financial information - only record those facts that are expressed in money terms
Any fact, however relevant to the user of the information, is ignored by the accountant if it cannot conveniently be expressed in money terms.
Resources acquired by the business are recorded at their original purchase price
Known as historical cost convention
11 REALISATION (of revenue)
Any change in the value of an asset may not be recognised until the moment the firm realizes or disposes of that asset.
Sale on credit - recognise revenue as soon as the goods are passed to the customer
Unrealised gains (e.g. increase in the value of stock (shares) prior to resale widely recognised by non-accountants (e.g. bankers) - can lead to problems.
12 ACCOUNTING PERIOD
Profit occurs over time and we cannot speak of profit for a period until we define the length of the period.
Maximum length of period normally used is one year
Supported by legislation normally required preparation of full audited accounts annually
Does not preclude the preparation of accounts for shorter periods
The formal published accounts period nearly always one year
Preparing accounts on an annual basis facilitates comparison between one year and previous years
Assists forecasting the next year
Accounts normally have to be prepared annually for tax purposes - tax is assessed on profits of a 12-month accounting period
Limited companies - accounts prepared annually to the "Accounting reference date"
Necessary to calculate annually the amount of profit available for distribution to shareholders by way of dividend
Accounting Standards were developed in an attempt to deal with subjectivity and to achieve comparability.
Many figures in financial statements are derived from the application of judgement in putting accounting concepts into practice.
Different businesses use different methods of recording transactions
Financial accounts for different businesses would be very different in form and content
Standards for the preparation of accounts have been developed over years
Various rules have been incorporated into legislation - Companies Act
Companies whose shares are traded on the Stock Exchange are subject to Stock Exchange Rules
Statements of Standard Accounting Practice
Financial Reporting Standards
International Financial Reporting Standards
1942 The Institute of Chartered Accountants of England and Wales began making recommendations about accounting practices.
To codify best practice to be used in particular circumstances
A series of 29 recommendations are issued over time
1960 late 1960s - lot of public criticism of financial reporting methods
1970 The Accounting Standards Committee (ASC) is set up with the object of developing definitive standards for financial reporting
Comprises representatives of six major accountancy bodies
Objectives of ASC:
To narrow the areas of difference in accounting practice
To ensure disclosure of departures from definitive standards
To provide wide exposure for new accounting standards
To maintain a programme of improving accounting standards
Accounting conventions lay down ground rules for accounting.
However, they still permit a variety of alternative practices to coexist.
Lack of uniformity of practices made it difficult for users of financial reports to compare results of different companies
Need for standards of accounting practice - to try to increase the comparability of company accounts
ASC issued 25 Statements of Standard Accounting Practice (SSAP) + a number of Exposure Drafts (ED) + Statement of Intent (SOI) + Statements of Recommended Practice (SORP)
Procedure: produce an exposure draft on a specific topic for comment by accountants and other users of accounting information - formal statement drawn up taking account of comments received and issued as a SSAP
Once adopted by the accountancy profession, any material departures by a company from the standard practice had to be disclosed in noted to financial statements.
Standards did not have the force of law to back them up
Members of accountancy profession required by their Code of Ethics to abide by them
Many serious criticisms - eventual demise of ASC
July 1987 Consultative Committee of Accountancy Bodies (CCAB) set up a review of standard setting process under chairmanship of Sir Ron Dearing
Dearing Report made several important recommendations
Government accepted all but one
Aug 1990 new standard setting structure was set up - ACCOUNTING STANDARDS BOARD (ASB)
Two tier system
The Financial Reporting Council (FRC) - policy making body for accounting standards - independent of the profession
The Accounting Standard Board -
More independent than ASC
Standards known as Financial Reporting Standards (FRS)
Accepted all SSAPs then in force - effective until replaced
Urgent Issues Task Force (UITF)
An offshoot of ASB
Tackle urgent matters not covered by existing standards or those which were causing diversity of interpretation
UITF issues a consensus pronouncement in order to detect whether or not accounts give a true and fair view
The Financial Reporting Review Panel (FRRP)
Chaired by a barrister
Examines and questions departures from accounting standards by large companies
Has power to apply to the court for an order requiring the company's directors to revise their accounts
1973 International Accounting Standards Committee set up - representatives from UK and other countries sit on the committee. Need for IASC arose because of
Growth of multi-national firms
Desire for common standards worldwide