ACCOUNTING PRINCIPLES

The going concern concept

The going concern concept implies that the business will continue to survive in
operational existence for the foreseeable future, and that there is no intention to put the
company into liquidation.
Financial statements must be prepared under the going concern concept unless the
company is being liquidated or if it has ceased trading.
The main significance of the going concern concept is that transactions should be valued
at the historical cost and not at the market value.

Accrual or matching concept

The accruals concept states that the revenue and costs must be recognized as they are
earned or incurred not when money is received or paid. They must be matched with one
another so far as their relationship can be established and dealt with in the income
statement of the period to which they relate. In other words all income and charges
relating to the financial year to which the account relate shall be taken into account
without regard to the date of receipt or payment.

Prudence
The prudence concept states that where alternative procedures, or alternative valuation
are possible the one selected should be one, which gives the most cautious presentation of
the business financial position or result.
The IASB’s framework for the preparation and presentation of financial statements
explains prudence as the application of a degree of caution in exercising judgment under
conditions of uncertainty.

Consistency
The consistency concept states that 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 comparison.

Money Measurement concept

The money measurement concept sates that only items that can be converted into
monetary terms will be recorded in the accounts. This helps comparison and arithmetical
manipulation of figures. The major limitation of this concept is that though certain events
may have a great positive or negative impact on a business, but because it can be
translated into monetary terms, it will not be recognized in the books. Examples include a
loyal, well-trained and motivated labour force, which can give the company a clear
superiority over an otherwise identical business, but because they cannot be evaluated in
monetary terms they do not appear anywhere in the accounts.
Materiality concept
Materiality means importance in terms of value. A transaction or event which is
significant in terms of value is said to be material. Only items material in amount or in
their nature will affect the true and fair view of the entity.
In preparing accounts it is important to assess what is material and what is not, so that
time and money is not wasted in the pursuit of excessive details
Material is highly subjective; example what is immaterial for a large company might be
material for a small sole trader.

Objectivity-neutrality
The information provided by the financial information needs to be neutral- in other words
free from deliberate bias. Financial information is not neutral if it has been selected or
presented in such a way to achieve a predetermined result or outcome. For example, if a
company has a bank loan of $50,000 and at the same time has a bank balance of $55,000,
it is misleading to show cash at bank of $5,000 because the users of financial statement
might conclude that the business is not indebted at all.

Substance over form

Transactions might be manipulated in such a way, that their legal definition might be
different from its economic reality (substance). In such an event, the legal definition
should be ignored and the economic reality should be recorded.

Historical Cost
According to the historical cost transactions should be recorded at values at which the
initial transactions took place.
Criticism of Historical Cost Accounting
Accounts prepared on a traditional historical cost basis can present financial information
in a misleading way
o Non-current asset values are unrealistic. The most striking example is property.
Revaluations of property are very often not reported consistently so that the
market values of property might be significantly different from the carrying
historical value in the balance sheet.
o Depreciation does not fully reflect the value of the asset consumed during the
accounting year. Depreciation is therefore understated in the income statement.
o During a period of high inflation the monetary value of stocks held may increase
significantly. Historical cost accounting lead to the unrealistic part of this holding
gain being included in the profit for the year. Profit is therefore overstated.
o In periods of inflation it follows that the value of money will have a lower real
value at the end of the period of time than it did at the beginning. A loss has been
incurred. This loss is not shown
o Comparisons over time are unrealistic. For example, if a company’s profit grew
by 25%, a shareholder’s initial reaction might be that the company had done
rather well. If however if it was then revealed that the inflation rate were 20%, the
apparent growth would seem less impressive.
Reasons for continued use of historical cost accounting
o It is easy and cheap. Other methods tend to be far more complicated.
o The fact that IAS 16 (PPE) permits non-current asset revaluation means that there
is less likelihood that a serious understatement of actual value will distort the
balance sheet valuation of the business.
o Users are aware of the limitations of HC and therefore they make appropriate
allowance in making any interpretations.
o The figures are easy to obtain, verifiable and therefore objective, being tied to
actual transactions. Other methods depend more on valuations and therefore
subjective.

The IASB's revised statement of principles for financial reporting

The Statement consists of eight chapters:

o The objective of financial statements.
o The reporting entity.
o The qualitative characteristics of financial information.
o The elements of financial statements.
o Recognition in financial statements.
o Measurement in financial statements.
o Presentation of financial information.
o Accounting for interests in other entities.

Chapter 1 — The objective of financial statements

The objective of financial statements is to provide information about the reporting

entity’s financial performance and financial position that is useful to a wide range of
users for assessing the stewardship of management and for making economic decisions.

The Statement then lists the users of financial statements and their information needs,
recognising that investors are the main users and that information satisfying their needs
will also be of use to the others.

The users considered in the Statement: are:

(a) Investors

Providers of risk capital are interested in information that helps them to assess the
stewardship of management and in taking decisions about their investment or potential
investment in the entity. They are, as a result, concerned with the risk inherent in, and
return provided by, their investments, and need information on the entity’s financial
performance and financial position that helps them to assess its cash-generation abilities
and its financial adaptability.
(b) Lenders

(c) Suppliers and other trade creditors

(d) Employees

(e) Customers

(f) Governments and their agencies

(g) The public

The Statement also recognises that financial statements have limitations, and lists the
following as examples of such limitations:

(a) They are a conventionalised representation of transactions and other events that
involves a substantial degree of classification and aggregation and the allocation of the
effects of continuous operations to discrete reporting periods.

(b) They focus on the financial effects of transactions and other events and do not focus
to any significant extent on their non-financial effects or on non-financial information in
general.

(c) They provide information that is largely historical, and therefore do not reflect future
events or transactions that may enhance or impair the entity’s operations, nor do they
anticipate the impact of changes in the economic or potential environment.

The information required by investors

The Statement identifies four areas in which investors require information:

(a) Financial performance

Information on financial performance is needed to provide:

i. an account of management’s stewardship;

ii. means of assessing the entity’s capacity to generate cash flows and the
effectiveness with which the entity has employed its resources;
iii. feedback on previous assessments of financial performance.

Information about financial performance is provided by the profit and loss account, the
statement of recognised gains and losses and the cash flow statement.

(b) Financial position

Information about financial position is needed to provide:

 i. details of economic resources controlled by the entity and the use made of them;
ii. details of financial structure; < liquidity means>
iii. details of an entity’s risk profile and risk management approach to evaluate its
current performance, financial adaptability and ability to generate cash in the
future;
iv. a means to assess the entity’s capacity to adapt to changes in the environment —
its financial adaptability.

Information about financial position is given in the balance sheet.

(c) Generation and use of cash

Investors need such information because it is useful in assessing and reviewing previous
assessments of:

i. liquidity and solvency;

ii. the relationship between profits and cash flows;
iii. the implications that financial performance has for future cash flows; and
iv. other aspects of financial adaptability.

Such information is mainly provided by the cash flow statement.

(d) Financial adaptability

An entity’s financial adaptability is its ability to take effective action to alter the amount
and timing of its cash flows so that it can respond to unexpected needs or opportunities.

Financial adaptability comes from several sources, including the ability to:

i. raise new capital, perhaps by issuing debt securities, at short notice;

ii. repay capital or debt at short notice;
iii. obtain cash by selling assets without disrupting continuing operations; and
iv. achieve a rapid improvement in the net cash inflows generated by operations.

Chapter 3 — The qualitative characteristics of financial information

Chapter 3 identifies the qualities which financial information should have.

There are four main headings, each with several sub-headings. The diagram (Figure 1)
on the next page, reproduced from the Statement, shows them all. The notes which follow
explain each point.

(1) Materiality
Materiality is, therefore, a threshold quality that is demanded of all information given in
the financial statements. Furthermore, when immaterial information is given in the
financial statements, the resulting clutter can impair the understandability of the other
information provided. In such circumstances, the immaterial information will need to be
excluded.

The principal factors to be taken into account in assessing materiality are:

(a) The item’s size is judged in the context both of the financial statements as a whole and
of the other information available to users that would affect their evaluation of the
financial statements. This includes, for example, considering how the item affects the
evaluation of trends and similar considerations.

(b) Consideration is given to the item’s nature in relation to:

i. the transactions or other events giving rise to it;

ii. the legality, sensitivity, normality and potential consequences of the event or
transaction;
iii. the identity of the parties involved; and
iv. the particular headings and disclosures that are affected.

If there are two or more similar items, the materiality of the items in aggregate as well as
of the items individually needs to be considered.

(2) Relevance

Information is relevant if it has the ability to influence the economic decisions of users
and is provided in time to influence those decisions.

Relevant information has predictive value or confirmatory value.

2a Predictive Value

Information has predictive value if it helps users to evaluate or assess past, present or
future events.

2b Confirmatory Value

Information has confirmatory value if it helps users to confirm or correct their past
evaluations and assessments.

Overall then, the criterion of relevance relates to economic decisions of users. It means
that information disclosed in financial statements is only valuable if it helps users to
make predictions about the future or if it confirms past evaluations.
For example, information about the current level and structure of asset holdings helps
users to assess the entity’s ability to exploit opportunities and react to adverse situations.
The same information helps to confirm past assessments about the structure of the entity
and the outcome of operations.

(3) Reliability

Information is reliable if:

(a) it can be depended upon by users to represent faithfully what it either purports to
represent or could reasonably be expected to represent;

(b) it is free from deliberate or systematic bias (i.e. it is neutral);

(c) it is free from material error;

(d) it is complete within the bounds of materiality; and

(e) in its preparation under conditions of uncertainty, a degree of caution (i.e. prudence)
has been applied in exercising judgement and making the necessary estimates.

3a Faithful representation

The portrayal of a transaction or other event in the financial statements depends, inter
alia, on:

(a) the rights and obligations arising and the weight attached to each;

(b) how the rights and obligations to which most weight has been attached are
characterised;

(c) which measurement basis (or bases) and presentation techniques are used to depict the
rights and obligations; and

(d) the way in which the elements arising from the transaction or other event are
presented in the financial statements.

3b Neutrality

The information provided by financial statements needs to be neutral — in other words,

free from deliberate or systematic bias. Financial information is not neutral if it has been
selected or presented in such a way as to influence the making of a decision or judgement
in order to achieve a predetermined result or outcome.

3c Freedom from material error

An unqualified external auditors’ report should be an assurance that the financial
statements are free from material error. This in turn is based upon the effectiveness of the
entity’s internal controls, including its internal audit department, if any.

3d Completeness

Information in financial statements must be complete, within the limits set by materiality
and by the structure and format of financial statements.

Prudence is the inclusion of a degree of caution in the exercise of the judgements needed
in making the estimates required under conditions of uncertainty, such that gains and
assets are not overstated and losses and liabilities are not understated. In particular, under
such conditions it requires more confirmatory evidence about the existence of, and a
greater reliability of measurement for, assets and gains than is required for liabilities and
losses.

However, it is not necessary to exercise prudence where there is no uncertainty. Nor is it

appropriate to use prudence in order, for example, to create hidden reserves or excessive
provisions, deliberately understating assets or gains, or deliberately overstating liabilities
or losses, because that would mean that the financial statements are not neutral and,
therefore, are not reliable.

(4) Comparability

Information in an entity’s financial statements gains greatly in usefulness if it can be

compared with similar information about the entity for some other period or point in time
in order to identify trends in financial performance and financial position. Information
about an entity is also much more useful if it can be compared with similar information
about other entities in order to evaluate their relative financial performance and financial
position.

Information in financial statements therefore needs to be comparable — at least as far as

is possible. Furthermore, to help users to make comparisons, such information needs to
be prepared and presented in a way that enables users to discern and evaluate similarities
in, and differences between, the nature and effects of transactions and other events taking
place over time and across different reporting entities. This can usually be achieved
through a combination of consistency and disclosure of accounting policies.

4a Consistency

Consistency is an important accounting concept but it cannot be applied in all

circumstances. For example, the introduction of a new accounting standard may require
changes. The point is that consistency of treatment and accounting policies will be
maintained as far as possible, with full disclosure of the effect of necessary changes when
they happen.
4b Disclosure

As suggested in 4(a), disclosure is important in achieving comparability.

Disclosures required in this context are:

the entity’s accounting policies and changes in them;

the effects of changes on the financial statements.

5 Understandability

It is no good having all the above points attended to if the financial statements are then
presented in a way difficult for users to understand. Two sub-headings are considered:

• users’ abilities; and

• aggregation and classification.

5a Users’ abilities

Financial statements have to deal with complex matters in many areas. Those preparing
financial statements are entitled to assume that users have a reasonable knowledge of
business and economic activities and accounting and a willingness to study with
reasonable diligence the information provided.

5b Aggregation and classification

The presentation of financial information should ensure that items are aggregated and
classified appropriately. See Chapter 7 next month for more on presentation.

Limits on the application of the qualitative characteristics

Balance between characteristics

It is not always possible to reconcile conflicts between the characteristics of relevance,

reliability, comparability and understandability, and a trade-off may be necessary. Some
examples given in the Statement are conflicts involving:

(i) Relevance and reliability

Sometimes the information that is the most relevant is not the most reliable and vice
versa. Choosing the amount at which to measure an asset or liability will sometimes
involve just such a conflict. In such circumstances, it will usually be appropriate to use
the information that is the most relevant of whichever information is reliable.

(ii) Timeliness
Conflict between relevance and reliability can also arise over the timeliness of
information. That is because a delay in providing information can make it out-of-date,
which will affect its relevance, yet reporting on transactions and other events before all
the uncertainties involved are resolved may affect the information’s reliability. On the
other hand, leaving information out of the financial statements because of reliability
concerns may affect the completeness, and therefore reliability, of the information that is
provided. Although financial information should generally be made available as soon as it
is reliable and entities should do all that they reasonably can to speed up the process
necessary to make information reliable, financial information should not be provided
until it is reliable.

(iii) Neutrality and prudence

There can also be tension between two aspects of reliability — neutrality and prudence
— because, whilst neutrality involves freedom from deliberate or systematic bias,
prudence is a potentially biased concept that seeks to ensure that, under conditions of
uncertainty, gains and assets are not overstated and losses and liabilities are not
understated. This tension exists only where there is uncertainty, because it is only then
that prudence needs to be exercised. When there is uncertainty, the competing demands of
neutrality and prudence are reconciled by finding a balance that ensures that the
deliberate and systematic understatement of gains and assets and overstatement of losses
and liabilities do not occur.

(iv) Understandability

It may not always be possible to present a piece of relevant, reliable and comparable
information in a way that can be understood by all the users with the capabilities
described in 5(a) above. However, information that is relevant and reliable should not be
excluded from the financial statements simply because it is too difficult for some users to
understand.