Accounting theory

Accounting Concepts
IdentiIy the users oI annual reports and
describe their inIormation needs.
Who are the users of annual reports?
1. The equity investor group, including existing and potential
shareholders.
2. The loan creditor group, including existing and potential
holders oI debentures and loan stock, and providers oI short-
term secured and unsecured loans and Iinance.
3. The employee group, including existing, potential and past
employees.
4. The analyst-adviser group, including Iinancial analysts and
journalists, economists, statisticians, researchers, trade
unions, stockbrokers and other providers oI advisory services
such as credit rating agencies.
IdentiIy the users oI annual reports and
describe their inIormation needs.
Who are the users of annual reports?
5. The business contact group, including customers, trade
creditors and suppliers and, in a diIIerent sense, competitors,
business rivals and those interested in mergers,
amalgamations and takeover.
6. The government, including tax authorities, departments and
agencies concerned with the supervision oI commerce and
industry, and local authorities.
7. The public, including taxpayers, ratepayers, consumers and
other community and special interest groups such as political
parties, consumer and environmental protection societies and
regional pressure groups.
&sers oI annual reports and their inIormation
needs.
Why these users need the financial information?
1. The equity investor group (The shareholders oI the company)
They want to know how eIIectively management is
perIorming and how much proIit they can withdraw Irom the
business Ior their own use.
2. The loan creditor group (The providers oI Iinance to the
company, example: banks)
&sers oI annual reports and their inIormation
needs.
Why these users need the financial information?
3. The employee group
4. The Iinancial analysts-adviser group
Need inIormation Ior their clients. For example, stockbrokers
need inIormation to advise investors, credit agencies want
inIormation to advise potential suppliers oI goods to the
company, journalists need inIormation Ior their reading
public.
&sers oI annual reports and their inIormation
needs.
Why these users need the financial information?
5. The business contact group (Example: suppliers, customers)
Suppliers want to know about the company`s ability to pay its
debts. The customers need to know that the company is a
secure source oI supply and is in no danger oI closing down).
6. The government
&sers oI annual reports and their inIormation
needs.
Why these users need the financial information?
7. The public
Want inIormation because enterprises aIIect them in many
ways, eg by providing jobs and using local suppliers, or by
aIIecting the environment (eg pollution)
8. The Inland Revenue
Accounting theory
Accounting concepts
Accounting bases
Accounting policies
Accounting standards
Accounting Theory
Concepts
Fundamental assumptions underlying the preparation of
financial statements
Bases
Methods developed to apply the concepts to specific
transactions
Policies
Specific to a particular organization
Chosen on the basis of suitableness
Accounting theory
Accounting Policies
specific to a firm
Accounting bases
methods
Accounting Concepts
broad principles
Accounting Theory (ExampIe ...)
CONCEPT Matching principle
BASES Methods of depreciation
(application of matching principle in
accounting for non-current assets)
POLCY Specific choice of method: straight
line or reducing balance
Accounting Concepts
Business entity concept.
The business is a separate entity distinct
from its owners or managers.
This concept requires the careful
separation of the financial affairs of the
business from its owners and other
businesses.
Accounting Concepts
Going concern
An enterprise is normally viewed as a
going concern, that is, as continuing in
operations for the foreseeable future.
t is assumed that the enterprise has no
intention to curtail the scale of its
operations.
Accounting Concepts
HistoricaI cost
Assets should be recorded initially at cost.
Main limitation of using historical cost:
n times of inflation, historical costs figures lack
relevance and can mislead users of financial
information.
n order to overcome this limitation, revaluation of
assets is allowed as an alternative to historical cost
accounting.
Accounting Concepts
Advantages of using historical cost:
istorical costs are perceived to be more
reliable because they can be verified.
The use of historical cost is cost-effective.
To use current market value means spending
money each time an asset is revalued
Accounting Concepts
AccruaI basis of accounting
ncome is recognized when earned and not
when it is received in cash;
Expenses are recognized when incurred and not
when they are paid in cash.
atching concept
#evenue earned must be matched against the
expenditure incurred in generating it.
Accounting Concepts
Revenue reaIization concept.
A sale should be recognized when:
the event from which it arises has taken place;
Sale is recognized when goods are delivered, or
when invoice is prepared.
Sale is not recognized when an order is received.
the receipt of cash is reasonably certain.
Sale on credit should be recognized as income
even if cash has not yet been received.
Accounting Concepts
ateriaIity.
nformation is material if its omission or
misstatement could influence the
economic decisions of users taken on the
basis of the financial statement.
Accounting Concepts
Prudence
Where aIternatives exist, one shouId seIect the
aIternative that gives the most cautious presentation
of the financiaI position or resuIt of the business.
Assets and profits shouId not be overstated, but a
baIance must be achieve to prevent the materiaI
overstatement of IiabiIities and Iosses.
Where a Ioss is foreseen, it shouId be anticipated
and taken immediateIy into account.
Accounting Concepts
onetary principIe
Accounting wiII deaI onIy with those items to which a
monetary vaIue can be attributed.
FinanciaI statements do not refIect factors that
cannot be measured in monetary terms: good
management, hardworking members of staff, etc.
Accounting Concepts
Consistency
The items in the financiaI statement shouId be presented and
cIassified in the same manner from one period to the next
Except under the foIIowing cases:
There is a significant change in the nature of the operations
of the business
A review of its financiaI statement presentation
demonstrates that reIevance is better achieved by
presenting items in a different way
A change is required by a new accounting standard.
Accounting Concepts
Substance over form.
Some transactions have a reaI nature that differs from their
IegaI form.
Whenever it is IegaIIy possibIe, the reaI substance shouId
prevaiI over the IegaI form.
An exampIe is a hire purchase transaction.
LegaI ownership of an asset on a hire purchase does not pass
untiI the Iast instaIment is paid, but it couId be misIeading to
present a baIance sheet in which such assets did not appear
untiI the end of the contract.
IIustration
n preparing the accounts of your company for the year end
March 31, 1999, you are faced with the following problems:
Explain how you would treat each of the above cases and
give reasons for the treatment.
The managing director wishes the company's good
industrial relations to be reflected in the accounts.
The long term future success of the company is extremely
uncertain.
Although the sales have not yet actually taken place,
some reliable customers of the company have placed
several large orders that are likely to be extremely
profitable.
One of the owners of the company has invested his
drawings in some corporate bonds and shares.
At the year end, an amount is outstanding in respect of
electricity bills.
During the year the company purchases #s 200,000
worth of stationery. These were still in use at the end of
the year.
The company had a poor trading year and the owners
believe that a more balanced result could be presented if
a LFO stock valuation method was adopted instead of
the present FFO method.
A debtor who owes a large amount of money is rumoured
to be going into liquidation.
The company owns some shares in a quoted company
which the auditors think are worthless.
Explain how you would treat each of the
above cases and give reasons for the
treatment.
Structure of the answer:
State the accounting principle that should be
applied. (1 mark)
Explain the principle briefly.(1 mark)
Apply the principle to the case given and state
your answer. (1 mark).
ExampIe1: The managing director wishes the company's good industriaI
reIations to be refIected in the accounts.
Step 1: State the accounting principIe that shouId be appIied. (1 mark)
This case shouId be evaIuated using the ETARY PRCPLE.
Step 2: ExpIain the principIe briefIy.(1 mark)
The monetary principIe states that financiaI statements shouId onIy
refIect events that can be measured in monetary terms.
Step 3: AppIy the principIe to the case given and state your answer. (1
mark).
n this particuIar case, the managing director wouId be mistaken to
refIect the fact that the business has good reIations with the cIients as
this event cannot be quantified in terms of money. (1 mark)
This point can be further eIaborated using the concept of non-purchased
goodwiII.
ExampIe2: The Iong term future success of the company is extremeIy
uncertain.
This case shouId be evaIuated using the GG CCER PRCPLE.
The going concern principIe states that a business entity is expected to
operate for an indefinite period of time.
t is assumed that the owners are not intending to cIose it down in the
foreseeabIe future. This means that assets wiII be continue to be vaIued
at cost and not at their seIIing prices.
n this particuIar case, the going concern principIe shouId be appIied.
The financiaI reports shouId continue to refIect the resuIts of the
operations of the business (profit/Ioss for the year) and the baIance
sheet shouId refIect the assets at cost price.
The factors that couId affect its future operations couId be discIosed in
the notes to financiaI statements.
ExampIe3: AIthough the saIes have not yet actuaIIy taken pIace, some
reIiabIe customers of the company have pIaced severaI Iarge
orders that are IikeIy to be extremeIy profitabIe.
This case shouId be evaIuated using the REALSAT PRCPLE.
The reaIisation principIe is a principIe used in the recognition of
income. When shouId income/revenue be recognized in the books?
t states the goods are considered soId when:
a. When they have been deIivered to customers; or
b. When the invoice has been prepared (credit saIe), i.e.,
even if cash has not yet been received.
n this case the receipt of an order does not constitute a saIe as yet.
Therefore the vaIue of the goods ordered shouId not be shown as saIes.
ExampIe4: ne of the owners of the company has invested his
drawings in some corporate bonds and shares.
The principIe that is appIicabIe to this case is the BUSESS
ETTY principIe.
t states that the business is a separate entity from the owner.
The personaI affairs of the owner shouId not be refIected in the
books of the business and vice versa.
n this case, the drawings of the owner shouId be recorded as a
business transaction, i.e., as a withdrawaI of capitaI.
But the investment constitutes a personaI transaction of the
owner and shouId not be refIected in the books of the business.
ExampIe5: At the year end, an amount is outstanding in respect of
eIectricity biIIs.
ExampIe6: During the year the company purchases Rs 200,000 worth of
stationery. These were stiII in use at the end of the year.
n both cases, the principIe that shouId be appIied is the accruaIs
concept.
The accruaIs concept is used in the recognition of income and
expenses.
According to this concept, an income shouId be recognized when it is
earned and not when it is received in cash. An expense shouId be
recognized when incurred and not when it is paid in cash.
n the case of the eIectricity biII, an expense shouId be recognized for
the eIectricity consumed during the month even if it is stiII not paid. A
IiabiIity shouId be recognized for the outstanding amount.
n the case of the stationery, the vaIue of the unused stationery shouId
be deducted from the expense for the year. An asset shouId be
recognized for the vaIue of the unused stationery, ie. Prepaid expense.
ExampIe7: The company had a poor trading year and the owners beIieve
that a more baIanced resuIt couId be presented if a LF stock
vaIuation method was adopted instead of the present FF
method.
The principIe that shouId be appIied is the CSSTECY
PRCPLE.
t states that items in the financiaI statement shouId be
presented and cIassified in the same manner from one period to
the next.
This is important so that meaningfuI comparisons can be made
between two accounting periods or between two firms.
n this case, the company is not aIIowed to change its method of
vaIuing stock to show higher profits.
ne couId add the reasons when one is aIIowed to impIement these
changes: when required by a new accounting standard, when there
is a change in the nature of the business, etc.
ExampIe8: A debtor who owes a Iarge amount of money is rumoured to be
going into Iiquidation.
ExampIe9: The company owns some shares in a quoted company which
the auditors think are worthIess.
Both cases shouId be anaIyzed using the prudence concept.
Where aIternatives exist, one shouId seIect the aIternative that gives the
most cautious resuIts of the business.
Assets and profits shouId not be overstated; Iosses shouId be
anticipated and taken into account.
The recognition of contingent IiabiIities is governed by AS 37.
n the first case, an estimated bad debt expense shouId be recognized
in the books (provision for bad debts).
n the second case, the vaIue of the investment in the baIance sheet
shouId be written off from the books and a Ioss shouId be decIared in
the P/L.