7. Accounting Concepts and Conventions

Question 1

What is the main objective of IAS 1?

To what does IAS 1 apply?

Answer 1

The main objective of IAS 1 is:
‘to prescribe the basis of general purpose financial statements, to ensure comparability with both the entity’s financials statements of previous periods and with the financial statements of other entities.’ (IAS 1: para. 1)

IAS 1 applies to all general purpose financial statements prepared and presented in accordance with IFRS Accounting Standards.

Question 2

What are general purpose financial statements?

Answer 2

General purpose financial statements are those intended to meet the needs of users who are not in a position to demand reports tailored to meet their particular information needs.

Question 3

What are the objectives of financial statements? (3)

Answer 3

The objectives of financial statements are:
1. To provide information about the financial position, performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.
2. To show the result of management’s stewardship of the resources entrusted to it.
3. To assist users in predicting the entity’s future cash flows and, in particular, their timing and certainty.

Question 4

What do the financial statements provide information about? (6)

Answer 4

1. Assets
2. Liabilities
3. Equity
4. Income and expenses (including gains and losses)
5. Other changes in equity
6. Cash flows

Question 5

What are the elements of financial statements? (3)

Answer 5

1. Assets
2. Liabilities
3. Equity

Question 6

Who is responsible for the preparation of the financial statements?

Answer 6

Preparation of the financial statements is the responsibility of the board of directors.

IAS 1 also recognises the value of a financial review by management and the production of any other reports and statements which may aid users.

Question 7

Define fair presentation.

Answer 7

Fair presentation is the faithful presentation of the effects of transactions, other events and conditions in accordance with the Conceptual Framework.

Question 8

What must be true in financial statements for fair presentation to be exercised? (3)

Answer 8

1. Compliance with IFRS Accounting Standards should be explicitly stated in a note to the financial statements.
2. All relevant IFRS Accounting Standards must be followed if compliance with the IFRS Accounting Standards is disclosed.
3. Use of an inappropriate accounting treatment cannot be rectified either by disclosure of accounting policies or notes/explanatory material.

Question 9

What is required for a fair presentation? (3)

Answer 9

1. Selection and application of accounting policies.
2. Presentation of information in a manner which provides relevant, reliable, comparable and understandable information.
3. Additional disclosures where required to enable users to understand the impact of particular transactions, events and conditions on the entity’s financial position and performance (IAS 1: para. 17)

Question 10

In what circumstance may a departure form IFRS accounting standards occur?

Answer 10

There may be (very rare) circumstances when management decides that compliance with a requirement of an IFRS Accounting Standard would be so misleading that financial statements would not meet their objectives.

Departure from the IFRS Accounting Standards my therefore be required to achieve a fair presentation.

Question 11

What should be disclosed in the event of a departure from IFRS Accounting Standards? (4)

Answer 11

1. Management confirmation that the financial statements fairly present the entity’s financial position, performance and cash flows;
2. Statement that all IFRS Accounting Standards have been complied with except in respect of departure from individual IFRS Accounting Standards, required to achieve a fair presentation;
3. Details of the nature of the departure, why the IFRS Accounting Standards treatment would be misleading, and the treatment adopted; and
4. Financial effect of the departure.

Question 12

Define Going Concern.

Answer 12

The entity in question is viewed as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or ceasing to trade.

This concept assumes that, when preparing a regular set of financial statements, the business will continue to operate in approximately the same manner for the foreseeable future (at least, but not limited to, the next 12 months).

Question 13

When an entity is not a going concern, how must this be communicated in the financial statements?

Give an example of an alternative basis on which financial statements may be prepared?

Answer 13

When an entity is not a going concern, the financial statements must state that they are prepared on a basis other than going concern, and clarify what this basis entails.

An example of a different basis would be the ‘break up’ basis of accounting.

When presenting financial statements using a break up basis of accounting, an entity’s assets are valued at their ‘break up’ value: the amount they would sell for (their net realisable value) if they were sold off individually in a forced sale and the business were broken up.

Since this forced sale is necessary because the business has foreseen problems in the next 12 months, financial statements prepared on a break-up basis will contain neither non-current assets nor non-current liabilities. All assets will be deemed for sales and all liabilities will be treated as becoming due within 12 months of the date of the statement of financial position.

Question 14

What should be disclosed when the going concern assumption is not followed?

What should be disclosed if there is uncertainty as to whether the entity is a going concern?

Answer 14

If the going concern assumption is not followed, that fact must be disclosed with:
1. The basis on which the financial statements have been prepared.
2. The reasons why the entity is not considered to be a going concern.

When there is uncertainty as to whether the entity is a going concern, this should be disclosed along with the nature of the uncertainty.

Question 15

What is accrual accounting?

Answer 15

Accrual accounting requires that transactions are recorded in the period in which they occur even if the resulting cash receipts and payments occur in a different period. (Conceptual Framework, para. 1.17)

Question 16

What are the basic principles of recording transactions in the financial statements according to accrual accounting? (2)

Answer 16

1. Entities should prepare their financial statements on the basis that transactions are recorded in them, not as the cash is paid or received (cash accounting), but as the income or expenses are earned or incurred in the reporting period to which they relate.
2. According to the accrual basis, when calculating profit, income earned must be matched against the expenses incurred in earning it.

Question 17

Context Example: Accrual basis.

Answer 17

See p.54

Question 18

How are the concepts of going concern and accruals linked?

Answer 18

If the business is assumed to be a going concern, it is possible carry forward the cost of unsold products as a charge against profits of the next period.

Question 19

Define Cash Accounting.

Answer 19

Under this method, a company records customer receipts in the period that they are received, and expenses in the period in which they are paid.

It is easier to use and can be useful for a smaller company, especially for tax purposes where cash flow may be an issue.

Under the accrual basis, a company may have to pay tax on profits before the cash is actually received by the business.

Question 20

To maintain consistency, the presentation and classification of items in the financial statements should stay the same from one period to the next, unless? (2)

Answer 20

1. There is a significant change in the nature of the operations, or a review of the financial statements indicates a more appropriate presentation; or
2. A change in presentation is required by an IFRS Accounting Standard.

Question 21

Why is consistency of presentation in financial statements important?

Answer 21

By having consistent presentation, the comparability of financial statements is enhanced, both over a period of time, and also between different companies.

Question 22

Define material in relation to accounting information.

Answer 22

Information is material if omitting, misstating or obscuring it could, individually or collectively, reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size of the nature of an item, or a combination of both, could be the determining factor. (IAS 1: para. 7)

Question 23

Explain the process of aggregation.

How may an item that is not individually material be presented in the financial statements?

Answer 23

Financial statements result from processing large numbers of transactions or other events that are then aggregated into classes according to their nature or funaction, such as ‘revenue’, ‘purchases’, ‘trade receivables’ and ‘trade payables’.

The final stage in the process of aggregation and classification is the presentation of condensed and classified items on the face of the statement of financial position or statement of profit or loss.

If an item is not individually material it is aggregated with other items on the face of the financial statements, though it may be separately classified in the notes.

Question 24

What is the rule of thumb for judging materiality by size?

What is the concept of materiality by nature?

Answer 24

There is no absolute measure of materiality. In relation to materiality by size it is common to apply a convenient rule of thumb (for example material items are those with a value of greater than 5% of net profits).

However, some items are regarded as particularly sensitive and therefore as being material by nature. Even a very small misstatement of such an item is taken as a material error; an example is the amount of remuneration paid to directors of a company.

Question 25

In what case relating to materiality may an IFRS Accounting Standard not be satisfied?

Answer 25

A specific disclosure requirement in an IFRS Accounting Standard need not be satisfied if the information is immaterial.

Question 26

To which of the qualitative characteristics does the Conceptual Framework link materiality?

Answer 26

The Conceptual Framework links materiality particularly to the qualitative characteristic of relevance.

Question 27

What are the rules relating to offsetting as set out in IAS 1?

Answer 27

Assets and liabilities, and income and expenditure must be presented separately in the financial statements.

IAS 1 does not allow these items to be offset against each other unless such a treatment is required or permitted by another IFRS Accounting Standard.

Question 28

Under what circumstances can income and expenses be offset? (2)

Answer 28

Income and expenses can be offset only when:
1. An IFRS Accounting Standard requires or permits it; or
2. Gains, losses and related expenses arising from the same/similar transactions are not material (in aggregate).

Question 29

What is the business entity concept?

Answer 29

This concept is similar to that of the separate entity principle: that accountants regard a business as a separate entity, distinct from its owners or managers.

The concept applies whether the business is a limited liability company (and so recognised in law as a separate entity), or a sole trader (in which case the business is not legally recognised as separate from its owners).

Question 30

What is the historical cost convention?

What is an important advantage of this concept?

Answer 30

A basic principle of accounting is that the monetary amount at which items are often measured in financial statements is at historical costs, i.e. at the amount which the business paid to acquire them.

An important advantage of this concept is that the objectivity of financial statements is maximised: there is usually a source document to prove the amount paid to purchase an asse or pay an expense.

Question 31

What possibilities should be considered when considering the cost or value of an asset? (5)

What is the advantage of the first two?

Answer 31

1. The original cost (historical cost) of the machine
2. Less than the historical cost (exact amount dependent on the length of useful life and when the asset is being valued)
3. The amount that would be received if the the asset was sold on the open market (fair value)
4. The present value of the cash flows the asset is expected to generate across its life (value in use)
5. The cost of an equivalent machine (current cost)

They are based on a figure (the machine’s historical cost) which is objectively verifiable.

Question 32

What does a complete set of financial statements include? (7)

Answer 32

1. Statement of financial position
2. Statement of profit or loss and other comprehensive income (which may be a separate statement for profit or loss and statement of other comprehensive income)
3. Accounting policies note
4. Statement of cash flows
5. Statement of changes in equity
6. Explanatory notes
7. A further statement of financial position from an earlier period where there has been a retrospective application of an accounting policy, a reclassification or a retrospective restatement.