Chapter 1: Accounting concepts and conventions

Question 1

What is the main objective of IAS 1?

Which financial statements does IAS 1 apply to?

Answer 1

The main objective of IAS 1 is:
‘To prescribe the basis for presentation of general purpose financial statements, to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities’

IAS 1 applies to all general purpose financial statements prepared and presented in accordance with IFRS Standards. General purpose financial statements are those intended to meet the needs of users who are not in a position to demand reports to meet their particular information needs.

Question 2

What are the objective of financial statements? (3)

Answer 2

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 3

What should financial statements provide information about? (6)

Answer 3

To fulfil these objective, financial statements must provide information about the entity’s:
1. Assets
2. Liabilities
3. Equity
4. Income and expenses (including gains and losses)
5. Other changes in equity
6. Cash flows

Question 4

What are the “elements of financial statements”?

Answer 4

Assets, liabilities and equity are called the elements of financial statements.

Question 5

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

Answer 5

1. Statement of financial position
2. Statement of profit or loss and other comprehensive income (which may be a single statement or a separate statement of 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 retrospective application of an accounting policy, a reclassification or a retrospective restatement.

Question 6

Define fair presentation.

Answer 6

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

The following points made by IAS 1 expand on the principle.
Compliance with IFRS Standards should be explicitly stated in a note to the financial statements.
All relevant IFRS Standards must be followed if compliance with IFRS Standards is disclosed.
Use of an inappropriate accounting treatment cannot be rectified either by disclosure of accounting policies or notes/explanatory material.

Question 7

What is required for a fair presentation according to IAS 1? (3)

Answer 7

1. Selection and application of accounting polices
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

Question 8

Why might departure from IFRS Standards be required?

Answer 8

There may be (very rare) circumstances when management decides that compliance with a requirement of an IFRS Standard would be so misleading that financial statements would not meet their objectives. Departure from the IFRS Standards may therefore be required to achieve a fair presentation.

Question 9

What should be disclosed if management decides to make a departure from an IFRS Standard? (4)

Answer 9

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

Question 10

Define Going Concern.

Answer 10

The entity 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 (or at least, but not limited to, the next 12 months). In particular the entity will not go into liquidation or cease trading, or have no realistic alternative but to liquidate or cease trading.

Question 11

What is required if a business is not a going concern?

Answer 11

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

An example of a different basis would be the ‘break up’ basis of accounting. When presenting the 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 to be for sale and all liabilities will be treated as becoming due within 12 months of the date of the statement of financial position.

Question 12

What must be disclosed if the going concern assumption is not followed? (3)

Answer 12

1. The fact that the going concern assumption is not followed.
2. The basis on which the financial statements have been prepared.
3. 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 13

Define accrual accounting.

Answer 13

Accrual accounting requires that transactions are recorded in the period in which they occurred even if the resulting cash receipts and payments occur in a different period.

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.

Accordingly to the accrual basis, when calculating profit, income earned must be matched against the expenses incurred in earning it.

Question 14

Define cash accounting.

Answer 14

Under this method, a company records customer receipts in the period they 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 accruals basis, a company may have to pay tax on profits before the cash is actually received by the business.

Question 15

How can consistency of presentation be maintained and what exceptions are there to this rule? (2)

Answer 15

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

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 Standard.

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

Question 16

Define material.

Answer 16

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 judged in the surrounding circumstances.

The size or the nature of an item, or a combination of both, could be the determining factor.

Question 17

Explain the measure of materiality.

Answer 17

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 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 if the amount of remuneration paid to directors of a company.

Question 18

What is the historic cost convention?

Answer 18

A basic principle of accounting is that the monetary amount at which items are often measured in financial statements is at historical cost, i.e., at the amount at 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 asset or pay an expense.

Question 19

Example:
A company acquires a machine to manufacture its products. The company expects to use the machine for four years, which is the ‘useful life’ of the machine.

At the end of two years, the company is preparing a statement of financial position and has to decide what monetary amount to give the machine.

What possibility can be considered? (5)

Answer 19

1. The original cost (historical cost) of the machine
2. Half of the historical cost, on the basis that half of its useful life has expired
3. The amount that would be received if the asset was sold on the open market (fair value)
4. The present value of the cash flows that the asset is expected to generate across its life (value in use)
5. The cost of an equivalent machine (current cost)

All of these valuations have something to commend them, but the great advantage of the first two is that they are based on a figure (the machine’s historical cost) which is objectively verifiable.