Chapter 2 Flashcards
What is an accounting conceptual framework as a theory?
explains the reasoning which underlies the preparation of financial statements.
What does an accounting conceptual framework set out?
generally accepted accounting principles, which form the basis of financial accounting and reporting standards
What questions do a framework answer?
What are financial statements?
What are they for?
Who are they for?
What makes them useful?
What is the objective of financial statements?
The objective of financial statements is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions.
What are the characteristics of useful financial information?
Useful information is characterised by qualities that may be categorised as:
Fundamental (i.e. essential)
Enhancing (i.e. a further improvement).
What are fundamental qualitative characteristics?
1) Relevance
2) Faithful representation
Fundamental qualitative characteristics: Relevance definition
Information is relevant when it influences the decisions that users take on the basis of that information. Relevant information helps users to assess past, present or future events (predictive value) and helps users to confirm past assessments (confirmatory value). Information needs to be material to be of any relevance to users.
Fundamental qualitative characteristics: Faithful representation definition
This means that information is generally complete, neutral, and free from error. It implies that financial information should reflect the economic substance of transactions, even where this is different from their legal form.
What are enhancing qualitative characteristics
1) Comparability
2) Verifiability
3) Timeliness
4) Understandability
Enhancing qualitative characteristics: Comparability
Users should be able to compare items within the financial statements from period to period and should be able to compare the financial statements of different entities.
Enhancing qualitative characteristics: Verifiability
Different knowledgeable and independent observers should be able to reach a consensus (not necessarily complete agreement) that particular information is faithfully represented. Some figures in a set of financial statements can be directly verified e.g. by counting cash.
Enhancing qualitative characteristics: Timeliness
To be useful, information must be provided to users within a reasonable time.
Enhancing qualitative characteristics: Understandability
information should be presented in such a way that it is understandable by users with reasonable business knowledge.
Going concern and financial statements
Financial statements are normally prepared on the assumption that the company is a going concern
If a company is not a going concern this fact must be disclosed within the financial statements
Define a going concern
it will continue in operation for the foreseeable future.
a business that is expected to continue operating and meeting its financial obligations without the threat of liquidation for the foreseeable future
Define ‘materiality’
Information is material if omitting it or misstating it could influence the decisions that users might make based on a set of financial statements. Items may be material due to their size or their nature.
Define ‘substance over form’
Faithful representation implies that financial information should reflect the economic substance of an entity’s transactions, even where this is different from their legal form.
Define ‘ business entity/separate entity concept’
The business is a separate entity from its owner. Double entry bookkeeping is based around this concept (see Chapter 4).
Define ‘accruals’
The accruals concept states that income and expenses should be recognised in the period in which they have been earned or incurred, rather than when cash is received or paid.
Define ‘consistency’
A business should use the same accounting treatment for similar events and transactions over a period of time. This leads to comparability.
Define ‘prudence’
This concept involves the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated.
What is the historic cost concept?
Transactions are recorded at their historic cost, in other words, the amount paid or invoiced.
What are the pros and cons of historic cost
Pro’s:
HC enhances verifiability and understandability of financial statements
Cons:
HC may not help with relevance or comparability
** IMPORTANT**
In periods of rising prices historic cost accounting may overstate profit and understate asset values
What are the alternative valuation methods?
Fair Value
Value in use
Net realisable value
Current cost
Valuation methods: Fair Value
the amount received or paid to sell an asset or transfer a liability in an arm’s length transaction
Valuation methods: Value in Use
the present value of the future cash flows associated with an asset or liability.
Valuation methods: Net realisable value
the net amount of cash that is expected to be received/paid upon selling/settling that item.
Valuation methods: Current cost
the amount of cash that would be paid today to acquire an equivalent asset. This method may be used in times of high inflation.
What are accounting policies?
the specific principles, conventions, rules and practices applied by an entity in order to reflect the effects of transactions in the financial statements.
How consistent should accounting policies be?
The same accounting policies should be adopted from year to year (“consistency”).
Changes should be rare and only made if required:
By a change in accounting standards, or
If the change will result in a more appropriate presentation of information.
Rules for changes in accounting policy
A change in accounting policy should be applied retrospectively, i.e. as though the new policy had always applied.
A change in an accounting estimate is an adjustment to the estimation technique that helps to calculate the carrying amount of an asset or liability.
Changes in accounting estimates result from new information or new developments.
Changes in accounting estimates are simply adjusted in the financial statements of the period in which they arise
what does a statement of profit or loss tell us?
The Statement of profit or loss tells the results of the accounting period, i.e. shows financial performance by way of a profit or loss
What is Revenue expenditure?
Expenses incurred in everyday trading
What are cost of sales?
Direct costs incurred in selling goods or services adjusted for movements in inventory