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