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
What is gross profit?
The excess of revenue over cost of sales
What are other expenses?
All other costs incurred by the business
What is Net profit?
The excess of revenue over total expenses
What does a simple statement of profit or loss look like?
Revenue
Cost of Sales
Gross Profit
Other Expenses
Net Profit
What is a statement of financial position
The Statement of financial position (sometimes called the Balance Sheet) is a “snapshot” of the business assets and liabilities at a particular date.
What does a simple statement of financial position look like?
Assets
Non-current assets
- Intangible assets
- Tangible assets
Current assets
Capital and liabilities
Capital (includes retained profits of the business)
Non-current liabilities
Current liabilities
What is asset expenditure?
Purchase / improvement of tangible non-current assets
What is the difference between asset expenditure and revenue expenditure
asset expenditure (amounts belong in the statement of financial position)
revenue expenditure (amounts belong in the statement of profit or loss, and therefore have a direct effect on profit).
Define Asset
A present economic resource which is controlled by a business,
i.e. something that the business owns or uses.
An economic resource is a right that has the potential to produce economic benefits
What is the asset hierarchy?
Asset
-Non-current assets
——Intangible Asset
——Tangible Asset
-Current Assets
What is a non-current asset?
Assets used over a period of more than one year
What is an intangible asset?
Has no physical existence but still has an ongoing value to the business.
Examples:
-Licence or Patent
-Goodwill
What is a tangible asset?
A physical object that can be seen / touched.
Examples:
-Land & buildings
-Computers
-Furniture
-Motor vehicles
What is a current asset?
Assets that continually flow through the business and are generally used within one year.
Examples:
-Inventory (the value of goods not yet sold)
-Receivables (amounts owed by customers)
-Cash at bank
define capital
The owners’ stake in the business / what the business owes the owner
(in companies this is known as “share capital”)
define liability?
A present obligation to transfer an economic resource, i.e. something owing to someone else.
What is the liability heirarchy?
Liability
-Non-current liability
-Current Liability
What is non-current liability?
Amounts repayable after more than one year, e.g.
-Bank loan
What is a current liability?
Amounts repayable within one year, e.g.
-Bank overdraft
-Trade payables
What is capital also called?
Equity
What is Equity?
Equity = the residual interest in the assets of an entity after deducting all its liabilities
What are the Equity equations?
EQUITY = ASSETS less LIABILITIES or
EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES
What is the Assets equation?
ASSETS = EQUITY (CAPITAL) + LIABILITIES.
What are the important limitations of traditional and financial statements?
-Based on Historial information
-The only report assets and transactions that can be measured reliably in money terms
Due to the limitations of traditional and financial statements, what are large companies now doing?
Most large companies now include non-financial (narrative) information in their published financial statements.
They may also produce additional seperate reports, such as environmental reports.
Some companies are now beginning to produce integrated reports
What is an integrated report?
An integrated report is a report to stakeholders on the strategy, performance and activities of an organisation to create and sustain value over the short, medium and long term.
What is a stakeholder?
A stakeholder is any person or organisation with an interest in any of the activities (not just financial performance) of a business entity. Stakeholders can include employees, customers, suppliers, business partners, local communities, legislators, regulators and policy-makers, as well as investors and lenders.
In an integrated report, what is value?
Value includes profit, but is much wider.
For example, a business may create value through developing new products, or looking after the interests of its employees, or through good customer service,
even though it may be impossible to measure the direct effect of these activities on the profits that it makes.
Why was Integrated Reporting developed?
- developed by the IIRC
The idea behind the integrated report is that a business creates value through all its resources and relationships, called capitals
Capitals are stocks of value that are affected by the activities of an organisation. For example, we have seen that a company’s financial capital is affected by its profits or losses, but as well as financial capital, a business can have manufactured, intellectual, human, social and relationship, and natural capital. An integrated report considers all these capitals.
What is a key benefit of integrated reporting?
it may help organisations to think holistically about strategy and plans and to manage key risks, thereby improving their future performance.
What are the guiding principles of an integrated report?
Strategic focus and future orientation
Connectivity of information
Stakeholder relationships
materiality
conciseness
reliability and completeness
consistency and comparability
guiding principles of an integrated report: strategic focus and future orientation
the report should provide insight into the entity’s strategy, and how this relates to its ability to create value
guiding principles of an integrated report: connectivity of information
the report should show a complete picture of the factors (and their interrelationships) that affect the entity’s ability to create value over time
guiding principles of an integrated report: stakeholder relationships
the report should provide insight into the nature and quality of the entity’s relationships with its key stakeholders
guiding principles of an integrated report: materiality
the report should disclose information about matters that substantively affect the entity’s ability to create value
guiding principles of an integrated report: conciseness
the report should be concise
guiding principles of an integrated report: reliability and completeness
the report should include all material matters, both positive and negative, in a balanced way and without material error
guiding principles of an integrated report: consistence and comparability
information should be presented on a basis that is consistent over time; and in a way that enables comparison with other entities
What are the content elements of an integrated report?
Organisational overview
Governance structure
Business Model
Risks and opportunities
Strategy and resource allocation
Performance
Outlook and challenges
Basis of presentation
Content elements: Organisational overview
Organisational overview and the external environment under which the entity operates
Content elements: Governance
Governance structure and how this supports the entity’s ability to create value
Content elements: Risks and opportunities
Risks and opportunities and how these affect the entity’s ability to create value
Content elements: Performance
Performance and achievement of strategic objectives for the period and outcomes in terms of effects on the capitals
Content elements: Outlook and challenges
Outlook and challenges facing the entity and their potential implications
Content elements: Basis of presentation
Basis of presentation: how the entity determines what matters should be included in the report and how these are quantified or evaluated
Concepts of capital - how to think about an entity’s profit?
It is possible to think of an entity’s profit as the difference between its capital at the beginning and end of a period.
capital could be defined in two ways
financial capital
physical/operating capital
Capital definition - financial capital
shareholders’ funds, represented by the share capital and reserves of a statement of financial position – an entity only makes a profit if its shareholders’ funds increase after taking inflation into account
Capital definition - physical/operating capital
Physical/Operating capital – the physical assets and liabilities needed to keep the company running – in times of rising prices, an entity can only earn a profit if its physical productive capacity increases during the year.
What is capital maintainence?
Capital maintenance is a concept that is intended to ensure that excessive dividends are not paid in times of rising prices, (i.e., that an entity’s capital is maintained).
What framework is used for the principles and elements of an integrated report?
The IIRC has issued The International <IR> Framework.</IR>
This explains the principles and concepts which should be followed in preparing an integrated report and sets out the elements that should be included.
