Chapter 2

Question 1

What is an accounting conceptual framework as a theory?

Answer 1

explains the reasoning which underlies the preparation of financial statements.

Question 2

What does an accounting conceptual framework set out?

Answer 2

generally accepted accounting principles, which form the basis of financial accounting and reporting standards

Question 3

What questions do a framework answer?

Answer 3

 What are financial statements?
 What are they for?
 Who are they for?
 What makes them useful?

Question 4

What is the objective of financial statements?

Answer 4

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.

Question 5

What are the characteristics of useful financial information?

Answer 5

Useful information is characterised by qualities that may be categorised as:
 Fundamental (i.e. essential)
 Enhancing (i.e. a further improvement).

Question 6

What are fundamental qualitative characteristics?

Answer 6

1) Relevance
2) Faithful representation

Question 7

Fundamental qualitative characteristics: Relevance definition

Answer 7

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.

Question 8

Fundamental qualitative characteristics: Faithful representation definition

Answer 8

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.

Question 9

What are enhancing qualitative characteristics

Answer 9

1) Comparability
2) Verifiability
3) Timeliness
4) Understandability

Question 10

Enhancing qualitative characteristics: Comparability

Answer 10

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.

Question 11

Enhancing qualitative characteristics: Verifiability

Answer 11

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.

Question 12

Enhancing qualitative characteristics: Timeliness

Answer 12

To be useful, information must be provided to users within a reasonable time.

Question 13

Enhancing qualitative characteristics: Understandability

Answer 13

information should be presented in such a way that it is understandable by users with reasonable business knowledge.

Question 14

Going concern and financial statements

Answer 14

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

Question 15

Define a going concern

Answer 15

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

Question 16

Define ‘materiality’

Answer 16

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.

Question 17

Define ‘substance over form’

Answer 17

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.

Question 18

Define ‘ business entity/separate entity concept’

Answer 18

The business is a separate entity from its owner. Double entry bookkeeping is based around this concept (see Chapter 4).

Question 19

Define ‘accruals’

Answer 19

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.

Question 20

Define ‘consistency’

Answer 20

A business should use the same accounting treatment for similar events and transactions over a period of time. This leads to comparability.

Question 21

Define ‘prudence’

Answer 21

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.

Question 22

What is the historic cost concept?

Answer 22

Transactions are recorded at their historic cost, in other words, the amount paid or invoiced.

Question 23

What are the pros and cons of historic cost

Answer 23

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

Question 24

What are the alternative valuation methods?

Answer 24

Fair Value
Value in use
Net realisable value
Current cost

Question 25

Valuation methods: Fair Value

Answer 25

the amount received or paid to sell an asset or transfer a liability in an arm’s length transaction

Question 26

Valuation methods: Value in Use

Answer 26

the present value of the future cash flows associated with an asset or liability.

Question 27

Valuation methods: Net realisable value

Answer 27

the net amount of cash that is expected to be received/paid upon selling/settling that item.

Question 28

Valuation methods: Current cost

Answer 28

the amount of cash that would be paid today to acquire an equivalent asset. This method may be used in times of high inflation.

Question 29

What are accounting policies?

Answer 29

the specific principles, conventions, rules and practices applied by an entity in order to reflect the effects of transactions in the financial statements.

Question 30

How consistent should accounting policies be?

Answer 30

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.

Question 31

Rules for changes in accounting policy

Answer 31

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

Question 32

what does a statement of profit or loss tell us?

Answer 32

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

Question 33

What is Revenue expenditure?

Answer 33

Expenses incurred in everyday trading

Question 34

What are cost of sales?

Answer 34

Direct costs incurred in selling goods or services adjusted for movements in inventory

Question 35

What is gross profit?

Answer 35

The excess of revenue over cost of sales

Question 36

What are other expenses?

Answer 36

All other costs incurred by the business

Question 37

What is Net profit?

Answer 37

The excess of revenue over total expenses

Question 38

What does a simple statement of profit or loss look like?

Answer 38

Revenue
Cost of Sales
Gross Profit
Other Expenses
Net Profit

Question 39

What is a statement of financial position

Answer 39

The Statement of financial position (sometimes called the Balance Sheet) is a “snapshot” of the business assets and liabilities at a particular date.