Chapter 5: The conceptual Framework, accounting concepts and conventions

Question 1

1.1 IASB Conceptual framework for financial reporting overview

Answer 1

The International accounting standards board is responsible for issuing international accounting standards. They come in the form of ISA and IFRS standards. The board issued its conceptual framework for financial reporting, this sets out the concepts that underlie the preparation and presentation of financial statements.
The conceptual framework states the objective is to ‘provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity’.
The framework identifies relevance and faithful representation as fundamental qualitative characteristics, these are required for information to be useful.
Relevance: financial information is useful if it can assist users’ decision making by helping them evaluate events or confirming or correcting their existing evaluations. Relevant information may have predictive value (assess future of the business) or confirmatory value (confirm past predictions). Information may be relevant in nature of materiality.
Faithful representation: information must be complete, neutral, free from error and show substance over form (presented in economic substance rather than legal form). Neutrality is supported through the exercise of prudence, which involves exercising caution under situations of uncertainty.
Enhancing characteristics
The relevance and faithful representation of information can be enhanced by the following qualitative characteristics:
- Comparability: information produced on consistent basis, the accounts should be comparable with the accounts of other entities and the same entity for earlier periods
- Verifiability: information can be checked; a consensus could be reached by observers that the information faithfully represents transactions or events
- Timeliness: information supplied on time to be used in decision making, recent information more useful, some information remains timely for a long time after the end of a reporting period
- Understandability: information must be understandable to users who have a reasonable knowledge of business and accounting
The conceptual framework identified the going concern basis as an underlying assumption.

Question 2

2.1 IAS 1 Presentation of financial statements

Answer 2

IAS 1 Presentation of financial statements deals with the structure and content of the financial statements, these formats are recommended. It states the statements comprises of:
- A statement of financial position
- A statement of profit or loss
- A statement showing either changes in equity or changes in equity except for those arsing with owners
- A statement of cash flow
- Accounting policies and explanatory notes
The objectives of IAS 1 is to ensure comparability through prescribing the basis for presentation of general purpose financial statements. The objectives of the accounts is to provide a summary of accounting transactions for a period.
IAS 1 requires the accounts should present fairly the financial position, financial performance, and cash flows of the equity. Fair presentation requires the faithful representation of the effects of transactions in accordance with the requirements of the conceptual framework. Application of IFRS standards is presumed to achieve such fair representation.
IAS 1 states that an entity those accounts comply with international accounting standards should disclose that. In rare circumstances management may conclude that compliance with international standards is misleading and depart from a requirement if necessary, to achieve fair presentation, this does require a disclosure note in the accounts with an estimation of the financial impact.
IAS 1 also requires the accounts to include comparative information, these comparative amounts should be reclassified where the accounts is amended. Comparative information means users can compare the performance year on year.

Question 3

3.1 Accounting concepts and conventions (accruals concept)

Answer 3

Accruals concept requires transactions and events to be recognised when they occur, not when cash is received or paid. Costs incurred in generating income are matched against the revenues they have generated.

Question 4

3.2 Accounting concepts (going concern)

Answer 4

This requires that the entity is viewed as continuing its operations for the foreseeable future (at least 12 months), an assumption is made that there is no intention or necessity to liquidate or curtail materially its operations. This means assets do not need to be valued on a break-up basis (the value they would be sold at separately if the business were liquidated). If the management of a business do not believe that the going concern concept should apply, this should be disclosed and the basis on which the accounts have been prepared and the reasons why the entity is not a going concern, should all be disclosed.

Question 5

3.3 Accounting concepts (materiality)

Answer 5

According to IAS 1, information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of effect of the item judged in the particular circumstances of its omission or misstatement. Determining whether an item is material is subjective and a % is used as a rule of thumb. Any decisions must be made in context.

Question 6

3.4 Accounting concepts (offsetting)

Answer 6

IAS 1 does not allow assets and liabilities or income and expenses, to be offset from one another unless another international accounting standards allows such treatment.

Question 7

3.5 Accounting concepts (historical cost convention)

Answer 7

Assets and liabilities are recorded in the statement of financial position at their historic cost. Assets are recorded at the amount of cash paid, or the fair value of the consideration given for them. Liabilities are recorded at the amount of proceeds received in exchange for the obligation. The advantage of historical cost accounting is it removes the subjectivity of estimating the value of an asset or liability.

Question 8

4.1 Regulation

Answer 8

The need for regulation:
- Regulation ensures accounts are reliable and prepared without unnecessary delay
- Financial accounts are used as the starting point for calculating taxable profits
- The annual accounts are the main document used for reporting to shareholders of a company on the condition and performance of the company
- The stock markets rely on the accounts published by companies
- International investors prefer information to be presented in a similar and comparable way

Question 9

4.2 How is accounting regulated

Answer 9

• Legislation: Companies Act 2006 requires set formats and content. Companies abide by this and accepted accounting standards
• Accounting concepts: help where judgement is required in accounting
• Financial reporting standards: clarify how to account for and present specific items in the accounts, the financial reporting council sets UK standards, the international accounting standards board sets international standards
• Generally accepted accounting practice: the set of accounting practices applied in a given country
• The concept of fair presentation: IAS 1 requires that accounts should present information fairly. The Companies Act 2006 requires accounts to give a true and fair view