Chapter 8 - Framework Of Accounting Flashcards
Users of financial statements
Existing and potential investors - To see how much profit has been made, to see how much money can be paid out in drawings of dividends, to see if the asset value of the business has increased or decreased
Lenders - To see how much profit has been made, to check to business will be able to pay interest on loans and make loan repayments, to see what security is available to cover loans
Other creditors (payables) - to decide whether to supply goods and services to the business, to assess if the business is able to pay suppliers
Framework of accounting
Consists of four main areas:
Accounting principles - business entity, materiality, going concern, accruals, consistency, prudence, money measurement
Accounting policies and characteristics - application of accounting policies, fundamental qualitative characteristics, supporting qualitative characteristics
Ethical principles of accounting - integrity, objectivity, professional competence and due care, confidentiality, professional behaviour
Accounting standards - international financial reporting standards
Business entity
This refers to the fact that financial statements record and report on the activities of one particular business or organisation. They do not include the assets and liabilities of those who play a part in owning or running the business.
Materiality
Some items in accounts are of such low value that it is not worthwhile recording them separately ie they are not material. For example small items such as a stapler may be grouped together in a sundry expense account so that low cost non current assets are treated as an expense rather than capital expenditure.
Materiality depends on the size of the business as items may be considered low cost at different amounts. It is for a business to set a policy as to what amount is material or not.
Going concern
Going concern presumes that the business to which the financial statements relate will continue to trade in the foreseeable future.
Accruals
This principle requires that income and expenses are matched so that they relate to the same goods or services and the same accounting period. Examples are: accruals of income and expenses, prepayments of income and expenses, provision for depreciation charges, allowance for doubtful receivables, opening and closing inventory adjustments.
Consistency
When a business adopts accounting policies it should continue to use such policies consistently.
Prudence
This principle requires that caution is excercised when making judgements under conditions of uncertainty.
Money measurement
This refers to the fact that the accounting system uses money as the common denominator for recording and reporting all business transactions. It is not possible to record the loyalty of a firm’s workforce or the quantity of a product because these cannot be reported in money terms.
Accounting policies and characteristics
Accounting policies are the methods used by a business to show the effect of financial transactions and to record assets and liabilities in the statement of financial position.
For financial information to be useful a business selects its accounting policies to fit with two qualitative accounting characteristics of:
Relevance - financial information that is useful to users of the financial statements
Faithful representation - financial information must correspond to the effect of transactions or events and should be complete, natural and free form error
The following four accounting characteristics enhance relevance and faithful representation:
Comparability, verifiability, timeliness, understandability
Material misstatement
Defined as when information contained in the financial statements is untrue.
The use of the word Material means the amount of the misstatement must be significant in relation to the size of the business.
Examples:
Profit is overstated - may encourage investors to buy a stake of the business
Integrity
Being straightforward and honest in all professional and business relationships
Objectivity
Being aware of conflicts of interest and not allowing the influence of others to bias or override professional judgements
Professional competence and due care
The accountant is up to date with current accounting standards and legal developments and carries out their work carefully, thoroughly and on a timely basis
Confidentiality
The profit and other information from the financial statements is not discussed with family and friends but only with the client and work colleagues entitled to know
Professional behaviour
The accountant records all aspects of the preparation of financial statements in an honest and truthful way, in compliance with relevant laws and regulations
Professional scepticism
As well as the application of ethical principles accounting staff should adopt an attitude of professional scepticism. The characteristics of this are:
Having a questioning mind
Being alert to conditions which may indicate possible misstatement due to error or fraud
Making a critical assessment of evidence
Accounting standards
Accounting standards have been developed to reduce the variety of accounting treatments used in financial statement.
Accounting standards take the form of:
International accounting standards (IAS)
International financial reporting standards (IFRS)
IAS 2 inventories
The purpose of this standard is to set out the accounting techniques to be used when valuing inventories. The rule is that inventories are to be valued at the lower of cost and net realisable value.
IAS 16: Property, plant and equipment
This standard sets out the accounting treatment for property, plant and equipment.
IAS 2: Valuation of inventories
At the end of the financial year it is essential for a business to make a physical inventory take for use in the financial statements. This involves accounting staff going into the stores, the shop or the warehouse and counting each item. The counted inventory is then valued as follows:
Number of items held x inventory valuation per item = inventory value
The value of inventory at the beginning and end of the financial year is used as an accruals adjustment to the financial statements.
The overriding principle of inventory valuation as set out in IAS 2 is that inventories are to be valued at the lower of cost and net realisable value. This means that two different inventory values are compared:
Cost:
The cost of purchase, delivery costs, cost of conversion ie to manufacture the product
Net realisable value:
The estimated selling price, less the estimated costs to get the product into the condition necessary to complete the sale
Inventory valuation methods
IAS 2 allows two different methods to be used to calculate the cost price of inventories:
FIFO - this method assumes that the first items received are the first to be used, so that the valuation of inventory on hand at any time consists of the most recently acquired items
AVCO - the average cost of items held at the beginning of the period is calculated, as new inventory is received a new average cost is calculated.
Effect on profit - different methods will have an effect on profit. In times of rising prices, fifo gives the highest profit (because the closing inventory is higher, being based on the latest prices), while AVCO gives a lower profit (because average cost lags behind the latest higher prices). In times of falling prices the reverse will be true. However over the life of a business total profit is the same in total, the profit is allocated to different years depending on which method is selected.
Inventory valuation methods
IAS 2 allows two different methods to be used to calculate the cost price of inventories:
FIFO - this method assumes that the first items received are the first to be used, so that the valuation of inventory on hand at any time consists of the most recently acquired items
AVCO - the average cost of items held at the beginning of the period is calculated, as new inventory is received a new average cost is calculated.
Effect on profit - different methods will have an effect on profit. In times of rising prices, fifo gives the highest profit (because the closing inventory is higher, being based on the latest prices), while AVCO gives a lower profit (because average cost lags behind the latest higher prices). In times of falling prices the reverse will be true. However over the life of a business total profit is the same in total, the profit is allocated to different years depending on which method is selected.
Calculating inventory at cost
The following examples show how to calculate the cost price of inventory from selling price and from a VAT inclusive value.
From selling price:
Inventory at selling price is £150,000
Sales margin is 30%
Cost of inventory is: £150,000 x 100-30/100 = £105,000 cost of inventory
From a vat inclusive value:
Inventory including vat is £90,000
VAT is 20%
Cost of inventory excluding vat is:
£90,000 x 100/120 = £75,000 cost of inventory
Example one is a margin and example two is a mark up
Journal entry for closing inventory
Once a valuation for closing investment is known entries must be made in the accounting system. These comprise a journal entry and a debit and a credit entry in the ledger accounts.
The accounting entries to record closing inventory are:
Debit inventory account (an asset which is recorded on the statement of financial position)
Credit statement of profit or loss (which transfers closing inventory to the statement of profit or loss)
