CHP 37 Flashcards
The four main concepts that have been widely used in relation to the periodic financial accounts of all businesses are:
- “Going concern” concept
- “Accruals” concept: revenue and costs are recognized as they are earned or incurred, not as money is received.
- “Consistency” concept: Consistency of accounting treatment of items within each accounting period and between different periods.
- “Prudence” concept: revenue and profits are not anticipated and provision is made for all known liabilities – whether these are known with certainty or best estimate. This concept should be free from deliberate or systematic bias.
- Accounting concepts
Prudence can be described as the inclusion of a degree of caution in the exercise of judgment in conditions of uncertainty, such that gains are not overstated and losses are not understated.
Thus the greater the uncertainty, the greater the tendency to aim at technical provisions exceeding the expected value of liabilities. This is as a neutral consequence of seeking to avoid understating liabilities.
Market-consistent liability valuation methods reflect risk and uncertainty on the basis of an arm’s length transactions between knowledgeable, willing parties.
To interpret accounts, one has to be familiar with:
- Rules governing the preparation of accounts
* Accounting rules and conventions that apply in the country concerned.
- Interpreting the accounts of financial service providers
Usually a going concern basis is used to aim to reflect true and fair value.
The accounts should be examined to see the effects of changes in accounting practice.
Pay attention to the basis used to value assets and the treatment in accounts of realized and unrealized capital gains and losses.
If assets are shown at market value – consider the variability of these values due to changing markets.
Reports accompanying the accounts may reveal the extent to which the results for the latest period have been affected by exceptional events – occurred and not occurred.
- Interpreting the accounts of financial service providers
2. 1. Insurance companies
Insurance business is subject to cyclical effects. Thus compare one provider’s profitability with another that transacts similar business.
In practice it is often hard to prepare accounts in accordance with the consistency principle because of uncertainty in determining the various items in the accounts, in particular provisions.
Profit can change from changing provision bases.
It may be possible to get an indication of the strength of provisions by examining individual accounting items (gross and net of reinsurance if available) and various ratios on one to another. Compare these with that from earlier years.
The amount of detail in the financial statements will dictate the feasibility of this.
Accounting ratios to be considered:
• Incurred expenses to premium income
• Commission to premium income
• Operating ratio
A sharp rise in premium income may be a sign of competitively low, and possibly unprofitable, premium rates.
Why benefit scheme reporting is different
Benefit schemes do not generate profits or losses.
Valuation of a benefit schemes generates a number for accumulated surplus or deficit. This amount may then be used to adjust the contribution rates for the succeeding period.
Disclosure – beneficiaries
Disclosure to beneficiaries (regarding their entitlements) is prescribed by legislation in many countries. This is done to attempt to improve the security of non-State pensions. Disclosure could include details of the: • Benefit entitlement • Contribution obligations • Expense charges • Investment strategy • Risks involved • Treatment of entitlements in the event of insolvency
Disclosure – regulation
Guidance or legislation on disclosure of information is important to ensure beneficiaries are not misled – intentionally or unintentionally.
Where disclosure is required by legislation, this may relate to information given to beneficiaries:
• On entry
• At regular intervals
• Once payments commence
• On request
• A combination of the above
Disclosure – benefit providers
Well designed info can help encourage individuals to make non-State benefit provision.
The form of benefit will largely dictate the level of understanding by members. Even so, there are many different ways of presenting the benefits that could clarify it for the members.
Poor disclosure could lead to false expectations by members about future benefits, this will lead to problems for the providers.
Disclosure – owners of benefit providers
The owners of the provider (owner of the sponsoring company) should be aware of the financial significance of the benefit obligations that exist. It is common practice in many countries to include these financial obligations in the company’s formal accounts.
In presenting benefit costs in the accounts it is important that the readers of the accounts are able to form a realistic opinion of the company’s current and future financial position.
A number of different accounting standards exist, but the common aim of most attempt to achieve:
- Recognizing the realistic costs of accruing benefits
- Avoid distortions resulting from fluctuations in the flow of contributions from the employer to the pension scheme
- Consistency in the accounting treatment from year to year (not necessarily from company to company)
- Disclosure of appropriate info
A number of different accounting standards exist, but the common aim of most attempt to achieve:
Differences that exist relate to the:
- Emphasis on the relative importance of the balance sheet and the income statements in demonstrating a true financial picture
- Choice of actuarial methodology
- Flexibility in setting of assumptions
- Smoothing of year on year fluctuations
- Amount of information to be disclosed
Possible disclosure requirements that may be needed include the:
- Assumptions used
- Actuarial method used
- Value of liabilities accruing over the year
- Increase in the past service liabilities at the start of the year
- Investment return achieved on the assets over the year
- Surplus / deficit over the year
- Change in the surplus / deficit over the year
- Benefit cost over the year in respect of any directors
- Membership movements
If companies spend more, what can it lead to?
Increased employment
Growth, but time lag before between increased investments and this
