Chapter 10

Accounting concepts and assumptions

 Learning objectives
 Describe the assumptions which are made when recording accounting data
 Explain why one set of financial statements has to serve many purposes
 Explain the implications of objectivity and subjectivity in the context of accounting
 Explain what accounting standards are and why they exist
 Describe the history of accounting standards in the UK and the current accounting
standard options for UK entities
 Explain the underlying concepts of accounting
 Explain how the concepts and assumptions of materiality, going concern, comparability
through consistency, prudence, accruals, separate determination, substance over form
and other concepts and assumptions affect the recording and adjustment of accounting
data and the reporting of accounting information
 If the financial statements were solely for the use of the owner(s), there would be no
need to adopt a common framework for the preparation and presentation of the
information contained within them
 However, there are a lot of other people who may be interested in seeing these financial
statements, need to be able to understand them
 For this reason that there has to be a commonly established practice concerning how
the information in the financial statements is prepared and presented
 Learn about some of the agreed practices that underpin the preparation of accounting
information
 Some of the regulations that have been developed to ensure that they are adhered to
 Objective of financial statements
 Should provide information about the financial position, performance and changes
in the financial position of an entity that is primarily useful to existing and potential
investors, lenders and other creditors in making decisions about providing resources
to the entity
 Decisions involve buying, selling or holding equity and debt instruments, and
providing or settling loans and other forms of credit
 Primary users need information about the resources of the entity to assess:
 Its potential for future net cash inflows
 Its stewardship, i.e. how effectively and efficiently management has used the entity's
resources
 In order to achieve this objective, financial statements are prepared on the basis of a
number of established concepts and assumptions and must adhere to the rules and
procedures set down in regulations called, 'accounting standards'
 Objectivity and subjectivity
 Use of a method which arrives at a value that everyone can agree to because it is
based upon a factual occurrence is said to be objective
 Everyone else knows where the value came from and can see that there is very
good evidence to support its adoption
 If, instead of being objective, subjective, would use your own judgement to
arrive at a cost
 Desire to provide the same set of financial statements for many different parties,
and provide a basis for measurement that is generally acceptable, means that
objectivity is sought in financial accounting
 If you are able to understand this desire for objectivity, then many of the
apparent contradictions in accounting can be understood, because objectivity is
at the heart of the financial accounting methods all use
 Financial accounting, seeks objectivity and it seeks consistency in how information
is prepared and presented
 To achieve this, there must be a set of rules which lay down the way in which the
transactions of the business are recorded
 Rules have long been known as 'accounting concepts’
 A group of these have become known as 'fundamental accounting concepts' or
'accounting principles' and have been enforced through their incorporation in
accounting standards issued on behalf of the accountancy bodies by accounting
standards boards, and by their inclusion in the relevant legislation governing
companies
 Accounting standards and financial reporting standards in the UK

 At one time, there used to be quite wide differences in the ways that accountants
calculated profits
 In the late 1960s a number of cases led to a widespread outcry against this lack of
uniformity in accounting practice
 In response, the UK accounting bodies formed the Accounting Standards Committee
(ASC)
 Issued a series of accounting standards, called Statements of Standard Accounting
Practice (SSAPs)
 ASC was replaced in 1990 by the Accounting Standards Board (ASB), which also
issued accounting standards, this time called Financial Reporting Standards (FRSs)
 Both these forms of accounting standards were compulsory, enforced by company
law
 From time to time, the ASB also issued Urgent Issue Task Force Abstracts

(UITFs)
 Generally intended to be in force only while a standard was being prepared or an

existing standard amended to cover the topic dealt with in the UITF
 Some issues do not merit a full standard and so a few UITFs were never replaced

by a new standard
 UITFs carried the same weight as accounting standards and their application was

compulsory for financial statements prepared under UK GAAP -the term for the

set of regulations and legislation applicable to and created for UK financial

statements
 SSAPs and FRSs were generally developed with the larger company in mind
 In an effort to make adherence to standards more manageable for smaller companies, in

1997 the ASB issued a third category of standard -the Financial Reporting Standard for

Smaller Entities (FRSSE)

 A collection of some of the rules from virtually all the other accounting standards
 Small entities could choose whether to apply it or continue to apply all the other

accounting standards
 The authority, scope and application of each document issued by the ASB was
announced when the document was issued
 Thus, even though each accounting standard and UITF must be applied by anyone
preparing financial statements under UK GAAP, in some cases certain classes of
organizations were exempted from applying some or all of the rules contained within
them
 In 2005, most companies whose shares were quoted on the London Stock Exchange
were required to switch to International Accounting Standards, and other entities could
do so if they wished

 By 2010, many had switched voluntarily to International GAAP
 Among those that had not switched to International GAAP, many had changed from
UK GAAP terminology in their financial statements (such as 'stock' and 'Profit and
Loss Account') to International GAAP terminology (such as 'inventory' and 'statement
of profit or loss’)
 Usefulness of UK accounting standards was clearly reducing.
 Consequently, in 2010 the ASB published an exposure draft on the future of financial
reporting in the UK and Republic of Ireland
 Proposed a revised Conceptual Framework aimed at balancing the needs of
preparers and users of financial statements; and sought to simplify UK standards into
a concise, coherent and updated form
 In 2012 the Financial Reporting Council (FRC) took over the work of the ASB
 It very quickly replacing almost all extant standards, initially with three Financial
Reporting Standards:
 FRS 100 Application of Financial Reporting Requirements (issued November 2012;
amended July 2014);
 FRS 101 Reduced Disclosure Framework (issued November 2012; amended July
2014);
 FRS 102 The Financial Reporting Standard applicable in the UK and Republic of
Ireland (issued March 2013)
 In March 2014, it issued a fourth: FRS 103 Insurance Contracts
 Smallest companies, continue to use the simplified version of UK standards,
Financial Reporting Standard for Smaller Entities, known as the FRSSE
 An updated version of the FRSSE was issued in July 2013
 International Accounting Standards
 Financial Reporting Council deals with the United Kingdom and Ireland
 Besides this and other national accounting boards, there is an international
organization concerned with accounting standards
 International Accounting Standards Committee (IASC) was established in 1973
and changed its name to the International Accounting Standards Board (IASB) in
2000
  Need for an IASB was due to:
 (a) The considerable growth in international investment
 Desirable to have similar accounting methods the world over so that investment
decisions are more compatible
 (b) The growth in the number of multinational organizations
 Organizations have to produce financial statements covering a large number of countries
 Standardization between countries makes the accounting work that much easier, and
reduces costs
 (c) As quite a few countries now have their own standard-setting bodies, it is desirable
that their efforts be harmonized
 (d) The need for accounting standards in countries that cannot afford a standard-setting
body of their own
Underlying accounting concepts
 A number of accounting concepts have been applied ever since financial statements
were first produced for external reporting purposes
 Become second nature to accountants and are not generally reinforced, other than
through custom and practice
The historical cost concept
 Assets are normally shown at cost price, and that this is the basis for valuation of
the assets
Money measurement concept
 Accounting information has traditionally been concerned only with those facts
covered by :
 (a) it can be measured in monetary units;
 and (b) most people will agree to the monetary value of the transaction
 The business entity concept
  The dual aspect concept
 Two aspects of accounting, one represented by the assets of the business and
the other by the claims against them
 Two aspects are always equal to each other
 Alternate form of the accounting equation:
 The time interval concept
 One of the underlying principles of accounting, the time interval concept, is that
financial statements are prepared at regular intervals of one year
 Companies which publish further financial statements between their annual ones
describe the others as 'interim statements’
 For internal management purposes, financial statements may be prepared far more
frequently, possibly on a monthly basis or even more often
 Underlying assumptions
 IASB Conceptual Framework lists two assumptions that must be applied if
financial statements are to meet their objectives: the accrual basis (also called
the accruals concept) and the going concern concept
Accrual basis
 Effects of transactions and other events are recognized when they occur and
they are recorded in the books and reported in the financial statements of the
period to which they relate
 Net profit is the difference between revenues and the expenses incurred in
generating those revenues, i.e
 Going concern
 Assumed that the business will continue to operate for at least twelve months
after the end of the reporting period
 Business is drawing up its financial statements at 31 December 2016
 Normally, using the historical cost concept, the assets would be shown at a total
value of £100,000
 However , that the business will be forced to close down in February 2017, only
two months later, and the assets are expected to be sold for only £15,000
 Would not make sense to keep to the going concern concept, and so we can
reject the historical cost concept for asset valuation purposes
 In the statement of financial position at 31 December 2016, the assets will be
shown at the figure of £15,000
 Rejection of the going concern concept is the exception rather than the rule
 where the going concern assumption should be rejected are:
 If the business is going to close down in the near future;
 Where shortage of cash makes it almost certain that the business will have to
cease trading;
 Where a large part of the business will almost certainly have to be closed down
because of a shortage of cash
 Qualitative characteristics of financial statements
 Make the information provided in financial statements useful to users are four principal
qualitative characteristics: understandability, relevance, reliability and comparability.
Understandability
 Information in financial statements should be readily understandable by users
Relevance
 Information in financial statements must be relevant to the decision-making needs of users
 To be relevant, information must influence the economic decisions of users by helping them
evaluate past, present or future events or confirming, or correcting, their past evaluation
Materiality
 Information is material if its omission or misstatement could influence the economic decisions
of users
 Depends on the size of the item or error judged in the particular circumstances of its omission
or misstatement
 Reliability
 To be useful, information must also be reliable
 To be reliable, information must be free from material error and bias and able to be
depended upon by users to represent faithfully what it claims to represent
Faithful representation
 A statement of financial position should represent faithfully the transactions and other
events that result in assets, liabilities and equity of the entity at the reporting date
Substance over form
 Transactions and other events must be accounted for and presented in accordance with
their substance and economic reality and not merely their legal form
Neutrality
 Information in financial statements must be free of bias
 Prudence
 Inclusion of a degree of caution in the exercise of the judgement needed in
making the estimates required under conditions of uncertainty (e.g. decisions
relating to bad debts and allowances for doubtful debts), such that assets and
income are not overstated and liabilities and expenses are not understated
Recognition of profits and gains
 Recognition of profits at an appropriate time has long been recognized as being in
need of guidelines and these have long been enshrined in what is known as the
realization concept
 Profit and gains can only be taken into account when realization has occurred and
that realization occurs only when the ultimate cash realized is capable of being
assessed (i.e. determined) with reasonable certainty
 Several criteria have to be observed before realization can occur:
 Notice that it is not the time
 When the order is received; or
 When the customer pays for the goods
 Only when you can be reasonably certain as to how much will be received
that you can recognize profits or gains
 Recognizing profits and gains now that will only be 100 per cent known in
future periods is unlikely to ever mean that the correct amount has been
recognized
 Misjudgments can arise when, for example, profit is recognized in one period,
and later it is discovered that this was incorrect because the goods involved
have been returned in a later period because of some deficiency
 Completeness
 To be reliable, information in financial statements must be complete within the
bounds of materiality and cost
Comparability
 Comparability requires consistency
 Measurement and display of the financial effect of similar transactions and other
events must be done in a consistent way throughout an entity and over time for
that entity, and in a consistent way for different entities
 Users must be informed of the accounting policies used in the preparation of the
financial statements
 Must be informed of any changes in those policies and of the effects of such
changes
 Financial statements must include corresponding information for the preceding
periods
 Constraints on relevant and reliable information

 Timeliness
 Balance between benefit and cost
 Balance between qualitative characteristics
Other assumptions
Separate determination
 In determining the aggregate amount of each asset or liability, the amount of each
individual asset or liability should be determined separately from all other assets
and liabilities.
 For example, if you have three machines, the amount at which machinery is shown
in the statement of financial position should be the sum of the values calculated
individually for each of the three machines
 Only when individual values have been derived should a total be calculated