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Accounting Unit 1 – Financial

SUBJECT: CAPE ACCOUNTING
UNIT: 1 – FINANCIAL ACCOUNTING
MODULE: 1 – ACCOUNTING THEORY, RECORDING AND CONTROL SYSTEMS
TOPIC: CONCEPTUAL FRAMEWORK OF ACCOUNTING

The International Accounting Standards Board (IASB) issued its 'Framework for the
Preparation and Presentation of Financial Statements' in 1989. This is referred to as its
conceptual framework.
The framework sets out the concepts that shape the preparation and presentation of
financial statements for external users. The framework does not have the status of an
accounting standard as also is the case with the 'Statement of Principles' from the UK
Accounting Standards Board (ASB). The IASB framework assists the IASB:
1. In the development of future International Financial Reporting Standards and in its
review of existing International Accounting Standards; and
2. In promoting the harmonisation of regulations, accounting standards and
procedures relating presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by
international standards.
In addition, the framework may assist:
3. Preparers of financial statements in applying international standards and in dealing
with topics that have yet to form the subject of an International Accounting
Standard
4. Auditors in forming an opinion as to whether financial statements conform with IFRS
5. Users of financial statements in interpreting the information contained in financial
statements prepared in conformity with IFRS
6. Those who are interested in the work of IASB, providing them with information
about its approach to the formulation of accounting standards.

The Elements of Conceptual Framework

Financial Reporting Objectives

The objectives of financial reporting are to provide information that is:

1. Useful to current and potential investors and creditors (and other users) in making
rational investment, credit, and other related decisions.
2. Helpful to current and potential investors and creditors (and other users) in assessing
the amounts, timing, and uncertainty of future cash flows such as dividends or interest
payments.
3. Accurate in reporting the economic resources (assets) of the business, including any
claims to those resources held by other entities (outstanding liabilities), as well as the
effects of any pending transactions, events, and circumstances that will affect the
company’s resources and claims to those resources.

Qualitative Characteristics of Accounting Information

Primary
The IASB states that the two most important attributes of accounting information in
terms of usefulness to external decision makers are relevance and reliability. These
attributes are called primary qualities.

Relevance is the capacity of accounting information to make a difference to the external

decision makers who use financial reports. Stated more technically, relevant accounting
information helps users to evaluate current conditions, make predictions about future
events (it has a predictive value), and confirm or correct prior expectations (it has
feedback value). Information possesses the attribute of relevance when it influences the
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Accounting Unit 1 – Financial
economic decisions of users by aiding the evaluation of past, present and future events
in both a predictive and confirmatory way.
Relevance can be evaluated according to two qualitative criteria:
1. Predictive value: Accounting information should be helpful to external decision
makers by increasing their ability to make predictions about the outcome of future
events. Decision makers working from accounting information that has little or no
predictive value are merely speculating intuitively.
2. Feedback value or confirmatory value: Accounting information should be helpful to
external decision makers who are confirming past predictions or making updates,
adjustments, or corrections to predictions.

To ensure reliability, accounting information must be free from error and bias and
faithfully represent what it claims to represent. It must not mislead or deceive.
Reliability must meet three qualitative criteria:
1. Representational faithfulness: This attribute is sometimes called validity. Information
must give a faithful picture of the facts and circumstances involved. Accounting
information must report the economic substance of transactions, not just their form and
surface appearance.
2. Verifiability: Accounting information should represent what it purports to represent
and should ensure that the selected method of measurement has been used without
error or bias. Verifiability pertains to maintenance of audit trails to information source
documents that can be checked for accuracy. Verifiability also pertains to the existence
of alternative information sources as backup. Verification implies a consensus and
implies that independent measures using the same measurement methods would reach
substantially the same conclusion. Therefore verifiability – relates to information being
communicated in an unbiased manner [faithfully represent, accurate, true and fair].
This means that different knowledgeable and independent observers could reach
consensus that the financial statements can be tested [can be proven ].
3. Neutrality: Accounting information must be free from bias regarding a particular
viewpoint, predetermined result, or particular party. Preparers of financial reports must
not attempt to induce a predetermined outcome or a particular mode of behavior (such
as to purchase a company’s stock).

Understandability – Information must be understandable to users who are mature and

willing to study the information diligently. Financial reporting provided to users must
not be so complex that a user with reasonable knowledge of business and economic
activities and accounting, and willingness to study the information with reasonable
diligence, would not be able to understand it.

Secondary
Certain types of accounting information are of little value for external decision makers
unless the data can be compared with data from other companies, with industry
averages, with composite data on a group of similar enterprises, or with specific
information for other accounting periods. These attributes are called secondary
qualities.
● Comparability enables users to identify similarities and differences between two or
more sets of economic circumstances. For example, an income statement should be
designed so that the revenue, expense, and net income information of one company
can be compared with that of other companies in the same industry.
● Consistency means that the reported information conforms to procedures that
remain unchanged from period to period. Comparisons over time are difficult unless
there is consistency in the way accounting principles are applied across fiscal years.
Therefore similar items such as inventory valuation and depreciation of fixed assets
must be treated in the same way in the accounting period and from one period to
the next.
● Substance over form – means that the economic substance of transactions and
events must be recorded in the financial statements rather than just their
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Accounting Unit 1 – Financial
legal form in order to present a true and fair view of the affairs of the entity. Thus
this is the concept that the financial statements and accompanying disclosures of a
business should reflect the underlying realities of accounting transactions. Three
criteria of this concepts is to look at the reward – who is benefiting from it, the risk
in terms of insurance- who would be liable and the ownership interms of the length
of the transaction when you look at it who would you say owns it.

ELEMENTS OF FINANCIAL STATEMENTS

Balance Sheet (Statement of Financial Position) Elements

✔ Assets are future economic benefits obtained or controlled by a particular entity as a
result of past transactions.
✔ Liabilities are the obligations of an entity to transfer assets or provide services to
other entities as a result of past transactions.
✔ Equity (Owner’s Equity) is the interest in the assets of an entity that remains after
subtracting its liabilities. It is the ownership interest in the entity.

Income Statement (Statement of Comprehensive Income) Elements

✔ Revenues are inflows of assets that arise from delivering or producing goods,
rendering services, or performing other activities that constitute the entity’s
ongoing central operations.
✔ Expenses are outflows of assets or the incurrence’s of liabilities that arise from
delivering or producing goods, rendering services, or carrying out activities that
constitute the entity’s ongoing central operations.
✔ Gains are increases in owner’s equity that do not result from revenues or
investments by owners.
✔ Losses are decreases in owner’s equity that do not result from expenses or
distributions to owners.
Note that revenues and expenses arise from the business’s ongoing central operations,
but gains and losses do not. Sales are revenues because most companies make sales and
earn interest as part of their central operations. Selling cars and trucks lies at the heart
of an automobile dealership. To this business, a gain on the sale of a truck is revenue,
and a loss on the sale is expense. However, a gain on the sale of a truck is not revenue
for a trucking company because that entity buys trucks for use rather than for sale.
Selling a truck is not a part of central operations.

Statement of Owner’s Equity / Statement of Changes in Equity Elements

✔ Investments by owners are increases in owner’s equity that result from the
owner’s transferring to the entity something of value. The most common
investment is cash, but owners sometimes invest land, buildings, legal services,
or other assets. In some cases, an owner’s investment in the business may
consist of paying off its liabilities.
✔ Distributions to owners are decreases in owner’s equity that result from the
owner’s transferring assets or services from the business to himself or herself, or
from the business taking on the owner’s liabilities. When the business is a
corporation, owner withdrawals are called dividends. The most commonly
distributed asset is cash, but businesses sometimes distribute other assets, such
as stock investments they hold in other companies, to their owners.

Statement of Cash Flows : in Module 3

RECOGNITION AND MEASUREMENT IN STATEMENTS

Financial accounting information is communicated to interested parties. IFRS addresses

six specific topic areas:
1. Recognition criteria.
2. Measurement criteria.
3. Environmental assumptions.
4. Implementation principles.
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5. Implementation constraints.
6. General-purpose financial statements.

Recognition Criteria

Recognition pertains to the point in time when business transactions are recorded in the
accounting system. Recognition is the process of recording and reporting an item as an
asset, liability, revenue, expense, gain, loss, or change in owners’ equity. Recognition of
an item is required when all four of the following criteria are met:
1. Definition: The item in question must meet the definition of an element of financial
statements.
2. Measurability: The item must have a relevant quality or attribute that is reliably
measurable (historic cost, current cost, market value, present value, or net realizable
value).
3. Relevance: The accounting information generated by the item must be significant,
that is, capable of making a difference to external users in making decisions.
4. Reliability: The accounting information generated by the item must be
representationally faithful, verifiable (subject to audit confirmation or second-source
collaboration), and neutral (bias free).

Environmental Assumptions

Four basic environmental assumptions that significantly affect the recording, measuring,
and reporting of accounting information. They are
I. Separate entity assumption/ Economic Entity Assumption
2. Continuity assumption / Going Concern Assumption
3. Unit of measure assumption.
4. Time period assumption.

Separate Entity Assumption/ Economic Entity Assumption Accounting deals with

specific, identifiable business entities, each considered an accounting unit separate and
apart from its owners and from other entities. A corporation and its stockholders are
separate entities for accounting purposes, even in the case of closely held private
corporations. Also, partnerships and sole proprietorships are treated as separate from
their owners, although this separation does not hold true in a legal sense.
Under the separate entity assumption all accounting records and reports are developed
from the viewpoint of a single entity, whether it is a proprietorship, a partnership, or a
corporation. The assumption is that an individual’s transactions are distinguishable from
those of the business he or she might own. For example, the personal residence of a
business owner is not considered an asset of the business, even though the residence
and the business are owned by the same person.

Continuity Assumption Under the continuity assumption, also known as the going.
concern assumption, the business entity in question is expected not to liquidate, but to
continue operations for the foreseeable future. That is, it will stay in business for a
period of time sufficient to carry out contemplated operations, contracts, and
commitments. This non liquidation assumption provides a conceptual basis for many of
the classifications used in accounting. Assets and liabilities, for example, are classified as
either current or long-term on the basis of this assumption. If continuity is not assumed,
the distinction between current and long-term loses its significance; all assets and
liabilities become current. Continuity also supports the measurement and recording of
assets and liabilities at historical cost.
If a business entity expects to be liquidated in the near future, conventional accounting,
based on the continuity assumption, is not appropriate. Such circumstances call instead
for the use of liquidation accounting, which values assets and liabilities at estimated net
realizable amounts (liquidation values).
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Unit-of-Measure Assumption The unit-of-measure assumption means that the results of
a business’s economic activities are reported in terms of a standard monetary unit
throughout the financial statements. Money amounts are thus the language of
accounting—the common unit of measure (yardstick) enables dissimilar items, such as
the cost of a ton of coal and an account payable, to be aggregated into a single total.
The unit of measure in the United States is the dollar; in Japan it is the yen. Different
units are used in other countries.

Time-Period Assumption the operating results of any business enterprise cannot be

known with certainty until the company has completed its life span and ceased doing
business. In the meantime, external decision makers require timely accounting
information to satisfy their analytical needs. To meet their needs, the time-period
assumption (or calendar constraint) requires that changes in a business’s financial
position be reported over a series of shorter time periods.
Although the reporting period varies, one year is the standard. Some companies use a
calendar year, and others use a fiscal year-end that coincides with the low point in
business activity over a 12-month period. In addition, companies also report
summarized financial information on an interim basis, usually quarterly.
A company may elect to use a reporting period that is either longer or shorter than the
standard 12-month calendar or fiscal year, but only if doing so better fits the company’s
normal business cycle. Companies in the shipbuilding industry, for example, may select a
longer reporting period because constructing a vessel and readying it for launch typically
require more than one year’s time.
The time-period assumption recognizes both that decision makers need timely financial
information and that recognition of accruals and deferrals is necessary for reporting
accurate information. Accrual and deferral items distinguish accrual-basis accounting. If
a demand for periodic reports did not exist during the life span of a business, accruals
and deferrals would not be necessary. A company’s financial statements are always
dated to reflect either a precise date (balance sheet) or a particular period of time
covered (income statement and cash flow statement).

Implementation Principles

Implementation principles govern the recognition of revenue, expense, gain, and loss
items for financial statement reporting purposes. Five separate implementation
principles apply to the recognition process:
1. Cost principle / Historical Cost Principle
2. Revenue principle.
3. Matching principle.
4. Full disclosure principle.
5. Relevance principle
Income is defined as revenues plus gains minus expenses and losses. The cost, revenue,
and matching principles are the fundamental principles governing income recognition.

Cost Principle Normally applied in conjunction with asset acquisitions, the cost principle
specifies that the actual acquisition cost be used for initial accounting recognition
purposes. The cash-equivalent cost of an asset is used if the asset is acquired via some
means other than cash.
The cost principle assumes that assets are acquired in business transactions conducted
at arm’s length, that is, transactions between a buyer and a seller at the fair value
prevailing at the time of the transaction. For non cash transactions conducted at arm’s
length, the cost principle assumes that the market value of the resources given up in a
transaction provides reliable evidence for the valuation of the item acquired.
The cost principle provides guidance primarily at the initial acquisition date. Once
acquired, the original cost basis of some assets is then subject to depreciation,
depletion, amortization, or write-down in conformity with the matching principle and
the conservatism constraint.
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Revenue Principle The revenue principle requires the recognition and reporting of
revenues in accordance with accrual basis accounting principles. Applying this principle
requires, first, that all four of the recognition criteria—definition, measurability,
relevance, and reliability—be met.
Revenue can be defined as inflows of cash or other enhancements of a business’s assets,
settlements of its liabilities, or a combination of the two. Such inflows must be derived
from delivering or producing goods, rendering service, or performing other activities
that constitute a company’s ongoing business operations over specific period of time.
More generally, revenue is measured as the market value of the resources received or
the product or service given, whichever is the more reliably determinable. This broader
definition comes into play in conjunction with non-cash transactions (exchanges of
goods and merchandise, or services performed).
The revenue principle pertains to accrual basis accounting and is not relevant to cash
basis accounting. Therefore, completed transactions for the sale of goods or services on
credit usually are recognized as revenue for the period in which the sale or service
occurs rather than in the period in which the cash is eventually collected. Furthermore,
related expenses are matched to these revenues.
The pattern of expense recognition varies. Some expenses are linked with revenues by a
direct cause-and-effect relationship, especially when the revenue and expense
transactions occur simultaneously. Examples are packaging, sales relevant information
about the asset inflows (normally either an increase in cash or a similar increase in
accounts receivable) to the seller is known. Sales must be accompanied by transfer of
ownership (or the performance of services).
In general, two conditions must be met if the revenue principle is to be satisfied. There
must be
I. Reasonable assurance of collection.
2. Substantial completion of transaction.

The first condition, reasonable assurance of collection, is necessary for the transaction
to result in a “probable future economic benefit.” This means there is an increase in
assets for the seller. Without this first condition, the concept of revenue recognition
would lack economic content.
The second condition, substantial completion, ensures that the seller has no major work
still to do. Incomplete transactions include products or goods shipped by the seller
(sometimes at the buyer’s request) with components and substantial parts yet to be
assembled, or billing a client in full when certain services specified in the contract have
yet to be performed. The logic behind the second condition is that buyers may cancel
sales, citing the seller’s failure to deliver or perform, resulting in no revenue to the
seller. The earnings process is not considered complete.
Transactions that pose revenue recognition uncertainties include installment sales, long-
term construction contracts, sales of land with minimal down payments, and sales of
franchises that require a certain level of performance on the part of the purchaser as a
condition of sale. In these transactions, and in others, both the determination of when
the earnings process is complete and the measurement of the revenue amount involved
can be difficult tasks.

Matching Principle Like the revenue principle, the matching principle is predicated on
accrual basis accounting, but matching refers to the recognition of expenses. All
expenses incurred in earning the revenue recognized for a period should be recognized
during the same period. If revenue is carried over (deferred) for recognition to a future
period, the related expenses should also be carried over or deferred since they are
incurred in earning that revenue.
Applying both the matching principle and the revenue principle determines the
reporting of net income. The matching principle is therefore one of the most pervasive
principles in terms of the sheer number of accounting judgments that it affects.
Application of the matching principal requires outlays that otherwise would be
expensed at the time cash is disbursed, using cash basis accounting, to be carried on the
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books as assets. These expenditures are made for materials, purchased services, and the
like that help earn future revenue. Only later, when the revenue is recognized, are the
asset accounts expensed. In this way revenues and related expenses are matched across
accounting periods.
Matching and accrual accounting are linked. Although a firm’s earning process is
continuous, its operating activities are reported over specific time intervals. Thus, some
of the firm’s activities may be completed within a specific time period, a year or a
quarter, whereas other activities may take place over several periods.

Full-Disclosure Principle The full-disclosure principle stipulates that the financial

statements report all relevant information bearing on the economic affairs of a business
enterprise. Additionally, the full-disclosure principle stipulates that the primary
objective is to report the economic substance of a transaction rather than merely its
form. This means that substance should not be blurred by the way the transaction is
presented. The aim of full disclosure is to provide external users with the accounting
information they need to make informed investment and credit decisions. Full
disclosure requires that the accounting policies followed be explained in the notes to
the financial statements.
Accounting information may be reported in the body of the financial statements, in
disclosure notes to these statements, or in supplementary schedules and other
presentation formats. For example, contracts for future delivery of goods or services
often are disclosed in the footnotes. Even though the transaction has not occurred,
existence of such contracts can have a material effect on a company’s future financial
position.

Prudence – Prudence is the inclusion of a degree of caution in the exercise of judgments

needed in making the estimates required under conditions of uncertainty, such that
assets or income are not overstated and liabilities or expenses are not understated.

Implementation Constraints

Consistency in the application of accounting principles and uniformity of accounting

practice within the profession may not be achievable in all cases. Exceptions are allowed
in special situations categorized according to four implementation constraints:
1. Cost—benefit constraint.
2. Materiality constraint.
3. Industry peculiarities constraint.
4. Conservatism constraint.
These constraints exert a modifying influence on financial accounting and reporting.

Cost—Benefit Constraint underlying the cost—benefit constraint is the assumption that

the benefits derived by external users of financial statements should outweigh the costs
incurred by the preparers of the information. Although it is admittedly difficult to
quantify these benefits and costs, the IASB often attempts to obtain information from
preparers on the costs of implementing a new reporting requirement. It does not,
however, try to estimate indirect costs, such as the cost of any altered allocation of
resources in the economy. The cost—benefit determination is essentially a judgment
call.

Materiality Constraint Materiality is defined as “the magnitude of an omission or

misstatement of accounting that, in the light of surrounding circumstances, makes it
probable that the judgment of a reasonable person relying on the information would
have been changed or influenced by the omission or misstatement.” The materiality
constraint is also called a threshold for recognition. The assumption is that the omission
or inclusion of immaterial facts is not likely to change or influence the decision of a
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rational external user. However, the materiality threshold does not mean that small
items and amounts do not have to be accounted for or reported. For example, fraud is
an important event regardless of the size of the amount.
To illustrate an instance where strict conformity with GAAP is not necessary because an
item is immaterial, consider a low-cost asset, such as a $9.95 pencil sharpener. This item
can be recorded as an expense in full when purchased rather than as an asset subject to
depreciation. The dollar amount involved is simply too small for external users to worry
about. Nor does it warrant distinction as a separate expense account item. The amount
is lumped instead into miscellaneous expenses.

Industry Peculiarities One of the overriding concerns of accounting is that the

information in financial statements be useful. The problem is that certain types of
accounting information might be critical for decision making in one industry setting, but
not in another. To illustrate such industry peculiarities, consider the differences
between a public utility’s business practices and those in the banking industry, between
railroads and mutual funds, or between insurance companies and mining companies.
Basically, each industry has its own way of doing things, its own business practices.
Under the industry peculiarities constraint, selective exceptions to generally accepted
accounting principles are permitted, provided there is a clear precedent in the industry.
Precedent is based on the uniqueness of the situation, the usefulness of the information
involved, preference of substance over form, and possible compromise of
representational faithfulness. For example, Corning Glass Works follows a standard glass
industry practice of accruing glass furnace repair costs before the actual repairs are
made. Such repairs lead to essentially an indefinite life for a glass furnace.

Conservatism The conservatism constraint holds that when two alternative accounting
methods are acceptable and both equally satisfy the conceptual and implementation
principles set out by the FASB, the alternative having the less favorable effect on net
income or total assets is preferable. For example:
• In recognizing assets, the lower of two alternative valuations would be recorded.
• In recognizing liabilities, the higher of two alternative amounts would be recorded.
• In recording revenues, expenses, gains, and losses where there is reasonable doubt as
to the appropriateness of alternative amounts, the one having the least favorable effect
on net income would be used.
Conservatism assumes that when uncertainty exists, the users of financial statements
are better served by understatement than by overstatement of net income and assets.
Prime examples include valuing inventories and other assets at the lower of cost or
current market value, and minimizing the estimated service life and residual value of
depreciable assets. Unfortunately, the use of an overly conservative practice may also
result in a negatively biased portrayal of a company’s financial condition. There is no
reason to believe that erring on the side of conservatism better serves the needs of
external users. The increasingly litigious business environment contributes to
conservative financial reporting.

Concepts of capital and capital maintenance

The framework focuses on two concepts of capital:

1. Financial concept of capital
2. Physical concept of capital.

The financial concept is linked to investment and is synonymous with net assets or
equity as highlighted in the accounting equation, whereas the physical concept is
relative to its operating capability or productive capacity as shown, for example in the
ratio of value added to non-current assets.
If the value of net assets at the end of a period is greater than that at the start of the
period, then a profit has been earned (after deducting any distributions to or from the
owners). This process is referred to as financial capital maintenance.
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Physical capital maintenance acknowledges that a profit is earned only if the physical
capacity (or operating capacity) of the entity (or resources or funds needed to achieve
that capacity) at the end of the period is greater than that at the start of the period,
after deducting distributions to or contributions from the owners.