FINANCIAL ACCOUNTING

1. Introduction to Accounting

NATURE AND PURPOSE OF ACCOUNTING

Accounting is considered the language of business. It has evolved throughout the years as information needs changed and became more complex. After finishing this article, the reader should be able to have a general understanding about accounting, be acquainted with the different definitions, know the different types of information found in accounting reports, and know the different uses of accounting information.

 

Some say that accounting is a science because it is a body of knowledge which has been systematically gathered, classified, and organized. It could be influenced by a lot of factors, specifically by economic, social and political events. Some say that accounting is an art because it requires creative skill and judgment. Furthermore, accounting is also considered as an information system because it is used to identify and measure economic activities, process the information into financial reports, and communicate these reports to the different users of accounting information.

 

To further understand what accounting is, we must take a look at the different definitions.

 

Accounting as a Science	Accounting as an Art	Accounting as an Information System
Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgment and decisions by users of information.	Accounting is the art of recording (journalizing), classifying (posting to the ledger), summarizing in a significant manner and in terms of money, transactions and events which are, in part, at least of a financial character, and interpreting the results thereof to interested users.	Accounting is a service activity, which functions to provide quantitative information, primarily financial in nature, about economic entities that is intended to to be useful in making economic decisions.

 

The first definition emphasizes the following:

 

•       Identifying - in accounting, this is the process of recognition or non-recognition of business activities as accountable events. Stated differently, this is the process which determines if an event has accounting relevance.

•       Measuring - in accounting, this is the process of assigning monetary amounts to the accountable events.

•       Communicating - As we could notice with the above definitions, one main similarity between the three is the impact of communication. In order to be useful, accounting information should be communicated to the different decision makers. Communicating accounting information is achieved by the presentation of different financial statements.

The second definition emphasizes the following:

 

•       Recording - The accounting term for recording is journalizing. All the accountable events are recorded in a journal.

•       Classifying - The accounting term for recording is posting. All accountable events that are recorded in the journal are then classified or posted to a ledger.

•       Summarizing - the items that are journalized and posted are summarized in the five basic financial statements.

 

The third definition emphasizes that accounting is a service activity and that Information provided by accounting could be classified into 3 types:

 

•       Quantitative information - this is information that is expressed in numbers, quantities or units

•       Qualitative information - this is information that is expressed in words

•       Financial information - this information is expressed in terms of money

 

Therefore, given the definitions, accounting is a service activity that is all about recording, classifying and summarizing accountable events in order to communicate quantitative, qualitative, and financial economic information, to different users in order to make relevant decisions.

 

 

OBJECTIVES OF ACCOUNTING

 

The objectives of accounting can be given as follows:

 

•       Systematic recording of transactions - Basic objective of accounting is to systematically record the financial aspects of business transactions i.e. book-keeping. These recorded transactions are later on classified and summarized logically for the preparation of financial statements and for their analysis and interpretation.

 

•       Ascertainment of results of above recorded transactions - Accountant prepares profit and loss account to know the results of business operations for a particular period of time. If revenue exceeds expenses then it is said that business is running profitably but if expenses exceed revenue then it can be said that business is running under loss. The profit and loss account helps the management and different stakeholders in taking rational decisions. For example, if business is not proved to be remunerative or profitable, the cause of such a state of affair can be investigated by the management for taking remedial steps.

 

•       Ascertainment of the financial position of the business - Businessman is not only interested in knowing the results of the business in terms of profits or loss for a particular period but is also anxious to know that what he owes (liability) to the outsiders and what he owns (assets) on a certain date. To know this, accountant prepares a financial position statement popularly known as Balance Sheet. The balance sheet is a statement of assets and liabilities of the business at a particular point of time and helps in ascertaining the financial health of the business.

•       Providing information to the users for rational decision-making - Accounting like a language of commerce communes the monetary results of a venture to a variety of stakeholders by means of financial reports. Accounting aims to meet the information needs of the decision-makers and helps them in rational decision-making.

 

•       To know the solvency position: By preparing the balance sheet, management not only reveals what is owned and owed by the enterprise, but also it gives the information regarding concern's ability to meet its liabilities in the short run (liquidity position) and also in the long- run (solvency position) as and when they fall due.

2. REGULATORY FRAMEWORK OF ACCOUNTING

The Institute of Certified Public Accountants of Kenya (ICPAK) was established in 1978. The

Institute is a member of the Pan-African Federation of Accountants (PAFA) and the International

Federation of Accountants (IFAC), the global umbrella body for the accountancy profession. The

Vision of the Institute is ‘A world class professional accountancy institute‘, while the Mission is ‘To develop and promote internationally recognised accountancy profession that upholds public interest through effective regulation, research and innovation’.

 

The Institute is guided by the following core values: Credibility, Professionalism and Accountability. The Institute draws its mandate from the Accountants Act (no 15 of 2008).

 

Its mandate includes:

 

The Accountants Act No 15, 2008 prescribes the following as the functions of the Institute:

 

•       To promote standards of professional competence and practice amongst members of the Institute

•       To promote research into the subject of accountancy and finance and related matters, and the publication of books, periodicals, journals and articles in connection therewith;  To promote the international recognition of the Institute.

•       To advise the Examination Board on matters relating to examinations standards and policies;

•       To advise the Minister on matters relating to financial accountability in all sectors of the economy;

•       To carry out any other functions prescribed for it under any of the other provisions of this Act or any other written law and

•       To do anything incidental or conducive to the performance of any of the preceding functions.

 

The International Federation of Accountants (IFAC)

 

The International Federation of Accountants (IFAC) was founded on 7 October 1977, in Munich, Germany, at the 11th World Congress of Accountants. IFAC comprises 179 member and associate member organisations in 130 countries, representing more than 2.5 million accountants in public practice, education, government service, industry, and commerce.

 

IFAC has established the following boards. We maintain separate pages for each board, with a history of developments for each board:

 

 

Body	Function
International Public Sector Accounting Standards Board (IPSASB)	Sets International Public Sector Accounting Standards (IPSAS) for use by the public sector
International Auditing and Assurance Standards Board (IAASB)	Sets International Standards on Auditing, Assurance Engagements and Related Services
International Accounting Education Standards Board (IAESB)	Develops International Education Standards

 

International Ethics Standards Develops the international Code of Ethics for Professional

Board for Accountants (IESBA)	Accountants
Public Interest Oversight Board (PIOB)	Oversees IFAC's standard-setting activities, particularly with respect to auditing, assurance, ethics, and independence. The PIOB also oversees IFAC's compliance activities.

 

 

IFAC also supports the IASB with respect to setting accounting standards.

 

The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is an independent, private-sector body that develops and approves International Financial Reporting Standards (IFRSs). The IASB operates under the oversight of the IFRS Foundation. The IASB was formed in 2001 to replace the International Accounting Standards Committee. Currently, the IASB has 14 members.

 

The IASB's role

Under the IFRS Foundation Constitution, the IASB has complete responsibility for all technical matters of the IFRS Foundation including:

 

-         Full discretion in developing and pursuing its technical agenda, subject to certain consultation requirements with the Trustees and the public

-         The preparation and issuing of IFRSs (other than Interpretations) and exposure drafts, following the due process stipulated in the Constitution

-         The approval and issuing of Interpretations developed by the IFRS Interpretations Committee

ACCOUNTING STANDARDS (IMPORTANCE AND LIMITATION)

 

Accounting standards is a set of standards, guidelines and procedures that are used when accounting for the affairs of most governmental and non-governmental bodies. The interpretation of numbers and the wherewithal to place them in the proper context are at the heart of accounting. Standards exist to ensure that accounting decisions are made in a unified and reasonable way.

 

The objective of setting standards is to bring about uniformity in financial reporting and to ensure consistency in the data published by enterprises. For accounting standards, to be useful tool to enhance the corporate governance and responsibility, two criteria must be satisfied, i.e.

 

i.               A standard must provide a generally understood and accepted measure of the phenomena of concern.

ii.            A standard should significantly reduce the amount of manipulation of the reported numbers and is likely to occur in the absence of the standards.

 

Accounting standards facilities uniform preparation and reporting of general purpose financial statements published annually for the benefit of shareholders, creditors, employee and public at large. They are very useful to the investors and other external groups in assessing the progress and prospects of alternative investments in different companies in different countries.

 

Accounting standards can be seen as providing an important mechanism to help in the resolution of potential financial conflicts of interest between the various important groups in society. It is essential that accounting standards should command the greatest possible credibility among shareholders, creditors, employee and public at large.

 

Their important can be summarized as follows:

 

Comparability

 

Paramount to the role of accounting standards is the universality that it brings to financial record keeping. Governmental organizations must follow accounting procedures that are the same as their counterparts, and non-governmental organizations must do the same. The result is that it is easy to compare the financial standing of similar entities. All comparisons within groups are a matter of comparing "apples to apples." This helps both external and internal observers weigh the state of an entity in the context of other comparable entities. For instance, the financial standing of a town can be measured against a neighboring town with the assumption that the pertinent numbers have been reached in a similar fashion.

 

Transparency

 

Accounting standards are designed to enforce transparency in organizations. The principles, procedures and standards that make up the generally accepted accounting principles were chosen with the purpose of ensuring that organizations lean in the direction of openness when deciding how to provide information to observers. This kind of transparency is especially important in the case of public entities, such as governments or publicly traded companies. Standards limit the freedom and flexibility of entities to use clever accounting to move items around or even to hide them.

Relevance

 

Standards work to help entities provide the most relevant information in the most reasonable way possible. In this way, an organization guided by accounting standards will generate the kind of financial information that observers are most interested in examining. Entities ultimately should provide information in a way that most fairly and clearly represents the current financial standing of the operation. The standards make it more difficult for organizations to misdirect observers and to fool them with data that does not have sufficient relevancy.

 

Audiences

 

Ultimately, the importance of accounting standards lies in the value that it brings to financial documents for the various audiences that view and make critical decisions based on it. An absence of accounting standards would make the work of investors, regulators, taxpayers, reporters and others more difficult and more risky. For instance, without standards, an investor who has studied the financial statements of a large publicly traded company would not know whether to trust the findings on those statements. Standards mean that taxpayers can see how their tax dollars are being spent, and regulators can ensure that laws are followed.

 

Limitations of accounting standards

 

i.        Alternative solutions to certain accounting problems may each have arguments to recommend them. Therefore, the choice between different alternative accounting treatments may become difficult. ii.      There may be a trend towards rigidity and away from flexibility in applying the accounting standards.

iii.     Accounting standards cannot override the statute. The standards are required to be framed within the ambit of prevailing statutes.

 

 

PROFESSIONAL ETHICS

 

A professional accountant is required to comply with the following fundamental principles:

 

a. Integrity

A professional accountant should be straight forward and honest in all professional and business relationships.

 

b. Objectivity

A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments.

 

c. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services.

 

d. Confidentiality

A professional accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose.

 

Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the profes-sional accountant or third parties.

 

e. Professional Behaviour

A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the  profession.

 

 

ACCOUNTING CONCEPT/PRINCIPLES

 

Accounting Concepts and Principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles.

 

In order to ensure application of the accounting concepts and principles, major accounting standard- setting bodies have incorporated them into their reporting frameworks such as the IASB Framework.

 

Following is a list of the major accounting concepts and principles:

•       Relevance

•       Reliability

•       Matching Concept

•       Timeliness

•       Neutrality

•       Faithful Representation

•       Prudence

•       Completeness

•       Single Economic Entity Concept

•       Money Measurement Concept

•       Comparability/Consistency

•       Understandability

•       Materiality

•       Going Concern

•       Accruals

•       Business Entity

•       Substance over Form

•       Realization Concept

•       Duality Concept

 

In case where application of one accounting concept or principle leads to a conflict with another accounting concept or principle, accountants must consider what is best for the users of the financial information. An example of such a case would be the trade off between relevance and reliability. Information is more relevant if it is disclosed timely. However, it may take more time to gather reliable information. Whether reliability of information may be compromised to ensure relevance of information is a matter of judgment that ought to be considered in the interest of the users of the financial information.

 

Relevance:

Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the financial statements in predicting future trends of the business (Predictive Value) or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece of information which assists users in confirming their past predictions may also be helpful in forming future forecasts.

 

Example:

A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last reporting period. The information is relevant to investors as it may assist them in confirming their past predictions regarding the profitability of the company and will also help them in forecasting future trend in the earnings of the company.

 

Relevance is affected by the materiality of information contained in the financial statements because only material information influences the economic decisions of its users.

 

 

Reliability

Information is reliable if a user can depend upon it to be materially accurate and if it faithfully represents the information that it purports to present. Significant misstatements or omissions in financial statements reduce the reliability of information contained in them.

 

Example:

 

A company is being sued for damages by a rival firm, settlement of which could threaten the financial stability of the company. Non-disclosure of this information would render the financial statements unreliable for its users.

 

Reliability of financial information is enhanced by the use of following accounting concepts and principles:

1.      Neutrality

2.      Faithful Representation

3.      Prudence

4.      Completeness

5.      Single Economic Entity Concept

Neutrality

Information contained in the financial st attempting to present them in a favored light. Information may be deliberately biased or systematically biased.

 

Deliberate bias

Deliberate bias: Occurs where circumstances and conditions cause management to intentionally misstate the financial statements.

Examples:

•       Managers of a company are provided bonus on the basis of reported profit. This might tempt management to adopt accounting policies that result in higher profits rather than those that better reflect the company's performance inline with GAAP.

•       A company is facing serious liquidity problems. Management may decide to window dress the financial statements in a manner that improves the company's current ratios in order to hide the gravity of the situation.

•       A company is facing litigation. Although reasonable estimate of the amount of possible settlement could be made, management decides to discloses its inability to measure the potential liability with sufficient reliability.

 

Systematic bias

Systematic bias: Occurs where accounting systems have developed an inherent tendency of favoring one outcome over the other over time. Examples:

Accounting policies within an organization may be overly prudent because of cultural influence of an over cautious leadership.

 

Faithful Representation

Information presented in the financial statements should faithfully represent the transaction and events that occur during a period.

 

Faithfull representation requires that transactions and events should be accounted for in a manner that represents their true economic substance rather than the mere legal form. This concept is known as Substance Over Form.

 

Substance over form requires that if substance of transaction differs from its legal form than such transaction should be accounted for in accordance with its substance and economic reality.

 

The rationale behind this is that financial information contained in the financial statements should represent the business essence of transactions and events not merely their legal aspects in order to present a true and fair view.

 

Example:

A machine is leased to Company A for the entire duration of its useful life. Although Company A is not the legal owner of the machine, it may be recognized as an asset in its balance sheet since the Company has control over the economic benefits that would be derived from the use of the asset. This is an application of the accountancy concept of substance over legal form, where economic substance of a transaction takes precedence over its legal aspects.

Prudence

Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies and significant estimates such that the assets and income of the entity are not overstated whereas liability and expenses are not under stated.

 

The rationale behind prudence is that a company should not recognize an asset at a value that is higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its respect in the future.

 

Example:

 

Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected selling price. This ensures profit on the sale of inventory is only realized when the actual sale takes place.

 

However, prudence does not require management to deliberately overstate its liabilities and expenses or understate its assets and income. The application of prudence should eliminate bias from financial statements but its application should not reduce the reliability of the information

 

Completeness

 

Reliability of information contained in the financial statements is achieved only if complete financial information is provided relevant to the business and financial decision making needs of the users. Therefore, information must be complete in all material respects.

 

Incomplete information reduces not only the relevance of the financial statements, it also decreases its reliability since users will be basing their decisions on information which only presents a partial view of the affairs of the entity.

 

Single Economic Entity Concept Consolidation Accounting

 

Consolidated financial statements of a group of companies are prepared on the basis of single economic entity concept.

 

Single Economic Entity Concept suggests that companies associated with each other through the virtue of common control operate as a single economic unit and therefore the consolidated financial statements of a group of companies should reflect the essence of such arrangement.

 

Consolidated financial statements of a group of companies must be prepared as if the entire group constitutes a single entity in order to avoid the misrepresentation of the scale of group's activities.

 

It is therefore necessary to eliminate the effects of any inter-company transactions and balances during the consolidation of group accounts such as the following:

 

•       Inter-company sales and purchases

•       Inter-company payables and receivables

•       Inter-company payments such as dividends, royalties & head office charges

 

Inter-company transactions must be eliminated as if the transactions had not occurred in the first place. Examples of adjustments that may be required to eliminate the effects of inter-company transactions include:

 

•       Elimination of unrealized profit or loss on the sale of assets member companies of a group

•       Elimination of excess or deficit depreciation expense in respect of a fixed asset purchased from a member company at a price that was higher or lower than the net book value of the asset in the books of the seller.

 

 

Money Measurement Concept in Accounting

  

Definition

Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and events that are capable of being measured in monetary terms are recognized in the financial statements.

 

Explanation

All transactions and events recorded in the financial statements must be reduced to a unit of monetary currency. Where it is not possible to assign a reliable monetary value to a transaction or event, it shall not be recorded in the financial statements.

 

However, any material transactions and events that are not recorded for failing to meet the measurability criteria might need be disclosed in the supplementary notes of financial statements to assist the users in gaining a better understanding of the financial performance and position of the entity.

 

Recognition Criteria

The recognition criteria defined by IASB and FASB require that the elements of financial statements (i.e. assets, liabilities, income and expense) must only be recognized in the financial statements if its cost or value can be measured with sufficient reliability. Therefore, an entity shall not recognize an element of financial statement unless a reliable value can be assigned to it.

 

Examples of Application

•       Skills and competence of employees cannot be attributed an objective monetary value and should therefore not be recognized as assets in the balance sheet. However, those transactions related to employees that can be measured reliably such as salaries expense and pension obligations are recognized in the financial statements.

•       Where it is not possible to measure reliably the amount of settlement of a legal claim against the company, no liability is recognized in the financial statements. Instead, the nature and circumstances surrounding the lawsuit are disclosed in the supplementary notes to the financial statements if considered material.

•       IAS 38 Intangible Assets -require that internally generated goodwill shall not be recognized as an asset in the balance sheet. This is due to the difficulty in identifying and measuring the cost of internally generated goodwill as distinct from the cost of running the day to day operations of the business.

 

However, IFRS 3 Business Combinations permit purchased goodwill to be recognized as an asset in the financial statements since the cost of purchased goodwill is usually determinable objectively as the amount of consideration paid in excess of the value of other identifiable assets of the acquired business.

 

Matching Principle & Concept

 

Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned.

 

Examples of the use of matching principle in IFRS and GAAP include the following:

 

•       Deferred Taxation

IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for taxable and deductible temporary differences arising in the calculation of income tax in a manner that results in the matching of tax expense with the accounting profit earned during a period.

•       Cost of Goods Sold

The cost incurred in the manufacture or procurement of inventory is charged to the income statement of the accounting period in which the inventory is sold. Therefore, any inventory remaining unsold at the end of an accounting period is excluded from the computation of cost of goods sold.

•       Government Grants

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires the recognition of grants as income over the accounting periods in which the related costs (that were intended to be compensated by the grant) are incurred by the entity.

 

 

Matching Vs Accruals Vs Cash Basis

 

In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting' are often used interchangeably. Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting.

 

However, the matching principle is a further refinement of the accruals concept. For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period. However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to 'match' the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences Timeliness of Accounting Information

 

Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time to fulfill their decision making needs.

 

Timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users while conversely, delay in provision of information tends to render it less relevant to the decision making needs of the users. Timeliness principle is therefore closely related to the relevance principle.

 

Timeliness is important to protect the users of accounting information from basing their decisions on outdated information. Imagine the problem that could arise if a company was to issue its financial statements to the public after 12 months of the accounting period. The users of the financial statements, such as potential investors, would probably find it hard to assess whether the present financial circumstances of the company have changed drastically from those reflected in the financial statements.

 

Examples

 

Users of accounting information must be provided financial statements on a timely basis to ensure that their financial decisions are based on up to date information. This can be achieved by reporting the financial performance of companies with sufficient regularity (e.g. quarterly, half yearly or annual) depending on the size and complexity of the business operations. Unreasonable delay in reporting accounting information to users must also be avoided.

 

In several jurisdictions, regulatory authorities (e.g. stock exchange commission) tend to impose restrictions on the maximum number of days that companies may take to issue financial statements to the public.

 

Timeliness of accounting information is also emphasized in IAS 10 Events After the Reporting Period which requires entities to report all significant post balance sheet events that occur up to the date when the financial statements are authorized for issue. This ensures that users are made aware of any material transactions and events that occur after the reporting period when the financial statements are being issued rather than having to wait for the next set of financial statements for such information.

 

Timeliness Vs Reliability - A Conflict

 

Whereas timely presentation of accounting information is highly desirable, it may conflict with the objective to present reliable information. This is because producing reliable and accurate information may take more time but the delay in provision of accounting information may make it less relevant to users. Therefore, it is necessary that an appropriate balance is achieved between the timeliness and reliability of accounting information.

Substance Over Legal Form

 

Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.

 

Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.

 

Example:

 

There is widespread use of substance over form concept in accounting. Following are examples of the application of the concept in the International Financial Reporting Standards (IFRS).

 

•       IAS 17 Leases requires the preparers of financial statements to consider the substance of lease arrangements when determining the type of lease for accounting purposes.

For example, an asset may be leased to a lessee without the transfer of legal title at the end of the lease term. Such a lease may, in substance, be considered as a finance lease if for instance the lease term is substantially for entire useful life of the asset or the lease agreement entitles the lessee to purchase the asset at the end of the lease term at a very nominal price and it is very likely that such option will be exercised by the lessee in the given circumstances.

•       IAS 18 Revenue requires accountants to consider the economic substance of the sale agreements while determining whether a sale has occurred or not.

For example, an entity may agree to sell inventory to someone and buy back the same inventory after a specified time at an inflated price that is planned to compensate the seller for the time value of money. On paper, the sale and buy back may be deemed as two different transactions which should be dealt with as such for accounting purposes i.e. recording the sale and (subsequently) purchase. However, the economic reality of the transactions is that no sale has in fact occurred. The sale and buy back, when considered in the context of both transactions, is actually a financing arrangement in which the seller has obtained a loan which is to be repaid with interest (via inflated price). Inventory acts as the security for the loan which will be returned to the 'seller' upon repayment. So instead of recognizing sale, the entity should recognize a liability for loan obtained which shall be reversed when the loan is repaid. The excess of loan received and the amount that is to be paid (i.e. inflated price) is recognized as finance cost in the income statement.

 

Importance

 

The principle of Substance over legal form is central to the faithful representation and reliability of information contained in the financial statements. By placing the responsibility on the preparers of the financial statements to actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the substance of the situation.

However, the principle of substance over form has so far not been recognized by IASB or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other accounting principles particularly reliability and faithful representation.

 

Comparability/Consistency

 

Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity's financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.

 

A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements.

 

Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.

 

Example:

 

If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past, it must continue to do so in the future to preserve consistency in the reported inventory balance. A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the accounting periods largely due to seasonal fluctuations in price

 

Comparability/Consistency

 

Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity's financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.

 

A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements.

 

Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.

Example:

 

If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past, it must continue to do so in the future to preserve consistency in the reported inventory balance. A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the accounting periods largely due to seasonal fluctuations in price

 

Understandability

 

Transactions and events must be accounted for and presented in the financial statements in a manner that is easily understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and accounting in general provided that such a user is willing to study the information with reasonable diligence.

 

Understandability of the information contained in financial statements is essential for its relevance to the users. If the accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user to understand despite having adequate knowledge of the entity and accountancy in general, then this would undermine the reliability of the whole financial statements because users will be forced to base their economic decisions on undependable information.

 

Materiality

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements (IASB Framework).

 

Materiality therefore relates to the significance of transactions, balances and errors contained in the financial statements. Materiality defines the threshold or cutoff point after which financial information becomes relevant to the decision making needs of the users. Information contained in the financial statements must therefore be complete in all material respects in order for them to present a true and fair view of the affairs of the entity.

 

Materiality is relative to the size and particular circumstances of individual companies.

 

Example - Size

 

A default by a customer who owes only $1000 to a company having net assets of worth $10 million is immaterial to the financial statements of the company.

 

However, if the amount of default was, say, $2 million, the information would have been material to the financial statements omission of which could cause users to make incorrect business decisions.

 

Example - Nature

 

If a company is planning to curtail its operations in a geographic segment which has traditionally been a major source of revenue for the company in the past, then this information should be disclosed in the financial statements as it is by its nature material to understanding the entity's scope of operations in the future.

 

Materiality is also linked closely to other accounting concepts and principles:

 

•       Relevance: Material information influences the economic decisions of the users and is therefore relevant to their needs.

•       Reliability: Omission or mistatement of an important piece of information impairs users' ability to make correct decisions taken on the basis of financial statements thereby affecting the reliability of information.

•       Completeness: Information contained in the financial statements must be complete in all material respects in order to present a true and fair view of the affairs of the company.

 

What is a Going Concern?

 

Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.

 

It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

 

What are possible indications of going concern problems?

 

•       Deteriorating liquidity position of a company not backed by sufficient financing arrangements.

•       High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.

•       Significant trading losses being incurred for several years. Profitability of a company is essential for its survival in the long term.

•       Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.

•       Increasing level of short term borrowing and overdraft not supported by increase in business.

•       Inability of the company to maintain liquidity ratios as defined in the loan covenants.

•       Serious litigations faced by a company which does not have the financial strength to pay the possible settlement.

•       Inability of a company to develop a new range of commercially successful products.

Innovation is often said to be the key to the long-term stability of any company.

•       Bankruptcy of a major customer of the company.

Accruals Concept

 

Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.

 

Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

 

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

 

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.

 

Business Entity Concept

 

Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.

 

Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings.

 

The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the balance sheet.

 

Realization Concept (Revenue Recognition Principle)

 

In accounting, also known as revenue recognition principle, refers to the application of accruals concept towards the recognition of revenue (income). Under this principle, revenue is recognized by the seller when it is earned irrespective of whether cash from the transaction has been received or not.

In case of sale of goods, revenue must be recognized when the seller transfers the risks and rewards associated with the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which is subsequently settled upon the receipt of the due amount from the customer.

 

In case of the rendering of services, revenue is recognized on the basis of stage of completion of the services specified in the contract. Any receipts from the customer in excess or short of the revenue recognized in accordance with the stage of completion are accounted for as prepaid income or accrued income as appropriate.

 

Example

Motors PLC is a car dealer. It receives orders from customers in advance against 20% down payment. Motors PLC delivers the cars to the respective customers within 30 days upon which it receives the remaining 80% of the list price.

 

In accordance with the revenue realization principle, Motors PLC must not recognize any revenue until the cars are delivered to the respective customers as that is the point when the risks and rewards incidental to the ownership of the cars are transferred to the buyers.

 

Importance

 

Application of the realization principle ensures that the reported performance of an entity, as evidenced from the income statement, reflects the true extent of revenue earned during a period rather than the cash inflows generated during a period which can otherwise be gauged from the cash flow statement. Recognition of revenue on cash basis may not present a consistent basis for evaluating the performance of a company over several accounting periods due to the potential volatility in cash flows

 

Dual Aspect Concept | Duality Principle in Accounting

 

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accounting that necessitates the recognition of all aspects of an accounting transaction. Dual aspect concept is the underlying basis for double entry accounting system.

 

Explanation

 

In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is made to a customer, only sales revenue will be recorded. However, the other side of the transaction relating to the receipt of cash or the grant of credit to the customer is not recognized.

 

Single entry accounting system has been superseded by double entry accounting. You may still find limited use of single entry accounting system by individuals and small organizations that keep an informal record of receipts and payments.

Double entry accounting system is based on the duality principle and was devised to account for all aspects of a transaction. Under the system, aspects of transactions are classified under two main types:

 

1.      Debit

2.      Credit

 

Debit is the portion of transaction that accounts for the increase in assets and expenses, and the decrease in liabilities, equity and income.

 

Credit is the portion of transaction that accounts for the increase in income, liabilities and equity, and the decrease in assets and expenses.

 

The classification of debit and credit effects is structured in such a way that for each debit there is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit effects and credit effects).

 

The application of duality principle therefore ensures that all aspects of a transaction are accounted for in the financial statements.

 

Example

 

Mr. A, who owns and operates a bookstore, has identified the following transactions for the month of January that need to be accounted for in the monthly financial statements:

 

 

	$
1. Payment of salary to staff	2,000
2. Sale of books for cash	5,000
3. Sales of books on credit	15,000

4.  Receipts from credit customers 10,000

5.  Purchase of books for cash             20,000

6.  Utility expenses - unpaid    3,000

 

 

 

Under double entry system, the above transactions will be accounted for as follows:

 

 

 

Account Title	Effect               Debit Credit                                                       $           $
1. Salary Expense	Increase in expense 2,000
Cash at bank	Decrease in assets                   2,000
2. Cash in hand	Increase in assets      5,000
Sales revenue	Increase in income                   5,000
3. Receivables	Increase in assets     15,000
Sales revenue	Decrease in income               15,000
4. Cash at bank	Increase in asset      10,000
Receivables	Decrease in asset                   10,000
5. Purchases	Increase in expense 20,000
Cash at bank	Decrease in asset                   20,000
6. Utility Expense	Increase in expense 3,000

               Accrued expenses Decrease in asset                   3,000