IA1: ACCOUNTING AND REPORTING CONCEPTS

ACCOUNTING AND REPORTING CONCEPTS

THE INTERNATIONAL ACCOUNTING STANDARDS BOARD FRAMEWORK

In July 1989, the International Accounting Standards Committee (IA SC), now replaced by the International Accounting Standards Board (IASB), produced a document titled, (or simply the “Framework”). This document sets out the concepts that determine how financial statements are prepared and the information they contain. This is why the IASB is also called the “conceptual framework”.

A conceptual framework is a clearly defined set of objectives and principles that can lead to the production of consistent accounting standards. The framework is therefore the “conceptual framework”. The frame of reference from which the accounting standards are issued by the IASB is constructed.

PURPOSE OF THE IASB FRAMEWORK

The framework is expected to serve the following purposes:

• Assist the IASB in the development of future accounting standards and in the review of existing standards.
• Assist the IASB in promoting harmonisation of regulations, accounting standards and procedures, relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by international accounting standards.
• Assist national standard-setting bodies in developing national standards.
• Assist preparers of financial statements in applying international accounting standards and in dealing with issues not yet covered by an International Accounting Standards (IA S).
• Assist auditors in forming an opinion as to whether financial statements conform to IASs.
• Assist users of financial statements in interpreting the information contained in financial statements that comply with IASs; and
• Provide those w ho are interested in the work of the IASB with information on its approach to the formulation of accounting standards.

STATUS AND SCOPE OF THE IASB FRAMEWORK

As stated above, the framework describes the basic concepts that guide the preparation of financial statements for presentation to a wide range of users. The framework is not an accounting standard; neither does it override the requirements of any specific Standard.

Thus, in the event of a conflict between the Framework and an International Financial Reporting Standard (IFRS), the latter will prevail. Such conflicts will gradually cease to exist as future accounting standards will be produced in accordance with the guidelines set by the framework.

The framework deals with the following:

(a) The objectives of financial statements.

• Underlying assumptions.
• Qualitative characteristics of financial statements.
• Definition, recognition and measurement of the elements of financial statements; and
•  Concepts of capital and capital maintenance.

THE OBJECTIVES OF FINANCIAL STATEMENTS

The objectives of financial statements are to provide information about the financial position, performance and changes in financial position that will assist wide spectrum of users in making useful economic decisions. It identifies the following users of financial information: investors, employees, lenders, suppliers, customers, government and the public.

Information relating to financial position is normally found in the balance sheet of an entity, and is affected by the following:

• Economic resources controlled by the entity. This information will enable users to predict the ability of the entity to generate cash.
• Financial Structure of the entity. Users can predict borrowing needs, distribution of future profits and the ability of the entity to raise new finance.
• Liquidity and solvency of the entity. Users need this information to predict the ability of the entity to meet its financial commitments as they fall due.

Information on the financial of an entity is basically provided by the income statement. Such information is useful in evaluating the returns obtained by an entity from the resources available to it.

Information about changes in financial position is contained in the cash and how the cash generated is utilized.

SELF ASSESSMENT EXERCISE

What could affect the information relating to financial position in the balance sheet?

UNDERLYING ASSUMPTIONS

The Framework specifies and explains the two main assumptions that underlie the preparation of financial statements. These assumptions are the accrual basis of accounting and the going concern principle.

Accrual Basis: When financial statements are prepared under the accrual basis of accounting, the effects of transactions and other events are recognized when they occur and not as cash or its equivalent are received or paid. They are recorded in the accounting records and reported in the financial statements, of the periods to which they relate.

Going Concern Basis: Under the going concern basis, the enterprise is regarded as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity to liquidate or reduce materially the scale of its operations.

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QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

Meaning of Qualitative Characteristics

According to the Framework, qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The Framework identifies four principal qualitative characteristics, namely: understandability, relevance, reliability and comparability.

Understandability

Information in financial statements should be readily understandable by users who have business, economics and accounting knowledge and willingness to study the information carefully. Although financial reports should be understandable, complex matters that are relevant to economic decision-making should not be excluded merely because they are too difficult for users to understand.

Relevance

To be useful, financial information should be relevant to the decision-making needs of users. According to the Framework, information has the quality of relevance when it influences the economic decision of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.

Information may be considered relevant either because of its nature (e.g. employee benefit expense) or because it is material. Financial information is material if its omission or misstatement could affect the economic decisions of users.

Although materiality is not classified as a threshold or cut-off point any information that fails the test of materiality need not be disclosed separately in the financial statements.

Reliability

According to the framework, information is said to be “reliable” when it is free from material bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be accepted to represent.

In view of the inherent difficulties in identifying certain transactions or in finding appropriate methods of measurement or presentation, financial statements cannot be perfectly “accurate”, hence faithful representation might be regarded as describing the closet that accountants can come towards the absolute of total accuracy (Lewis and Pendrill, 1996).

Reliability is enhanced when the following principles are observed in the presentation of financial statements:

• Substance over form. Transactions should be accounted for according to their substance and economic reality even if their legal form is different.
• Information should be objective and free from bias.
• Reasonable effort should be made to ensure that the position, or degree of success of an entity is not overstated (Alexander and Britton, 1996); and
• Financial information must be complete, if the information is to be reliable.

Comparability

• Users should be able to compare the financial statements of an entity through time (that is, over a period of time), to identify trends in its financial position and performance.
• Users should also be able to compare the financial statements of different entities to determine their relative financial positions, performance and changes in financial positions.

To effectively compare an entity’s financial information over time, accounting transactions should be consistently treated and correspondingly, information of preceding periods should be disclosed. Similarly, to compare financial information across entities, the financial statements of the different entities should comply with the requirements of a set of accounting standards and their separate accounting policies should be disclosed.

‘Trade-Offs’ between Qualitative Characteristics of Financial Statements

There is usually a ‘trade-off’ between the different qualitative characteristics discussed above.

Emphasis on one of the attributes may lead to a reduction in the application of another desirable quality. Under such circumstances, it is necessary to strive to achieve an appropriate balance among the characteristics in order to meet the objectives of financial statements.

Examples of these ‘trade-offs’ are as follows:

• In some cases it may take some time for every detail of a transaction to be determined. In such cases, financial information cannot be presented on a timely basis if financial statements are to be reliable. On the other hand, delay in presenting financial statements may affect the relevance of the information. A balance has to be struck between the benefits of reliability and relevance. The overriding consideration should be how best the information satisfies decision-making needs.
• ‘Trade-off’ between cost and Benefit

There is also ‘trade-off’ between cost and benefit of preparing and presenting financial information. In principle, the benefit derived by users should exceed the cost of providing and presenting the information.

• ‘Trade-off’ between Qualitative Characteristics

‘Trade-offs’ may also arise between the qualitative characteristics in other circumstances. For instance, market values are more relevant but less reliable than historical costs. On the other hand, historical costs are usually not relevant for decision-making purposes.

True and fair View/fair Presentation

Financial statements are usually required to give a true and fair view, or present fairly the financial position and performance of an entity. The framework does not define these concepts but it states that the application of qualitative characteristics of financial information and compliance with appropriate accounting standards will lead to financial statements that give a true and fair view.

ELEMENTS OF FINANCIAL STATEMENTS

The financial effects of transactions and events are grouped into broad classes in the Framework. These classes comprise the elements of financial statements, namely: assets, liabilities, equity, income and expenses. The first three elements are shown in the balance sheet and are used in measuring the financial position of an entity, while the last two elements (income and expenses) are used to measure the performance of an entity and are shown in the statement, otherwise known as the profit and loss account or income and expenditure account.

The Framework defines the elements as follows.

Assets

An asset is a resource controlled by an entity as a result of past events and from future economic benefits is expected to flow to the entity.

Note the following key terms/phrases used in the above definition:

Resource Controlled by an Entity

An entity has control over a resource if it can direct the use of the resources for its benefit.

Past Events

The events should have occurred before the ownership of the asset.

Future Economic Benefits

The resource controlled by the entity should have the potential to contribute directly or indirectly to the receipt of cash and cash equivalents by the entity.

Liability

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity, of resources embodying economic benefits. Based on this definition, a liability is not merely an obligation; it is a present obligation.

A present obligation is different from a future commitment. Other key terms include past events and outflow of an economic benefit, for example, transfer of cash or other assets by the enterprise.

• Equity

Equity is the residential interest in the assets of the entity after deducting all its liabilities.

• Income items

These have been defined by the Framework as increases in economic benefits during the accounting period, in the form of inflows or enhancements of assets or decrease of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

• Expenses

These are decreases in economic benefits during an accounting period in the form of outflows or depletions of assets or incurring of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

Recognition of the Elements of Financial Statements Recognition Criteria

According to the Framework, recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the following criteria for recognition:

• It is probable that any future economic benefit associated with the item will flow to or from the entity; and
•  The item has a cost or value that can be measured reliably.

It is necessary to note that the first recognition criterion is that the items should meet the definition of an element of financial statements.

Recognition Stages

Under the framework, the recognition of assets and liabilities fall under three stages. These are:

• Initial recognition

This occurs when an item first meets the definition of an asset or a liability (for instance, the acquisition of a building).

• Subsequent re-measurement

This involves changing the value at which an asset or a liability was initially recognized (that is, if a building is partly destroyed or when assets are re-valued by professional revaluers, the carrying values will be restated).

• De-recognition

This occurs when an item no longer meets the definition of an asset or liability (for instance, if the building is sold or completely destroyed).

Measurement of the Elements of Financial Statements

The Framework defines “measurement” as the process of determining the monetary amount at which the elements of financial statements are to be recognized and carried in the balance sheet and income statement. It identifies four bases of measurement, namely: historical cost, current cost, realisable (settlement) value and present value.

Historical cost

Assets are recorded at the amounts of cash and cash equivalents paid or the fair value of the consideration given in exchange for them at the time of acquisition. Liabilities are recorded at the amounts of proceeds received in exchange for the obligations.

Current cost

Assets are carried at the amount of cash or cash equivalent required to acquire the same or identical assets currently. Liabilities, on the other hand, are carried at the undiscounted amount currently required to settle the obligation.

Realisable (settlement) value

According to the Framework, a realisable value is the amount of cash or cash equivalents that will currently be obtained by selling an asset in an orderly disposal, while “settlement value” refers to the undiscounted amount of cash and cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

Present value

This refers to a current estimate of the present discounted value of the future net cash flow in the normal course of business.

The Framework does not require the application of any particular basis. In practice, historical cost is the most common basis; the other bases are applied as appropriate. For instance, stock is valued at the lower of cost and net realisable value, in accordance with the prudence concept of “not counting chickens before they are hatched”.

CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

Concepts of Capital: The Framework identifies two concepts of capital: Financial concept of capital and physical concept of capital. Under the financial concept, capital is the net asset or equity of the enterprise; but under the physical concept, capital is the productive capacity of the enterprise.

Concepts of capital Maintenance: As with the concepts of capital, the framework identifies two types of capital maintenance concepts: financial capital maintenance and physical capital maintenance. Generally, capital is maintained when an enterprise has as much capital at the end of the year as it had at the beginning.

Thus, financial capital is maintained when the nominal money capital at the end of the year to the figure at the beginning. Similarly, physical capital is maintained when the physical productive capacity at the year end is equal to the productive capacity at the beginning.

Financial capital maintenance is sometimes classified into money financial capital maintenance (already explained above) and real financial capital maintenance which is achieved when the purchasing power of an entity’s shareholders’ fund is as much at the end of the year as at the beginning.

CONCLUSION

In this unit, it is concluded that an enterprise records a profit when its capital at the end of the year exceeds its capital at the beginning of the same year. The Framework defines “profit” as the residual amount that remains after expenses (including capital maintenance adjustments, where applicable) have been deducted from income. Any amount over and above that required to maintain the capital at the beginning of the period is “profit”.

Source: National Open University of Nigeria