ACCOUNTING CONCEPTS

• 1.      Accruals basis (matching concept)
  Accruals basis accounting (accruals accounting, the accruals concept) depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.
  ·          Revenue from sales and other income should be reported in the period when the income arises (which might not be the same as the period when the cash is received).
  ·          The cost of sales in the statement of comprehensive income must be matched with the sales. Income and ‘matching’ expenses must be reported in the same financial period.
  ·          Other expenses should be charged in the period to which they relate, not the period in which they are paid for.
  
   
  Example 1: Accruals basis
  A company prepares its financial statements to the 30 June each year.
  It sells goods for Rs. 50,000 to a customer on 6 June Year 2, but does not receive a cash payment from the customer until 15 August Year 2.
  Accruals basis:
  The sale is recognised as income in the year to 30 June Year 2, even though the cash is not received until after the end of this financial year.
  
  
  
  
  
  2.      Consistency
  
  
  The content of the financial statements must be presented consistently from one period to the next.
  The presentation can be changed only if necessary to improve the quality of information presented in terms of its usefulness to the users or if a new rule requires a change.
  
  
  
  
  3.      Completeness
  The objective of financial reporting is to provide useful information. Information is only useful if a person can rely on it.
  To be reliable, information should be complete, subject to materiality and cost.
  (There is no need to include information if it is not material, and greater accuracy is not required if the cost of obtaining the extra information is more than the benefits that the information will provide to its users).
  Completeness refers to whether all transactions that occurred during the period have been recorded.
  Example: Completeness
  The accruals example can be used to illustrate this.
  A company rents office space at a cost of Rs. 6,000,000 per year paid 12 months in arrears (this means that the company pay the rent at the end of the year).
  The first payment is due on 30 June Year 2.
  The company prepares its financial statements to 31 December each year.
  The company will not have received an invoice for the rent when it is preparing its financial statements for 31 December Year 1
  If the company does not accrue for the expense that relates to the 6 months to 31
  December year 1 the information would be incomplete
  
  
  
  
  4.      True and fair view (faithful representation)
  Financial statements should give a true and fair view of the financial position, financial performance and changes in financial position of an entity. Another way of saying this is that financial statements should provide a faithful representation of these.
  This is achieved by following all the rules set out in law and accounting standards.
  Faithful representation
  Financial reports represent economic phenomena by depicting them in words and numbers.
  To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent.
  A perfectly faithful representation would have three characteristics. It would be:
   complete – the depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.
   neutral – the depiction is without bias in the selection or presentation of financial information; and of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process.
  
  
  
  
  5.      Materiality
  The relevance of information is affected by its materiality.
  Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.
  An error which is too trivial to affect a user’s understanding of financial statement is referred to as immaterial.
  There is no absolute measure of materiality that can be applied to all businesses.
  In other words there is no rule that says any item greater than 5% of profit must be material. Whether an item is material or not depends on its magnitude or its nature or both in the context of the specific circumstances of the business.
  Magnitude
  Whether an item of a given size is deemed to be material depends on the context of the number in relation to other numbers in the financial statements.
  
  
  Example: Materiality
  A business owes Mr A Rs. 1,000,000 and is owed Rs. 950,000 by Mr B.
  Instead of showing an asset of Rs. 950,000 and a liability of Rs. 1,000,000, the business shows a single liability of Rs. 50,000.
  This is a material misstatement. Although the amount is correct it hides the fact that the amount is in fact made of two much larger amounts. A user would be unable to judge the risk associated with Mr B’s ability of pay unless the two amounts are shown separately.
  Nature
  Businesses are sometimes placed under a legal obligation to disclose certain information in their financial statements (for example, companies must disclose directors’ remuneration). Omission of such amounts is always a material misstatement regardless of the size of the amount in relation to the other numbers in the financial statements.
  
  
  
  
  
  
  
  6.      Prudence
  Financial statements must sometimes recognise the uncertainty in business transactions. For example, if a business is owed Rs. 1,000,000 by a number of its customers, there will be some uncertainty as to whether all the money will actually be collected. Prudence involves allowing for some caution in preparing financial statements, by making reasonable and sensible allowances in order to avoid overstating assets or income and to avoid understating expenses or liabilities.
  As a general indication of prudence, rules exist to prevent a business recognizing an asset in its financial statements at an amount greater than the cash it will generate. When such a circumstance arises the asset is reduced in value down to the cash expected to result from the ownership of the asset.
  Example: Prudence
  A company has receivables of Rs. 10,000,000.
  The company knows from experience that about 2% of its receivables will not be collected because of customers being in financial difficulty.
  It is prudent to make an allowance for doubtful debts to 2% of receivables (but it would be inappropriate to make an excessive allowance, say 10% of receivables).
  The company would recognise an allowance of Rs. 200,000 to set against the receivable in the statement of financial position showing a net amount of Rs. 9,800,000 (10,000,000 less 200,000).
  The Rs.200,000 would also be recognised as an expense in the statement of comprehensive income.
  
  
  
  
  7.      Going concern basis
  This means that financial statements are prepared on the assumption that the entity will continue to operate for the foreseeable future, and does not intend to go into nor will be forced into liquidation. The going concern assumption is particularly relevant for the valuation of assets.
  The going concern basis of accounting is that all the items of value owned by a business, such as inventory and property, plant and equipment, should be valued on the assumption that the business will continue in operation for the foreseeable future. The business will not close down or be forced to close down and sell off all its items (assets). This assumption affects the value of assets and liabilities of an entity, as reported in the financial statements.
  If a business entity is not a going concern, and is about to be closed down and liquidated, the value of its assets would be their estimated value in the liquidation process. Assets are valued differently on a going concern basis.
  
  
  
  
  8.      Substance over form
  The use of the term faithful representation means more than that the amounts in the financial statements should be materially correct. It implies that information should present clearly the transactions and other events that it is intended to represent.
  To provide a faithful representation, financial information must account for transactions and other events in a way that reflects their substance and economic reality (in other words, their true commercial impact) rather than their legal form. If there is a difference between economic substance and legal form, the financial information should represent the economic substance.
  IFRSs contain many rules that are based on this concept.
  Example: Substance over form (leases)
  Alpha rents (leases) an asset from Beta.
  The asset is expected to be useful for 10 years after which it will be scrapped.
  Alpha has a contract to use the asset for 10 years.
  Analysis:
  The substance of the transaction is that Alpha has bought the asset from Beta.
  Beta would only agree to let Alpha use the asset for all of its useful life if the rentals received from Alpha covered Beta’s costs of buying the asset and gave Beta a financial return. This is the same as Alpha borrowing money and buying the asset.
  Alpha must recognise the leased asset as if it owns it and also must recognise a liability to pay for the asset.
  
  
  Example: Substance over form (sale and repurchase agreements)
  Gamma sells an asset to Delta for Rs. 1,000,000.
  There is a contract in place under which Gamma must buy the asset back off Delta for Rs. 1,100,000 in 12 months’ time.
  Gamma continues to use the asset in exactly the same way as before, even though
  Delta is now its legal owner.
  Analysis:
  The substance of the transaction is that Gamma has not sold the asset to Delta but has borrowed money from Delta.
  Gamma must recognise a liability for Rs. 1,000,000.