Sunday, August 9, 2009

Paper 1.1 Chapter 2

Paper 1.1
Chapter 2

The Accounting Concepts – Part 1 (The Summary)

Just a basic summary of those little things that we always tend to forget.
The Going Concern Concept implies that a business is a going concern, i.e. that
there is no reason to expect the liquidation of assets. Thus, the business may be
valued at its historical, or current cost, rather than its break-up or replacement
value. A further example to illustrate the application of the Going Concern concept,
may be clearly seen, when stock is valued. It is a practice to value stock at the lower
of its net realizable value or cost of purchase, this is because the going concern
concept implies that the stock is held to be sold at a future date.

The Accruals Concept is based on several ‘ideas’ or practices, which may be clearly
illustrated, if summarized in the following form:

1. Revenue and Costs must be recognized as they are earned or incurred.
2. Revenues must be matched with costs, and vice versa, and dealt with in the profit
and loss account of the period to which they relate.

It is for this reason, that we actually disclose the value of the creditors in the Balance
Sheet, and the value of debtors. Furthermore, although we may have paid rent of
BD 1000, for the next two years for example, we may only note the amount relevant
to this year’s profit and loss account, and the remaining balance, as a prepayment in
the Balance Sheet.

Furthermore, this is the reason why it is required to account for sales and purchases
when made, even though on credit, rather than when they are paid for.

As well as this, the figure for closing stock is also deducted from the figure of
purchases because the figure of closing stock relates to the opening stock figure of
next year’s accounts.

The Prudence Concept

1. a) Where there are alternative procedures
b) Or alternative valuations
c) The one selected should be the one which gives the most cautious
presentation of the business’s financial position or results.

2. a) Revenues and profits are not anticipated but are related to the period in
which they occur. E.g. when a sale is made.
b) Provision is made for all known expenses or losses whether these are known
for certain or just estimates.

What definition means in layman’s terms is simply, if the company is in doubt about
an expense or a liability that it may have, it should create a provision for it
immediately, and if the company anticipates any future gains or profits, from a future
sale for example, it should ignore it, unless realized.


1. Provisions for Bad & Doubtful Debts
2. Stock should be valued at the lower of net realizable value or cost

Sales Revenue could be realized, if the following circumstances apply:

1. The transaction is for a specific quantity of goods at a known price.
2. The sales transaction is completed or it is known for certain that it will be
3. Cash is received for a purchase, or it is virtually certain that cash will eventually be

Consistency Concept states that similar items within a single set of accounts, should
be similarly accounted for, and that they are treated the same from one period to

The Entity concept states that a business must be regarded as a separate entity
distinct from its owners or managers.

Money Measurement, states that accounts will only deal with those items to which a
monetary value can be attributed, which means that subject matter such as staff is

Separate Valuation Principle refers to the amount/cost attributable to an asset /
liability, since the valuation should deal with each component separately. E.g. an
independent valuation should be obtained for each item of stock, and their net
realizable values should then be aggregated to obtain the total value of stock.

The Materiality Concept refers to the following:

Only items material in amount or in their nature affect the true & fair view given by a
set of accounts. In other words, immaterial items are not paid that much attention.
But this is obviously based on a subjective judgment in deciding whether an item is
immaterial or not. Either way, the amount of the item and its context must be

Historical Cost Convention states that transactions should be recorded at their cost.

Stable Monetary Unit states that the Financial Statements must be expressed in
terms of a monetary unit, e.g. $.

Objectivity Concept states that accounts must be free from bias or subjectivity as
much as possible.

Time Interval, states that the activities of an entity must be split up into blocks of time,
e.g. daily, monthly or annually.

Substance Over Form, refers to a transaction in two distinct ways, ‘subject’ and
‘form’. Thus, the transaction should be accounted for and presented in accordance
with their economic ‘substance’ not their legal ‘form’. E.g. assets required on a hire
purchase are not legally owned by the buyer even though the substance of the
transaction refers to the buyer as the owner.

The Realization Concept states that revenues and profits are recognized when they
are realized. Basically the Realization Concept refers the question of when does an
entity realize a profit or a gain?
Simply, revenue may be recognized at the point of sale, when the following
conditions are satisfied:

1. The product or service has been provided to the buyer
2. The buyer recognized his liability to pay for the goods
3. The ownership of the goods has passed from the seller to the buyer.
4. The buyer has indicated his willingness to pay.
5. The monetary value of the goods has been established.

Revenue or profits may also be recognized at other situations even if a sale hasn’t
been established, such as:

1. Longterm Contracts, where profits/revenues are recognized when the production
on a section of the total contract is complete, rather than when the entire project is
2. Retail & Hire Purchase, where an actual sale isn’t made unless the buyer finishes
all of his installments. In this case, profit would be the interest added to the cost of
the asset sold.

Paper 1.1 Chapter 1

Paper 1.1
Chapter 1

The Definition, Purpose, and the Regulatory Framework of Accounting

Well, this report isn’t an introduction to accounting as it may seem to be. It’s more like
a summary to the purpose of studying paper 1.1 .

Accounting is a way of recording, analyzing, and summarizing transactions of a

Transactions are recorded in books of prime entry, and then analyzed and posted to
the ledgers and finally they are summarized in the financial statements.

Yet, the term ‘Accounting’ not only refers to Financial Accounting, but moreover,

a) Management Accounting
b) Financial Management
c) Auditing

The Purpose, of going through the process of preparing financial statements, may not
be required or needed by most companies, yet some must comply to do so by law.
Nonetheless, they are prepared so that owners, managers, lenders and other
interested parties can see how the business is doing. In other words, to provide
information about the financial position, performance and financial adaptability of an
enterprise that is useful to a wide range of users.

Depending on the users of financial statements, many may require access to different
information, but all share some basic needs. Some of the basic users of financial and
accounting information are:

a) Managers
b) Shareholders
c) Trade contacts
d) Providers of Finance
e) Governments and their Agencies, e.g. Inland Revenue and Registrar of
f) Employees
g) Financial Analysts and Advisors
h) Investors/ Public

As one may imagine, it may be very hard to satisfy all of the different users, yet, the
basic financial statements at the end of the day, are:

a) The Profit and Loss Account
b) The Balance Sheet

Furthermore, some companies may be required to produce annual reports, which
contain :

Non-Financial Statements, such as:
a) Director’s Report
b) Auditors’ Report
c) Chairman’s Report

Limited companies are required by law to prepare and publish accounts annually. The
form and content of the accounts are regulated primarily by the Companies Act 1985,
but must also comply with accounting standards.

The Regulatory System

Basically the Company Law requires that all companies must comply with the
Companies Act. Of the many requirements and regulations, it must be brought to one’
s attention, that the Financial Statements are required to represent a True and Fair
view of the state of affairs and Profit and Loss.

The Accounting Standard’s Board, previously known as the Accounting Standard’s
Committee, has issued the Accounting Standards, such as FRS’s and SSAP’s. The
accounting standards were developed with the aim of narrowing the areas of
difference and variety in accounting practice.

The Urgent Issues task force is an important part of the ASB in that it is required to
tackle urgent matters not covered by existing standards. The review panel, is
concerned with the examination and questioning of departures from accounting
standards by large companies.

Furthermore, the companies are required to follow the Accounting Policies, set out in
FRS 18 and the Companies’ Act. Those policies, are summarized in the diagram
above, but it must be noted that there is a distinction between the accounting policies
and accounting estimates.

The accounting policy is concerned with:

a) the recognition
b) Selection of measurement base and
c) Presentation

Of assets, liabilities, gains and losses of an entity. E.g. ‘Prudence or Accruals’? The
choice must be based on which may provide the most true and fair view.

The accounting estimate is the method used to establish the monetary value of
assets, liabilities, gains and losses using the measurement base selected by the
accounting policy,
e.g. depreciation (straight line or reducing balance?)

The ASB also developed a Statement of Principles, which is concerned by:

a) the objective of financial statements
b) the reporting entity
c) The qualitative characteristics of financial information.

Basically the statement of principles provided a Conceptual Framework, which forms
the theoretical basis for determining which events should be accounted for, how they
should be measured and how they should be communicated to the user. A conceptual
framework is a statement of generally accepted theoretical principles, which form the
frame of reference for financial reporting. These theoretical principles provide the
basis for the development of new reporting standards and the evaluation of those
already in existence. In other words, they are there to provide consistency, clarity and

Furthermore, companies are required to comply with the regulations of the European
union, and various international bodies, and any stock exchange requirements
depending on their circumstances.

In addition to the Financial Statements, limited companies are required to provide
certain notes and disclosures to the accounts, such as:

1. Statement of movements in reserves
2. Details of Fixed Assets
3. Details of post balance sheet events
4. Details of contingent liabilities and contingent assets
5. Details of research and development expenditure.
6. Statement of total recognized gains and losses.
7. Note on historical cost profits and losses.

The following are the important features of Financial Statements

1- Relevance 3-Reliability 5-Objectivity 7-Comparability
2-Comprehensibility 4-Completeness 6-Timeliness

The Qualitative Characteristics of Financial Statements

a) Relevance – Info that has the ability to influence decisions, Predictive Value,
Confirmatory Value.
b) Reliability – Info that is complete and faithful representation. Free from material
error, faithful representation, neutral, complete, and prudence.

a) Comparability – similarities and differences can be discerned and evaluated.
Consistency and Disclosure.
b) Understandability – the significance of the information can be perceived. Users’
abilities, Aggregation and classification.