ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing
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Chapter 2: Qualitative characteristics of financial information and the fundamental bases of accounting
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for rent by 31 December Year 1, but there will be accrued rental costs for six months
($300,000) which must be included as an expense in profit and loss for Year 1.
Deferred income. Deferred income is revenue that an entity receives in advance,
that relates to goods or services that will be provided in a future accounting period.
Revenue should not be ‘recognised’ until the goods or services have been delivered.
For example, a deposit of $800 received from a customer for goods that have not yet
been delivered should not be recognised in revenue until the goods are eventually
delivered.
Exercise 1
A company prepares its financial statements to 31 December each year. It hires an
item of equipment for the period 1 November Year 1 to 30 April Year 2, at a cost of
$30,000. However, it does not have to pay the hire charge until the end of the hire
period, at the end of April Year 2.
What expense for equipment hire, if any, should be included in the income
statement for the year to 31 December Year 1?
2.6 Going concern basis
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.
For example, 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.
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Alternative bases of accounting and valuation
Alternative bases of measurement
Historical cost accounting
Changes in accounting policy
3 Alternative bases of accounting and valuation
3.1 Alternative bases of measurement
In financial reporting, a number of different bases are used to measure assets,
liabilities, revenue and expenses. It is convenient to think of different bases of
valuation in terms of the valuation of:
assets, and
expenses.
Assets, liabilities, income and expenses can be measured in the following ways:
Historical cost. This is the actual amount of cash paid or received. For example,
the historical cost of an item of equipment is the amount that it cost to buy (at
some time in the past).
Current cost. Assets might be valued at the amount that would have to be paid
to obtain an equivalent current asset ‘now’. For example, if a company owns
shares in another company, these assets might be valued at their current market
value. Similarly, a company that owns a building might choose to value the
building at its current market value, not the amount that it originally cost.
Realisable value or settlement value. Assets might be valued at the amount that
would be obtained if they were disposed of now (in an orderly disposal). The
term ‘net realisable value’ might also be used, meaning realisable value less the
costs of selling or disposing of the item.
Present value. This is a current value equivalent of an amount that will be
receivable or payable at a future time. For example, suppose that a payment of
$12,100 is due to be received in two years’ time, and it has been estimated that
the effective cost of interest is 10% per year. The amount receivable should be
reported at its present value, which is $12,100 × (1/1.10)
2
) = $10,000. Present
value might also be called economic value.
Replacement cost. The replacement cost of an asset is the cost of buying an
equivalent asset today. Similarly, the replacement cost of goods sold is the cost
that would now be incurred to replace the item that has been sold.
In financial accounting, it is usual to measure most items at historical cost, but the
other methods of measurement are also used in certain cases. For some assets, an
entity has choice about which method of measurement to use.
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3.2 Historical cost accounting
Financial statements are prepared under the historical cost accounting convention.
Under this convention, most assets, liabilities and items of revenue and expense are
recorded and reported at their actual historical cost.
International accounting standards permit the use of other bases of valuation, and
sometimes require the use of a different basis. Even so, the term ‘historical cost
accounting’ is applied to the normal method or basis for preparing financial
statements.
Advantages of historical cost
Using historical cost to give a money value to assets and the cost of sales has certain
advantages.
It is objective. It is an amount of money that has actually been paid, or a cost that
can be measured from historical data. There is no element of judgement or
opinion in the valuation.
It is simple. Unless assets are valued at historical cost, it becomes necessary to re-
value them regularly and change their current value (replacement cost or
realisable value) or present value.
It seems logical. It seems logical to suppose that if an item is sold for $1,000 and
its historical cost was $700, a profit of $300 has been made.
Disadvantages of historical cost
Unfortunately, there are some important disadvantages with historical cost
accounting, especially in a period of high price inflation.
When price inflation means that the current value or replacement cost of assets is
continually rising, historical cost would cease to represent a realistic value for
some long-term assets (non-current assets). An obvious example is land and
buildings, which are often used for many years and whose value tends to rise
over time. For example suppose that historical cost is used to value buildings
purchased in 1970, 1985, 2000 and 2009. Their total historical cost would not
represent their actual value, and the historical cost of each asset would not be
comparable because they were bought at different times.
When the rate of inflation is very high, the historical cost of sales might not be a
suitable basis for measuring the cost of sales. For example suppose that a retail
company sells an item for $10,000 which has a historical cost of sale of $6,000,
but to replace the item that as been sold from the supplier would now cost
$6,500. It could be argued that the profit on the transaction is only $3,500 (and
not $4,000) if the company wishes to continue trading at the same level in ‘real
terms’.
The conclusion is that historical cost accounting, particularly in a period of high
inflation, tends to:
under-state the value of assets, and
under-state the cost of sales and so over-state profits.
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To some extent, these disadvantages of historical cost accounting are overcome by
allowing or requiring entities to use alternative bases of valuation for certain assets,
liabilities and items of revenue and expenses.
3.3 Changes in accounting policy
Financial information should be comparable. To be comparable, items should be
measured consistently on the same basis and consistent methods of accounting
should be used.
The basis or method of accounting that an entity uses for the measurement or
valuation of items and transactions is called an accounting policy. Accounting
policies are defined as ‘the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements’
(IAS8).
Changes in accounting policy are highly undesirable, because they can affect the
comparability of financial information in the current year with information
prepared in earlier years before the change of policy.
International Accounting Standard Number 8 (IAS8) states that an entity should not
change its accounting policies, except in two unusual circumstances:
if the change is required by a new accounting standard (a new IFRS)
if the change results in financial statements that present reliable and more
relevant financial information.
In the rare event that an entity does change an accounting policy, it is required by
IAS8 to make the changes retrospectively, and alter the figures for the previous
financial year as well as the current year in which the policy is changed.
Entities are required to show comparative figures for the previous financial year in
their financial statements for the current year. To the extent that these are affected
by the change of accounting policy, they must be changed.
Practice multiple choice questions
1 Which one of the following is NOT an aspect of the reliability of financial information?
A fair presentation
B substance over form
C neutrality
D completeness
(2 marks)
2 If there is undue delay in reporting financial information, the information might lose
its:
A relevance
B reliability
(1 mark)
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3 Which of the following statements are correct?
1 Prudence requires that expenses should never be over-stated in the financial
statements.
2 The going concern assumption is that the business entity will continue in
operation for the foreseeable future.
3 Complex items should not be excluded from the financial statements on the
grounds that they would not be understandable for many users.
A (1) and (2) only are correct
B (1) and (3) only are correct
C (2) only is correct
D (2) and (3) only are correct.
(2 marks)
4 Which of the following statements are correct?
1 In a period of inflation, historical cost accounting tends to under-state asset
values and profits.
2 The business entity concept means that in financial statements the business entity
is treated as being separate from its owners.
3 If an item is not material, its omission would not affect the reliability of the
information in the financial statements.
A (1) and (2) only are correct
B (1) and (3) only are correct
C (2) only is correct
D (2) and (3) only are correct.
(2 marks)
5 A company prepares its financial statements to 31 December each year. It pays rental
costs on an office building annually in advance. It paid rental costs of $600,000 on 31
May Year 1 and $660,000 on 31 May Year 2.
What is the expense for office rental for the year to 31 December Year 2?
A $625,000
B $630,000
C $635,000
D $660,000.
(1 mark)
6 A company prepares its financial statements to 31 December each year. It hires an item
of equipment for the period 1 November Year 1 to 30 April Year 2, at a cost of $42,000.
However, it does not have to pay the hire charge until the end of the hire period, at the
end of April Year 2.
What expense for equipment hire, if any, should be included in the income statement
for the year to 31 December Year 1?
A $4,000
B $7,000
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C $14,000
D $28,000.
(1 mark)
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Paper F3 (INT)
Financial Accounting
CHAPTER
3
The accounting equation and
double-entry book-keeping
Contents
1 Businesstransactionsanddocuments
2 Theaccountingequationandbusiness
transactions
3 Book‐keeping:accounts,ledgersandbooksof
primeentry
4 Basicrulesofdouble‐entrybook‐keeping
5 Accountbalances:openingandclosingbalances
6 Informationtechnologyandfinancialreporting
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Business transactions and documents
The main data sources in an accounting system
Sales transactions
Sales transactions and accounting records
Purchase transactions
Purchase transactions and accounting records
From source documents to accounting records
1 Business transactions and documents
1.1 The main data sources in an accounting system
An accounting system or book-keeping system records data about business
transactions, and this data is eventually used to prepare financial statements at the
end of the accounting period.
The data that is recorded comes from a variety of documents, which are often in
paper form but might be in electronic form within a computerised system.
Businesses sell goods or services to their customers. They also buy materials and
parts and services from suppliers. They hire employees and pay them for the work
they do. They also incur other expenses, such as the costs of building rentals, and
the costs of gas, electricity and water supply. All these transactions – and more – are
recorded in the accounting system of the business.
For many businesses, the main types of business transaction are:
sales, sometimes for cash but often on credit
purchases of goods and services, usually on credit
cash receipts and cash payments.
There are other transactions, which are recorded differently. Payments to
employees, for example, are recorded within the payroll system. Purchases of non-
current assets are similar to purchases of goods in many ways, although separate
records are maintained of non-current assets (in a ‘non-current assets register’).
For the purpose of the examination, you need to be aware of the documentation and
processes within a normal sales transaction cycle and a normal purchases
transaction cycle.
The things you need to know are:
What are the main documents and what is the purpose of each document?
What information does each document contain?
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1.2 Sales transactions
A business might sell goods or services to a customer. This creates revenue or
income for the business.
Cash sales
Sales might be for cash, which means that the customer pays immediately, in notes
and coin, by debit card, credit card, cheque or by some less common method such as
banker’s draft.
When a business sells goods for cash, it should give the customer a receipt. It should
also keep a record of each sale. In shops, details of each sale transaction are recorded
by the equipment at the cash desk. In an old-fashioned cash register, for example,
each transaction is printed on a ‘till roll’. Computerised point of sale systems in
supermarkets and stores record each cash sale transaction automatically.
Credit sales
Many businesses sell their goods or services on credit, which means that they give
the customer time to pay. Typically a business will give its customers 30 days credit,
meaning that the customer must pay by the end of 30 days from the date of sale.
A credit sale transaction may begin with an order from the customer. Orders are
documented. The customer might send his own purchase order. Orders taken
verbally, say by telephone, are copied on to a sales order document (or into the
seller’s computer system, as a sales order.)
When the goods are delivered to the customer, the seller often provides a delivery
note, stating the quantity and type of goods have been delivered. When goods are
sent by post, or when delivery might take some time, the seller might send notice to
the customer that the goods have been despatched and are on their way (in a goods
despatched note). For example, with internet sales the seller will often send a goods
despatched note to the customer in the form of an e-mail message.
The seller will also send an invoice to the customer.
Sales invoices
For credit sales, the customer is given a sales invoice. A sales invoice is simply a
request for the customer to pay, and it includes details such as:
the goods or services purchased by the customer
the amount payable
if sales tax is payable, the invoice shows the amount payable before sales tax, the
sales tax and the total amount payable including sales tax
the time by when the payment should be made. Customers are expected to pay
invoices in full by the latest specified date on the invoice.
Sales invoices also include other information, such as:
the name and address of the business sending the invoice (on the ‘letter head’ for
the invoice)
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other contact details
the name and address of the customer, and possibly a customer identity number
the sales invoice number: a business should number its sales invoices
sequentially.
Some invoices have a tear-off counterfoil or remittance advice, which the customer
is asked to send with the payment. The counterfoil includes the customer’s identity
number, the invoice number and the total amount payable. A counterfoil helps a
business to identify what payments are for when cheques are received through the
post.
Statements
Some businesses also send statements to customers, as well as invoices. Statements
may be used when a customer buys goods or services regularly. Typically,
statements are sent to customers every month or perhaps every three months,
listing:
the amount still owed by the customer at the beginning of the statement period
the amounts purchased by the customer in the period (each sale/purchase
transaction is itemised separately)
amounts paid by the customer in the period (each payment is itemised
separately)
the amount owed by the customer at the end of the statement period.
Sales returns and credit notes
Sometimes a customer returns goods that have been sold to him. One reason for
sales returns is that the goods might be in bad condition and of unsatisfactory
quality.
When a customer returns goods, having bought them on credit, it might seem that
the logical thing to do is to re-issue an invoice for a smaller amount. In practice, this
does not usually happen. Instead, the seller issues the customer with a credit note.
Credit notes are, in effect, a reduction in an amount payable, documented as a
separate transaction. For example, if there is an invoice to a customer for $200 and
the business agrees to reduce the amount payable by $40 because some of the goods
were of poor quality, a credit note is issued to the customer for $40. The customer is
required to pay $160, which is the invoice for $200 less the credit note for $40.
1.3 Sales transactions and accounting records
The data about sales transactions recorded in an accounting system comes from:
sales invoices
credit notes
payments by customers (e.g. cheque and remittance advice)
receipts (the seller’s copy) in the case of cash sales.