CIMA - C2 Fundamentals of Financial Accounting

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100 6: From trial balance to financial statements ⏐ Part B Accounting systems and accounts preparation

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101

Preparing accounts:

concepts and

conventions

Introduction

IAS 1 Presentation of financial statements identifies a number of accounting concepts which

it describes as fundamental assumptions of accounting. These are explained in Section 1.

Section 2 covers how values are determined.

Topic list Syllabus references

1 Accounting concepts and principles A (2)

2 Costs and values A (4), (5)

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102 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation

1 Accounting concepts and principles

Eight accounting concepts and principles

1 Going concern

2 Accruals

3 Prudence

4 Consistency

5 Materiality

6 Substance over form

7 Business entity (the entity concept)

8 Money measurement

IAS 1 describes going concern, accruals and consistency as fundamental assumptions of accounting.

1.1 Going concern

Going concern implies that the business will continue in operation for the foreseeable future, and that there is no

intention to put the company into liquidation or to make drastic cutbacks to the scale of operations.

The main significance of the going concern concept is that the assets of the business should not be valued at their

'break-up' value, which is the amount that they would fetch if they were sold piecemeal and the business were thus

broken up. Rather, they are included in the statement of financial position at a value which reflects their value to the

business.

1.2 Accruals

The accruals concept states that, in computing profit, amounts are included in the accounts in the period when they are

earned or incurred, not received or paid.

This is illustrated in the example of Emma (5.6 in Chapter 1). Profit of $100 was computed by in effect matching the

revenue ($200) earned from the sale of 20 T-shirts against the cost ($100) of acquiring them.

However, if had Emma sold 18 T-shirts, it would be incorrect to charge her income statement with the cost of 20 T-

shirts, as she would still have two T-shirts in inventory. Therefore, only the purchase cost of 18 T-shirts ($90) would be

matched with her sales revenue ($180), leaving her with a profit of $90.

Her statement of financial position would therefore look like this.

Assets

Inventory (at cost, ie 2 × $5)

Receivables (18 × $10)

180

190

Proprietor's capital (profit for the period)

Liabilities

Payables

100

190

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Key term

Assessment

focus point

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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 103

In this example, the concepts of going concern and accruals are linked. As the business is assumed to be a going

concern, it is possible to carry forward the cost of the unsold T-shirts as a charge against profits of the next period.

Question

Going concern

If Emma decided to give up selling T-shirts, how would the two T-shirts in the statement of financial position be valued?

Answer

The going concern concept no longer applies and the value of the two T-shirts in the statement of financial position will

be a break-up valuation rather than cost. Similarly, if the two unsold T-shirts are unlikely to be sold at more than their

cost of $5 each (perhaps because of damage or a fall in demand) then they will be shown on the statement of financial

position at their net realisable value (ie the likely eventual sales price less any expenses to make them saleable, eg

repairs) rather than cost. This shows the application of the prudence concept.

UK company legislation gives legal recognition to the accruals concept, stating that: 'all income and charges relating to

the financial year to which the accounts relate shall be taken into account, without regard to the date of receipt or

payment.' This requires businesses to take account of sales and purchases when made (rather than when paid for) and

to carry unsold inventory forward in the statement of financial position rather than to deduct its cost from profit for the

period.

1.3 Prudence

Prudence is the concept that specifies, in situations where there is uncertainty, appropriate caution is exercised in

recognising transactions in financial records.

For example, inventory should be stated in the statement of financial position at cost rather than their selling price so as

to take into account the uncertainty of disposal.

Prudence guards against the understatement of assets and overstatement of liabilities. It encourages a even handed

approach to the recognition of liabilities, in particular.

Question

Prudence 1

A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing $100. During the

year he sells 17 machines at $150 each. How should the remaining machines be valued at 31 December if:

(a) He is forced to close down his business at the end of the year and the remaining machines will realise only $60

each in a forced sale?

(b) He intends to continue his business into the next year?

Answer

(a) If the business is to be closed down, the remaining three machines must be valued at the amount they will realise

in a forced sale, ie 3 × $60 = $180.

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104 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation

(b) If the business is regarded as a going concern, the inventory unsold at 31 December will be carried forward into

the following year. The three machines will therefore appear in the statement of financial position at 31 December

at cost, 3 × $100 = $300. The prudence concept dictates that they be valued at cost, not expected sales value.

Question

Prudence 2

Samson Feeble trades as a carpenter. He has undertaken to make a range of kitchen furniture for a customer at an

agreed price of $1,000. At the end of Samson's accounting year the job is unfinished (being two thirds complete) and the

following data has been assembled.

Costs incurred in making the furniture to date

800

Further estimated cost to completion of the job

400

Total cost

1,200

The incomplete job represents work in progress at the end of the year which is an asset, like inventory. Its cost to date is

$800, but by the time the job is completed Samson will have made a loss of $200. What is the effect of this on Samson's

statement of financial position and income statement?

Answer

The full $200 loss should be charged against profits of the current year. The value of work in progress at the year end

should be its net realisable value, which is lower than its cost. The net realisable value is $600, comprising costs

incurred to date of $800, less the loss foreseen of $200.

Sales revenue will be 'realised' and so 'recognised' in the income statement in the following cases.

(a) The sale transaction is for a specific quantity of goods at a known price, so that the sales value of the transaction

is known for certain.

(b) The sale transaction has been completed, or else it is certain that it will be completed (eg in the case of long-term

contract work, when the job is well under way but not yet completed by the end of an accounting period).

eventually be received from the customer or cash is actually received.

Usually, revenue is 'recognised' either when a cash sale is made, or when the customer promises to pay on or before a

specified future date, and the debt is legally enforceable.

The prudence concept is applied here in the sense that revenue should not be anticipated, before it is reasonably certain

to 'happen'.

The application of the prudence concept to revenue is also known as the realisation concept.

Assessment

focus point

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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 105

Question

Realised profit

A realised profit arises when?

A A customer's order is received

B A receivable pays an invoice

C A property is revalued upwards

D Goods are sent to a customer, who will purchase on credit, the invoice will be sent later

Answer

B Correct.

A The sale has not yet occurred, it is far too early to recognise profit.

C This is an unrealised surplus, it will only become realised if the property is sold.

D This is too early in the sales cycle to recognise a profit. The sale is not for cash and the customer has not yet

accepted the goods.

1.4 Consistency

Accounting is not an exact science. There are many areas where judgement must be used in determining money values

for items appearing in accounts. Certain procedures and principles are recognised as good accounting practice, but there

are often various acceptable methods of accounting for similar items.

The consistency concept states that in preparing accounts consistency should be observed in two respects.

(a) Similar items within a single set of accounts should be given similar accounting treatment.

(b) The same treatment should be applied from one period to another in accounting for similar items. This enables

valid comparisons to be made from one period to the next.

1.5 Materiality

Apart from error, there will be many areas where two different accountants will come up with different figures for the

same item. The materiality concept is relevant in this context.

A matter is material if its omission or misstatement would reasonably influence the decisions of a user of the accounts.

In preparing accounts it is important to decide what is material and what is not, so that time and money are not wasted

in the pursuit of excessive detail.

Question

Materiality

You have recently paid $4.95 for a waste paper bin which should have a useful life of about five years. Should you treat it

as a non-current asset?

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106 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation

Answer

No, because of the materiality concept. The cost of the bin is very small. Treat the $4.95 as an expense in this year's

income statement.

1.6 Substance over form

Substance over form is the principle that transactions and other events are accounted for and presented in accordance

with their substance and economic reality and not merely their legal from.

Substance over form usually applies to fairly complicated transactions. It is very important because it stops businesses

distorting their results by using the letter of the law instead of commercial reality.

1.7 The entity concept

Entity concept: accountants regard a business as a separate entity, distinct from its owners or managers.

This concept applies whether the business is a limited liability company (and so recognised in law as a separate entity)

or a sole trader or partnership (in which case the business is not legally separate). So, in the example of Emma in

chapter 1, the money she transferred to her business bank account becomes, in accounting terms, a business asset (but

legally remains a personal asset).

Acceptance of this concept has important practical consequences. In the case of a small business run by a single

individual, the owner's personal affairs and business affairs may appear to be inextricably linked eg Emma may conduct

her business from home. In preparing the business accounts, it is essential to separate out her private transactions.

Question

Entity concept

Suppose that Emma withdraws a number of T-shirts from her stock to give to friends, how would this be reflected in her

accounts?

Answer

The correct accounting treatment is to regard her as having purchased the goods from the business, which is a

completely separate entity. The subsequent gift to her friends is then a private transaction and is not recorded in the

books of the business. Emma should pay for the T-shirts by taking money from her own purse and putting it into the till,

or she should regard the withdrawal as a repayment of capital. Otherwise, the business accounts will give a misleading

picture.

1.8 The money measurement concept

Money measurement concept: accounts deal only with items to which a monetary value can be attributed.

Key term

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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 107

In Chapter 1, we distinguished between an asset such as a machine (which might be valued at its original purchase cost,

its replacement cost etc) and an asset such as the flair of a manager or the dedication of the workforce. The machine is

valued and included in the statement of financial position, flair and dedication are not included, yet they can be of

enormous importance to the success of a business. Recognising this, accountants in recent years have tried to suggest

ways of 'bringing them on to the statement of financial position' by attributing values to them. 'Human resource

accounting' is beyond the scope of this book, but you should be aware of the problems it attempts to address.

Question

Money measurement

Perhaps it is too glib to say that monetary values can never be attributed to the skill of the workforce. There is at least

one high-profile industry where such valuations are commonplace. Can you think of it? And do you know what the

accounting consequences are in that industry?

Answe

The industry referred to is of course the world of sport, particularly football, where transfer fees appear to provide an

objective valuation of a player's worth. Many football clubs are run as substantial businesses, some of them with shares

quoted on the UK Stock Exchange. As such, their accounting practices are widely publicised and discussed. In almost all

cases, however, they make no attempt to include the value of players on their statement of financial position, presumably

because such values fluctuate wildly with the form and fitness of the players concerned. Transfer fees are usually shown

simply as a cost in the income statement.

1.9 Accounting policies and accounting estimates

IAS 1 also considers three other concepts extremely important. Prudence, substance over form and materiality should

govern the selection and application of accounting policies.

Accounting policies should be chosen in order to comply with International Accounting Standards. Where there is no

specific requirement in an IAS or IFRS, policies should be developed so that information provided by the financial

statements is:

(a) Relevant to the decision-making needs of users.

(b) Reliable in that they:

(i) represent faithfully the results and financial position of the entity.

(ii) reflect the economic substance of events and transactions and not merely the legal form.

(iii) are neutral, that is free from bias.

(iv) are prudent.

(v) are complete in all material respects.

(d) Understandable

Accounting policies are different to accounting estimates. Estimates arise due to the uncertainties in business dealings

eg bad debt allowances, depreciation. If there is a change in an accounting estimate, the difference should be written

off to the same income statement expense item that the original provision was charged to.

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108 7: Preparing accounts: concepts and conventions ⏐ Part B Accounting systems and accounts preparation

2 Costs and values

2.1 Historical cost

A basic principle of accounting is that resources are normally stated in accounts at historical cost, ie at the amount

which the business paid to acquire them.

An important advantage of doing this is that the objectivity of accounts is maximised: there is usually documentary

evidence to prove the amount paid to buy an asset or pay an expense. In general, accountants prefer to deal with costs,

rather than 'values'. Valuations tend to be subjective and to vary according to what the valuation is for.

A company acquires a machine to manufacture its products, with an expected useful life of four years. At the end of two

years the company is preparing a statement of financial position and has to value the asset.

Possible costs and values

• Original cost (historical cost)

• Half of the historical cost (half of its useful life has expired)

• Secondhand value

• Replacement cost of an identical machine

• Replacement cost of a more modern (technologically advanced) machine

• Economic value (ie the amount of the profits it is expected to generate during its remaining life)

All of these valuations have something to commend them, but the great advantage of the first two is that they are based

on the machine's historical cost, which is verifiable. The subjective judgement involved in the other valuations,

particularly the last, is so great as to lessen the reliability of any accounts based on them. The second method, or a

variation of it, is the one which will normally be used (see Chapter 9).

2.2 Example: costs and values

Brian sets up in business on 1 January 20X6 selling accountancy textbooks. He buys 100 books for $5 each and by 31

December 20X6 he manages to sell his entire inventory, all for cash, at a price of $8 each. On 1 January 20X7 he

replaces his inventory by purchasing another 100 books. This time the cost of the books has risen to $6 each. Calculate

the profit for 20X6.

Solution

In conventional historical cost accounting, Brian's profit would be computed as follows.

Sale of 100 books (@ $8 each) 800

Cost of 100 books (@ $5 each)

500

Profit for the year

300

The purchase of the books is stated at their historical cost. Although this is accepted accounting practice, and is the

method we will be using, it involves an anomaly which can be seen if we look at how well off the business is.

On 1 January 20X6 the assets of the business consist of the 100 books which Brian has purchased as inventory. On 1

January 20X7 the business has an identical inventory of 100 books, and also has cash of $200 (ie $800 received from

customers, less the $600 cost of replacing inventory). So despite making a profit of $300, measured in the conventional

way, the business appears to be only $200 better off.

This anomaly can be removed if an alternative accounting convention is used. Suppose that profit is the difference

between the selling price of goods and the cost of replacing the goods sold. Brian's profit is as follows.

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Part B Accounting systems and accounts preparation ⏐ 7: Preparing accounts: concepts and conventions 109

Sale of 100 books 800

Cost of replacing 100 books sold @ $6 each

600

Profit for the year

200

Now the profit for the year is exactly matched by the increase in the company's assets over the year.

2.3 Capital maintenance

The capital of a business (also called its net worth) is the excess of its assets over its liabilities, and represents the

proprietor's interest in the business.

One way of calculating profit measures how well off a business is at the beginning of a period compared to the end of the

period. The difference (after allowing for drawings and injections of new capital) is the profit or loss for the period. On

this basis, profit depends on the valuation of the assets and liabilities

Returning to the example of Brian and using historical cost, the value of his business at 1 January 20X6 and 1 January

20X7 is as follows.

20X6 20X7

$ $

Inventory (at historical cost) 500 600

Cash

200

500

800

The value of the business has risen by $300 over the year and this is the amount of profit we calculated on the historical

cost basis. We can say that the original capital of the business, $500, has been maintained and an additional $300

created. This is the financial capital maintenance concept.

However, in times of high inflation, if we keep capital at its historic cost the value in real terms will be diminished. So, in

order to maintain capital, it is necessary to adjust for inflation.

Question

Capital maintenance

At 31.12.X1, the capital of a business was $100,000. During the year ended 31.12.X2 the business made a profit of

$20,000. If inflation was running at 10%, what amount should be needed to maintain the capital?

A $100,000

B $120,000

C $110,000

D $90,000

Answer

C. At the beginning of the year, the capital was $100,000. With inflation running at 10%, the capital needs to increase by

10% to maintain capital ($100,000 + 10% × $100,000 = $110,000).

Instead of using historical costs, it is theoretically possible to measure capital in physical terms. Brian's physical capital

was originally 100 books; on 1 January 20X7, it consists of an identical 100 books plus $200 cash. We can say that

Brian's original physical capital has been maintained and an addition to capital of $200 has been created. This is

equivalent to the profit we computed on a replacement cost basis.

Key term

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