BA1109 Business Accounting Lecture 2

Accounting principles and rules Dr Jill Collis

Jill Collis and Roger Hussey, 2007

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Learning objectives

After completing this topic you should be able to

Explain the need for regulation Describe the main accounting principles Identify the key elements of the regulatory framework for different types of entity in the UK Explain the importance of international accounting standards and the conceptual framework to users

Independent study
Study Chapter 2 (Collis and Hussey, 2007) Do Q4 (same instructions as last week)
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The story so far

Accounting is the process of identifying, measuring, recording and communicating economic transactions (Collis and Hussey, 2007, p. 5) and there are two main branches
Financial accounting, which is primarily concerned with communicating a true and fair view to external users Management accounting, which is primarily concerned with communicating information to internal users

The legal status of the business affects the number of owners, their financial liability, legal formalities, how capital can be raised and financial disclosure
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Accounting principles and concepts

Accounting is a measurement system that presents the financial statements in as neutral a way as possible (ASB, 2009a) The fundamental accounting principles and concepts that guide accounting fall into three categories (Dyson, 2004)
Boundary concepts, that place limits on what data is recorded and communicated in the financial statements Measurement concepts, that guide how data is recorded Ethical concepts, that guide the accountants judgement in applying the spirit of the principle
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Examples of boundary concepts

Business entity concept

Only include information that relates to the economic activities of the entity and not those of its owner(s)

Going concern concept

Prepare the financial statements on the basis that the entity is a going concern and will continue in operation for the foreseeable future as far as it is known, unless it is known otherwise (see Economist, 2008) Eg If it is closing, non-current assets are shown at NRV rather than NBV and IAS 2 Inventories requires closing inventory to be shown at the lower of historical cost or NRV
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Examples of measurement concepts

Materiality concept
Only items of information that are material are included. An item is material if its omission or misstatement could influence the economic decisions of users Materiality depends on the size of the omission or error (eg sales of 10 omitted vs. sales of 10,000 omitted)

Money measurement concept

Only include items that can be measured in monetary terms (assumption that currency is stable and holds its value over time) Advantage is that economic activities can be quantified and summarised, but nonfinancial information is excluded
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Examples of measurement concepts (continued)

Historical cost concept the values of assets are based on

their original acquisition cost, unadjusted for subsequent changes in price or value
Some accounting standards, such as IFRS 3 Business Combinations, now require or allow the use of fair value (eg replacement cost, net realisable value, value in use)

Accruals concept revenue and costs are recognized as they are earned and incurred irrespective of when cash is received or paid (realization principle), and they are matched with one another (matching principle) and dealt with in the profit and loss account (income statement) of the period to which they relate (period principle)
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Examples of ethical concepts

Prudence concept
Revenue and profits are not anticipated, but are included in the income statement only if there is reasonable certainty that they will be received. However, provision for all known expenses and losses must be made, whether the amount is known with certainty or is only a best estimate in the light of the information available

Consistency concept
There is uniformity of accounting treatment of items of a similar nature within each accounting period and from one period to the next
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Purpose of the regulatory framework

The purpose of the regulatory framework for financial reporting is to ensure that companies prepare their financial statements in a standard way and produce high quality, reliable information
External users rely on the integrity and judgement of the directors to provide such information

Regulatory framework is known as UK GAAP

The term Generally Accepted Accounting Principles (GAAP) originated in the USA when they had no company law and referred to best practice in large and respected companies. Today, we use GAAP to refer to all financial reporting requirements (Alexander and Nobes, 2007)
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Three main elements of the regulatory framework for financial reporting (UK GAAP)

Company law (CA2006) set by government

Important in setting the general regulatory framework Incorporates EU company law as part of the harmonization programme aimed at smoothing out regulatory differences between member states

Accounting standards set by accountancy profession

Detailed guidance on how particular transactions or events should be reflected in the financial statements

Listing rules of the London Stock Exchange set by the Financial Services Authority
For listed public limited companies only
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Company law (mandatory for limited liability entities)

Company law (CA2006) incorporates EU Company Law Directives

Lays out the form and contents of the financial statements and the additional information to be provided in the notes Provides the overriding rule that the statement of financial position should give a true and fair view of the state of affairs of the company as at the end of the financial year; and the income statement should give a true and fair view of the profit or loss of the company for the financial year No formal definition, but essentially true means the financial statements are in accordance with the facts (accurately reflect the underlying transactions) and fair means they are not misleading
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Company law (CA2006) General requirements for limited liability entities

Must keep accounting records and prepare an annual report and accounts
Income statement (profit and loss account) and statement of financial position (balance sheet), signed by a director Other financial statements and group accounts may also be required Notes to the accounts Auditor's report on the truth and fairness of the view given by financial statements, signed by the auditor (exemption for most small entities) Directors' report signed by a director or company secretary
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Companies Act 2006 Some of the key changes

Change For public and private companies

Constitution
Articles of Association Objects

Memorandum of Association is no longer an active document but a record of facts at the time of incorporation
Articles of Association are the core document approved by members that gives directors their operational parameters No need to state the objects, so no restriction on firms activities

Statement of capital
One-member companies

The concept of authorised capital has been removed, leaving the focus on the number of shares issued and share capital
Must be at least one natural person who must be 16+, thus giving ultimate accountability to a human being

Electronic Once approved by members, the companys website can be communication used to transmit all corporate documentation Annual report and accounts PLCs must submit to Companies House and investors within 6 months of the year end; private companies within 9 months
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Adapted from Wearden, 2009, p. 33

Accounting standards (Semi-mandatory)

An accounting standard is an authoritative statement of how a particular type of transaction or other event should be reflected in the financial statements. Compliance with accounting standards is normally necessary for financial statements to give a true and fair view (Collis and Hussey, 2007, p. 34)
The UKs Accounting Standards Board (ASB) issues Financial Reporting Standards (FRSs) and the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRSs) Small private companies can adopt the Financial Reporting Standard for Smaller Entities (FRSSE)
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International convergence and EU harmonization

International accounting standards

Some countries have highly developed, prescriptive regulation, whilst others have minimal regulation, which is not satisfactory in todays global marketplace and this has led to demand for international accounting standards

EU harmonization programme aimed at smoothing out regulatory differences between Member States
Member States must adopt EU Company Law Directives Since 2005, all group companies with a listing on an EU stock exchange must prepare their consolidated accounts using International Financial Reporting Standards (IFRSs)
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International Financial Reporting Standards

The International Accounting Standards Committee (IASC) Foundation funds and appoints the members of the International Accountings Standards Board (IASB) and other operational bodies that support it
IASB issues International Financial Reporting Standards (IFRSs), which set out the rules and procedures for the measurement, valuation and disclosure of an accounting transaction or event Today, IFRSs have been adopted/adapted for use by all or some listed companies in 171 countries (Pacter, 2009)

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Summary of main elements of the regulatory framework

UK GAAP Company Law (CA2006) UK law Accounting standards ASB (FRS) Stock Exchange Rules
Companies listed on LSE or AIM

EU directives

IASB (IFRS)
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Conceptual frameworks

A conceptual framework is a statement of theoretical principles that provides guidance for financial accounting and reporting (Collis and Hussey, 2007, p. 39)
Having a conceptual framework helps avoid overlaps, contradictions and loopholes in accounting standards

The UKs Statement of Principles for Financial Reporting (SoP) (ASB, 1999) was based on the Framework for the Preparation and Presentation of Financial Statements (IASB, 1989)
We will focus on the IASB Framework
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Objective of financial statements (IASB Framework)

The first principle is that the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB, 1989, paragraphs 12-14)
This objective applies to general purpose financial statements (those intended for users who are not in a position to demand special purpose reports that meet their specific information needs, such as tax returns) But what makes financial information useful to users?
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Exercise 1 What makes financial information useful?

How useful are your bank statements?

Yes/No 1. Is any item insignificant or irrelevant? 2. Does the information help you make spending or borrowing decisions? 3. Is the information an accurate record of your cash transactions? 4. Can you compare it with previous periods? 5. Can you understand the information?

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Qualities that make financial information useful

Qualities

Understandability Should be readily understandable (assumed that users have reasonable knowledge and a willingness to study the information)

Relevance Should be capable of influencing users decisions (if information is not material, it is not relevant)

Reliability Should be a complete and faithful representation, neutral and prudent

Comparability Should be timely and prepared on a consistent basis so users can make comparisons

Adapted from IASB, 1989 and ASB, 1999

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Constraints on relevant and reliable information

Timeliness
Undue delay may lead to loss of relevance

Balance between benefit and cost

Benefits should exceed the cost of preparing the information

Balance between qualitative characteristics

The relative importance of the qualities in different cases is a matter of professional judgement (IASB, 1989, paras 33-45)

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True and fair view

Although the IASB Framework does not deal directly with the concept of true and fair, it comments
The application of the principal qualitative characteristics and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view or as presenting fairly such information. (IASB, 1989, para 46)

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Conclusions

Financial accounting is guided by a large number of accounting principles and a regulatory framework (UK GAAP) consisting of company law, stock exchange rules and accounting standards FRSs and IFRSs are underpinned by conceptual frameworks (the SoP and the IASB Framework)
The objective of general purpose financial statements is to provide information that is useful to users (7 groups) for making economic decisions and assessing stewardship To be useful it must be understandable, relevant (must be material), reliable and comparable
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