CIMA BA3 Study Text 2023-20290 PDF

Chapter 1 The accounting environment Chapter learning objectives When you have completed this chapter, you should be able to: explain the principles and concepts of financial accounting apply the accounting equation to record the effect of transactions. 1 The accounting environment 1 Introduction This chapter provides: an introduction to the accounting environment and an introduction to the fundamental issues associated with financial accounting. Much of the chapter relates to the first syllabus area ‘accounting principles, concepts, and regulations’. This chapter covers: the different types of business entity the need for accounting records and which accounting records are maintained the concept of stewardship the user groups of financial accounting information the definition of accounting, including use of coding in record keeping the differences between financial and management accounting the elements of the financial statements the accounting equation, including classification of transactions the qualitative characteristics of financial information the historical cost convention and other valuation bases the explanation of accounting concepts and fundamental terms, and a glossary of accounting terms. 2 Chapter 1 2 What is a business entity? A business is an entity that regularly enters into transactions that are expected to provide a reward measurable in monetary terms. It is thus obvious from everyday life that many business entities exist. What is less obvious is that their organisational (legal) structure and therefore their accounting requirements may differ. There are two main reasons for the different organisational structures that exist – the nature of their activities and their size. Note that information relating to the different types of entity organisational structure is provided for information and awareness only to provide context and understanding for your financial accounting studies. Many accounting transactions will be common to all types of business entity, such as cash receipts and payments and, therefore, the same accounting principles will apply irrespective of the nature of the business entity. However, note that you will not be examined on specialised transactions relating to partnerships, local or national government or non-profit making entities. The focus of your studies for this subject is accounting principles and transactions relating to sole traders and companies. For convenience, and to be consistent with CIMA terminology, reference will usually be made to an 'entity', rather than a 'business' or an 'organisation' or 'company'. Profit-making entities Some entities are formed with the intent of making profits from their activities for their owners: (a) Sole traders (sole proprietors) Who are they? These are entities that are owned by one person. They tend to be small because they are constrained by the limited financial resources of their owner. The sole trader will also have unlimited personal liability for debts incurred by the business. (b) Partnerships Who are they? These are entities owned by two or more persons working in common with a view to making a profit. The greater number of owners compared with a sole trader increases the availability of finance and this is often the reason for forming such a structure. As with a sole trader, each of the partners in the business has unlimited personal liability for debts incurred by the business. 3 The accounting environment (c) Limited liability companies ('companies') Who are they? These are entities recognised in law as ‘persons’ in their own right. Thus a company may own assets and incur liabilities in its own name. There is a separation in law between ownership of the company by shareholders and its management by directors. The crucial distinction between a company and either a sole trader or a partnership is that the shareholders of a company have only limited liability for debts incurred by the business, whereas sole traders and partners have unlimited personal liability for debts incurred by the business. The accounting requirements of companies must meet certain minimum obligations imposed by legislation, for example, via company law and other regulations. Some of these requirements also constitute recommended accounting practice for other types of business entity. Two types of company can be identified: private limited companies and public limited companies. Who are they? Public limited companies are ‘listed’ on a stock exchange. Listed companies may have many thousands of owners (shareholders) who are even further removed from the running of the business. In private limited companies the owners are usually also actively involved in running the business. In this way they are similar to sole traders and partnerships. This is rarely true of public companies, where the owners are unlikely to be involved in the day-to-day activities of the business. Instead, the shareholders will elect a board of directors to manage the company on a day-to-day basis on their behalf. These distinctions can be important when considering the accounting requirements, which are more onerous for public companies. The accounting requirements relating to the financial statements of companies are considered in more detail in subsequent chapters of this publication. 4 Chapter 1 Non-profit-making entities Other entities are formed with the objective of providing services, without intending to be profitable in the long term: (a) Clubs and societies Who are they? These entities exist to provide facilities and entertainments for their members. They are often sports and/or social clubs and most of their revenue is derived from the members who benefit from the club’s facilities and activities. They may carry out some activities that are regarded as ‘trading’ activities, in which profits are made, but these are not seen as the main purpose of the entity. For example, a tennis club may hold a summer barbeque to raise funds for the club. (b) Charities Who are they? These exist to provide services to particular groups, for example people with special needs and to protect the environment. Although they are regarded as non-profit-making, they often carry out trading activities, such as running shops to raise income. (c) Local and central government Who are they? Government departments are financed by members of society (including businesses). Their finances are used to provide the infrastructure in which we live, and to redistribute wealth to other members of society. The accounting requirements of local and central government are not within the syllabus and learning objectives of this subject. 3 The need for accounting records While recognising that many businesses will maintain their accounting records using computerised accounting packages or spreadsheets, it is important for those studying BA3 to be aware of the principles and processes that underpin these packages. Accounting records are used to record transactions entered into by an entity, whatever form it may take (e.g. sole trader, partnership, company etc.). This information can then be used to meet a range of needs or requirements as follows: they help an entity to record, summarise and classify transactions in a logical and systematic manner they help managers to easily locate information required, such as details relating to an individual sales or purchase transaction 5 The accounting environment they help managers to easily keep track of amounts owing to the entity from customers and amounts owed to suppliers they help managers and owners to meet legal obligations relating to the maintenance of accounting records they form the basis of preparation of management accounting information used by managers for control and decision-making purposes they form the basis of financial accounting information used to prepare annual accounts for business owners and other interested parties, such as tax authorities. What accounting records are maintained? In most entities, the principal transactions that take place include sales, purchases (of goods and of services) and payroll-related transactions. Other transactions include incurring costs for rent, heat and light, fuel and power and office expenses such as telephone, postage and stationery. All of these transactions (and any others entered into by an entity) must be adequately captured by the accounting system to form the basis of preparation of financial accounting and management accounting information. With most transactions a supporting document will be created to confirm that the transaction has taken place, when the transaction took place and the associated value of the transaction. This documentation is vital to the financial accountant, who uses the information on the documents as a data source to initiate the measurement and recording of the transactions. The table below summarises the main types of business documentation and sources of data for an accounting system, together with their content and purpose. In computerised systems, the information contained in these documents could be entered directly into the system. Soft copies of the documents may be exchanged between businesses without being printed – referred to as the paperless office. Contents Purpose Quotation Quantity/description/ To establish cost from details of goods various suppliers and required. cross refer to purchase order. Purchase order Details of supplier, Sent to supplier as request e.g. name, address. for supply. To check to the Quantity/description/ quotation and delivery details of goods required note. and price. Terms and conditions of delivery, payment, etc. 6 Chapter 1 Sales order Quantity/description/ Cross checked with the details of goods required order placed by customer. and price. Sent to the stores/ warehouse department for processing of the order. Despatch note Details of supplier, Provided by supplier. (goods despatched e.g. name and address. Checked with goods note – GDN) Quantity and description received and purchase of goods. order. Goods received Quantity and description Produced by the business note (GRN) of goods. receiving the goods as proof of receipt. Matched with despatch note from supplier and purchase order. Invoice Name and address of Issued by supplier of supplier and customer; goods as a request for details of goods, payment. For the supplier e.g. quantity, price, selling the goods/services value, sales tax, terms this will be treated as a of credit, etc. sales invoice. For the customer this will be treated as a purchase invoice. Statement Details of supplier, Issued by the supplier. e.g. name and address. Checked with other Includes details of date, documents to ensure that invoice numbers and the amount owing is values, payments made, correct. refunds, amount owing. Credit note Details of supplier, Issued by the supplier. e.g. name and address. Checked with documents Contains details of regarding goods returned. goods returned, e.g. quantity, price, value, sales tax, terms of credit, etc. Debit note Details of the supplier. Issued by the business Contains details of receiving the goods. Cross goods returned, referred to the credit note e.g. quantity, price, issued by the supplier. value, sales tax, terms of credit, etc. 7 The accounting environment Remittance advice Method of payment, Sent to supplier with, or as invoice number, account notification of, payment. number, date, etc. Receipt Details of payment Issued by the selling received. business indicating the payment received. 4 The concept of stewardship Stewardship is a relationship of accountability by one person or group for their management of resources and decision-making on behalf of another person or group (sometimes referred to as a principal). In a financial accounting context, employees (whether managers or directors) are ultimately accountable to the owners of that business (such as shareholders in a corporate entity) for the use of resources under their control and for the outcome of decisions they make in the use of those resources. Accountability or stewardship is therefore exercised by managers and directors periodically providing financial accounting information to their principal or business owner, normally in the form of annual financial statements. As such, the steward is placed in a position of trust to manage and account for the resources placed under their control by the principal. Accordingly, they should uphold fundamental ethical principles as follows: Integrity Objectivity Professional competence and due care Confidentiality Professional behaviour. Ethical issues are considered in more detail in BA4 Fundamentals of Ethics, Corporate Governance and Business Law. The stewardship role of management In a sole trader business or a partnership the owners of the business entity are answerable only to themselves. They own the business entity and they are responsible for its day-to-day operations. In a corporate entity this is not necessarily the case. With the exception of owner- managed companies, it is likely that shareholders do not have any involvement in the day-to-day activities of the running and decision- making of the business entity. They provide the capital and they appoint directors to manage the business entity on their behalf. 8 Chapter 1 In return the directors will receive remuneration in the form of salary and other benefits. The profit generated by the entity, however, belongs to the shareholders. It is the responsibility of the directors/management to ensure that the assets of the entity are safeguarded. This may involve ensuring that: all assets are recorded correctly, they exist, and are properly maintained and insured procedures are in place to prevent misappropriation or misuse of assets the accounting system is efficient and effective no expenditure is undertaken, or liability incurred, without proper procedures for its authorisation and control the financial statements are prepared in accordance with current legislation and accounting standards. The term often given to these responsibilities is ‘the stewardship function’. Management acts as stewards on behalf of shareholders, members and other beneficiaries, and may be answerable if they fail in this duty. That is not to say that it is their responsibility to make as much profit as possible, or even that they are to blame if losses are made, but that they must take appropriate steps to manage the risks, within the confines of the business world. 5 Who uses financial information? Accounting information is used by many discrete groups, both individuals and entities. To develop an understanding of how financial statements may be used, it is useful to classify these users into groups, and to consider the reasons why they use financial statements and what benefit or understanding they hope to gain from doing so. Any classification of this sort is somewhat arbitrary, and many users fall into more than one classification. However, the following groups are commonly recognised as having particular needs for accounting information. 9 The accounting environment (a) The investor group Owners are better able to make decisions regarding their investment (e.g. should they sell shares or retain shares or buy more shares?) if they have relevant information. They are also able to make decisions regarding how the business entity is managed and controlled (e.g. vote to appoint or remove directors). What do they require? This group includes both existing and potential owners of shares in corporate entities. They require information concerning the performance of the corporate entity measured in terms of its profitability and the extent to which those profits are to be distributed to shareholders. They are also interested in the social/economic policies of the corporate entity so that they may decide if they wish to be associated with such an entity. For example, does the corporate entity adhere to sound ethical principles and environmental practices? (b) The lender group What do they require? This group includes both existing and potential providers of secured or unsecured, long or short-term loan finance. They require information relating to the ability of the entity to repay the interest on such loans as they fall due. Additionally, they are also interested in the longer-term growth and stability of the entity to ensure that it is capable of repaying loans at the due date. In addition, if the loan is secured, the value of the assets used as security is important as a means of recovering the amount due if the entity defaults on repayment. (c) The employee group What do they require? This group includes current, potential and past employees. They require information relating to the ability of the entity to pay wages and pensions on a continuing basis. In addition, they are interested in the future prospects of the entity because these issues will affect job security and employment prospects within the entity. (d) The analyst/adviser group What do they require? This group includes a range of advisers to investors, employees and the general public. The needs of these users will be similar to those of their clients. The difference is, perhaps, that in some instances, the members of this group will be more technically qualified and experienced to understand and evaluate financial accounting reports. 10 Chapter 1 (e) The business contact group What do they require? This group includes customers and suppliers of the entity. Customers will be concerned to ensure that the entity has the ability to provide the goods/services requested and to continue to provide similar services in the future. Suppliers will wish to ensure that the entity will be capable of paying for the goods/services supplied when payment becomes due. (f) The government What do they require? This group includes taxation authorities, plus other local and national government agencies and departments. The taxation authorities will calculate the entity's taxation liability based upon the accounting reports and information submitted. Other government agencies will collect economic and financial data to measure and evaluate national and regional economic performance, such as employment rates and production or output levels. (g) The public What do they require? This group includes taxpayers, consumers and other community and special interest groups. They require information relating to the policies and practices of the entity and how those policies and practices affect the community. For example, the general public has become increasingly aware of, and interested in, the environmental impact a business entity has as a result of its trading activities, and what may be done to minimise any adverse impact. Similarly, the general public has also developed an interest in whether an entity takes advantage of exploitative working and employment practices to minimise operating costs. When an entity is perceived to be operating in a way which is not socially responsible, it may affect the reputation of that entity and also its profitability if, for example, there is a consumer boycott of its products. (h) Internal users What do they require? The management of the entity requires information to assist it in the performance of its duties. Three different levels of management can be identified: Strategic – this is the most senior level of management within an entity. In a commercial entity it is referred to as the board of directors. This level of management requires information to assist it with major decisions affecting the long-term future of the entity. 11 The accounting environment Tactical – this is often referred to as middle management. This level of management requires information to support it with monitoring performance and to make decisions to enable the entity to achieve its short- to medium-term targets. Operational – this is the level of management responsible for decisions which control and manage the day-to-day activities of the entity. It is common for information to be provided to this level of management in non-financial terms, such as hours worked, quantity of components produced, and so on. Having considered what a business entity is, and who the principal users of financial information are, it is now appropriate to consider what accounting is, how accounting information is recorded and how it is summarised. 6 An overview: what is accounting? What is the objective of recording and summarising accounting transactions and how is that information then used? The objective of recording and summarising transactions is to provide useful and relevant financial information to the managers, owners and other parties interested in an entity. In the context of financial accounting, this is achieved by the preparation of financial statements. A significant proportion of the syllabus for this subject deals with the recording, summarising and classifying of accounting transactions to prepare financial statements. Again, in practice this may be done by way of computerised accounting packages, but there is the requirement for you to understand the manual system which operates behind these systems. How are accounting transactions recorded and summarised? Transactions are initially recorded (i.e. listed) in books of prime entry. These books are simply a record of similar transactions recorded in sequential order (e.g. sales made on credit), which are periodically totalled, with the totals posted 12 Chapter 1 into the double-entry accounting system. This enables an individual transaction to be captured or recorded in a book of prime entry, whilst minimising the number of entries made in the double-entry accounting system. This principle will apply regardless of the method used to record accounting transactions. Small entities with relatively few transactions may maintain a manual set of accounting records. Larger entities may enter into hundreds of thousands of transactions each year and they may use computerised accounting records to manage the volume of transactions effectively. Whichever method of maintaining accounting records is used, it will be based upon the same bookkeeping principles. As each transaction is recorded in a book of prime entry, it will also have a code applied. One common feature of most accounting systems is the use of coding systems that are logical, comprehensive and also flexible enough to enable summarisation and further analysis to be made. Books of prime entry are considered in further detail later in this publication. Further detail on accounting Accounting can be described as being concerned with measurement and management. Measurement is largely concerned with the recording of past data, and management with the use of that data in order to make decisions that will benefit the entity. The measurement process is not always easy. One of the most common problems is that of when to recognise or record a transaction. For example, if we obtain goods from a supplier with payment due 60 days after the goods have been received, when should that transaction be recorded? The following possibilities may be considered: when the order was placed when the goods were received when the invoice was received from the supplier; or when the supplier was paid. Accounting, therefore, involves the exercise of judgement by the person responsible for converting data into meaningful information. It is this feature that distinguishes accounting from bookkeeping. Accounting may be defined as: the classification and recording of monetary transactions the presentation and interpretation of the results of those transactions in order to assess financial performance for an accounting period and the financial position at the end of that accounting period the monetary projection of future activities arising from the alternative planned courses of action. 13 The accounting environment Note the three aspects considered in this definition: recording, reporting and forecasting: 1 Accounting is partly a matter of record-keeping. The monetary transactions entered into by a business entity need to be controlled and monitored, and for this a permanent record is essential. For an efficient system of record-keeping, the transactions must first be classified into categories appropriate to the enterprise concerned. 2 At appropriate intervals, the individual transactions must be summarised as a basis for preparation of statements of financial performance and position of a business entity. 3 Finally, accounting information can be the basis for planning and decision-making. An alternative explanation is that accounting is part of the management information system (MIS) of an entity. In this context, the accounting element is referred to as an accounting information system (AIS). Accounting can thus be said to be a method of providing information to management (and other users) relating to the activities of an entity. In order to do this it relies on the accurate collection of data from sources both internal and external to the entity. The recording of this data is often referred to as bookkeeping. 7 Use of accounting information 14 Chapter 1 The accounting system of a business entity records and summarises accounting transactions so that useful information can be prepared for managers and others. Managers need accounting information to help them to manage and control the entity (management accounting) and to prepare financial statements for external users (financial accounting). Normally financial accounting consists of preparing financial statements for external users which comprise the following: statement of profit or loss and other comprehensive income – comprises a summary of income and expenses for an accounting period statement of financial position – comprises a summary of assets and liabilities and capital at a specific date statement of changes in equity – comprises a summary of the movement in capital or equity (i.e. ownership interest) for an accounting period statement of cash flows, and notes to the financial statements. This information is crucial to various stakeholders of the business entity, who will analyse that information to make significant economic decisions. It is of vital importance that stakeholders have good quality information to be able to make their decisions. As you progress through your studies for this subject, you will learn how to record accounting transactions and how to prepare financial statements. Subject BA2 Fundamentals of Management Accounting deals with the use of accounting information for management and control purposes. 8 Financial accounting and management accounting Financial accounts are produced primarily for owners of business entities and external users. International Accounting Standards (IAS® Standards) and International Financial Reporting Standards (IFRS® Standards) help to reduce the differences in the way that companies draw up their financial statements in different countries. Management accounts are prepared for managers and others who control the business entity. The key distinctions between financial accounting and management accounting are summarised in the following diagram. 15 The accounting environment Financial accounting Financial accounting can be described as the classification and recording of monetary transactions of an entity in accordance with established concepts, principles, accounting standards and legal requirements, and their presentation, by means of various financial statements, during and at the end of an accounting period. Further detail on financial accounting Two points in particular are worth noting about this description: 1 Financial statements must comply with accounting rules published by the various regulatory bodies. In other words, an entity does not have a completely free hand as to how it prepares and presents financial statements. The reason for this is that the financial statements are primarily intended for the use of people outside of the entity. Without access to the more detailed information available to insiders, these interested parties may be misled unless financial statements are prepared based upon uniform principles and standards. 16 Chapter 1 2 Financial accounting is partly concerned with summarising the transactions of an accounting period and classifying and presenting the summary in a coherent form. This is because financial statements are intended for use by external third parties. These outsiders have a need for, and a right to receive, specified financial accounting information at defined intervals, and not be subject to the discretion and choice of management. Management accounting Management accounting can be described as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Further detail on management accounting Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, lenders, regulatory agencies and tax authorities. Although the needs of external users of accounts are addressed in this definition, the emphasis of management accounting is upon providing information to help managers to control and direct the business entity. The nature and extent of information produced, and the way in which it is presented, is at the discretion of the managers concerned: they will request whatever information, in whatever format, they believe to be appropriate to meet their needs. Internal and external information Just as distinctions can be made between financial accounting and management accounting, distinctions can also be made between the nature and extent of information available within a business entity for management and control purposes, and information available to external third parties as follows: Internal information External information 1 Availability This is confidential This is available to and retained within anyone who can the entity access it – usually from a public registry 2 Frequency As and when Usually annually – as required by the entity required by law and e.g. weekly, monthly regulation etc. 17 The accounting environment 3 Content and No standard content Standard format and format or format required – content set by as required to meet legislation and business needs. It technical accounting may be very detailed standards. Typically it and may contain is highly summarised budgeted and with focus upon forecast information, historical financial along with financial information and non-financial information 4 External audit No external audit Most companies are requirement to requirement required to have an provide external audit credibility to information 5 Compliance There is no Annual financial with technical requirement for this, statements must accounting although may be comply with technical standards desirable to do so accounting standards The remainder of this publication will focus upon financial accounting, and the preparation of financial statements. As a basis for doing this, a number of important accounting terms, principles and concepts need to be defined and explained. 9 Elements of the financial statements The IASB® Conceptual Framework for Financial Reporting (’Framework’ or ‘Conceptual Framework) identifies five 'elements of the financial statements' as follows: Assets ) These elements are Liabilities ) used to form the basis of Capital ) the statement of financial position Income ) These elements are used to form the basis of Expenses ) the statement of profit or loss Each of the elements will now be defined and explained before going on to consider the accounting equation and financial statements in more detail. 18 Chapter 1 Asset The Conceptual Framework defines an asset 'a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits’ (Framework, para 4.4). This usually means that an asset has been purchased and is owned by the entity. However, be aware that it is possible to have control or use of an asset without owning it, for example, when leasing or hiring an asset. Further detail on assets Examples of assets are land, buildings, plant and machinery, motor vehicles, inventories of goods, receivables, bank balances and cash. Assets may be described as tangible or intangible. Tangible assets are those that have physical substance and can be seen or touched (e.g. land, buildings, equipment, inventories, etc.). Intangible assets do not have physical substance and cannot be seen or touched (e.g. owning a licence or a brand). Usually intangible assets have some form of legally-based rights or entitlement, such as a patent or registered trademark. You will learn more about intangible assets in Chapters 7 and 8 of this publication. Liability The Conceptual Framework defines a liability as 'a present obligation of the entity to transfer an economic resource as a result of past events’ (Framework, para 4.26). Further detail on liabilities Thus a liability can be described as an amount owed by a business entity to an individual or other business entity. Examples of liabilities are payables, loans received and bank overdrafts. 19 The accounting environment Capital (also known as equity) The Framework defines equity as 'the residual interest in the assets of the entity after deducting all its liabilities' (Framework, para 4.63). In this context, capital or equity is not easy to define, but it can be regarded as a special kind of liability that exists between a business entity and its owner(s). In effect, it shows the net amount invested in the business entity by the owner(s) and would be due to them if business activities were terminated. The above elements can then be arranged into the accounting equation as follows: Assets = Liabilities + Capital, or Capital = Assets – Liabilities, or Liabilities = Assets – Capital The accounting equation will be studied in more depth towards the end of this chapter. Further detail on capital To return to the accounting equation, you can perhaps see that the assets of an entity have been provided, or ‘financed’, by liabilities due to either outsiders or to the owners. This emphasises the importance of the separate entity concept described previously. As we regard the owners as being separate from the business entity itself, we can regard the amount owed by the business entity to its owners as a kind of liability. Effectively, we can restate the accounting equation in an even simpler form: Assets of the business entity = Liabilities of the business entity This statement is always true no matter what transactions the business entity undertakes. Any transaction that increases or decreases the assets of the business entity must increase or decrease its liabilities by an identical amount. You may be wondering exactly what is meant by saying that capital is an amount ‘owed’ by the business entity to its owners. How can the business entity ‘owe’ anything in this way? How has it incurred a debt? The answer is that when a business entity commences, it is common for the owners to ‘invest’ some of their private or personal resources into the business. As the business entity operates it generates its own resources in the form of profits, which technically belongs to the owners. Some of the profit may remain in the business entity, whilst some profit may be withdrawn by the owners in the form of goods or cash. This withdrawal of profits in simple entity structures such as sole traders is known as ‘drawings’. 20 Chapter 1 Income The Framework defines income as 'increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims' (Framework, para 4.68). In simple terms, for most business entities this will be sales revenue earned on the sale of goods or provision of services to customers. It could also include other items such as bank interest received. Expense The Framework defines expenses as 'decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims'(Framework, para 4.69). This may occur, for example, when purchasing goods for resale or by incurring operating and other costs such as wages, heat and light charges or repairs to factory machinery. Capital and revenue transactions Since the accounting equation makes use of three of the elements of the financial statements as follows: Assets – Liabilities = Capital or, it can be re-stated as: Assets = Capital + Liabilities It therefore demonstrates the relationships that exist within any business entity. The equation is the basis of one of the most common accounting statements prepared – the statement of financial position. This equation will form the basis of much of your studies for this subject to record accounting transactions. It will be considered in further detail later in this publication. Consequently, it is important that you understand the following distinctions: between capital and revenue transactions, and between cash and profit. 21 The accounting environment Capital transactions Capital transactions relate to costs incurred that will affect the entity in the long term, i.e. more than a year. For the purpose of your studies for this subject we will assume this relates to purchases of non-current assets such as buildings, plant and machinery etc. Capital costs or capital expenses will NOT be included as an expense in the statement of profit or loss but as a non-current asset in the statement of financial position. Revenue transactions Revenue transactions relate to expenses that will only affect the entity in the current accounting period, for example wages, rent payable and vehicle running costs. Revenue expenses will be included as expenses in the statement of profit or loss and NOT in the statement of financial position. Capital transactions = statement of financial position Revenue transactions = statement of profit or loss Capital and revenue transactions – further information Capital transactions The word ‘capital’ means different things in different contexts. You have already seen how the word is used to identify the investment by an owner in the business entity. Capital transactions are those that affect the business entity in the long term, as well as in the current period. Capital expenditure is expenditure on non-current assets, and capital receipts would result from the disposal of those assets. Other transactions that are regarded as capital transactions are the obtaining of, and repayment of, non-current finance. Capital transactions initially affect the statement of financial position. Of course, non-current assets are used up over a number of years, and so eventually they will be consumed. We account for this by including depreciation in the statement of profit or loss. You will consider this is more detail as you progress through your studies for this subject. Revenue transactions Revenue transactions are those that affect the entity in the current accounting period. Revenue receipts come from sales, and sometimes in the form of income from investments. Revenue expenditure is expenditure on items that are consumed in the current accounting period, for example the running expenses of the entity, cost of sales and so on. Revenue transactions affect the figures in the statement of profit or loss. 22 Chapter 1 Cash and profit A key point to understand is the difference between cash and profit. Cash may be regarded as the value of notes and coins (including bank balances) an entity has access to at any point in time. Consequently, cash transactions are accounted for based upon the date of receipt and payment of cash. Profit is the difference between sales revenue less expenses incurred during an accounting period, which is accounted for on an accruals basis. In effect, this means that transactions are accounted for on the date that they are entered into, which may not be the same as the date of receipt or payment of cash. It is explained further elsewhere in this chapter. The profit or loss for an accounting period will not be matched by an equal increase or decrease in the cash and bank balances of an entity for several reasons. This may be demonstrated by two relatively simple examples as follows: consider the situation of a business entity that sells goods on credit for $100. When the sale is made, sales revenue of $100 can be recorded in the accounting records. However, there will not be an equivalent increase in the cash and bank balances until the customer actually pays for the goods at some later date. consider the situation of a business entity that purchases new office equipment at a cost of $500, paying cash immediately. This represents the purchase of a non-current asset, and the reduction in the value of another asset (cash and bank balances) by $500. Therefore, this transaction affects only the statement of financial position and does not immediately affect the profit or loss for that accounting period. As you progress through your studies for this subject, you will come across further examples of transactions which do not have an equal impact upon profit and cash. Some of those transactions are noted below for reference: some accounting transactions do not affect the profit or loss for an accounting period, but do affect cash and bank balances, such as: – capital introduced into the business entity by the proprietor – cash drawings from the business entity by the proprietor – purchase of non-current assets, such as property plant and equipment. some accounting transactions do affect the profit or loss for an accounting period, but do not affect cash and bank balances, such as: – accounting for accruals and prepayments – accounting for depreciation – accounting for irrecoverable debts and allowances for receivables. 23 The accounting environment 10 The qualitative characteristics of financial information So far, we have considered who the users of financial information are, and for what purpose they may require financial information. All of the user groups identified, both internal and external to the entity, require that financial information provided should be useful. In this context, information should: enable its recipient to make effective decisions be adequate for taking effective action to control the entity or provide valuable details relating to its environment be compatible with the responsibilities and needs of its recipient be produced at optimum cost be easily understood by its recipient be timely, and be sufficiently accurate and precise for the purpose of its provision. The Framework requires that financial information should have certain qualitative characteristics to ensure that it meets the needs of users. The Framework identifies two fundamental qualitative characteristics and four enhancing qualitative characteristics as follows: (i) Fundamental qualitative characteristics – Relevance – Faithful representation. (ii) Enhancing qualitative characteristics – Comparability – Verifiability – Timeliness – Understandability. Note that the content relating to the qualitative characteristics of useful financial information is relevant in subject F1 Financial Reporting in the CIMA’s CGMA® Professional Qualification 24 Chapter 1 Further detail on qualitative characteristics For decisions to be made, the information must be relevant to the decision and be clearly presented, stating any assumptions upon which the information is based, so that the user may exercise judgement as appropriate. Often, better information may be provided at additional cost or after an additional time delay. The adequacy of information is important, and factors such as the cost of the information and the speed with which it is available may be more important than it being 100 per cent accurate. The information provided must be communicated to the person responsible for taking any action in respect of the information provided. In this regard it is better to distinguish information between that which relates to controllable aspects of business activities and that which relates to non-controllable aspects. The controllable aspects may then be further divided into those that are significant and an exception reporting approach applied. Fundamental qualitative characteristics (i) Relevance – Is guided as per the Framework in terms of information becoming relevant when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming or correcting their past evaluations. The relevance of information can be affected by its nature and materiality. Some items may be relevant to users simply because of their nature whereas some items may only become relevant once they are material. Hence, materiality is a threshold quality of information rather than a primary characteristic. According to the Framework, information is material if its omission or misstatement could influence the decisions of users. Materiality – As per the Framework materiality is an entity- specific aspect of relevance and depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements i.e. would an inappropriate decision or judgement be made if information was not available or if it had been misstated? 25 The accounting environment (ii) Faithful representation In accordance with the Framework is information is to represent faithfully the transactions and other events that it purports to represent, they must be accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Financial information should possess the following characteristics if it is to faithfully represent the performance and position of a business entity: Completeness To be understandable information must contain all the necessary descriptions and explanations. Neutrality Information must be neutral, i.e. free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome. Free from error Information must be free from error within the bounds of materiality. A material error or an omission can cause the financial statements to be false or misleading and thus unreliable and deficient in terms of their relevance. Free from error does not mean perfectly accurate in all respects. For example, where an estimate has been used the amount must be described clearly and accurately as being an estimate. Enhancing qualitative characteristics The Framework identified that the following items are required as enhancing characteristics of useful financial information: Comparability Users must be able to compare financial statements over a period of time in order to identify trends in financial position and performance. Users must also be able to compare financial statements of different entities to be able to assess their relative financial position and performance. In order to achieve comparability, similar items should be treated in a consistent manner from one accounting period to the next and from one entity to another. However, it is not appropriate for an entity to continue accounting for transactions in a certain manner if alternative treatments exist that would be more relevant and reliable. Disclosure of accounting policies should also be made so that users can identify any changes in these policies or differences between the accounting policies of different entities. 26 Chapter 1 Verifiability Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation i.e. counting cash at a specific date. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology i.e. recalculating inventory amounts using the same cost-flow assumption such as first-in, first-out method. Timeliness Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it becomes. Understandability Information needs to be readily understandable by users. Information that may be relevant to decision making should not be excluded on the grounds that it may be too difficult for certain users to understand. Understandability depends on: the way in which information is presented, and the capabilities of users. It is assumed that users: have a reasonable knowledge of business and economic activities, and are willing to study the information provided with reasonable diligence. For information to be understandable users need to be able to perceive its significance. 27 The accounting environment 11 The historical cost convention At what value should transactions be recorded? Normally, transactions are recorded at historical cost. This is the agreed monetary value of a transaction at the time it takes place. For example, the cost of raw materials purchased from a supplier, or the cost of a machine purchased for use in the business entity. It also applies to sales transactions – they will be recorded at the agreed monetary value when the transaction takes place. The advantages of using historical cost include: it is easily understood by most people it is usually easy to reliably identify or determine e.g. by reference to a purchase invoice it is an objective basis of measurement, whereas other valuation bases such as fair value or market value are subjective. The disadvantages of using historical cost include: it may not be relevant to the needs of some users of financial information who require information based upon current costs and prices it may become out of date, particularly when considering the impact of inflation on costs over a period of time it presumes that historical cost is based upon a stable unit of currency which enables comparison over time; this is probably not the case. As you progress through your studies for this subject, you will learn that there are other bases of measuring financial transactions for inclusion in the financial statements, but historical cost is the most comprehensive and commonly used basis of measurement. Further detail on historical cost Traditionally, financial statements have been prepared using the historical cost concept and, to a large extent, still are. This is a system of accounting in which all values are based on the costs incurred or revenue receivable at the date of the transaction. This means that all of the assets, liabilities, expenses and revenue are recorded using the costs and prices ruling at the date of the transaction as the basis of any accounting entries. This method is objective as each value can be supported by the amount paid to the third party at the date of the transaction. However, it is accepted that this concept has many shortcomings, and over the years many attempts have been made by accountants to develop alternative valuation or measurement methods. The main difficulty with the concept is that in times of changing price levels, it has the effect of overstating profits and understating asset values. 28 Chapter 1 Consider the purchase of two plots of land: one was purchased 3 years ago for $5,000 and the second plot, identical in terms of size and function, was purchased in the current year for $9,000. If you told an external user that you have two plots of land; one valued at $5,000 and one at $9,000 they would assume that the second plot was either larger or more valuable to the business entity. This, however, is not the case as they are identical. They were simply purchased in different economic circumstances. In this situation, the historical cost concept has painted a misleading picture of the assets of a business entity. Consider a second example: you purchase a plot of land today for $10,000. You do absolutely nothing to it, leaving it to grow wild. Alternatively, also for $10,000, you could have purchased 100,000 units of your entity's core raw material. Two years later you sell that land, completely untended, for $12,000. With that $12,000 you could now purchase 100,000 units of your entity's core raw material, which has also inflated in value. In the financial statements you record a $2,000 profit upon disposal of the land. However, ask yourself: has your business entity actually received any increased benefit from owning this land? No: your purchasing power is the same as it was two years previously. So have you really made a profit and is it misleading to the users of the financial statements to suggest as such? Why is this a problem? Well consider a further example: You set up a business entity and you acquire 10,000 widgets from a supplier at a cost of $10 each, giving a total cost of $100,000. You sell the widgets for $10.50 each, earning revenue of $105,000. You have just made a profit of $5,000; you can pat yourself on the back for some business well done. Or can you? In the interim period the purchase cost of your widgets has increased to $11. So how many replacement items can you now purchase for your business entity with $105,000? Only 9,545: your business has just shrunk because you have not earned enough revenue to replace your inventory. Ideally, you should have priced your product at $11.50 or more so that you could have replaced all 10,000 items and retained some profit for yourself. It can be seen that the use of the historical cost concept thereby overstates profits and understates statement of financial position asset values. Application of this concept reduces the usefulness of financial statements produced. 29 The accounting environment The theory of capital maintenance As seen in the example above; during inflationary times, the profit may only be sufficient to replace inventory, assets and pay for expenses, if the same level of activity is to be maintained. In that case, it is not really a ‘profit’ at all, as we think of profits as being an improvement. Indeed, the profit may not even be sufficient to maintain that level of activity, and – even worse – if some or all of the profits are paid out to the owners of the business entity, the level of activity may have to be reduced. In this case, the business entity has failed to maintain sufficient capital to support the same level of business activity. Capital maintenance is therefore important as it implies profit is only earned if the value of the entity's net assets or operating capacity has increased during the accounting period. The Framework makes reference to: financial capital maintenance – profit is made only if the financial or monetary amount of net assets at the end of the reporting period exceeds the amount at the start of the period, after excluding transactions with owners physical capital maintenance – profit is made only if the physical productive capacity of the entity exceeds the physical productive capacity at the start of the period, after excluding transactions with owners. Whilst historical cost is the most commonly adopted basis for recording transactions, some transactions may be recorded using alternative bases, such as: fair value – this may be considered to be the market value of an item i.e. at what price could it be sold? net realisable value – this is the estimated selling price of an item, less any further costs that must be incurred in order to make the sale. These bases, along with the accounting requirements relevant to their application, will be explained in subsequent chapters of this publication as you progress with your studies for this subject. 12 The accounting equation in action The accounting equation is a simple expression of the fact that at any point in time the assets of the entity should be equal to the equity plus the liabilities. For every transaction that an entity enters into their will be a dual effect. The dual effect principle states that every transaction has two financial effects. (a) If, for example, you spend $2,000 on a car and pay for it by cheque, you will have $2,000 less money in the bank, but you will have acquired an asset worth $2,000. 30 Chapter 1 (b) Again, if you owe a payable $100 and sent them a cheque for that amount, you will owe $100 less than before, but you will have $100 less money in the bank. To see the accounting equation in action, study the following worked example. Worked Example 1.A On 31 March, Ahmed’s employment with GSL came to an end and on 1 April, Ahmed set up in business as a sole trader trading as ‘Ahmed’s Matches’, to sell boxes of matches from a tray on a street corner. Ahmed deposited $100 into a bank account opened in the name of Ahmed’s Matches. He persuaded a supplier of matches to let him have an initial inventory of 400 boxes, costing 5¢ each, and promised to pay for them one week later. During his first day of trading he sold 150 boxes at 12¢ each – generating $18 in cash. Feeling pleased, he took $5 from the cash tin and treated himself to supper at the local café. He also wrote a cheque for $5 to his supplier in part payment for the initial inventory of boxes. Required: Illustrate the effect of each of these transactions upon the accounting equation. Solution To begin with, the only asset of the business entity was $100 in the business bank account. Capital invested by Ahmed also amounted to $100 and the accounting equation would then be as follows: Assets = Liabilities + Capital Bank $100.00 = 0 + Capital $100.00 The business entity then acquired matches worth $20 with a corresponding liability due to the supplier. The accounting equation now looks like this: Assets = Liabilities + Capital Bank $100.00 Payables $20.00 Capital $100.00 Inventory $20.00 ––––––– ––––––– ––––––– $120.00 = $20.00 + $100.00 ––––––– ––––––– ––––––– 31 The accounting environment When Ahmed sold 150 boxes, he made a profit of (150 × 7¢) = $10.50. His remaining inventory was reduced to 250 boxes at 5¢ each ($12.50). He also acquired a further asset in the process: cash in hand of $18. The accounting equation now looks like this: Assets = Liabilities + Capital Bank $100.00 Payables $20.00 Original capital $100.00 Cash in hand $18.00 Profit $10.50 Inventory (20 – 7.50) $12.50 –––––– ––––– –––––– $130.50 = $20.00 + $110.50 –––––– ––––– –––––– Don't forget that when Ahmed sold the inventory we must remove the cost of items sold from the inventory balance, i.e. 150 boxes × 5¢ = $7.50. We can see that the sale had three effects on the accounting equation – inventory was reduced by the cost of the goods sold, i.e. $7.50, cash increased by the amount the goods were sold for, i.e. $18 and the capital balance increased by the profit on the sale amounting to $10.50. Then Ahmed withdrew $5 from the business entity for his private use. This amount (referred to as drawings) reduced the sum owed to him by the business entity. The accounting equation now looks like this: Assets = Liabilities + Capital Bank $100.00 Payables $20.00 Original capital $100.00 Cash in hand (18 – 5) $13.00 Profit earned $10.50 Inventory $12.50 Less: drawings ($5.00) –––––– ––––– –––––– $125.50 = $20.00 + $105.50 –––––– ––––– –––––– Finally, Ahmed made a payment to his supplier, reducing the funds in the business bank account, and also reducing the amount of the liability due to the supplier. The accounting equation now looks like this: Assets = Liabilities + Capital Bank Payables (100 – 5) $95.00 (20 – 5) $15.00 Original capital $100.00 Cash in hand $13.00 Profit earned $10.50 Inventory $12.50 Less: drawings ($5.00) –––––– ––––– –––––– $120.50 = $15.00 + $105.50 –––––– ––––– –––––– 32 Chapter 1 Test your understanding 1 J Jones commenced business on 31 January 20X1, transferring $5,000 from her personal bank account into a business bank account. During the first week of February 20X1 the following transactions occurred: 1 Feb Bought motor van costing $800 paying by cheque 2 Feb Bought goods on credit: P Smith $400 E Holmes $250 3 Feb Sold goods for cash $600 (cost $400) 4 Feb Banked cash $600 Paid P Smith $400 by cheque 5 Feb Sold goods on credit (cost $200) J Amos $200 A Turner $300 Required: Show the accounting equation at the end of each day's transactions. Accounting coding systems As a method of summarising and classifying transactions in an organised manner, business entities usually make use of coding systems as part of their record-keeping. Such coding systems enable managers to access relevant information, whether it is an individual transaction, or a group of similar transactions. By now you will realise that a busy entity will have a large number of ledger accounts and subsidiary records within and outside the accounting system. Using the titles of accounts to locate and cross-reference transactions could be difficult in such situations. Imagine the tax authorities maintaining all the records of individual taxpayers according to their name. There will be hundreds of thousands of taxpayers with the surname Smith, or Khan or Jones – and thousands called John Smith or Helen Jones. Each needs a unique code to identify them from the others. The same applies to accounting systems. The ledger accounts require unique codes, as do inventory items, employees on the payroll and so on. We could simply number them 1, 2, 3 and so on, but that would not be particularly helpful in locating an individual item. Some kind of coding system is needed. This is particularly important in computerised systems, which use codes to transfer data throughout the system. With computerised accounting software packages, the coding system be pre-populated on purchase or built especially for the business itself. 33 The accounting environment Entities could perhaps start with the five main categories of ledger accounts, for example: Assets Code 1 (e.g. machinery and inventory) Liabilities Code 2 (e.g. bank loans) Capital Code 3 (e.g. ownership interest in the entity) Expenses Code 4 (e.g. wages and heat and light) Revenues Code 5 (e.g. sales revenue). The five categories noted above are referred to as 'the elements of the financial statements' and are defined and explained in this chapter. This could then be subdivided into more specific categories, for example: Non-current assets Code 12 (e.g. machinery) Current assets Code 13 (e.g. inventory of goods for sale). Non-current assets could be further divided into types, for example, plant (1), motor vehicles (2), office equipment (3) and so on. Codes could be included to identify the location of such items within the entity, e.g. sales department, purchasing department, wages department and factory locations for example. This would enable depreciation to be charged to the department that utilises a particular non-current asset. The following structure illustrates how a coding system may be used for a nominal ledger in a large entity. A six-digit code is used: the first digit represents the functional analysis; digits 2 and 3 represent the cost centre (i.e. the department); and digits 4–6 represent the type of expense involved. Function Cost centre Nominal ledger expense (within production) analysis 1 Production 10 Machining 100 Raw material X 2 Sales 11 Assembly 101 Raw material Y 3 Administration 12 Finishing 201 Skilled-labour wages 202 Unskilled-labour wages 203 Salaries 301 Rent 601 Postage 602 Stationery An example code could be 110202, which represents unskilled-labour wage cost incurred in the machining cost centre of the production function. 34 Chapter 1 It is generally accepted that codes should be: (a) Unique. In order to avoid ambiguity, each item must have only one possible code. (b) Useful. There is no point in using a code if there is to be no benefit from its use. The code will need to be logical and understood by those who use and apply it. (c) Compact. It is generally accepted that the shorter the code the easier it is to learn and therefore the likelihood of mistakes and confusion is reduced. Thus, a code should be as short and compact as possible. (d) Meaningful. If the code can be made meaningful by the characters of the code being connected in some way to the item that the code represents, the code will be more easily remembered and understood. (e) Self-checking. The biggest problem with the use of codes is that users of the codes often remember them incorrectly. To ensure that the information provided by the system is of value, each of the codes used must be validated. If a numeric code is used it can be designed in such a way as to be self-checking – this will help in identifying coding mistakes and avoid the processing and production of incorrect information. (f) Expandable. When designing a coding system it is important to consider the requirements of the entity in the future. The design of accounting systems often involves a large amount of time and this is then followed by a period when the users are learning the system. If the code is not expandable, then it is likely that the system will have to be changed sooner rather than later. This will be costly in design time and will cause difficulties because the users of the system will have to learn the new system. (g) Standard size. If codes are of varying size, then different users may write the same code differently. For example, if a part of a coding system comprises up to four characters, then the three-digit code AB1 could be written in a number of ways, with spaces and dashes in different places. Using AB01 would prevent this. Use of accounting coding systems therefore helps an entity to classify, arrange and summarise its accounting transactions. 13 Accounting concepts This introduction to the accounting environment would not be complete without explanation of some key accounting concepts which you will encounter throughout your accountancy studies. As you consider these concepts, bear in mind that they often require the exercise of judgement and estimation to arrive at reasonable or acceptable monetary values to include in the accounting records when absolute precision may be impossible or very time-consuming to achieve. 35 The accounting environment The need for concepts reflects the fact that accounting is not a precise science – it requires understanding rather than rote or mechanical learning of techniques. These concepts could form the basis of questions in the examination – either being able to define a concept or to apply it based upon information provided. Note that accounting concepts may also be referred to a 'accounting principles' or 'accounting conventions'. Separate entity concept During the discussion of user groups earlier in this chapter, reference was made to the principle that the law recognises a corporate entity as a ‘person’ in its own right, distinct from the personalities of its owners (known as shareholders). This represents application of the 'separate entity' concept, whereby the owners of the business entity are regarded as separate from those who manage and control the activities of the entity. This concept is applied when recording accounting transactions for any business entity, irrespective of whether there is a legally-recognised separation of ownership and control of that business entity. For example, a sole trader both owns and manages the business entity, but the accounting records are maintained as if the business entity was separate or distinct from its owner. The consequence of applying this concept is that the financial statements prepared for a business entity will present only the financial performance and position of the business entity itself. Any transactions between the owner(s) of the business entity and the entity itself will be reflected within the capital or equity section of the statement of financial position. For larger entities, this concept also helps to illustrate application of the stewardship relationship between the entity managers/directors who prepare the financial statements for the benefit of the entity owners (shareholders). Further detail – separate entity concept Consider the situation of a corporate entity that incurs debts in its own name and then has difficulty in paying them. Its suppliers may be entitled to seize the assets owned by the corporate entity. However, they have no claim against the personal assets owned by the shareholders (the business owners): it is the corporate entity that owes money, not its owners. In law, this distinction does not exist with other forms of business entity, such as the sole proprietor. If Bill Smith is in business as a plumber, trading under the name of ‘Smith & Co. Plumbing Services’, the law recognises no distinction between the business and the individual. If there are debts outstanding for plumbing supplies, and the business assets of Smith & Co. are insufficient to pay them, the suppliers can demand payment from Bill Smith the individual, who may be forced to sell his personal assets – home, car, and so on. In this respect the accounting concept does not correspond with the strict legal form of the business entity. 36 Chapter 1 It is an absolutely crucial concept in accounting that, regardless of the legal form of a business entity – corporate entity, sole trader, partnership or whatever – the business entity is treated as a separate entity from its owner(s). For accounting purposes, Bill Smith the individual is not the same as Smith Plumbing Services. This reflects the fact that accounting information relates only to business transactions. What Bill Smith does as an individual is of no concern to the accountant, and his private transactions must be kept quite separate from the business transactions of Smith & Co. Students sometimes find this concept hard to grasp, particularly when they notice that, as a consequence of it, Bill Smith the individual can actually have business dealings with Smith & Co. For example, Bill may take some copper piping from the inventory held by Smith & Co. in order to repair the heating system in his own home. From the accounting point of view, a business transaction has occurred: Smith & Co. has supplied an individual called Bill Smith with some piping, and its value must be accounted for. Despite its apparent artificiality, the significance of this concept will become apparent as you progress through your studies for BA3 and apply the principles of the accounting equation. Accruals or matching concept This concept refers to the basis upon which income and expenses are recognised in the statement of profit or loss. Income recognised in the statement of profit or loss should be matched with the expenses incurred in earning or generating that inflow of economic benefits to determine the profit or loss for an accounting period. Income is recognised when it has been earned, not when the cash is received from the customer. Expenses are recognised when they are incurred, not when the cash is paid to the supplier. For example, it may be necessary to estimate how many years a machine is likely to be used in the business, so that its cost or usage can be spread over that time period. This concept will be considered and applied in subsequent chapters of this publication. Prudence concept This concept refers to the basis upon which items are measured or valued for inclusion in the financial statements. In the statement of financial position, assets should not be overvalued and liabilities should not be undervalued. In the statement of profit or loss, income should be recognised only when it is probable that it will be received, and expenses are recognised as soon as they are incurred. In effect, when there is doubt regarding the precise value of an item for inclusion in the financial statements, caution should be exercised, so that assets and income are not overstated and liabilities and expenses are not understated. For example, it may be necessary to form a judgement on whether any amounts due from credit customers may not be received, and to recognise such amounts as an expense. This concept will be visited throughout subsequent chapters of this publication. 37 The accounting environment Accounting policies and estimation techniques Accounting policies are the principles, conventions, rules etc. applied by a business entity when determining the value at which assets and liabilities, revenue and expenses, will appear in the financial statements. Management should use those policies which it believes will be most useful to those who rely on the financial statements. These users will include, for example, shareholders and lenders, as discussed earlier in this chapter. Management can assess which policies will be most useful by considering the characteristics of useful information, as discussed earlier, including, for example, relevance and reliability. The implementation of accounting policies requires certain items to be estimated. We can appreciate that the preparation of financial statements relies on judgement and that not all values used can be regarded as definitive or precise. Accountants have developed a number of techniques to arrive at figures which have to be estimated. For example, we will see as we progress through our studies for this subject that a business entity may calculate an allowance for receivables, but this is only an estimate as to which trade receivables may not pay. This allowance is normally calculated based upon assessment of knowledge relating to each specific receivable or customer as appropriate. This is a technique to estimate future irrecoverable debts based upon the information available at that time. Another example we will encounter in our studies for this subject is depreciation, where the straight-line method and the reducing-balance method are two techniques used to estimate the consumption of a non- current asset in a specific accounting period, over its expected useful life to the business. Going concern concept This concept assumes that a business entity will continue to operate for the foreseeable future, which is normally interpreted as being for twelve months following the accounting year end. Application of this concept enables financial statements to be prepared without the need to account for realisable or break- up values of assets and liabilities, which would result in the preparation of financial statements with limited value to users. The Framework states that this is an underlying assumption when preparing financial statements. If this is not an appropriate assumption, there should be disclosure in the financial statements to explain the basis on which the financial statements have been prepared. As you progress through your studies for this subject, you will realise that many accounting treatments are based upon application of this concept. For example, when accounting for a non-current asset, an entity will estimate how many years of use that asset will provide so that its cost can be spread over that useful life. This is known as depreciation and will be explained in more detail in the chapters dealing with non-current assets. When accounting for depreciation 38 Chapter 1 of non-current assets, it is assumed that there will be future years against which the cost of the non-current asset can be allocated. When calculating accruals and prepayments, it is assumed that the business entity will still be operating in the following accounting period. Money measurement concept Application of this concept requires that items are included in the financial statements only if and when they can be reliably measured in monetary terms. For example, many business entities refer to their employees as one of their greatest assets. However, the monetary value of employees to the business entity (as distinct from their payroll costs) cannot be reliably determined, and therefore are not included as assets in the statement of financial position. Monetary measurements are used because if all the items covered by an accounting statement are stated as an amount of money, then the cost of the items can be identified and their aggregate cost determined. Therefore, there is a unity of meaning that makes financial statements readily understood and provides a common denominator for financial analysis. Materiality concept Materiality is a concept applied to the preparation of annual financial statements for investors and other external interested parties. Information is regarded as material if its omission or misstatement will change the view presented by the financial statements: in other words, it may lead users of financial statements to make inappropriate judgements or decisions based upon that financial information. Materiality is also a threshold quality such that only material items and values are presented in the financial statements, with immaterial or insignificant information summarised, aggregated or omitted from being reported in the financial statements. This allows users to focus upon the material or significant information that is relevant to them. For example, consider the situation of a business entity that had an inventory valuation of $917,148 at the end of the accounting year. Would this valuation be materially or significantly misstated if it was included in the annual accounts at a rounded amount of, say, $917,000, or expressed in another way as $0.9m? Hopefully, you can form a judgement that some degree of approximation or rounding does not materially or significantly change the inventory valuation reported in the annual accounts and can still be regarded as reliable information for users of financial statements. Thus the materiality concept should make the financial statements relevant to users. The distinction between what is significant and what is not varies depending on the size of the entity, and is a matter of judgement. Determining at what point an item becomes material depends partly on value, partly on the nature of the item concerned and partly on its effect on the results that will be reported. 39 The accounting environment The consistency concept The consistency concept states that the accounting treatment of like items should be accounted for in the same way, within an accounting period and from one accounting period to the next. The usefulness of financial accounting lies to a considerable extent in the conclusions that may be drawn from the comparison of the financial statements of one year with those of a preceding year, or of one entity with another. Much of the information thus derived would be meaningless if the choice of accounting methods were not applied consistently year by year. An example of an accounting issue where consistency is important is the method of valuation of inventory which is stated at the lower of cost and net realisable value. The objectivity concept Financial statements should not be influenced by the personal bias of the person preparing them. Thus, figures used in financial statements should be objective. Ideally, this should mean that any two accountants would produce the same figure, for example, for profit. In practice, there is always some judgement when preparing financial statements but when exercising that judgement the accountant should be neutral and not try to produce, for example, a larger, or smaller, profit to benefit his/her own purposes. Financial statements which are objective should be reliable. The dual aspect concept This concept is the basis of double-entry bookkeeping and it means that every transaction entered into has a dual effect on the position of the entity as recorded in the ledger accounts at the time of that transaction. The realisation concept This concept states that we recognise sales revenue as having been earned at the time when goods or services have been supplied, i.e. when the contractual obligation has been satisfied. In basic terms, sales are realised when the right to receive revenue has been earned by the reporting entity. If income has been earned but not yet received we should also recognise a matching asset as well as the sales revenue. The asset represents the right to receive benefit (usually cash), from the customer. Although not within the BA3 CGMA syllabus , the following illustration demonstrates this concept well. Consider the situation of goods sold on a 'sale- or-return' basis. The goods are not strictly ‘sold’ until they have been accepted by the buyer or the deadline for their return has passed. Strictly speaking the sale of these goods should only be recognised by a business entity when it is virtually certain that the goods will not be returned and the sale transaction is therefore regarded as complete. 40 Chapter 1 14 Glossary of terminology CIMA’s CGMA® Professional Qualification is an international qualification. Consequently, it is important that the terminology used in the examination is standardised to ensure understanding and to avoid confusion. The majority of this terminology is sourced from IAS 1 Presentation of Financial Statements and IAS 7 Statement of Cash Flows. However, there are some terms in other areas of the syllabus which may have more than one meaning in different countries. The table below summarises some of the official terminology used by CIMA, along with examples of alternative terms which may be use in countries around the world to aid student understanding. CIMA Terminology Examples of alternative terminology Concept Convention Separate entity concept Business entity concept Dual effect concept Dual aspect concept Not-for-profit Non-trading organisation/entity organisation/entity Nominal ledger General ledger Cashbook Bank/Cash account Value added tax, central sales tax, service tax, Sales tax goods and services tax Social security tax National insurance Corporation tax (entities), Pay as You Earn Income tax (PAYE) (individuals) Inventory Stock Irrecoverable debts Bad debts Allowance for receivables Provision for doubtful debts Accumulated depreciation Provision for depreciation Loan notes Loan stock, debentures Sales ledger Debtors' ledger, receivables' ledger Purchase ledger Creditors

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