Topic 2 - Conceptual Framework and Accounting Concepts (Part 1) - OCR

TOPIC 2 Conceptual Framework and Accounting Concepts (Part 1) 1 ndi20  Learning Outcomes 1) The role of conceptual framework 2) The function of International Accounting Standards Board (IASB) 3) The four major areas of co...

TOPIC 2 Conceptual Framework and Accounting Concepts (Part 1) 1 ndi20  Learning Outcomes 1) The role of conceptual framework 2) The function of International Accounting Standards Board (IASB) 3) The four major areas of conceptual framework 4) The accounting concepts and principles 5) The structure of financial reporting requirements 2  Conceptual Framework Set out / offer the basic concepts that underlie the preparation and presentation of financial statements The conceptual framework plays an important role in the development of new and revision of previously standards. With the fundamental concepts, it acts as a guide in developing accounting and reporting standards by providing a common foundation on which to consider merits of alternatives. 3  So, who sets the standards? International Accounting Standards Board (IASB) Provides the framework for preparation and presentation of financial statements. Based on International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) to determine how financial statements are prepared and information the financial statements contained. 4 The basis for the conceptual framework addresses four major areas a. Objectives of financial b. Qualitative statements: What are the characteristics: What are purposes of financial the qualities of useful reports? financial information? d. Recognition, c. Elements: What is an measurement and asset? A liability? A reporting: How should the revenue? An expense? objectives, qualities and Owner’s equity? element definitions be implemented? 5 a. Objectives of financial reports (Financial Statements) The need to prepare the financial reports (Financial Statements): To provide information on performance (SOCI), financial position (SOFP) and cash flows (SOCF) of the company. To help users to make wise economic decisions (e.g. making investment and credit decisions, financial structuring, solvency – long and short term). It also show the result of management’s stewardship of the resources entrusted to it. 6 To meet these objectives, financial reports (financial statements) should provide information on: Liabiliti Assets es to assist users Owner’s Income to predict the equity likely outcome of company in future Expense Cash s flows 7 b. Qualitative characteristics of useful financial information (financial statements ) Understandability Clear and easily understood by the user in the form of language used, content and layout. Relevance The information must enable users to predict future events or confirm past events. It should be able to influence. Reliability Information must be free from error or bias. 8  b. Qualitative characteristics of useful financial information (financial statements )…(continued) Comparability For financial information to be useful it must be comparable similar transactions and events must be accounted for in a similar manner. Timeliness Financial information ought to be produced within a reasonable time frame. Information that takes long time to produced tends to be outdated and would have impact on decision making (e.g. lost of sales / market share). Completeness Information should be made sufficiently for management to make a good business judgement. 9  c. Elements of Financial Statements Revenu es Asset s SOCI SOF P Owner’ Liabiliti es s equity Expens es 10  Assets Actual resources that are owned by the business. Non-current assets / Fixed assets Long-livedassets, usually have a life span that is more than a year. Examples: land; buildings; motor vehicles; machinery; furniture; office equipment; computer; fixtures and fittings. Current assets Liquid assets. Life span is less than a year. Examples: inventory (stocks); debtors, prepayments, short-term deposit, cash at bank; cash in hand. 11  Liabilities Amount owed to outsiders (e.g. debts of a business). They are future obligations that will entail an outflow of economic resources from the business. 12  Liabilities Current liabilities Owed less than a year. Examples: bank overdraft; creditors; accruals Non-current liabilities Owed more than a year. Examples: bank loan; mortgage 13  Owner’s Equity The amounts invested into a business by owner. Amounts that the business owes to the owner. Example: The owner of One M2M Saloon contributes Cash RM10,000 and RM20,000 worth of delivery van as Capital to the business. ~The OE contributed is RM 30,000 that 14 is in the form of cash RM10,000 and  Revenues and Expenses Revenues Income or earnings generated for a period. Expenses The costs of running the business for a said period. 15  d. Recognition, Measurement and Reporting The conceptual framework provides guidance to determine what information should be incorporated into financial statements and when. Recognition criteria Foran item to be recognised, it must meet one of the definitions of the elements of financial statements. Anitem must be reliably measurable in monetary terms in order for it to be recognised. If the item cannot be reliably measured, then disclosure is preferable to recognition. 16  d. Recognition, Measurement and Reporting … (continued) Measurement (bases available) Historical cost Cost at the date of acquisition or when they are incurred. Current replacement cost The amount needed to replace an item with an identical one (the price that entity would pay to replace the existing asset with similar asset). Current market value Price that could be obtained by selling an asset in an orderly liquidation (the highest price that seller would accept for an asset). Net realizable value Valuation technique to evaluate an asset’s worth while in inventory. 17  Historical Cost Most widely used. Theamount recorded is the original amount paid (not subjected to future changes). Example: If we paid RM5,000 for a building (2009), this will be the cost shown in SOFP (2019), even when the building has increased in value (due to inflation). Good Bad OBJECTIVE. Original cost FIXED. Does not take of the asset confirmed inflation / changing through an original prices into account. invoice. Does not show the EASY to use and understand. true value of Enable business to KEEP companies assets. TRACK of their assets. 18  Current Replacement Cost Attempts to put a realistic value on assets. “What would it cost to replace the existing assets with the identical / same assets at today’s prices?” Example: A company values its tangible assets at replacement cost based on expert valuation. Good Bad REALISTIC VALUATION Takes into account Difficult to arrive at technical and an objective value economic for the replacement developments, assets. inflation, experience and etc. 19  Current Market Value Worthof asset (property) if sold in present-day market. The expected or likely price a seller is willing to sell the asset and also the buyer is willing to purchase the asset. 20  Net Realizable Value (NRV) Used for valuing inventory (if the value is lower than cost value) Formula : NRV = Selling price – Selling costs in completing the sale 0r NRV = Expected selling price – Cost incurred in getting an inventory ready for sale Example: A company inventory: Expected selling price = RM100 Additional Completion Cost = RM20 Advertise = RM10 Hence, NRV will be RM100 - RM20 - RM10 = RM70 21  d. Recognition, Measurement and Reporting … (continued) Reporting The conceptual framework indicates that a “full set of financial statements” is necessary to meet the objectives of financial reporting. Included in the recommended set are: Financial position at the end of the period (SOFP) Earnings (net income) for the period (SOCI) Cash flows during the period (SOCF) Investmentsby and distributions to owners during the period (SOCE) 22  LEARNING OUTCOME At the end of the lesson, students must be able to understand and explain: 1) The role of Conceptual framework. 2) The function of IASB. 3) The four major areas of Conceptual framework. 4) The accounting concepts and principles. 5) The structure of financial reporting requirements. 23  Going Concern The business is assumed to operate in the foreseeable future. Usually more than a year (at least 12 months from the B/S date). If there is no going concern problem, the assets are valued at historical cost concept. Example: A business draws up its financial statements at 31 / 12 / 2019. Using the historical cost concept, the assets = RM50,000. However, the business is forced to close down in February 2020. Assets are expected to be sold for RM30,000. Treatment: In the SOFP at 31 / 12 / 2019, the assets = RM30,000 24 *Note: In this case, we reject going concern and hence reject historical cost concept.  Consistency The accounting policies / presentation / classification of items in financial statements should stay the same and consistently applied to similar items over time. Example: Every year, Company A has been using the straight line method to depreciate its computers. However, for this current year, it started to depreciate using reducing balance method. Question: Is this correct? Answer: Company A is wrong as there is no consistency in its accounting method. 25  Accruals and Matching Concept Accrual Concept Requires revenue and expenses to be recognised and recorded when earned or incurred, and NOT when cash is received or paid. Matching Concept Revenue earned must be matched against the expense incurred in earning it when computing profit. It makes a distinction between: Receiptof cash and the right to receive cash (revenue) Payment of cash and the obligation to pay cash (expense) 26 27  Prudence or Conservatism Concept Recognise revenue only when it is earned (reasonably certain) and also to provide for anticipated losses when they are likely to incur (reasonably possible) – to avoid from overstated the revenue and understated the expense. Gains are only reported when they are realised. Exercisedegree of caution in making judgment under uncertain situations. Example: Debt that has been owing for a long time. Will it be paid? Should the accountant be an optimist or pessimist? Requires that financial statements are ‘neutral’: Neither gains nor losses should be overstated / understated. 28  Substance Over Form It means that if the real nature and effect of a transaction differ from its legal form, the real nature and effect should be recognised instead of the legal form, unless the law prohibits this. Therelevance of the concept is that its application enhances the usefulness of the financial statements. Example: Hire purchase (Car) From a legal point of view: Thecar does NOT belong to the business until all the hire purchase installments have been paid. From the economic point of view: The company have used the car for business purposes. The car will still be shown in the Statement of Financial Position as if it were legally owned by the business. Hence, the substance (real nature) has taken the importance 29 over the form (legal form).  Materiality Itrelates to the cost or value attached to the item in relation to the overall operation of the business. Information is MATERIAL if its inclusion or omission of it will influence the economic decision of user of the financial statements. Example: One paper clip price at RM0.20 Answers: Price is too small Not worth recording Not a material item Hence, should be expensed out. 30  Completeness Reports should present a well rounded picture of the economic activities of the reporting entity. Example: Besides financial information, reporting should also provide information about an entity’s corporate social responsibility (CSR), environmental reporting and other non-financial reporting. Reportsmust be complete, within the restrictions of materiality and cost, to be reliable. Omission may cause information to be misleading. 31  Business Entity Concept The business is separate from its owner / owners. This means that the business can own assets, has liabilities and enter into business transactions. The business is a ‘legal person’ (separate legal entity) and can sue and be sued just like any individual. Theaffairs of a business are to be treated as being quite separate from the non-business activities of its owners. Item recorded in the books are all restricted to the business transactions. 32  Money Measurement Concept / Monetary Concept The value of all business transactions / value of goods can be expressed in common money terms for easy evaluation and comparison. Limitation: Issues such as good location, unique and specific skills possessed by its employees will not be recorded in books because it is very hard to quantify in monetary terms. Nevertheless, this can be of enormous significance to the success of a business. 33  DUAL ASPECT CONCEPT  Every transaction has two aspects – a ‘debit’ and a ‘credit’. The sum of all debits must be equal with the sum of all credits.  Example: When an asset is acquired, one of the following events will also take place: another asset is forgone a liability (obligation to pay) is undertaken a profit has been earned 34  1) Historica 12) Dual l cost concept 2) Going aspect concern concept 11) Money 3) measureme Consisten nt concept cy Accounti ng 4) 10) Accruals concepts Business and concept entity conventio ns 5) 9) Matching Completen concept ess 6) Prudence 8) or Materiali 7) conservat ty Substanc ism e over concept form 35  Structure of Financial Reporting Requirements Final Reports Supplementary Financial Non-financial Financial Statements Statements Information Accounting Statement of Statement Statement Statement Policies and Comprehensi of Financial of Changes of Cash ve Income Explanatory Position in Equity Flows Notes 36  Financial Statements The five components which constitute “full set of financial statements”: Statement of Comprehensive Income (SOCI) Statement of Financial Position (SOFP) Statement of Changes in Equity (SOCIE) Statement of Cash Flow (SOCF) Accounting Policies and Explanatory Notes 37  Statement of Comprehensive Income: Shows the revenues and expenses and resulting net income or net loss for a specific period of time. Statement of Financial Position: Reports the assets, liabilities, and owner’s equity at a specific date. Statement of Changes in Equity: Summarizes the changes in owner’s equity for a specific period of time. Statement of Cash Flows: Summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.  Notes to the financial statements: Provide additional information which is not available on the face of financial statements but that is necessary for fair presentation. 38  Example: XYZ Sdn Bhd Statement of Comprehensive Income for the year ended 31 December 2020 RM RM Sales 137,000 (-) Expenses: Secretarial salaries 40,000 Office rent 12,000 Electricity expenses 6,000 Telephone 1,500 Duplicating services 1,000 Office supplies 760 Professional dues 440 Investigative services 1,700 Travel and entertainment 3,600 (67,000) Net profit 70,000 39  Example: XYZ Sdn Bhd Statement of Financial Position as at 31 December 2020 RM RM RM Non-current asset: 100,000 Buildings Current assets Inventory 127,000 Account receivables 20,000 Cash 25,000 172,000 (-) Current liabilities Account payables 80,000 Accruals 12,000 (92,000) 80,000 180,000 40 Owner’s equity: Capital 180,000  Example: XYZ Sdn Bhd Statement of Changes in Equity for the year ended 31 December 2020 RM RM RM Capital Retained Owner’s earnings equity Balance as at 1.1.2020 85,000 52,000 137,000 Add: Right issues 27,400 - 27,400 Net retained earnings - 18,400 18,400 Less: Bonus issues - (2,800) (2,800) Balance as at 31.12.2020 112,400 67,600 180,000 41  Example: XYZ Sdn Bhd Statement of Cash Flows for the year ended 31 December 2020 RM Net cash provided by operating activities 90,000 Net cash used for investing activities (110,000) Net cash provided by financing activities 40,000 Net increase in cash 20,000 Beginning cash balance 5,000 Ending cash balance 25,000 42 END OF TOPIC 2 TOPIC 3 43