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Sunday, January 31, 2010

Calculations for Incomplete Records

In practice there should not be any missing item in the opening balance sheet of the business, because it should be available from the preparation of the previous year’s final accounts.

Credit sales and debtors

If business does not keep a record of its sales on credit, the value of these sales can be derived from the opening balance of trade debtors, the closing balance of trade debtors, and the payments received from the trade debtors during the period. Credit sales are:

Payments received from trade debtors -------------X
(+) Closing balance of trade debtors -----------------X
(-) Opening balance of trade debtors ----------------(X)
= Credit sales of the period -------------------------------X

Purchases and trade creditors

A similar relationship exists between purchases of stock during a period, the opening and closing balances for trade creditors, and amounts paid to trade creditors during the period.
If we wish to calculate an unknown amount for purchases, the amount would be derived as follows:

Payments to trade creditors ---------------------------X
(+) Closing balance of trade creditors -------------X
(-) Opening balance of trade creditors ------------(X)
= Purchases during the period -----------------------X


Saturday, January 30, 2010

Incomplete Records Accounts

Incomplete records problems occur when a business does not have a full set of accounting records, either because:
  • The proprietor of the business does not keep a full set of accounts
  • Some of the business accounts are accidentally loss or destroyed

The problem for the accountant is to prepare a set of year end accounts for the business; i.e. a trading, profit and loss account, and a balance sheet. Since the business does not have a full set of records, preparing the final accounts is not a simple matter of closing off accounts and transferring balances. The task of preparing the final accounts involves:

  • Establishing the cost of purchases and other expenses
  • Establishing the total amount of sales
  • Establishing the amount of creditors, accruals, debtors and prepayments at the end of the year


Friday, January 29, 2010

Contingent Assets

Financial reporting standards define a contingent asset as:

A possible asset that arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity’s control
A contingent asset must not be recognized. Only when the realization of the related economic benefits is virtually certain should recognition take place. At that point, the asset is no longer a contingent asset.

An entity should not recognize a contingent asset or liability but they should be disclosed by way of notice to the financial statements.


Thursday, January 28, 2010

Contingent Liabilities

Financial reporting standards define contingent liabilities as:
  • A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control; or
  • A present obligation that arises from past events but is not recognized because, it is not probable that a transfer of economic benefits will be required to settle the obligation, or the amount of the obligation cannot be measured with sufficient reliability.

As a rule of thumb, probable means more than 50% likely. If an obligation is probable it is not a contingent liability-instead, a provision is needed.

Treatment of contingent liabilities

Contingent liabilities should not be recognized in financial statements but they should be disclosed. The required disclosures are:

  • A brief description of the nature of the contingent liability
  • An estimate of its financial effect
  • An indication of the uncertainties that exist
  • The possibility of any reimbursement


Wednesday, January 27, 2010

Provisions for Restructuring

Financial reporting standards define a restructuring as a Program me that is planned and is controlled by management and materially changes either:
  • The scope of a business undertaken by an entity
  • The manner in which that business is conducted.

The financial reporting standards give the following examples of events that may fall under the definition of restructuring.

  • The sale or termination of a line of business
  • The closure of business location in a country or region or the relocation of business activities from one country region to another
  • Changes in management structure, for example, the elimination of a layer of management
  • Fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations

The question is whether or not an entity has obligation, legal or constructive at the balance sheet date.

  • An entity must have a detailed formula plan for the restructuring.
  • It must have raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.

Costs to be included within a restructuring prevision

The financial reporting standards state that a restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both:

  • Necessary entailed by the restructuring
  • Not associated with the ongoing activities of the entity.

The following costs should specifically not be included within a restructuring provision.

  • Restructuring or relocating continuing staff
  • Marketing
  • Investment in new systems and distribution networks


Tuesday, January 26, 2010


Financial statements must include all the information necessary for an understanding of the company’s financial position. Provisions, contingent liabilities and contingent assets are “uncertainties” that must be accounted for consistently if are to achieve this understanding.

A provision is a liability of uncertain timing or amount.

A liability is an obligation of an entity to transfer economic benefits as a result of past transactions or events.

The financial reporting standard distinguishes provisions from other liabilities such as trade creditors and accruals. This is on the basis that for a provision there is uncertainty about the timing or amount of the future expenditure. Whilst uncertainty is clearly present in the case of certain accruals the uncertainty is generally must less than for provisions.

Financial reporting standard states that a provision should be recognized as a liability in the financial statements when,
  • An entity has a present obligation as a result of a past event
  • It is probable that a transfer of economic benefits will be required to settle the obligation
  • A reliable estimate can be made of the obligation

Measure of Provisions

The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. The estimates will be determined by the judgment of the entity’s management supplemented by the experience of similar transactions.

Allowance is made for uncertainty. Where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditure required to settle the obligation. An appropriate discount rate should be used.


Monday, January 25, 2010

Events after the Balance Sheet Date

Non adjusting events

Non adjusting events those that are indicative of conditions that arose after the balance sheet date.

Consequently they do not result in changes in amounts in financial statements. They may, however, be of such materiality that their disclosure is required by way of notes to ensure that financial statements are not misleading.

A number of examples are given in financial reporting standards,
  • Decline in market value of investments.
  • Declaration of dividends after the balance sheet date, to be disclosed instead in the notes to the financial statements.

If non adjusting events are material, then disclosure is made in the notes to the accounts of:

  • The nature of events,
  • An estimate of its financial affect or a statement that such an estimate cannot be made.

The financial reporting standards give a number of examples of events after the balance sheet date needing disclosure.

  • A major business combination after the balance sheet date or disposing of a major subsidiary.
  • Announcing a plan to discontinue an operation.
  • Major purchases and disposals of assets, or expropriation.
  • The destruction of a major production plant by a fire.
  • Announcing, or commencing the implementation of, a major restructuring.
  • Major ordinary share transactions and potential ordinary share transactions.
  • Abnormally large changes in asset prices or foreign exchange rates.
  • Changes in tax rates, or tax laws enacted or announced, that have a significant affect on current and deferred tax assets and liabilities.
  • Entering into significant commitments or contingent liabilities.
  • Commencing major litigation arising solely out of events that occurred after the balance sheet date.


Sunday, January 24, 2010

Events after the Balance Sheet Date

Events after the balance sheet date are those events, favorable and unfavorable, that occur between the balance sheet date and the date when the financial statements are authorized for issue.

The financial statements are significant of a company’s success or failure. It is important, therefore, that they include all the information necessary for an understanding of the company’s position.

Adjusting events

Adjusting events are events after the balance sheet date “that provide evidence of conditions that existed at the balance sheet date.

Financial reporting standards cite a number of events after the balance sheet date which normally should be classified as adjusting events. They include:
  • The settlement after the balance sheet date of a court case that the entity had a present obligation at the balance sheet date. The adjustment may be to a provision under financial reporting standards or to set up a new provision because it is no longer a contingent liability
  • The receipt of information indicating that an asset was impaired at the balance sheet date, or that the amount of impairment needs to be adjusted
  • The determination after the balance sheet date of the cost of assets purchased or the proceeds from assets sold before the balance sheet date
  • The determination of the amount of any profit sharing or bonus payments if there was a present legal or constructive obligation at the balance sheet to make such payments due to events before that date
  • The discovery of fraud or errors that show the financial statements are incorrect


Saturday, January 23, 2010

Disclosure Requirements for Research and Development Expenditure

The companies act does not require disclosure of the total amount of research and development expenditure during an accounting period, but accounting standards requires that all large companies should disclosure this total, distinguishing between current year expenditure and amortization of deferred development expenditure.

Accounting standards requires the following companies to disclose research and development expenditure.
  • All public companies
  • All special category companies
  • All holding companies with a public limited companies or special category company as a subsidiary
  • All companies who satisfy the criteria, multiplied by 10, for defining a medium sized company

Where differed development costs are included in a company’s balance sheet the following information must be given in the notes to the accounts:

  • Movements on deferred development expenditure, and the amount brought forward and carried forward at the beginning and end of the period.
  • The accounting policy used to account for research and development expenditure should be clearly explained.


Friday, January 22, 2010

Examples of Research and Development and Non Research and development Items

Research and development items

Examples given by accounting standards of activities that would normally be included in research and development are:

  • Experimental, theoretical or other work aimed at the discovery of new knowledge or the advancement of existing knowledge.
  • Searching for applications of that knowledge.
  • Formulation and design of possible applications for such work.
  • Testing in search for, evaluation of, product, service, or process alternatives.
  • Design, construction and testing of pre-production prototypes and models and development batches.
  • Design of products, services, processes or systems involving new technology or substantial improving those already produced or installed.
  • Construction and operation of pilot planets.

Non Research and development Items

Examples of activities that would normally be excluded from research and development include:

  • Testing and analysis either of equipment or product for purpose of quality or quantity control.
  • Periodic alterations to existing products, services or processes even though these may represent some improvements.
  • Operations research not tied to a specific research and development activity.
  • Cost of corrective action in connection with break-downs during commercial production.
  • Legal and administrative work in connection with patent applications, records and litigation and the sale or licensing of patents.
  • Activity, including design and construction engineering, relating to the construction, relocation, rearrangement or start-up facilities or equipment other than facilities or equipment whose sole use is for a particular research and development project.
  • Market research.


Thursday, January 21, 2010

Categories of Research and Development Costs

In the accounting standards defines research and development expenditure as falling into more of the following categories.
  1. Pure research is originally research to obtain new scientific or technical knowledge or understanding. There is no clear commercial and in view and such research work does not have a practical application. Companies and other business entities might carry out this type of research in the hope that it will provide new knowledge which can subsequently be exploited.
  2. Applied research is originally research work which also seeks to obtain new scientific or technical knowledge, but which has a specific practical aim or application. Applied research may develop from pioneering pure research, but many companies have full time research teams working on applied research projects.
  3. Development is use of existing scientific and technical knowledge to produce new products or systems, prior to starting commercial production operations.

How to distinguish these categories?

The dividing line between each of these categories will often be indistinct in practice, and some expenditure might be classified as research or as development. It may be even more difficult to distinguish development costs from production costs.

Accounting standards states that although there may be practical difficulties in isolating research costs and development costs, there is a difference of principle in the method of accounting for each type of expenditure.

  • Expenditure on pure and applied research is usually a continuing operation which is necessary to ensure a company’s survival.
  • One accounting period does not gain more than any other from such work, and it is therefore appropriate that research costs should be written off as they are incurred.
  • The development of new and improved products is different, because development expenditure is incurred with a particular commercial aim in view and in the reasonable expectation of earning profits or reducing costs.
  • In these circumstances it is appropriate that development costs should be deferred and matched against the future revenues.


Wednesday, January 20, 2010

Research and Development Costs

Large companies may spend significant amounts of money on research and development activities. These amounts must be credited to cash and debited to an account for research and development expenditure. The accounting problem is how to treat the debit balance on research and development account at the balance sheet date.

There are two possibilities.
  1. The debit balance may be classified as an expense and transferred to the profit and loss account. This is referred to as writing off then expenditure.
  2. The debit balance may be classified as an asset and included in the balance sheet. This is referred to as capitalizing or carrying forward or deferring the expenditure.

The argument for writing off research and development expenditure is that it is an expense just like rates or wages and its accounting treatment should be the same.

The argument for carrying forward research and development expenditure is based on the accruals concept. If research and development activity eventually leads to new or improved products which generate revenue, the costs should be carried forward to be matched against that revenue in future accounting periods.


Sunday, January 17, 2010

Purchased Goodwill

Purchased goodwill has been defined as “the excess of the price paid for a business over the fair market value of the individual assets and liabilities acquired”.

The accounting treatment of purchased goodwill

Once purchased goodwill appears in the accounts of a business, we must decide what to do with it. Purchased goodwill is basically a premium paid for the acquisition of a business as a going concern: included, it is often referred to as a “premium on acquisition”. When a purchaser agrees to pay such a premium for goodwill, he does so because he believes that the true value of the business is worth more to him than the value of its tangible assets.

One major reason why he might think so is that the business will earn good profits over the next few years and so he will pay a premium now in the expectation of getting his money back later. He pays for the goodwill at the time of purchase, and the value of the goodwill will eventually were off.

Goodwill is a changing thing. A business cannot last forever on its past reputation; it must create new goodwill as time goes on. Even goodwill created by a favorable location might suddenly disappear, for example a newsagent’s shop by a bus stop will lose its location value if the bus route is axed.

Since goodwill erodes it would be inadvisable to keep purchased goodwill indefinitely in the accounts of a business.

The treatment of goodwill is the subject of an accounting standard. The Financial reporting standard requires that goodwill should be capitalized and shown in the balance sheet as an intangible fixed asset. It is than amortized over its expected economic life.
Amortization is the name for depreciation in the case of intangible fixed assets.


Saturday, January 16, 2010

Accounting for Goodwill in Business

If a business has goodwill it means that the value of the business as a going concern is grater than the value of its separate tangible assets.

Goodwill is crated by good relationships between a business and its customers, for example:
  • By building up a reputation for high quality products or high standards of service.
  • By responding promptly and helpfully to queries and complaints from customers.
  • Through the personality of the staff and their attitudes to customers.

The value of goodwill to a business might be extremely significant. However, goodwill is not usually valued in the accounts of a business at all, and we should not normally expect to find an amount for goodwill in its balance sheet.

On reflection, this omission of goodwill from the accounts of a business might be easy to understand.

  • The goodwill is inherent in the business but it has not been paid for, and it does not have an “objective” value. We can guess at what such goodwill is worth, but such guesswork would be matter of individual opinion, and not based on hard facts.
  • Goodwill changes from day to day. One act of bad customer relations might damage goodwill and one act of good relations might improve it. Staff with a favorable personality might retire or leave to find another job, etc. Since goodwill is continually changing in value, it cannot realistically be recorded in the accounts of the business.

Purchase of goodwill

There is one exception to the general rule that goodwill has no objective valuation. This is when a business sold. People wishing to set up in business have choice of how to do it they can either buy their own fixed assets and stock and set up their business from scratch, or they can buy up an existing business from a proprietor willing to sell it.

When a buyer purchases an existing business, he will have to purchase not only its fixed assets and stocks but also the goodwill of the business.


Friday, January 15, 2010

Summary about Accounting Concepts

In preparing financial statements, certain fundamental accounting concepts are adopted as a framework.
Two such accounting concepts are identified in financial reporting standards accounting policies as the bedrock of accounting.

A number of other accounting concepts may be regarded as fundamental.


Thursday, January 14, 2010

Presentation of Financial Statements

Aspects of this post have also given rise to some controversy. The post begins by making the general point that financial information is presented in the form of a structured set of financial statements comprising primary statements and supporting notes and, in some cases, supplementary information.

Components of financial statements

The primary financial statements are as follows.
  • Profit and loss account
  • Statement of total recognized gains and losses
  • Balance sheet
  • Cash flow statement

Profit and loss account and statement of total recognized gains and losses are the “statements of financial performance”.

The notes to the financial statements “amplify and explore” the primary statements; together they from an “integrated whole”. Disclosure in the notes does not correct or justify non disclosure or misrepresentation in the primary financial statements.

“Supplementary information” embraces voluntary disclosures and information which is too subjective for disclosure in the primary financial statement and the notes.

Accounting for interests in other entities

Financial statements need to reflect the effect on the reporting entity’s financial performance and financial position of its interest in other entities. This involves various measurement, presentation and consolidation issues which are dealt with in this post of the statements.

The statement of principles does not have direct effect. It is not an accounting standard with which companies have to comply. Having said that, it is influential and persuasive, especially where there is no specific standard dealing with an issue. The statement should help structure new statements and create a coherent framework; this in turn will prevent controversy and help enhance the reputation of the accounting profession.


Wednesday, January 13, 2010

Recognition and Measurement in Financial Statements

Recognition in financial statements

Three stages are used for recognition if assets and liabilities.
  1. Initial recognition
  2. Subsequent re measurement
  3. De recognition

Measurement of financial statements

For this, with its emphasis on current values, is fairly radical and controversial. The following approach is taken.

  • Initially, when an asset is purchased or liability incurred, the asset/liability is recorded at the transaction cost, that is historical cost, which at that time is equal to current replacement cost.
  • An asset/liability may subsequently be “remeasured”. In a historical cost system, this can involve writing down an asset to its recoverable amount. For a liability, the corresponding treatment would be amendment of the monetary amount to the amount ultimately expected to be paid.
  • Such re-measurements will, however, only be recognized if there is sufficient evidence that the monetary amount of the asset/liability has changed and the new amount can be reliably measured.


Tuesday, January 12, 2010

Elements of Financial Statements

The elements of financial statements are listed. They are:
  • Assets
  • Liabilities
  • Ownership interest
  • Gains
  • Losses
  • Contributions from owners
  • Distribution to owners

Any item that does not fall within one of the definitions of elements should not be included in financial statements. The definitions are as follows.

Assets are rights or other access to future economic benefits controlled by an entity as a result of past transactions or events.

Liabilities are obligations of an entity to transfer economic benefits as a result of past transactions or events.

Ownership interest is the residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets.

Gains are increases in ownership interest, other than those relating to contributions from owners.

Losses are decreases in ownership interest, other than those relating to distributions to owners.
Contributions from owners are increases in ownership interest resulting from investments made by owners in their capacity as owners.

Distributions to owners’ decreases in ownership interest resulting from transfers made to owners in their capacity as owners.


Monday, January 11, 2010

The Objective of Financial Statements

The main points rose here as follows
  • The objective of financial statements is to provide information about the financial position, performance and financial adaptability of an enterprise that is useful to a wide range of users for assessing the stewardship of management and for making economic decisions.
  • It is acknowledge that while all not all the information needs of users can be met by financial statements, there are needs that are common to all users. Financial statements that meet the needs of providers of risk capital to the enterprise will also meet most of the needs of other users that financial statements can satisfy.

Users of financial statements other than investors include the following.

  1. Employees
  2. Lenders
  3. Suppliers and other creditors
  4. Customers
  5. Government and their agencies
  6. The public

The limitations of financial statements are emphasized as well as the strengths.

All of the components of financial statements (balance sheet, profit and loss account, cash flow statement) are interrelated because they reflect different aspects of the same transactions.

The exposure draft emphases the ways financial statements provide information about the financial position of an enterprise. The main elements which affect the position of the company are:

  1. The economic resources it controls
  2. Its financial structure
  3. Its liquidity and solvency
  4. Its capacity to adapt to changes in the environment in which it operates (called financial adaptability)

The exposure draft discusses the importance of each of these elements and how they are disclosed in the financial statements.


Sunday, January 10, 2010

Statements of Principles in Accounting

The Accounting Standards Board (ASB) published as exposure draft of its statement of principles for financial reporting. The statement consists of eight chapters.
  1. The objective of financial statements
  2. The reporting entity
  3. The qualitative characteristics of financial information
  4. The elements of financial statements
  5. Recognition in financial statements
  6. Measurement in financial statements
  7. Presentation of financial information
  8. Accounting for interest in other entities

Purpose of the statement of principles

The following are the main reasons why the Accounting Standards Board (ASB) developed the statement of principles.

  • To assist the Accounting Standards Board (ASB) by providing a basis for reducing the number of alternative accounting treatments permitted by accounting standards and company law
  • To provide a framework for the future development of accounting standards
  • To assist auditors in forming an opinion as to whether financial statements conform with accounting standards
  • To assist users of accounts in interpreting the information contained in them
  • To provide guidance in applying accounting standards
  • To give guidance on areas which are not yet covered by accounting standards
  • To inform interest parties of the approach taken by the Accounting Standards Board (ASB) in formulating accounting standards

The role of the statement can thus be summed up as being to provide consistency, clarity and information.


Saturday, January 9, 2010

The Search for a Conceptual Framework

A conceptual framework, is a statement of generally accepted theoretical principals which from the frame of reference for financial reporting. These theoretical principles provide the basis for the development of new reporting standards and the evaluation of those already in existence.
The financial reporting process is concerned with providing information that is useful in decision making process. Therefore a conceptual framework will form the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user.

Although it is theoretical in nature, a conceptual framework for financial reporting has highly practical final aims.

The need for a conceptual framework is demonstrated by the way UK standards originally developed. Standards were produced in haphazard ways to fight abuses. Had an agreed framework existed, the old accounting standards committee could have acted as an architect ed or designer, rather than a fire fighter, building accounting rules on the foundation of sound, agreed basic principles.

The framework deals with,
  • The objective of financial statements
  • The qualitative characteristics that determine the usefulness of information in financial statements
  • The definition, recognition and measurement of the elements from which financial statements are constructed
  • Concepts of capital and capital and maintenance

The International Accounting Standards Board (IASB) believes that future international harmonization of accounting methods can best be promoted by focusing on these four topics since they will then lead to producing financial statements that meet the common needs of most users.


Friday, January 8, 2010

Accounting Policies & Estimates

Accounting policies

An accounting policy is concerned with the,
  • Recognition
  • Selection of measurement base and
  • Presentation

Of assets, liabilities, gains and losses of an entity

The most appropriate accounting policy should be selected in order give a true and fair view. Two points should be noted about this approach.

  1. Accounting policies must confirm to the relevant accounting standards. They can be changed only where standard allows choice.
  2. Accounting policies should not be chopped and charged on an ad hock basis. A balance must be struck to achieve consistency and reliability.

Accounting estimates

An accounting estimate is the method used to establish the monetary value of assets, liabilities, gains and losses using the measurement base selected base selected by the accounting policy.

Accounting estimates involve the use of judgment when applying an accounting policy.


Thursday, January 7, 2010

Substance over Form & Periodicity Concept

Substance over form

Substance over form means that transactions should be accounted for and presented in accordance with their economic substance, not their legal form.

An example of substance over form is that of assets acquired on hire purchase. Legally the purchaser does not own the asset until the final installment has been paid. However, the accounting treatment is to record a fixed asset in the accounts at the start of the hire purchase agreement. The substance of the transaction is that the business owns the asset. The same could be said of assets acquired under long term lease.

The time interval concept (Periodicity concept)

The activities of an entity are conveniently split up into blocks of time, be these days, months, quarters or years. The activities continue to occur but the intervals are placed so as to record activities between two points in time. The time intervals under consideration are usually of equal length to facilitate comparison, but this does not need to be the case. Therefore accounts are usually prepared annually.


Wednesday, January 6, 2010

Revenue Recognition Concept

Accruals accounting is based on the matching of costs with the revenue they generate. It is crucially important under this convention that we can establish the point at which revenue may be recognized so that the correct treatment can be applied to the related costs.

For example, the costs of stock should be carried as an asset in the balance sheet until such time as it is sold; they should then be written off as a charge to the trading account.

Therefore accountants must be clear be clear at what moment the sale of the item takes place. The decision has a direct impact on profit since under the prudence concept it is unacceptable to recognize the profit on sale until a sale has taken place.

Revenue is generally recognized as earned at the point of sale, because at that point four criteria will generally have been met.
  1. The product or service has been provided to the buyer.
  2. The buyer has recognized his liability to pay for the goods or services provided and the seller has recognized that ownership of goods has passed from himself to the buyer.
  3. The buyer has indicated his willingness to hand over cash or other assets in settlement of his liability.
  4. The monetary value of the goods or services has been established.

At earlier point of business cycle there will not in general be firm evidence that the above criteria will be met. Until work on a product is complete, there is a risk that some flaw in the manufacturing process will necessitate its writing off; even when the product is complete there is no guarantee that is will find a buyer.

At later points in the business cycle, for example when cash is received for the sale, the recognition of revenue may occur in a period later than that in which the related costs were charged. Revenue recognition would then depend on fortuitous circumstances, such as the cash flow of a company’s debtors, and might fluctuate misleadingly from one period to another.


Monday, January 4, 2010

Stable Monetary Unit Concept

The financial statements must be expressed in terms of a monetary unit,

For example in the USA the $

It is assumed that the value of this unit remains constant.
In practice, of course, the value of the unit is not usually constant and comparisons between the accounts of the current year and those of previous years may be misleading.

Objectivity (neutrality) concept

Objectivity means that accountants must be free from bias. They must adopt a neutral stance when analyzing accounting data.

An accountant must show objectivity in his work. This means he should try to strip his answers of any personal opinion or prejudice and should be as precise and as detailed as the situation warrants. The result of this should be that any number of accountants will give the same answer independently of each other.

In practice, objectivity is difficult. To accountants faced with the same accounting data may come to different conclusions as to the correct treatment. It was to combat subjectivity that accounting standards were developed.

The Realization Concept

The realization concept means that revenue and profits are recognized when realized.


Sunday, January 3, 2010

The Historical Cost Convention

Historical cost means transactions are recorded at the cost when they occurred.
A basic principal of accounting is that resources are normally started in accounts at historical cost, i.e. at the amount which the business paid to acquire them. An important advantage of this procedure is that there is usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an expense.

In general, accounts prefer to deal with costs, rather than with values. This is because valuations tend to vary according to what the valuation is for. For example, suppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a balance sheet and has to decide what monetary amount to attribute to the asset.

Numerous possibilities might be considered,
  • The original coat (historical cost) of the machine
  • Half of the historical cost, on the ground that half of its useful life has expired
  • The amount the machine might fetch on the secondhand market
  • The amount it would cost to replace the machine with an identical machine
  • The amount it would cost to replace the machine with a more modern machine incorporating the technological advances of the previous two years
  • The machines economic value, i.e. the amount of the profits it is expected to generate for the company during its remaining life

All of these valuation have something to commend them, but the great advantage of the first two is that they are based on a figure (the machines historical cost) which is objectively verifiable. The subjective judgment involved in the other valuations. Particularly the last is so great as to lessen the reliability of any accounts in they are used.


Saturday, January 2, 2010

The Materiality Concept

Only items material in amount or in their nature will affect the true and fair view given by a set of accounts.

An error which is too trivial to affect anyone’s understanding of the accounts is referred to as immaterial. In preparing accounts it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive details.

Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb.

For example to define material items as those with a value greater than 5% of the net profit disclosed by the accounts.

However some items disclosed in accounts are regarded as particular sensitive and even a very small misstatement of such an item would be regarded as material.

An example in the accounts of a limited company might be the amount of remuneration paid to directors of the company.

The assessment of an item as material or immaterial may affect its treatment in the accounts.
For example, the profit and loss account of a business will show the expenses incurred by the business grouped under suitable captions; but in the case of very small expenses it may be appropriate to lump them together under a caption such as “sundry expenses” because a more detailed breakdown would be inappropriate for such immaterial amounts.

In assessing whether or not an item is material, it is not only the amount of the item which needs to be considered. The context is also important.


Friday, January 1, 2010

The Separate Valuation Principle

The separate valuation concept states that, in determining the amount to be attributed to an asset or liability in the balance sheet, each component item of the asset or liability must be determined separately.

These separate valuations must then be aggregated to arrive at the balance sheet figure.

For example, If a company’s stock comprises 50 separate items, a valuation must be arrive at for each item separately; the 50 figures must then be aggregated and the total is the stock figure which should appear in the balance sheet.

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