The Theory of Financial Accounting

ADVANCED FINANCIAL ACCOUNTING

CHAPTER ONE

The theory of financial Accounting

Chapter objectives:

After completing this chapter student should be able to:

Understand and appraise the accounting principles and theories.
Understand method of valuation of shares
Understand limitation of financial statements and how to overcome them.

CRITICAL APPRAISAL OF ACCOUNTING PRINCIPLES

-Accounting is a language of business. Like any language, several rules are there to guide and moderate the usage and interpretation to facilitate communication.

-To prepare and produce the above accounting framework a set of practice has developed that provide guidelines for Financial Accounting. These guidelines are referred to as principles and concepts. The most used term is General Acceptable Accounting Principles (GAAP).

-Accounting concepts / postulate are ideas and assumptions which are fundamental to accounting. They portray the economic, political, social and legal environment in which accounting operates. These are also called basic assumptions.

-Theoretical concepts – These are self evident statements that portray the nature of accounting entities operating in free economy characterized by private ownership of property.

Principles: the accounting principles are general accounting rules derived from both the objectives and theoretical concepts of accounting, which govern the development of accounting techniques. These are also called: ‘Basic features of Financial Accounting.’

Accounting concepts / Assumptions/ postulates:

-The accounting postulates are basic assumption or fundamental propositions concerning the economic and political in which accounting operates. They include

The entity postulate
The going-concern postulates
The monetary unit postulate
The accounting period postulate
Historical postulate

The entity postulate:

-The specific entity or separate entity basic assumption “holds that for accounting measurement purposes the particular entity being accounted is carefully distinguished from all other similar and related entities or persons.

That is an accounting entity is held to be separate and distinct from its owners. This concept requires the careful separation of the financial affairs of the business from its owners and other businesses.

-There can be two approach for these;

(i)The firm oriented approach

(ii)The user oriented approach

-In firm oriented approach, an accounting entity is defined as “the economic unit responsible for the economic activities and administrative control of the unit” e.g. sole proprietorship, partnership, company etc. This view is held be FASB.

-Under the user oriented approach “the interest of the users rather than the economic activities and administrative control of the business unit is considered. The view is held by AAA (American Accounting Association).

The going concern postulate:

-The underlying assumption is that “the business will not be sold or liquidated in the near future but will continue to carry on its operational objectives independently.” It is also called continuity postulate.

Fixed assets in a business enterprise are those with which we carry on the business. They are not meant for resale. That is why fixed assets are shown in the balance Sheet at original cost less depreciation (in Historical cost accounting). An enterprise is normally viewed as a going concern, that is, as continuing in operations for the foreseeable future.

It is assumed that the enterprise has no intention to curtail the scale of its operations.

Monetary unit postulate:

-This postulate holds that money is the unit of measurement of all economic activity. Accounting is focused on measurement and reporting, in monetary terms of the flow of resources into an out of an organization.

-The monetary unit was chosen in accounting as a common denominator to account for the transactions of a firm in a uniform manner. It ensured comparability.

-In view of the general stability of money, this unit of measure postulate was regarded as ‘stable monetary postulate’.

-But during the past two decades due to inflation in many countries, the purchasing power of money has fallen considerably. This postulate is therefore no longer in a position to play the role of ‘stable monetary unit’.

Accountingwill deal only with those items to which a monetary value can be attributed.

Financial statements do not reflect factors that cannot be measured in monetary terms: good management, hardworking members of staff, etc.

The accounting period postulate:

-This postulate holds that ‘finance reports depicting the changes in wealth of a firm should be disclosed periodically’. Normally for one year

Historical cost

This postulate holds that Assets should be recorded initially at cost.
Main limitation of using historical cost:
In times of inflation, historical costs figures lack relevance and can mislead users of financial information.
In order to overcome this limitation, revaluation of assets is allowed as an alternative to historical cost accounting.

Advantages of using historical cost:

Historical costs are perceived to be more reliable because they can be verified.

The use of historical cost is cost-effective.

To use current market value means spending money each time an asset is re-valued

Cost: Financial Accounting Recorded at cost not market value
Dual Aspect: Debit/credit.
Matching the postulate holds that Revenue earned must be matched against the expenditure incurred in generating it.

ACCOUNTING PRINCIPLES

Basic accounting principles are general decisions rules which govern the development of accounting techniques. Some call it Basic Accounting Features

They include the following:

(i)The Revenue principle

(ii)The cost principle

(iii)The cost principle

(iv)The matching principle

(v)The objectivity principle

(vi)The full disclosure principle

(vii)Materiality

(viii)Consistency

(ix)ConservatismThe exceptions or modifying constraints.

(x)Timeliness

(xi)Cost benefit

(xii)Industry practice

The Revenue Principles

It is also called ‘Realization principle’. The principle states that – Revenue should be recognized in the period when the sale is made – and revenue should be measured as the cash received plus the cash equivalent of any other item received.

Revenues are recognized when they are “realized or realizable. They are realized when products (good or Services) merchandise or other assets are exchanged for cash or claims to cash.

Further, revenue is recognized when they are ‘earned’.

Income is recognized when earned and not when it is received in cash;

Expenses are recognized when incurred and not when they are paid in cash.

Example: A sale should be recognized when:

the event from which it arises has taken place;

Sale is recognized when goods are delivered, or when invoice is prepared.
Sale is not recognized when an order is received.

The receipt of cash is reasonably certain.

Sale on credit should be recognized as income even if cash has not yet been received.

The cost principle:

-Cost is the amount, measured in money, of cash expended or other property transferred, capital stock issued, service performed or a liability incurred in consideration of goods or services received or to be received.

-In other words ‘expenses are the using or consuming of goods and services in the process of obtaining revenues

-The period an expense is deemed to be incurred is the period in which the goods are used or the services are received.

-The FASB in its SFAC No. 5. States that expense (and losses) are generally recognized when an entity’s economic benefit are used up in delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations or when previously recognized assets are expected to provide reduced or further benefits.

-That is why depreciation is treated as an expense

-Expense is measured by the valuation of the goods or services used or consumed.

The matching principle

-The matching principle holds that all the expenses incurred in generating revenue should be identified or matched with the revenue generated, period by period.

-Matching principle holds that all expenses should be recognized in the same period as the associated revenue.

-The association between revenue and expense depend on one of the following criteria:

(i)Direct matching of expired cost with the period e.g. cost of goods sold matched with related sale.

(ii)Direct matching of expired cost with the period e.g. president’s salary for the period

(iii)Allocation of costs over periods benefited e.g. depreciation.

(iv)Expensing all costs in the period incurred unless it can be shown that they have further benefits e.g. advertisement.

Objectivity Principle

The objectivity principle holds that ‘accounting must be carried out on an objective and factual basis. For instance in making fair market value as a basis of valuing fixed assets, there is a likelihood of great subjectivity of the valuation – machinery.

-Thus, historical cost method is more objective because there is some element of verifiability.

-Objectivity connotes different things to different people

For some an objective measure is an impersonal measure i.e. it’s free from the personal bias of the measurer.
For others measures which are based on verifiable evidence are regarded as objective.
Objectivity may also mean ‘consensuses among a given group of qualified measures.

The Full disclosure principle

The full disclosure principle “specifies that there should be complete and understandable reporting on the financial statements of all significant information relating to the economic affairs of the entity.

-To meet the requirement of this principle, all published statements are supported by a section called ‘notes to financial statements’.

-There is a general consensus that the disclosure should be full, fair and adequate.

-‘Full’ refers to a complete and comprehensive presentation of information;

-‘Fair’ implies an ethical constraint dictating an equitable treatment of users.

-‘Adequate’ connotes a minimum set of information to be disclosed.

The exception or modifying principles:

a)Cost – benefit

-The cost-benefit modifying principle holds that “the cost of applying an accounting principle should not exceed the benefit.” i.e. the benefit of providing any additional accounting information should be greater than the cost of providing it. The cost should be measured from the user’s point of view.

b)Materiality

-In accounting, an item or event is considered material if the knowledge of it would affect a user’s decision. Thus only material and significant event should be recorded. The decision on material depends on the nature of business and its size.

-SEC Regulation S-X states “that materiality matter is one about which an average prudent investor ought reasonably to be informed”. And material information is “such – Information as is necessary to make the required statement in the light of the circumstances under which they are made not misleading.”

-Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statement.

-Thus, materiality is essentially a matter of professional judgment.

c)Consistency

The consistency principle holds that “in the accounting process all concepts, principles and measurements approaches Should be applied in similar or consistent way from one period to the next in order to ensure that the data reported in the financial statement are reasonable comparable over time.

The items in the financial statement Should be presented and classified in the same manner from one period to the next

Except under the following cases:

There is a significant change in the nature of the operations of the business

A review of its financial statement presentation demonstrates that relevance is better achieved by presenting items in a different way

A change is required by a new accounting standard.

-Auditors are required to report on any inconsistency in reported statements.

d)Conservatism /prudence

The principle “holds that when more than one accounting or measurement alternative is permissible for a transaction, the one having the least favourable immediate effect on the net income or owner’s equity usually should be selected.

-Simply put, provide for all liabilities and expenses but provide for minimum income.

-Lately, some accountants are of the opinion that ‘conservatism’ should be replaced by ‘prudence’ whereby accountants will apply ‘reason’ in applying accounting techniques.

Where alternatives exist, one should select the alternative that gives the most cautious presentation of the financial position or result of the business.

Assets and profits should not be overstated, but a balance must be achieved to prevent the material overstatement of liabilities and losses.

Where a loss is foreseen, it should be anticipated and taken immediately into account.

e)Substance over form.

Some transactions have a real nature that differs from their legal form.

Whenever it is legally possible, the real substance should prevail over the legal form.

An example is a hire purchase transaction.

Legal ownership of an asset on a hire purchase does not pass until the last instalment is paid, but it could be misleading to present a balance Sheet in which such assets did not appear until the end of the contract.

f)Timeliness:

One of the primary qualities desired in useful accounting information is that it should be relevant.

-Timeliness implies providing interested parties with adequate, reliable information at a reasonable time to enable them make sound decision.

g)Industry Practice;

The unique characteristics or peculiar nature of some industries and business enterprise require the use of different accounting methods. For example banks insurance in some countries reports certain investment securities at market (rather than lower of the cost and market) because these securities are traded frequently.

-Similarly, in farm (Agricultural) industry crops are reported at market value or net realizable value because it is costly to develop an accurate cost number of individual crops.

ACCOUNTING THEORY

Accounting theory provides a general frame of reference by which accounting practices can be judged, and it also guides the way to the development of new practices and procedures.

Measurement of income

Sir John Hicks, the economist expressed this view i.e. that profit represents an increase in wealth or ‘well-offness, by saying that the profit was the maximum value which a person could consume during a period and still be well off at the end of the period as at the beginning. In terms of a limited company, the Sandilands committee said that a company’s profit for the year is the maximum value which the company can distribute as dividends during the year, and still be as well off at the end of the year as it was at the beginning.

There are basically two approaches to the measurement of wealth of a business:

a)Measuring the wealth by finding the values of the individual assets of a business.

b)Measuring the expectation of future benefits.

LIMITATION OF FINANCIAL STATEMENTS

Limitations of financial statements and how to overcome

The balance sheet does not reflect current values because accountants have adopted an historical cost basis in valuing and reporting the assets and liabilities. To overcome this current cost concept (specific price-level changes) is more useful or a net realizable value concept or some variant should be adopted.
In preparation of financial statements, an accountant is confronted with the potential dangers of bias, misinterpretation, inexactness and ambiguity. In order to minimize these dangers, accountants carry out their work within a framework of generally accepted accounting principles (GAAP).
In a balance sheet, judgment must be used. Even if significant changes in the price level do not occur, the determination of the collectivity of receivables, the saleability of inventory, and the useful life of the long-term tangible and intangible assets are difficult to determine.
The income numbers are often affected by the accounting policies and methods employed e.g. one company may choose to depreciate its plant assets on an accelerated basis, another on a straight line basis.
The balance sheet necessarily omits many items that are of financial value to the business but cannot be measured objectively. This is overcome by preparing another statement that shows these items.
Accountants do not include many items that contribute to the general growth and well-being on an enterprise. Items that cannot be quantified with any degree of reliability have to be discarded as part of accounting income because of the impracticality of their measurement.
Financial statements only deal with the overall profitability of the business concern for a specified period. They do not deal with the product-wise, job-wise, process-wise, department-wise profitability of the business. Hence necessary accounts need to be made to account for these particular costs.
Financial statements do not provide data for the comparison of the costing results of a particular period with that of other periods of operation of the same business concern or with that of other concerns in the same line of industry.

This is a SAMPLE (Few pages have been extracted from the complete notes:-It’s meant to show you the topics covered in the full notes and as per the course outline

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