16 minute read
Topic 3 Accounting Theories
from FINANCIAL REPORTING
by mooc sas
3.1 The Purposes of Accounting Theory
• Helps to evaluate existing practice. E.g., are methods and techniques used by accountants valid or correct in terms of what it should be? This is to eliminate unnecessary diversities in accounting treatment for similar items. • From the evaluation of existing practices, reasons for diversity that cannot be eliminated may be discovered and explained. This will enhance our understanding of the current practice and facilitate in regulating the profession by policymakers. • The theory also assists in the development of future practice where it serves as the basis in the development of accounting standards. As business practices become more sophisticated, new accounting problems may arise that require the development of new techniques and procedures. • The goal of the theory is to provide a coherent set of logical principles that form the general frame of reference for evaluating and developing new accounting practices.
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3.2 The Accounting Bodies that Regulate the Accounting Standards in Malaysia.
Malaysian Accounting Standards Board (MASB) was set up to issue new standards, review or adopts existing accounting standards, issue statements of principles and to develop a conceptual framework. MASB has also adopted some of the IASs as extant standards. As the relevant standards are issued and adopted, the extant IASs will be superseded by these standards.
3.3 The Use of Accounting Informations
1. Determine how liquid your business is. By calculating a few ratios, you can determine if you have enough current assets to pay your current debts. This is particularly important if you have one or more customers who are slow to pay you and you are anxiously awaiting their payments. 2. Assess your long-term solvency. Solvency is the ability to pay your long-term debts. If you are short on cash, will you be able to pay your long-term obligations? Even if you have good cash flow today, is there any possibility this may change? We need to think long-term so that our business can continue to operate effectively. 3. Provide a snapshot of how well, i.e., efficiently, your business is running. The income statement is a good place to see how well, or poorly, operations are generating revenues and managing expenses. 4. Obtain outside financing. A banker or investor will want to review your financial statements and perform their analysis on the numbers. Your ability to obtain financing will be based on those results.
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5. Make purchasing decisions, such as a new truck or equipment, or other business decisions such as moving to a bigger (or smaller) location. 6. Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.
• Management: for analyzing the organization's performance and position and taking appropriate measures to improve the company results. • Employees: for assessing a company's profitability and its consequence on their future remuneration and job security. • Owners: for analyzing the viability and profitability of their investment and determining any future course of action.
Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.
Creditors: for determining the creditworthiness of the organization. Terms of credit are set by creditors according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks.
Tax Authorities: for determining the credibility of the tax returns filed on behalf of the company.
Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.
Customers: for assessing the financial position of its suppliers which is necessary for them to maintain a stable source of supply in the long term.
Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set to protect the interests of the stakeholders who rely on such information in forming their decisions.
External users have communicated accounting information usually in the form of financial statements. The purpose of financial statements is:
a) to cater to the needs of such diverse users of accounting information to assist them in making sound financial decisions b) To provide information about the financial position, performance and changes in the financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB Framework).
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3.6 The Nature and Purposes of the Conceptual Framework
• An accounting conceptual framework can be defined as: “a coherent system of inter-related objectives and fundamentals that should lead to consistent standards that prescribe the nature, function and limits of financial accounting and financial statements.” (AT Foulks Lynch, 1998) • A conceptual framework guides the body responsible for establishing accounting standards and ensures that standards are based on fundamental principles; it provides a frame of reference for resolving accounting questions in the absence of a specific promulgated standard. It also determines bounds for judgment in preparing financial statements; it increases financial statement user’s understanding of, and confidence in, financial statements and enhances comparability (Elliott & Elliott,2009) • MASB has issued a guideline called the framework for the Presentation of
Financial Statements. The importance of the framework is that in the absence or lack of a reporting standard, the preparers of financial statements are to apply the requirements of the framework. • Some of the areas the framework covers are the qualitative characteristics of financial statements, and the recognition and measurement of the elements of financial statements. • The objectives of a conceptual framework are: to ensure statements are convergent leading to a single set of high-level global accounting standards, to identify the users and provide them with the information that is most useful to them, to solve accounting disputes, to define the objectives of financial statements and to define fundamental principles which they do not have to be repeated in accounting standards (Soumis par dauphalex, janvier 2011).
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3.7 The Accounting Framework.
The accounting framework consists of 3 main components:
1. The objectives of financial reporting 2. Qualitative characteristics and constraints of financial reporting information. 3. Recognition and measurement of elements of a financial statement.
3.7.1 The Objectives of Financial Reporting
Financial reporting should accomplish the following:
a) Provide information useful for making rational investment and credit decisions. b) Provide information to help current and potential investors and creditors assess the amount, timing and uncertainty of future cash flows. c) Provide information about the economic resources of a firm and claims on those resources. d) Provide information about a firm’s operating performance during a period. e) Provide information about how an enterprise obtains and uses cash. f) Provide information about how management has discharged its stewardship responsibility to owners. g) Include explanation and interpretations to help understand the financial information provided.
The framework lists four principal qualitative characteristics of useful financial information.
a) Understandability
There are many different users and decisions makers. The level of accounting and business knowledge they possess, the methods of decision-making they already possess and their ability to obtain additional information differ among various decisionmakers. It is assumed that users of financial information have a reasonable knowledge of business, accounting and economic activities and, with due diligence, will be able to analyses the information provided.
b) Relevance
Information can influence the economic decision of users. By evaluating past, present and future events, useful information can be derived. For information to be useful, it has
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to be relevant to the decisions that are being made. For information to be relevant, it must assist users in making and evaluating decisions.
c) Reliability
Financial information is reliable if it is free from error and bias, and represents faithfully the events and transactions that have occurred. Reliable information reflects the events or transactions that have taken place. If the financial statements are prepared under conditions of uncertainty, then caution is advised in exercising judgment and in making any estimates. In other words, prudence is to be applied.
d) Comparability
In order to make decisions, users need to compare information between entities and over some time. The information from different entities is comparable if there is consistency in the accounting treatment of the economic events and transactions over time and in the disclosure of accounting policies.
e) Timeliness
If there is a delay in supplying the information, the information may be relevant in a limited manner even though it may be reliable. Therefore, entities have to find a balance between providing timely information which is relevant and reliable. More of one may mean less of the other.
f) Verifiability
Information is reliable if it can be verified by various means. Transactions are always recorded by examining source documents that will form the evidence for the transactions.
g) Faithful representation
Information provided should represent the transactions and events that have taken place as to the recognition, measurement and presentation of these transactions and events. Absence of faithful representation will make information unreliable. However, sometimes there may be difficulty in identifying the transaction or event or even in measuring an item. For example, where a loan for three months in renewed constantly, it may not be a current liability but long term liability.
h) Completeness
Information in the financial statements has to be complete; otherwise, it will not be reliable and relevant.
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The element of financial statement:
a) Assets b) Liability c) Equity d) Income e) Expenses
Recognition criteria
a) Any future economic benefit associated with the item will probably flow to from the entity. b) The item has a cost or value that can be measured reliably.
Measurement
If the time value of money is significant, the entity can disclose the carrying amount of the assets and liabilities discounted at present value.
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3.8 Accounting Concept and Conventions.
a) Historical cost
Assets are recorded at the amount of cash or cash equivalent paid or the fair value of the consideration given to acquire them.
b) Monetary measurement
Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
c) Separate Entity
This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
d) Realization
With this convention, accounts recognize transactions (and any profits arising from them) at the point of sale or transfer of legal ownership - rather than just when cash changes hands. For example, a company that makes a sale to a customer can recognize that sale when the transaction is legal - at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later - if the customer has been granted some credit terms.
e) Materiality
An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgment. Where decisions are required about the appropriateness of a particular accounting judgment, the "materiality" convention suggests that this should only be an issue if the judgment is "significant" or "material" to a user of the accounts. The concept of "materiality" is an important issue for auditors of financial accounts.
f) Going Concerned
This concept simply implies that the business will continue to operate for the foreseeable future and that it isn't suddenly going to cease trading. The significance of this concept is that the assets of the business are not valued at their "break-up" value.
The concept assumes that the owners of a company intend to continue its trading over the long term (at least 12 more months). It that is not the case, they will need to disclose that fact and present slightly different financial statements.
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For example:
Suppose Melor Trading acquired a machine at RM100,000 and this machine has an estimated life of 5 years. Let us also assume that the machine has no other use outside Melor Trading’s’ business and could only be sold for scrap at RM15,000 after one year.
It is normal to write-off the cost of this asset to the profit and loss account, over this timeframe. That is, depreciation of RM20,000 per annum would be charged to the profit and loss account. So, at the end of the first year, the value of the machine in the books would be RM80,000, rather than the RM15,000 scrap value.
Although it doesn't seem very prudent, because Jo Blogs will continue to trade and the machine will therefore be used in the business. It is the "Going Concern" concept that allows the higher valuation.
g) Consistency
Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change
h) Prudence
A company should not recognize an asset at a value that is higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its respect in the future.
I) Matching
Income should be properly "matched" with the expenses of a given accounting period.
j) Accrual
Under the accrual basis, transactions and events are recognized when they occur and are recorded and reported in the financial statements in the period to which they relate irrespective of whether cash was received or paid.
k) Periodicity
This principle entails a business to complete the whole accounting process of a business over a specific operating period. It may be monthly, quarterly or annually. For the annual accounting period, it may follow a Calendar or Fiscal Year.
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Financial statement
Objectives Elements Framework
User
Internal User External user
Figure 2: Summary of Accounting Framework
Qualitative characteristics
Principal
Other principals
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Exercise 1
Mars Sdn Bhd has invested in shares of Mybank Bhd through Bursa Malaysia amounting of RM150,000 in the last five years. Recently, the shares of Mybank have increased, and the value of the investment is RM450,000. Mars Sdn Bhd recorded RM150,000 as investment cost in Syarikat Mybank.
● Accept/Appropriate ● Prudence Concept ● The investment must be recorded at the amount whichever lower between the cost and the market value.
According to the Conservative concept/ prudent concept, the accountant should aware of recognizing the gain or losses from the transactions. If we expected losses, we should provide an estimation of losses in accounts, however, if we expected the gain from such transactions, we should not recognize it till we receive it. So the profit or loss of the company may not under-stated or over-stated due to the above matter.
Exercise 2
Mars Sdn Bhd has decided to promote product ‘X’ through mass-media and other printing- media. Product ‘X’ is expected to be in the market in the next ten (10) months, starting from January 2021. RM500,000 has been spent in August 2019 for advertising and promotion purposes. Mars Sdn Bhd has recorded RM500,000 as promotion and advertising expenses in Profit and Loss Account for the year ended 31 December 2019.
• Not Accept/ Not Appropriate • Accrual Concept • RM500,000 should be recorded as Prepaid Expenses. The prepaid expenses should be excluded from the current expenses but shown as a current liability in the balance sheet. • The current expenses are expenses incurred in the current year.
Exercise 3
Mars Sdn Bhd bought 100 units of computer amounting of RM200,000 which have a useful life of 5 years. The Directors of the company had proposed RM200,000 to be charged as expenses for the current accounting period due to the rapid changes in Information Technology Systems and those computers may not be in use in the future.
• Not Accept/ Not Appropriate • Matching Concept • RM200,000 cannot be classified as revenue expenses. It should be classified as capital expenses. Thus, it cannot be eliminated against current profit, the
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assets should be depreciated annually and the annual depreciation should be charged to Profit and Loss Account. • Or Historical Cost Concept • In addition, according to the Historical Concept, RM200,000 was selected due to the objectivity of the transactions and it should be shown in the balance sheet as Non-Current Assets.
Exercise 4
Twilight Sdn Bhd placed an order worth RM35,000 for product ‘Y’ on 1 October 2020 to Syarikat Gamma. Twilight has paid a deposit of RM 7,000 on the same date. Product ’Y’ is expected to be ready by 15 February 2021. However, Mars Sdn Bhd has recorded RM35,000 as revenue on 1 October 2020. (5 marks)
• Not Accept/ Not Appropriate • Realization Concept • According to the Realization concept, Mars Sdn Bhd should recognize the sales on 15 February 2021 when the product is transferred to Syarikat Citrus.
The selling should be recognized at the selling date when the seller transfers the title to the buyer. According to this case, the selling date was 15 February 2021 when the product is ready and been transfer to the Syarikat Citrus. • The number of sales should be recorded is RM35,000 on 15 February 2021.
Exercise 5
Equipment and Motor Vehicles of Mars Sdn Bhd are being depreciated by 15% and 20% respectively on a straight-line basis. The Directors of Mars Sdn Bhd has proposed to reduce the rate of depreciation for both assets to 10% and 15%. As a result, total expenses can be cut down by RM25,000 per annum.
• Not Accept/ Not Appropriate • Consistency Concept • According to the Consistency Concept, the rate of depreciation cannot be changed. It must use the same rate annually so that the company can measure the performance and financial status yearly. • However, if the directors want to change the rate of depreciation, it must discuss in meeting and have to take all the effect of the changes to the account and the appropriate disclosure and presentation should be made in the notes to the accounts.
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Questions
Question 1
Describe the meaning for the doctrine below: i. Reliability ii. Consistency iii. Prudence
Question 2
a) Based on the three (3) below discuss whether the action taken by the company was right or not. Give your reason based on the proper accounting treatment.
b) Inventory cost RM45 000, has market valued RM30 000. The company recommends that inventory be recorded in the amount of RM30 000.
c) Mekar Bhd purchased a machine at cost RM250 000 on 1 January 2002. The estimated economic life for the machine was 15 years. However in year 2008 , the company will liquidate and the management has agreed to reduce the economic life for the machine for 7 years only.
d) Machine at cost RM65 000 have depreciation RM20 000 with fair value RM80 000. The company recommended that the machine recorded at the amount of RM80 000 and the surplus will show at Income Statements.
e) As a token of appreciation to all employees, the management has held an annual dinner costing of RM50, 000 including meals and souvenirs. RM15,000 is a deposit for the annual dinner and had been paid in the current year. The balance of RM35,000 is still due. Both amounts are charged into entertainment expenditure account in Profit and
Loss Account.
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