INTERMEDIATE ACCOUNTING I
INTRODUCTION
1.1 Accounting
It is the process of identifying, measuring and interpreting of economic information that assists users of this information to make informed judgments or decisions.
1.1.1 History of Accounting
It is not known who ‘invented’ accounting. However accounting records were used by ancient traders, farmers, e.t.c. to control their assets, monitor their costs, collect payments and calculate earnings. In 1494, Luca Pacioli an Italian monk codified existing bookkeeping practice i.e. ‘the double entry bookkeeping system.’
Accounting continued to develop but increased in importance with the rise in popularity of companies as the predominant form of business entity. Due to the separation of ownership and management, shareholders had less detailed knowledge of business operations. Hence, accountants were required to produce and interpret financial information to enable shareholders to make decisions. Accounting standards were later developed to make it easier to compare different companies and the accounting profession grew in order to assist in the application of these sometimes, complex accounting standards.
The growth in computerization has seen a reduction in traditional bookkeeping work, and with globalization it means that many clients have been multinational companies requiring advice on many areas in addition to accounting.
1.1.2 Bookkeeping vs. Accounting
Bookkeeping is the art and science of correctly recording in books of accounts all those business transactions that result in the transfer of money or money’s worth.
Accounting is mainly concerned with the design of the system of records, the preparation of reports based on the recorded data, the interpretation of the reports and finally communicating the results of the interpretation to interested persons.
1.1.3 Sub-fields of Accounting
a. Financial Accounting - It is mainly concerned with recording business transactions in the books of accounts in a way that the financial performance for a particular period and financial position on a particular date can be known.
b. Cost Accounting - It relates to the collection, classification, ascertainment of cost & its accounting and cost control relating to the various elements of cost i.e. materials, labour and overheads.
c. Management Accounting - It relates to the use of accounting data collected with the help of financial accounting and cost accounting for the purpose of policy formulation, planning, control and decision making by management.
d. Tax Accounting - It assists in complying with the provisions of complex tax laws governing income tax, sales tax, excise duties, custom duties e.t.c.
1.1.4 Users of Financial Statements and Accounting Information
a. Managers - They need information about an entity’s financial situation as it is currently and as it is expected in future hence enabling them to manage the business efficiently and to make effective decisions.
b. Shareholders - They need to know the profitability of an entity and how much of profits they can withdraw from the entity for their own use.
c. Employees - They have a right to information about the entity’s financial situation because their future careers and salaries/wages depend on it.
d. Lenders of finance - They need to be sure that the entity is able to pay interest payments and principal amounts promptly.
e. Suppliers and Customers - Suppliers need to know about the entity’s ability to pay debts while customers need to know that the entity is a secure source of supply.
f. Taxation authorities - They need to know about the entity’s profits in order to assess the tax payable by the entity.
g. Financial analysts and Advisers - They need information for their clients or audience.
h. The Public
1.2 The Conceptual Framework
The International Accounting Standards Board (IASB) is the body mandated to develop international accounting standards (IAS)/international financial reporting standards (IFRS). The Conceptual Framework for Financial Reporting (The Framework) is the main reference document for the development of accounting standards. The Framework can also be described as a theoretical base, a statement of principles, a philosophy and a map. However it should be noted that the Framework is not an accounting standard, and where there is perceived to be a conflict between the Framework and the specific provisions of an accounting standard, then the accounting standard prevails.
The IASB Framework was approved by the IASC Board in April 1989 for publication in July 1989, and adopted by the IASB in April 2001. In September 2010, as part of a bigger project to revise the Framework the IASB revised the objective of general purpose financial reporting and the qualitative characteristics of useful information. The Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users. The Conceptual Framework deals with:
· The objective of financial reporting
· The qualitative characteristics of useful financial information
· The definition, recognition and measurement of the elements from which financial statements are constructed
· Concepts of capital and capital maintenance
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
1.2.1 The Qualitative Characteristics of Financial Information
Qualitative characteristics identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information). Examples of qualitative characteristics of financial information include;
a. Relevance
Only relevant information can be useful. Information is relevant when it helps users evaluate past, present or future events or it confirms or corrects previous evaluations. Information on the financial position and performance is often used to predict future position and performance and other things of interest to the user such as the likely dividend, wages rises. The manner of showing information will enhance the ability to make predictions e.g. by highlighting unusual items.
b. Faithful representation
Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the transactions or finding an appropriate method of measurement or presentation.
c. Comparable
Users must be able to compare an entity’s financial statements
a) Through time to identify trends
b) With other entity’s statements, to evaluate their relative financial position, performance and changes in financial position.
The consistency of treatment is important across like items over time, within the entity and across all entities.
d. Understandable
Users must be able to understand financial statements. They are assumed to have some business, economic and accounting knowledge and to be able to apply themselves to study the information properly.
e. Verifiable
The ability through consensus among measurers to ensure that information represents what it purports to represent or that the chosen method of measurement has been used without error or bias.
f. Timely
Users should have information available to them before it loses its capacity to influence decisions.
1.2.2 The Elements of Financial Statements
The IASB indicates that the elements directly related to the measurement of financial position are assets, liabilities and equity while the elements of financial performance are income and expenses. These are defined as follows:
· An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
· A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
· Equity is the residual interest in the assets of the entity after deducting all its liabilities.
· Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
· Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
The Framework also lays out the formal recognition criteria that have to be met to enable elements to be recognised in the financial statements. The recognition criteria that have to be met are that;
· an item that meets the definition of an element and
· it is probable that any future economic benefit associated with the item will flow to or from the entity and
· the item’s cost or value can be measured with reliability.
1.2.3 Capital and Capital Maintenance
The IASB explains the concept of capital maintenance as concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.
1.3 Accounting Concepts & Conventions
Accounting principles are guidelines to establish standards for sound accounting practices and procedures in reporting the financial status and periodic performance of a business.
Accounting standards are written /policy document issued by governments or professional institutes or other regulatory bodies covering various aspects of recognition, measurement, treatment, presentation and disclosure of accounting transactions in the financial statements.
Accounting principles can be classified into two categories;
· Accounting concepts – they are the basic assumptions or conditions upon which the science of accounting is based.
· Accounting conventions – they are the circumstances or traditions which guide the accountants while preparing the accounting statements.
Accounting Concepts
1.3.1 Business Entity Concept
This concept implies that a business unit is separate and distinct from the person who supplies capital to it. The accounting equation (Assets = liabilities + capital) is an expression of this concept since it shows that the business itself owns the assets and in turn owes to the various claimants.
1.3.2 Money Measurement Concept
Money is the most reliable unit of measurement in order to achieve homogeneity of financial data. The advantages of expressing business transactions in terms of money is that money serves as a common denomination by means of which heterogonous facts about a business can be expressed in terms of numbers (i.e. money) which are capable of additions and subtractions.
1.3.3 Going Concern Concept
It is assumed that a business unit has a reasonable expectation of continuing business of a profit for an indefinite period of time. Transactions are recorded in the books keeping in view the going concern aspect of the business unit. It is because of this concept that supplies supply goods and service and other business firms enter into business transactions with the business unit.
1.3.4 Cost Concept
This concept implies that an asset is recorded in the books at the price paid to acquire it and that this cost is the basis for all subsequent accounting for the asset. This concept does not mean that the asset will always be shown at cost but it means that cost becomes the basis for all future accounting for the asset.