One problem that has been encountered is that due to differing economic systems, (Black 2002) there is no generally agreed framework in which to concur the objectives of financial reporting.
2.0 State and explain the four fundamental accounting concepts as set out in SSAP 2 and restated in FRS 18
2.1 SSAP 2 – Disclosure of Accounting Policies
Issued in November 1971, the Statement of Standard Accounting Practice 2 (SSAP2),. It focuses on four fundamental accounting concepts and they are as follows:
The going concern concept:
This is relevant to the Profit and Loss Account and the Balance Sheet (Black 2002), in that they should show no reasons or indications that the Company may fall into debt or at worst liquidation in the foreseeable future. They should, (Blake 1997), not show any indications that the Company may need to make any cut backs to its operations. The accounts should reflect that the business will continue to trade as it has been doing so.
The accruals concept:
The accruals concept means that costs should be identified as being purchased on the date that they are received and not when money is paid out, this is referred to as the revenue being earned at a specific time, an accrued expense. These may be in the form of electricity or telephone, these may have been used but no invoice received at the end of the accounting year, therefore the amount due is treated as a liability. This concept also includes the matching process, this happens when revenues are linked with their relevant expenses in the profit and loss account during the accounting period to which they relate.
The Consistency Concept:
In order to compare financial statements from one year to the next, the information that is reported needs to be consistent. It is also helpful when comparing the accounts of one company with another, this information is crucial when making the decision as to whether to invest in a particular Company or to assess the amount of profit a Company is making from one year to the next. (Glautier & Underdown 1995)
The Prudence Concept
According to (Glautier & Underdown 1995), the two principle rules that make up the prudence concept are:
- Never anticipate money gained from profit to cover any liabilities in the year, therefore provision must be made for any losses or liabilities that the Company may incur.
- In valuing an asset, always take the lesser amount so as not to rely on a higher cost given for that asset to cover any costs that the Company may face.
2.2 FRS 18 – Accounting Policies
The standard of accounting policies was reviewed and in December 2000 FRS 18 replaced SSAP2. The four concepts were considered and updated.
Going Concern:
This, along with accruals, forms the basis of accounting and therefore remains relatively unchanged. A specific requirement states that following the directors assessment, if there is any doubt about the liquidity of the Company, then this should be explained and highlighted.
Accruals
This concept is also considered to be a fundamental concept and has only been slightly changed. The change refers to the exclusion of matching revenues with their relevant expenses. Therefore this can no longer be used in the justification of deferring costs. It also states that only profits that have materialised into cash at the date of the balance sheet can be included in the profit & loss account.
Prudence and Consistency
These are no longer considered to be rudimentary and are now merely elements of accounting practise to be taken into consideration when preparing reports.
As stated by (Black 2002 ),Prudence features in the objective of ‘reliability’. It is no longer good practise to under estimate assets or over estimate liabilities as this gave an impression of understated profits.
Consistency has been replaced by comparability. Accounting needs to be able to change and improve, this would have been limited through the concept of consistency.
According to (Black 2002) it is a legal requirement that the financial reports provide a ‘true and fair view’ of the transactions made by the Company during the course of a year. Accounting Standards outline the specific procedures required to produce consistent and functional reports.
3.0 Explain the relationship between the fundamental accounting concepts, the four key objectives of FRS18 and the statement of principals for financial reporting
In 1990 the ASB set up a project to produce a document to help give an understanding of the Boards methods in defining the Accounting Standards and to give clarity to the type and function of information which is reported in general purpose financial statements. This document is called the Statement of Principles (SOP). (Black 2002)
The fundamental accounting concepts as stated in SSAP2 and restated in FRS18, the objectives of FRS18 and the Statement of Principles link together in the following ways:
Chapter 3 of SOP – Qualitative characteristics of financial information
This chapter sets out what makes financial information useful. The 4 objectives of FRS18 are included in this. As stated in (Black 2002), they are referred to as ‘qualitative characteristics’, meaning attributes having a high standard of excellence.
Those relating to content are:
- Reliability – The information given must be of its entirety, give a true reflection of what is being reported, be unbiased and take on the concept of prudence – re SSAP2
- Relevance – Reported data can be used for the purpose of forecasting and provides support in the decision making process
Those relating to presentation are:
- Comparability – Equivalent information can be identified and evaluated, giving consistency and conformity, when seen for example in the 5 year review
- Understandability – This purports to the significance of the information and how easy it is for the user i.e. the present or potential investor, to comprehend
Chapter 5 of SOP – Recognition in Financial Statements
- An item contained within a financial statement is stated both in words and in monetary value The matching/accruals concept is used with regard to assets and liabilities and gains and losses, rather than money earned and money paid out.
Chapter 6 of SOP – Measurement in Financial Statements
- Provides a general appraisal of the measurement of assets and liabilities in comparison with gains and losses. The monetary amount is always recorded in terms of ‘historical cost’ i.e. the original amount paid out for the item. On this basis, the going concern concept is relevant.
Chapter 7 of SOP –Presentation of Financial Information
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Data should be presented in a structured format containing primary statements with supporting notes. It should therefore make the information more understandable which in turn enables the comparability of financial statements. The issues of understandability and comparability are pertinent to this chapter in highlighting the relationship of certain items with relevant information, making it far clearer to interpret and comprehend.
In Summary, The Statement of Principles forms the basis for financial reporting in the UK; it is not a Standard but aids the formulation of the Accounting Standards. It is particularly relevant to the four objectives of FRS18 and the fundamental concepts of SSAP2, with comparisons in four out of its eight chapters
4.0 Define and give two examples of accounting bases and accounting policies
4.1 Accounting Bases
Accounting bases are methods used for calculating information for financial statements. The two most commonly used bases are the straight line basis and the declining balance method. It generally depends on the item with regard to which basis is used. The purpose of using different bases is to allocate the cost of the asset over the agreed number of years applying it to each year independently.
4.11 The Straight Line Method
This accounting basis divides the net cost of the asset equally over the expected number of years of its working life. With regard to depreciation it assumes that the value of the asset will decline equally over the number of years that are deemed to be how long it will be of use to the company.
An example of this would be that if a computer was bought for £2,000, and was deemed to last for 3 years and its estimated resale value was £800, the formula would be:
£2,000 - £800 = £400 a year
3 years
Therefore £400 would be added to the Profit & Loss account and shown as a liability each year.
4.12 The Declining Balance Method
Instead of an even division every year, the declining or reducing balance method takes into consideration that an item like a vehicle depreciates in value more quickly in the first year than in subsequent years of its useful life. Therefore the depreciation amount for the first year is calculated and then for each subsequent year a percentage of the value of the asset is deducted.
This method is most commonly used for motor vehicles, for example if a truck was bought for £50,000, the first years depreciation figure may be £12,000, which is more than the agreed subsequent years depreciation amount of 20%. Then for Years 2 – 4 20% is deducted each year to reflect the vehicles decline in value, until the asset value is reached at the end of the 4 year term
4.2 Accounting Policies
Accounting Policies are found within the notes to the financial statements section in an Annual Report. They are specific accounting bases (Glautier & Underdown 1995) giving an explanation of how the figures in the financial statements have been attained. It is the company’s choice as to which accounting basis is most appropriate to use in preparing the financial information and in accordance with FRS18, it must be stated which Accounting Policy is used in order to give a true and fair reflection of all financial transactions.
4.21 Depreciation
All tangible assets apart from freehold land have allowance made on them for depreciation. Each year these assets are stated on the balance sheet at cost price less the accumulated depreciation. The purpose of this is to write off the cost over a certain number of years according to its useful life. In practise certain assets are given a fixed number of years before they are subject to depreciation, e.g. generally vehicles depreciate over a period of four years or what is deemed to be their estimated life. Buildings are usually anywhere between 30 – 50 years. (Ramsden 2003)
4.22 Goodwill
Goodwill is listed as an intangible asset to the company, it is formed on the basis of reputation that the company has assumed as well as a skilled and valuable workforce, the brand that it is actually selling and its geographic base to name but a few. It is basically the difference in amount that the company is worth according to its book value and the amount that the company would be sold for on the open market. As stated by (Ramsden 2003) the contributions to goodwill comprise of many things, but it is fundamentally worth what a buyer perceives its worth to be. Goodwill may be written off to reserves and charged in the profit and loss account on the sale of the business. It can also be capitalised and then paid off using the straight line method over the number of years deemed to be its economic life.
5. 0 Examine the Accounts of two limited companies and outline two accounting policies from each
Colefax Group plc & New Look plc
5.01 Depreciation
The Colefax Group outlines how depreciation is calculated using the straight line method, e.g. it states that the residual value – the amount that the item is deemed to be worth at is time of replacement – is subtracted from the price that it was bought for and this figure is then divided by the number of years that the company will use it for before it is replaced. A list is then provided showing this.
Any assets that are being manufactured are not subject to depreciation
New Look states that tangible fixed assets are recorded at cost less depreciation. Cost includes any extras charged. Freehold land does not depreciate. Depreciation exists to write off the cost less anything that it is worth at the end of its life.
5.02 Stocks
The accounting policies refer to stock as being valued at either cost price or the net realisable value, as stated by (Black 2002).
The pricing method used in calculating the value of stock is the first in first out (FIFO) basis and this includes logistical and finishing costs according to (Holmes & Sugden 1990). The first items that have been bought in are the first to be sold.
New Look states that stock is valued at cost price or net realisable value, whichever is the lower amount. There is no mention of the pricing method so this could make a difference on the profits attained.
5.1 Examine how the figures contained in the final accounts would be different if different policies had been adopted.
5.11 Depreciation
If the reducing balance method was used to calculate depreciation a different amount would show on the P&L account and the balance sheet each year. In the case of motor vehicles with an original cost of £383,000 and a residual value of £27,000, at the end of the 4 years the figures would be the same, but over years 1-3 the amount that is accounted for can affect the Net Profit figures quite dramatically.
The following table shows the difference:
In summary, the annual provision amount on the P&L account if the straight line method is used in year 1, will be £97,140 less than if the reducing balance method is used, as stated by (McKenzie 1994) some companies prefer this way of calculation as it is more akin to ‘real’ depreciation.
If the reducing balance method is used, it would be prudent to analyse the accounts over the 4 year period, as looking at year 1 or year 4 in isolation may give a distorted view.
The way an accounting policy is presented can alter the amount the company reports its profits. If there is a low charge for depreciation, then the asset value of an item appears to be higher, this also makes the profits to appear higher in the P&L account. If the P&L account is read without reading the explanation then a false view can be given
5.12 Valuation of Stocks
As suggested by (McKenzie 1994) a different method in calculating value is by using the average cost. This is when deliveries are received which are priced differently and therefore an average price is taken over the year. This is not entirely accurate and as stated by (Holmes & Sugden (1990), stock needs to be valued consistently because a slight difference in price can affect the reported profits quite dramatically.
In the case of New Look, where we don’t know how they have valued their stocks, if the stock is valued higher at year end, this could mean that the cost of the goods could have been very low and a greater profit was realised. (Holmes & Sugden (1990)
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Susanne Erricker Page of 11 Year, Semester 1