B301 Unit 1 Conceptual framework of financial reporting

The Development of AccountingTheories                                             Top     

Definition

A coherent set of logical principles that

• Provides a better understanding of existing practices to practitioners, investors, managers and students.

• Provides a conceptual framework for evaluating existing accounting practices.

• Guides the development of new practices and procedures.

Purpose

• Establish unifying principles that can serve as the basis of a system for recording financial data, any such theoretical system should enable the measurement of data in ways that are both internally consistent and externally valid.

2 Approaches

• The deductive approach (演繹法): objectives --> postulates --> principles --> accounting theory

  • Objective: The primary objective of financial statements is to provide information to shareholders and others for use in the making of economic decisions.

  • Postulate (假設): e.g. A going concern.

  • Principles: An asset should be recognized as such if it is likely to generate future economic benefits and its cost can be measured reliably.

  • Rule: Accounting practice (accounting standards).

• The inductive approach (歸納法): observation of current practices--> principles --> generalization of accounting theory

　The conceptual framework                                                                     Top

• A deductively-derived accounting framework supported by objectives, assumptions and principles.

• Developed to provide a coherent frame of reference for justifying existing accounting standards and for developing new accounting standards on a consistent basis.

• International Accounting Standards Committee (IASC) -- Framework for the Preparation and Presentation of Financial Statements (1997).

Purpose of Financial Statements                                                            Top

1) General purpose:

• B/S, P & L a/c, Cash Flow Statements.

• Aimed at a wide range of users.

• Provide information for shareholders and creditors.

2) Specific purpose: Corporate Report (1975)

• Statements of value added, money exchange with government, future prospect, corporate objectives, employment report & transactions in foreign currency.

• Prepared to meet the needs of specific user groups.

Main users of financial statements

• Existing shareholders (Primary users)

• Potential investors

• Creditors

• Investment & credit analysts

• The government

• Taxation

• Employee

• Society at large

GAAP (Generally accepted accounting principles)

• A term defined in the US Accounting Practices Board (APB): to describe the basis on which financial statements are normally prepared.

• "Generally" allows for alternative accounting practices which could be more appropriate under special circumstances.

• Similar to SSAP.

Financial reporting framework in Hong Kong                                                        Top

Statement 2.01 -- Framework for the Preparation and Presentation of Financial Statements (1997)

• Objective of financial statements:

• balance sheet: financial position

• income statement: performance

• cash flow statements: the sources and uses of cash

• Other uses of financial statements: Users are advised to obtain additional information from other sources rather than rely solely on financial statements.

• Preparation of financial statements: Management is responsible for keeping proper accounting records and preparing financial statements that give a 'true and fair view'.

2 Underlying assumptions

• Accrual: the effects of transactions and other events are recognized when they occur (not when cash is received or paid).

• Going concern: an entity will continue in operation for the foreseeable future

• Qualitative characteristics of accounting information

  • Understandable

  • Relevant

    • Timeliness

  • Reliable

    • Completeness

    • Verifiability

    • Free from material error and bias (neutrality)

    • Faithful representation

    • Substance over form

    • Prudence

  • Comparability (including consistency)

• The elements of financial statements

  • Asset: a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

  • Liability: a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

  • Equity: the residual interest in the assets of the enterprise after the deduction of all its liabilities.

  • Income: an increase in economic benefits during the accounting period in the form of inflows of assets or decreases in liabilities other than those relating to contributions from equity participants.

  • Expenses: decreases in economic benefits during the accounting period in the form of outflows of assets or the realization of a liability, other than those relating to distribution to equity participants.

• Measurement of elements

  • Historical costs

  • Realizable (settlement) value

  • Present value

  • Current cost

• True and fair view: not defined in the Ordinance or SSAP and the Guidelines. Financial statements are generally assumed to give a true and fair view if they are prepared in compliance with the existing accounting standards.

Asset valuation, income measurement and capital maintenance               Top

Historical cost accounting (HCA):

Assets are valued at their original purchase price.

• Advantages:

  • Actual amount paid;

  • Objective and reliable;

  • Little change with cost if price is stable;

  • Now, still have not identified a simpler, more objective and reliable measuring tools to replace historical cost.

  　

• Disadvantages:

  • For non stable prices, the value of assets change over time;

  • Fails to reflect the replacement value of goods or services;

  • Fails to provide meaningful information to decision makers.

Current purchasing power (CPP) method

The cost of assets is restated by the retail price index (RPI) or Consumer Price Index (CPI) in HK to reflect the changing value of assets at the balance sheet date.

Current value (Current cost accounting, CCA) method

• Replacement Cost (RC) -- The amount has to be paid to replace an assets

• Net Realizable Value (NRV) -- The amount for selling an assets less any cost incurred

• Economic Value (EV) -- Estimated present value of the cash flows generated if the assets were retained

• Deprival Value --The value of an deprived asset = the loss suffered.

  It is the lower of

  • (a) replacement cost and

  • (b) the higher of net Realizable value and the economic value (recoverable amount)

Deprival Value

• The value of an asset to its owner is equivalent to the loss he would suffer if he were deprived of it.

• It is generally thought that an asset cannot be greater than its replacement cost since the maximum loss an owner would incur were he to be deprived of the asset would be the cost of replacing it.

• Replacement cost is considered to be the appropriate measure of an asset's deprival value.

Revenue recognition, realization & matching

• Recognition: take place when an accounting transaction is recorded

• Realization: Revenue or costs may be regarded as having be earned or incurred

• Matching: matching of related revenues and costs

How capital is valued

• Either in terms of nominal money or

• Constant purchasing power: profit represents the increase in physical production capacity over the period.

Appendix: Basic Accounting Concepts                                                    Top

• Economic entity

• Going Concern

• Accrual basis

• Revenue recognition

• Matching (expense recognition)

• Periodicity

• Monetary unit

• Prudence (Conservatism)

• Materiality

• Full disclosure