Assumptions, methods, and procedures that constitute accounting policies of a firm.

the possible ways in which accounting concepts may be applied to financial transactions, e.g. the
methods used to depreciate assets, how intangible assets or work in progress are dealt with.

Accrual Accounting

Because of the potential economic distortions caused by recording only cash transactions, GAAP
requires revenue and expenses to be recorded on an accrual basis. This means that a business
records revenue when the earning process is complete, not necessarily when cash is received. For
example, a tavern that allows customers to run a tab records revenue when the customer receives
the drink, not when the tab is paid. 

Similarly, an accrual basis of accounting requires expenses to be recorded when the business
receives the goods and services, not necessarily when the business actually pays for them.  If a
bar receives a supply of napkins but does not pay for them for thirty days, the expense is
recognized when the napkins are delivered and used, not when the bill is paid.

Advantages and Disadvantages of Cash and Accrual Systems  

A business that records revenue only when cash is received, and expenses only when they are
paid is said to be on the cash basis of accounting. An obvious advantage of the cash basis over
the accrual basis is that it is much simpler. An accrual system requires more accounts, including
accounts receivable, accounts payable, inventory, prepaid expenses, and deferred revenue. Each
of these accrual accounts requires making estimates and sometimes complex computations. As in
machinery, the more moving parts the more potential problems. 

The cash basis accounting approach requires no complete measurements or estimates. An

expense is recognized only when a vendor is paid for a product or service. Revenue is recorded
only when a customer or client pays for products sold or services rendered.

The disadvantage of the cash basis system is that for any particular short period of time operating
results can be greatly distorted from economic reality. The distortions usually result from
transactions occurring near the end of accounting periods.

Does Cash Basis Accounting Always Provide Different Operating Results ?

The answer is no. If most of a firm’s sales are cash sales and most expenses are paid
immediately, there is little difference between the measured operating results using a cash basis
versus an accrual basis of accounting. However, if a business extends credit to customers, has
credit extended to it, or carries significant amounts of inventory, the differences in reported
operating results using the two approaches can be significant.  
For many businesses, cash collections may lag behind earnings by two to three months.
Payments on expenses may also lag as much as sixty days from the receipt of goods and services.
In these cases, cash basis earnings may greatly differ from accrual basis earnings.

Over the entire life cycle of a business, cumulative operating results are the same under both
bases of accounting. In fact, year to year the differences may not be that great if the levels of
revenue and expense remain stable and the collection and payment cycles do not fluctuate. The
greatest variation between accrual and cash basis accounting tends to occur in the initial and
ending periods of a firm’s life cycle, or during periods of significant growth or decline. Short
term monthly and quarterly reporting also can be greatly different.  As our friend Jim indicated,
accurate short-term reporting is very important in managing a business.

The main purpose of financial statements is to provide financial information to the users to assist
them in their economic decisions. The financial statements basically present the financial
information in such form that it is not only understandable but also useable. That is why financial
statements present the financial effects of different business events that also includes business
transactions.

In order to enhance the quality of information in financial statements, business transactions are
grouped in different classes or categories on the basis of their economic characteristics. The
broad classes or categories are called elements of financial statements.

In IASB Framework for the Preparation and Presentation of Financial Statements

(Framework) there are in total FIVE elements of financial statements mentioned which are as
follows:

1. Assets
2. Liabilities
3. Equity
4. Income
5. Expense

Framework went on further to explain which combination of elements are used to measure
financial position, financial performance and changes in financial position of the entity.

 The elements directly related to the measurement of financial position of the entity are
assets, liabilities and equity. These elements are presented in the Statement of
Financial Position which was previously known as Balance Sheet.
 The elements directly related to the measurement of financial performance of the entity
are income and expense. These elements are presented in the Income Statement.
 The elements directly related to the measurement of changes in financial position
involves the elements of both balance sheet and income statement and depends on the
circumstances. So, elements that are used to measure the change in financial position
cannot be strictly specified.
 Statement of changes in equity and Statement of cash flows collectively provide an
insight into the changes in financial position of the company. And as we know both of
these statements involve mostly all of the above five items and sometimes less therefore,
elements are not mentioned in the framework for such measurement.

Another important point to remember is that each element in itself is a group of many
transactions and each group can further be broken down to different groups i.e. sub-
classification can be done within each element depending on the nature, characteristics,
function, time and other factors.

For example, Assets can be further divided into Non-current assets and Current assets. These
sub-classes will NOT be treated as separate elements rather sub-classes of a particular
element.

How elements are to be combined to measure specific financial aspect is not mentioned in the
framework rather it is mentioned in the International Accounting Standards (IASs). IASs
provide the instructions regarding formant of presentation, calculations, measurement and other
accounting aspects.

Measurement of the elements of financial statements

Measurement is the process of determining the monetary amounts at which the elements of the
financial statements are to be recognized and carried in the balance sheet and income statement.
This involves the selection of the particular basis of measurement.

A number of different measurement bases are employed to different degrees and in varying
combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected
to be paid to satisfy the liability in the normal course of business.

(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to
be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the
undiscounted amount of cash or cash equivalents that would be required to settle the obligation
currently.

(c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried
at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected
to be paid to satisfy the liabilities in the normal course of business.

(d) Present value. Assets are carried at the present discounted value of the future net cash
inflows that the item is expected to generate in the normal course of business. Liabilities are
carried at the present discounted value of the future net cash outflows that are expected to be
required to settle the liabilities in the normal course of business.

The measurement basis most commonly adopted by entities in preparing their financial
statements is historical cost. This is usually combined with other measurement bases. For
example, inventories are usually carried at the lower of cost and net realizable value, marketable
securities may be carried at market value and pension liabilities are carried at their present value.

n financial reporting, a conceptual framework is a theory of accounting prepared by a standard-

setting body against which practical problems can be tested objectively. A conceptual framework
deals with fundamental financial reporting issues such as the objectives and users of financial
statements, the characteristics that make accounting information useful, the basic elements of
financial statements (e.g., assets, liabilities, equity, income, and expenses), and the concepts for
recognising and measuring these elements in the financial statements.

Benefits of a conceptual framework for financial reporting include: establishing precise

definitions that facilitate discussion of accounting issues; providing guidance to accounting
standard setters when developing and reviewing financial reporting rules; helping to ensure that
accounting standards are internally consistent; helping preparers and auditors to resolve financial
reporting problems in the absence of an accounting standard; and helping to limit the volume of
accounting standards by providing an overarching theory of accounting that can be applied to
specific reporting problems.