UNIT - 1

INTRODUCTION TO REGULATORY &

CONCEPTUAL FRAMEWORK OF
ACCOUNTING AND ACCOUNTING
POLICIES

Compiled by: Muhammad Munir Ahmad

Reviewed by: Dr. Syed Muhammad Amir Shah

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 CONTENTS

Objectives of the Unit:

1.1 Introduction
1.2 Important Bodies
1.2.1 IFRS Foundation.
1.2.2 The IASB (International Accounting Standards Board)
1.2.3 The IFRS Interpretations Committee
1.3 The Regulatory Framework of Accounting
1.3.1 Financial Reporting Council
1.3.2 Accounting Standards Board
1.3.3 Financial Reporting Review Panel
1.3.4 Urgent Issues Task Force
1.3.5 Why a regulatory framework is necessary
1.4 Principles-Based and Rules-Based Framework
1.5 The Conceptual Framework of Accounting
1.6 Qualitative Characteristics of Financial Information
1.6.1 Introduction
1.6.2 Materiality
1.6.3 Understanding
1.6.4 Relevance
1.6.5 Reliability
1.6.6 Comparability
1.7 Elements of the Financial Statements
1.8 Recognition of Assets, Liabilities, Income and Expenses
1.9 Accounting Policies, Changes in Accounting Estimates and Errors.
1.9.1 Accounting Policies
1.9.2 Estimation Techniques
1.9.3 Prior Period Adjustment
1.9.4 Accounting Concepts
1.9.4.1 The going Concern assumption:
1.9.4.2 The accruals basis of accounting
1.9.4.3 Matching concept
1.9.4.4 Consistency of presentation
1.9.4.5 Materiality and aggregation

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 1.9.4.6 Materiality Concept
1.9.4.7 Offsetting
1.9.4.8 Prudence
1.9.4.9 Substance over form
1.9.4.10 Objectivity
1.9.4.11 Realisation concept
1.10 Measurement in Financial Statements
1.10.1 Historical cost:
1.10.2 Replacement cost (of an asset)
1.10.3 Fair value:
1.10.4 Net realizable value (of an asset):
Assessment questions
Appendix 1.1
Appendix 1.2

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 OBJECTIVES OF THE UNIT

After studying this unit the student will be able to:

a. To understand the regulatory framework and its importance

b. Describe the structure and objectives of the International Accounting Bodies
c. To understand the conceptual framework and its importance
d. Understand the elements of financial statements
e. Differentiate between a principles-based and a rules-based framework
f. Comprehend the recognition criteria in financial statements
g. Distinguish between an accounting policy and an accounting estimates
h. Understand the different measurement criteria in financial statements

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1.1 Introduction
Almost every country has its own accounting language. The language describes how
particular types of transactions and other events should be reflected in financial statements. Like
US GAAP, German GAAP etc. or IACs. However, the differences between two country’s GAAP
may be relatively minor that is similar to comparing languages like Dutch with Afrikaans or
Scottish with Irish. These differences, however small, will still result in miscommunication.
The acronym "IAS" stands for International Accounting Standards. This is a set of
accounting standards set by the International Accounting Standards Committee (IASC), located
in London, England. The IASC has a number of different bodies, the main one being the
International Accounting Standards Board (IASB), which is the standard-setting body of the
IASC.
The IASC does not set GAAP, nor does it have any legal authority over GAAP. However,
a lot of people actually do listen to what the IASC and IASB have to say on matters of
accounting.
When the IASB sets a new accounting standard, a number of countries tend to adopt the
standard, or at least interpret it, and fit it into their individual country's accounting standards.
These standards, as set by each particular country's accounting standards board, will in turn
influence what becomes GAAP for each particular country. For example, in the United States,
the Financial Accounting Standards Board (FASB) makes up the rules and regulations which
become GAAP. The best way to think of GAAP is as a set of rules that accountants follow. Each
country has its own GAAP, but on the whole, there aren't many differences between countries.
To avoid the miscommunication, accounts all over the world are joining together to
develop a single global accounting language, that is understandable and of a high quality. The
rules of this language are explained in a set of global standards, i.e. IFRS. All the countries that
adopt the global accounting language, must comply with these rules (IFRSs).
To fulfill the Need for one globally accepted accounting standards that could provide
quality, reliability and transparency in financial reporting, in the year 2001 IASC was
restructured and IASB (International Accounting Standards Board) was born. IASB adopted all
the Pronouncements issued by its predecessor body and all subsequent pronouncements where
Termed as IFRS. In short the rules of our global accounting consist of:
♦ The Framework
♦ The global accounting standards (IFRS), including both the (i) standards (IASs
and IFRS) and their (ii) Interpretations (SICs and IFRICs), short detail is as under:
♦ IAS – Standards issued before 2001 (total 41 IAS issued)
♦ IFRS –Standards issued after 2001 (total 13 IFRS issued)

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 ♦ SIC-Interpretations of accounting standards, giving specific guidance on unclear
issues (34 SIC)
♦ IFRIC- Newer interpretations, issued after 2001 (15 IFRIC) All International
Accounting Standards (IASs) and Interpretations issued by the former IASC
(International Accounting Standard Committee) and SIC (Standard Interpretation
Committee) continue to be applicable unless and until they are amended or
withdrawn.

1.1.1 Significance of IFRS adoption

During the last decade with the advent of Globalization , the need and importance of
IFRS has gained strength , especially after their adoption by the European Union in 2005 and the
Securities and Exchange commission of the US allowing foreign listed companies to file
financial statements with IFRS (without reconciliation with the US GAAPS . At present more
than 100countries permit or require the use of IFRS, and many more look forward to achieving
convergence /adoption by 2011. This global recognition for IFRS is on account of following
benefits:
♦ Comparability: Financial Statements of local entities can be easily and reliably be compared
with their Global peers; this feature allows prospective investors and stakeholders, in assessing
the performance of entities accurately
♦ Cross – Border Investments: Adoption/convergence with IFRS is likely to promote
investments, because of the goodwill which IFRS enjoys with the Global investor
communities
♦ Multiple-Reporting: Different entities within the group that reside in different
jurisdictions maybe required to prepare a dual set of financial statements for external
financial reporting; one for local statutory financial reporting in the home country and
second for reporting to the parent company. This increases the efforts of the finance
function, introduces complexity in financial reporting and increases costs of the finance
function. Group-wide adoption of IFRS will eliminate the need for such multiple reporting,
if IFRS is accepted or required in all countries of operation
♦ Cost of Capital: IFRS eliminates barriers to cross-border listings as it is accepted as a global
financial reporting framework and allows companies to seek admission to almost all of the
world's bourses. Even in cases where listing on overseas exchanges is permitted using local
GAAP, international investors generally ascribe an additional risk premium if the underlying
financial information is not prepared in accordance with international standards.

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1.1.2 Objective of IFRS
The objective of IFRS is to develop, in the public interest, a single set of high quality,
understandable and enforceable global accounting standards that require high quality, transparent
and comparable information in financial statements and other financial reporting to help
participants in the world's capital markets and other users make economic decisions and to promote
the use and rigorous application of those standards taking into account of the special needs of small
and medium-sized entities and emerging economies and thus bring about convergence of national
accounting standards and International Accounting standards.

1.1.3 Scope of IFRS

IFRS set out recognition, measurement, presentation and disclosure requirements of
transaction and events in general purpose financial statements. General purpose financial
statements are intended to meet the common needs of shareholders, creditors, employees, and the
public at large for information about an entity's financial position, performance, and cash flows.
Other financial reporting includes information provided outside financial statements that assists
in the interpretation of a complete set of financial statements or improves users' ability to make
efficient economic decisions. IFRS applies to the general purpose financial statements and other
financial reporting by profit-oriented entities regardless of their legal form. Entities other than
profit-oriented business entities may also find IFRSs appropriate. IFRS apply to individual
company and consolidated financial statements. Some IFRS allows both a 'benchmark' and an
'allowed alternative 'treatment’.

1.1.4 IFRS versus GAAP

The statement of GAAP is short for: Statements of Generally Accepted Accounting
Practice. These include the documented acceptable methods used by businesses to ‘recognise,
measure and disclose’ business transactions. The best of these statements from all over the world
are being merged into the IFRSs, which is short for International Financial Reporting Standards.
The biggest difference is that IFRS provides fewer detailed rules than U.S. GAAP. IFRS also
contains limited industry-specific guidance.
Because of longstanding convergence projects between the IASB and the FASB, the
extent of the specific differences between IFRS and GAAP has been shrinking. Yet significant
differences do remain, most any one of which can result in significantly different reported results,
depending on a company's industry and individual facts and circumstances. For example:
♦ IFRS does not permit Last In, First Out (LIFO).
♦ IFRS uses a single-step method for impairment write-downs rather than the

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 two-step method used in U.S. GAAP, making write-downs more likely.
♦ IFRS requires capitalization of development costs once certain qualifying criteria
are met. U.S. GAAP generally requires development costs to be expensed as
incurred, except for costs related to the development of computer software, for
which capitalization is required once certain criteria are met.

1.2 IMPORTANT BODIES BEHIND THE IFRS

1.2.1 IFRS Foundation.
The IFRS (International Financial Reporting Standards) Foundation is an independent,
not-for-profit private sector organization working in the public interest. Its principal objectives
are:
♦ To develop a single set of high quality, understandable, enforceable and globally
accepted international financial reporting standards (IFRSs) through its
standard-setting body, the IASB;
♦ To promote the use and rigorous application of those standards;
♦ To take account of the financial reporting needs of emerging economies and small
and medium-sized entities (SMEs); and
♦ To promote and facilitate adoption of International Financial Reporting Standards
(IFRSs), being the standards and interpretations issued by the IASB, through the
convergence of national accounting standards and IFRSs.
The governance and oversight of the activities undertaken by the IFRS Foundation and its
standard-setting body rests with its Trustees, who are also responsible for safeguarding the
independence of the IASB and ensuring the financing of the organization. The Trustees are
publicly accountable to a Monitoring Board of public authorities.

1.2.2 The IASB (International Accounting Standards Board)

The IASB is the independent standard-setting body of the IFRS Foundation, established
in April, 2001 in replacement of International accounting Standards Committee which was
established in June 1973 in London. Its members (currently 15 full-time members) are
responsible for the development and publication of IFRSs, including the IFRS for SMEs and for
approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee
(formerly called the IFRIC). All meetings of the IASB are held in public and webcast. In
fulfilling its standard-setting duties the IASB follows a thorough, open and transparent due
process of which the publication of consultative documents, such as discussion papers and
exposure drafts, for public comment is an important component. The IASB engages closely with

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stakeholders around the world, including investors, analysts, regulators, business leaders,
accounting standard-setters and the accountancy profession.

1.2.3 The IFRS Interpretations Committee

The IFRS Interpretations Committee is the interpretative body of the IASB. The Interpretations
Committee comprises 14 voting members appointed by the Trustees and drawn from a variety of countries
and professional backgrounds. The mandate of the Interpretations Committee is to review on a timely
basis widespread accounting issues that have arisen within the context of current IFRSs and to provide
authoritative guidance (IFRICs) on those issues. Interpretation Committee meetings are open to the public and
webcast. In developing interpretations, the Interpretations Committee works closely with similar national
committees and follows a transparent, thorough and open due process.

1.3 THE REGULATORY FRAMEWORK OF ACCOUNTING

The regulatory framework of accounting consists of the followings:
♦ The Regulatory System
♦ Regulatory Bodies
♦ Standard- Setting Process
The Regulatory System
The current standard-setting regime was introduced in 1990 and is as follows:

Financial Reporting Council

The FRC Promotes Good
Financial Reporting

Accounting Standards Board Financial Reporting Review Panel

The ASB develops, issues and The FRRP inquiries into apparent
withdraws accounting standards. Departures from accounting standards and the
provisions of the companies Acts in the annual
accounts of large companies.
Urgent Issue Task Force
The UITF assists the ASB in areas
Where an accounting standard or
Companies Act provision exists, but
Where unsatisfactory or conflicting
interpretations have developed or
Seem likely to develop.

1.3.1 Financial Reporting Council

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 The role of the Financial Reporting Council (FRC) is to guide the standard-setting
process and to ensure that its work is properly funded. It is also the ‘Political’ front to the bodies
involved in the standard setting process and produces and annual review which summarizes
recent events and likely action by the bodies. The FRC comprises around 25 members drawn
from the users and preparers of accounts, and auditors.

1.3.2 Accounting Standards Board

The aims of the ASB are to establish and improve financial accounting and Reporting
standards, for the benefit of users, preparers, and auditors of financial information.
The ASB intends to achieve its aims by:
♦ Developing principles to guide it in establishing standards and to provide a
framework within which others can exercise judgment in resolving accounting
issues
♦ Issuing new accounting standards, or amending existing ones, in response to
evolving business practices, new economic developments and deficiencies being
identified in current practice
♦ Addressing urgent issues promptly
♦ Working with the International Accounting Standards Board (IASB), with
national standard setters and relevant European Union (EU) institutions to
encourage high quality in the IASB's standards and their adoption in the EU.

1.3.2.1 The ASB has:

♦ up to ten members
♦ a full-time chairman
♦ a full-time technical director
♦ part-time members who are all well versed in accounting and financial matters.

1.3.3 Financial Reporting Review Panel

The FRRP has about 30 members and is concerned with the examination and questioning
of departures from accounting standards by large companies. In consultation with the Financial
Services Authority (FSA) (the regulator of listed companies) it will select industry sectors which
are likely to give rise to difficult accounting issues.
It will then select from each of them a number of accounts for review and will also
investigate matters that are brought to its attention.

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1.3.3.1 The powers of the FRRP are:
♦ For serious breaches it can now require companies to redraft the offending
accounts
♦ For minor faults it is more likely to ask the companies for an assurance that the
rules will be complied with in the future.

1.3.4 Urgent Issues Task Force

The UITF is a committee of the Accounting Standards Board (ASB) and is made up of a
number of people of major standing in the field of financial reporting.

1.3.4.1 The role of the UITF is to:

The UITF is only concerned with significant disparities of current practice or major
developments likely to create serious divergences in the future.
♦ Help the ASB in situations where either an accounting standard or a provision of the
Companies Act exists, but where different interpretations, which may be unsatisfactory or
conflicting, have developed
♦ Determine a consensus (UITF Abstract) of the appropriate accounting treatment
♦ Reach this consensus by relying on principles rather than detailed rules.
The UITF is only concerned with significant disparities of current practice or major
developments likely to create serious divergences in the future.

1.3.5 Why a regulatory framework is necessary

A regulatory framework for the preparation of financial statements is necessary for the
following reasons:
 Financial statements are used by a wide range of users – investors, lenders, customers,
etc.
 They need to be useful to these users
 They need to be comparable
 They need to provide some basic information
 They increase users’ understanding of and confidence in financial statements
 They regulate the behaviour of companies towards their investors.
Accounting standards on their own would not be a complete regulatory framework. In
order to fully regulate the preparation of financial statements and the obligations of companies
and directors legal and market regulations are also required.

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1.4 PRINCIPLES-BASED AND RULES-BASED FRAMEWORK
1.4.1 Principles-based framework:
 Based upon a conceptual framework such as the Statement of Principles
 Accounting standards set on the basis of the conceptual framework.
No of accounting standards are designed on the basis of principles based conceptual
framework of accounting, named as International accounting standards and International
financial reporting standards. (See Appendix 1 and Appendix 2).

1.4.2 Rules-based framework:

‘Cookbook’ approach
Accounting standards are a set of rules which companies must follow.
On the basis of rules based accounting, number of rules are designed named as GAAP’s,
which are implemented on these countries which don’t follow the International Accounting
Standards or International Financial Reporting Standards, For example USA is one of the
countries, which follow GAAP’s known as US GAAP.
1.4 THE CONCEPTUAL FRAMEWORK OF ACCOUNTING

CONCEPTUAL FRAMEWORK

THE STATEMENT OF
PRINCIPLES

QUALITATIVE CHARACTERISTICS ELEMENTS OF FINANCIAL

OF FINANCIAL INFORMATION STATEMENTS

MATERIALITY RECOGNITION OF ELEMENTS

OF FINANCIAL STATEMENTS

UNDERSTANDABILITY RELEVANCE RELIABILITY COMPAARABILITY

1.5.1 Introduction
There are two main approaches to accounting:
 Principles based approach such as that used by the IASB
 Rules based approach such as that used in the USA.

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1.5.2 What is a conceptual framework?
A conceptual framework is:
 a coherent system of interrelated objectives and fundamental principles
 a framework which prescribes the nature, function and limits of financial accounting and
financial statements.

1.5.3 Why have a conceptual Framework
There are a variety of arguments for having a conceptual framework:
 It enables accounting standards and generally accepted accounting principles (GAAP) to
be developed in accordance with agreed principles.
 It avoids ‘fire-fighting’, whereby accounting standards are developed in a piecemeal way
in response to specific problems or abuses.
 ‘Fire-fighting’ can lead to inconsistencies between different accounting standards, and
between accounting standards and legislation.
 Lack of a conceptual framework may mean that certain critical issues are not addressed,
e.g. until recently there was no definition of basic terms such as ‘assets’ or ‘liabilities’ in
any accounting standards.
 As transactions become more complex and businesses become more sophisticated it helps
preparers and auditors of accounts to deal with transactions which are not the subject of
an accounting standard.
 Accounting standards based on principles are thought to be harder to circumvent.
 A conceptual framework strengthens the credibility of financial reporting and the
accounting profession for the user’s countries.
 It makes it less likely that the standard-setting process can be influenced by ‘vested
interests’ (e.g. large companies/business sectors).

1.5.4 Alternative rules-based system
A possible alternative to a conceptual framework is a prescriptive ‘cookbook’ approach
based on rules rather than principles. This is the approach in the US
Principles are harder to circumvent and therefore preferable to a rules-based approach.

1.5.5 Purposes of the Framework

The conceptual framework published by the IASB is called the Framework. It includes
guidance with regard to
 The qualitative characteristics of financial information

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  The elements of financial statements
 Recognition of the elements of financial statements.
The purpose of the Framework is to:
 Help the IASB in their role of developing future accounting standards and in reviewing
existing IFRSs
 Help the IASB by providing a basic for reducing the number of alternative accounting
treatments permitted by IFRSs
 Help national standard-setting bodies in developing national standards
 Help those preparing financial statements to apply IFRSs and also to deal with areas
where there is no relevant standard
 Help auditors when they are forming an opinion as to whether financial statements
conform with IFRSs
 Help users of financial statements when they are trying to interpret the information in
financial statements which have been prepared in accordance with IFRSs
 Provide information to other parties that are interested in the work of the IASB

1.6 QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION

1.6.1 Introduction
Qualitative characteristics are the attributes that make information provided in financial
statements useful to others.
The statement of principles identifies four qualitative characteristics:
 relevance
 reliability
 comparability
 understandability
All are subject to a threshold quality of materiality.

1.6.2 Materiality
The Statement of Principles discusses materiality.
Information is material to the financial statements if its misstatement or omission might
reasonably be expected to influence the economic decisions of users.
 It is a threshold quality which should be applied to all information in the financial
statements.
 Information that is material needs to be included in the financial statements.
 Information that is not material should not be included.

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  Whether information is material will depend upon the size if the item and its nature but
within the particular circumstances of the item and the entity.

1.6.3 Understanding
Understandability depends on:
 The way in which information is shown in the financial statements
 The capabilities of the users of the financial statements.
It is assumed that users:
 Have a reasonable knowledge of business and economic activities
 Are willing to study the information provided with reasonable diligence.
For information to be understandable users need to be able to perceive its significance; it
must be included in the financial statements if it is relevant and reliable even if it is difficult for
some users to understand.

1.6.4 Relevance
Information is relevant if it has the ability to influence the economic decisions of users
and is provided in time to influence those decisions.

1.6.4.1 Qualities of relevance

Relevance can be evaluated according to three qualitative criteria:
i. Timeliness: Accounting information should be timely if it is to influence decisions.
Like the news of the world, stale financial information has less impact than fresh
information. Lack of timeliness reduces relevance.
ii. Predictive Value: Accounting information should be helpful to external decision
makers by increasing their ability to make predictions about the outcome of future events.
Decision makers working from accounting information that has little or no predictive value
are merely speculating.
iii. Feedback value: accounting information should be helpful to external decision makers
who are confirming past predictions or making updates, adjustments, or corrections to
predictions.

1.6.5 Reliability
Reliable information can be depended upon to present a faithful representation and is
neutral, error free, complete and prudent.

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1.6.5.1 Qualities of reliability
Like relevance, reliability must meet three qualitative criteria:
i. Representational faithfulness: Accounting information should represent what are
purports to represent and should ensure that the selected method of measurement has
been used without error or bias. This attribute is sometimes called Validity. Information
must report the economic substance of transactions, not just their form and surface
appearance.
ii. Verifiability: Verifiability pertains to maintenance of audit trails to information source
documents that can be checked for accuracy. Verifiability also pertains to the existence of
alternative information sources as backup. Verification implies a consensus and implies
that independent measures using the same measurement methods would reach
substantially the same conclusion.
iii. Neutrality: Accounting information must be free from bias regarding a particular
viewpoint, predetermined result, or particular party. Preparers of financial reports must
not attempt to induce a predetermined outcome or a particular mode of behavior

1.6.6 Comparability
Comparability enables users to identify similarities and differences between two or more
sets of economic circumstances.
For example, users must be able to:
 Compare the financial statements of an entity over time in order to identify trends
 Compare the financial statements of different entities in order to evaluate their relative
financial position and performance.
For this to be possible there must be consistency and disclosure of accounting policies.
An important implication of comparability is that users are informed of the accounting
policies employed in preparation of the financial statements, any changes in those policies and
the effects of such changes. Compliance with accounting standards, including the disclosure of
the accounting policies used by the entity, helps to achieve comparability.
Because users wish to compare the financial position and the performance and changes in
the financial position of an entity over time, it is important that the financial statements show
corresponding information for the preceding periods.

1.7 ELEMENTS OF THE FINANCIAL STATEMENTS

1.7.1 Assets

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 Assets are rights or other access to future economic benefits controlled by an entity as a
result of past transactions or events.

Explanation:
 Controlled by the entity: Control is the ability to obtain the economic benefits and to
restrict the access of others
 Past events: The event must be ‘Past’ before an asset can arise. For example, a machine
will only become an asset when there is the right to demand delivery or access to the
asset’s potential.
 Future economic benefits: these are evidenced by the prospective receipt of cash. This
could be cash itself, a debt receivable or any item which may be sold.

1.7.2 Liabilities
Liabilities are an entity’s obligations to transfer economic benefits as a result of past
transactions or events.

Explanation:
 Obligations: these may be legal or constructive. A constructive obligation is an obligation
which is the result of expected practice rather than required by law or a legal contract.
 Transfer economic benefits: This could be a transfer of cash, or other property, the
provision of a service, or the refraining from activities which would otherwise be
profitable.
 Past transaction or events: The event must be ‘Past’ before a liability can arise.

1.7.3 Ownership interest

Ownership interest is the residual amount found by deducting all liabilities of the entity
from all of the entity’s assets.

Explanation:
It may also be called Equity interest. The above mentioned definition describes the
residual nature of equity interest. Owner’s wealth can be increased whether or not a distribution
is made. The sharing may be in different proportions. Equity interest is usually analyzed in
financial statements to distinguish interest arising from owner’s contributions from that resulting
from other events. The latter is split into different reserves which may have different applications
or legal status.

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1.7.4 Income/Gains
 Transactions that result in increases in ownership interest, not resulting from
contributions from owners.
 An increase in economic benefits during an accounting period in the form of cash
inflows, or enhancements of assets or decreases in liabilities.

1.7.5 Expense/Losses
 Transactions that result in decreases in ownership interest, not resulting from
distributions to owners.
 Decreases in economic benefits during the accounting period in the form of outflows or
depletion of assets or incurrence of liabilities.

1.7.6 Contribution from owners

Contributions from owners are increases in ownership interests resulting from transfers
from owners in their capacity as owners.

1.7.7 Distribution to owners

Distributions to owners are decreases in ownership interest resulting from transfers to
owners in their capacity as owners.

1.8 RECOGNITION OF ASSETS, LIABILITIES, INCOME AND EXPENSES

Recognition
Recognition is the depiction of an element by words and by a monetary amount in the
financial statements.

1.8.1 Recognition of assets

An asset will only be recognized if it gives rights or other access to future economic
benefits controlled by an entity as a result of past transactions or events, and it can be measured
with sufficient reliability.

1.8.2 Recognition of liabilities

A liability will only be recognized if there is an obligation to transfer economic benefits
as a result of past transactions or events, and it can be measured with sufficient reliability.

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1.8.3 Recognition of income
Income is recognized in the profit and loss account when an increase in future economic
benefits arises from an increase in an asset (or a reduction in a liability), and this can be
measured reliably.

1.8.4 Recognition of expenses

Expenses are recognized in the profit and loss account when a decrease in future
economic benefit arises from a decrease in an asset or an increase in a liability and this can be
measured reliably.
1.8.5 Balance sheet approach to recognition
It can be seen therefore that:
 Income is an increase in an asset/decrease in a liability
 Expenses are an increase in a liability/decrease in an asset
As income and expenses are therefore recognized on the basis of changes in assets and
liabilities this is known as a balance sheet approach to recognition.

1.9 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND

ERRORS.
1.9.1 ACCOUNTING POLICIES
Accounting policies are the principles, bases, conventions, rules and practices applied by
an entity which specify how the effects of transactions and other events are reflected in the
financial statements.
IAS 8 requires an entity to select and apply appropriate accounting policies complying
with International Financial Reporting Standards (IFRSs) and Interpretations to ensure that the
financial statements provide information that is:
 Consistent with accounting standards
 Judged against the objectives of relevance, reliability, comparability and
understandability.

1.9.1.1 Change of accounting policy

Accounting policies are normally kept the same from period to period to ensure the
comparability of financial statements over time.
IAS 8 requires accounting policies to be changed only if the change:
 Is required by IFRSs or

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  Will result in a reliable and more relevant presentation of events or transactions
A change in accounting policy has been made if there has been a change in:
 Recognition, e.g. development expenditure now recognized as an expense rather than an
asset
 Representation, e.g. depreciation now included in cost of sales rather than administrative
expenses, or
 Measurement basis, e.g. stating assets at replacement cost rather than historical cost.

1.9.1.2 Disclosure requirements

When a change in accounting has a material effect on the current period or any prior
period presented, or may have a material effect in subsequent periods, the following disclosures
should be made:
 The reasons for the change
 The amounts of the adjustments recognized in the current period and the previous period
presented
 The amount of the adjustment relating to periods prior to those included in the financial
statements.

1.9.2 ESTIMATION TECHNIQUES

An estimation technique or Accounting estimate is a method adopted by an entity to
arrive at estimated amounts for the financial statements. e.g. change in useful life, residual value
and method of depreciation of non-current assets.

1.9.2.1 Accounting for changes in estimates

IAS 8 requires that:
 The effects of a change in accounting estimate should be included in the income
statement in the period of the change and, if subsequent periods are affected, in those
subsequent periods.
 The effects of the change should be included in the same income or expenses
classification as was used for the original estimate
 If the effect of the change is material, its nature and amount must be disclosed.

1.9.3 PRIOR PERIOD ADJUSTMENT

Prior period adjustments are material adjustments applicable to prior periods arising
from:

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  Changes in accounting policy or
 Correction of fundamental errors.

1.9.3.1 Prior period adjustments tend to be quite rare.

Fundamental errors are extremely rare. They are those errors which are so large that they
destroy the true and fair view.

1.9.3.2 Accounting for a prior period adjustment

To find the prior period adjustment figure calculate what amounts would have been in the
opening balance sheet for the current year on the new basis.
The difference in opening net assets for the current year on the new basis compared to the old
basis gives the prior period adjustment.

1.9.3.3 Use the prior period adjustment to adjust:

 Opening reserves for the current year, shown in the statement of reserves and in the
statement of total recognized gains and losses
 Opening shareholders’ funds in the reconciliation of movements in shareholders’ funds
 Balance sheet comparatives in the current year’s accounts.

1.9.4 ACCOUNTING CONCEPTS

Two accounting concepts as playing a pervasive role in the selection of accounting
policies:
 The going concern assumption
 The accruals basis of accounting.

1.9.4.1 The going Concern assumption:

Under the going concern assumption, the business entity in question is expected not to
liquidate but to continue operations for the foreseeable future. That is, it will stay in business for
a period of time sufficient to carry out contemplated operations, contracts, and commitments.
This non liquidation assumption provides a conceptual basis for many of the
classifications used in accounting. Assets and liabilities, for example, are classifies as either
current or long term on the basis of this assumption. If continuity is not assumed, the distinction
between current and long term loses its significance; all assets and liabilities become current.
Continuity supports the measurement and recording of assets and liabilities at historical cost.

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 If a business entity expects to be liquidated in the near future, onventional accounting,
based on the continuity assumption, is not appropriate. Such circumstances call instead for the
use of liquidation accounting, which values assets and liabilities at estimated net realizable
amounts (liquidation values)
An entity should prepare its financial statements on a going concern basis unless:
i. The entity is being liquidated or has ceased trading
ii. The directors either intend to liquidate the entity or to cease trading, or have no realistic
alternative but to do so.
The directors should assess whether there are significant doubts about an entity’s ability
to continue as a going concern.

1.9.4.2 The accruals basis of accounting

Accruals basis accounting requires that an event that alters the economic status of a firm
as represented in its financial statements be recorded (recognized) in the period in which the
event occurs rather than in the period when cash changes hands.
An entity should prepare its financial statements, except for cash flow information, on the
accruals basis of accounting.

1.9.4.3 Matching concept

According to the accrual assumption in computing profit, revenue earned must be
matched against the expenditure incurred in earning it. OR
Simply, matching cost with revenue is called the matching concept for example taking
the difference of sales and cost of sales sold to find gross profit is nothing but the matching
concept.

1.9.4.4 Consistency of presentation:

To maintain consistency, the presentation and classification of items in the financial
statements should stay the same from one period to the next.
Exceptions to the above rule:
The above stated rule could be changed when there is a significant change in the nature of
the operations or a review of the financial statements presentation indicates a more appropriate
presentation, for example;
i. Changing depreciation method from straight line to diminishing balance or
ii. Changing method for valuation of closing stock from LIFO to FIFO

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1.9.4.5 Materiality and aggregation
Amounts which are immaterial can be aggregated with amounts of a similar nature or
function and need not presented separately.

1.9.4.6 Materiality Concept

Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of financial statements, for example; if abnormal loss is not
disclosed in the F.S it would mislead the users of F.S in their decisions so it is material and must
be disclosed.

1.9.4.7 Offsetting
IAS 1 does not allow the assets and liabilities to be offset against each other (because
then there would be no need for B/S)
Income and expenses can only be offset only when:
i. An IAS permits/requires or
ii. Gains, losses and related expenses arising from the same/similar transactions are not
material (aggregate).

1.9.4.8 Prudence
The inclusion of a degree of caution in the exercise of the judgments needed in making
the estimates required under conditions of uncertainty, such that assets or income are not
overstated and liabilities or expenses are not understated.
For example; Valuation of closing stock at lower of cost and NRV and subtracting the provisions
for doubtful debts from total debtors is an ample example of the prudence concept.

1.9.4.9 Substance over form

The principle is that the transactions and other events are accounted for and presented in
accordance with their substance and economic reality and not merely their legal form.

1.9.4.10 Objectivity
The rule that an accountant must be free from bias is called objectivity

1.9.4.11 Realization Concept

Revenue and profits are recognised when realised or revenue and profit are not
anticipated.

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1.10 MEASUREMENT IN FINANCIAL STATEMENTS
 Historical cost
 Replacement Cost
 Fair Value
 Net Realizable Value
 Economic Value

1.10.1 Historical cost:

Assets are recorded at the fair value of the consideration given to acquire them at the time
of their acquisition. Liabilities are recorded at the fair value of the consideration received in
exchange for incurring the obligations at the time they were incurred.

1.10.1.1 Demerits or deficiencies of historical cost accounts

In periods in which prices change significantly, historical accounts have grave
deficiencies:
 Carrying value (CV) of non-current assets is often substantially below current value
 Inventory in the statement of financial position reflects prices at the date of purchase or
manufacture rather than those current at the year end
 Income statement expenses do not reflect the current value of assets consumed so profit
in real terms is exaggerated
 If profit were distributed in full, the level of operations would have to be curtailed
 No account is taken of the effect of increasing prices on monetary items
 The overstatement of profits and the understatement of assets prevent a meaningful
calculation of return on capital employed (ROCE)

1.10.1.2 Alternatives to historical cost accounting

The alternative to historical cost accounting is a form of current value accounting either:
 Constant purchasing power (CPP), or
 Current cost accounting (CCA)

1.10.2 Replacement cost (of an asset):

The most economic current cost of replacing an existing asset with an asset of equivalent
productive capacity or service potential.

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1.10.3 Fair value:
The amount for which an asset or liability could be exchanged between knowledgeable,
willing parties in an arm’s length transaction.
It may be described as, the amount at which that asset (or liability) could be bought (or
incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in
a forced or liquidation sale.

1.10.4 Net realizable value (of an asset):

The estimated selling price in the ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale
It is defined in similar terms by other standard setters and in other authoritative literature.
It has sometimes been described as “net selling value” and “net market value”. While not explicit
in the above definition, it is presumed to be a current value, that is, the value on the measurement
date. Again, the equivalent liability definition does not seem to have been formally defined in
accounting literature, but it is proposed that it may be defined as the estimated amount that
would be incurred in the ordinary course of business to be released from the liability on the
measurement date plus the estimated costs necessary to secure that release.

ASSESSMENT QUESTIONS
i. Describe what is meant by a conceptual framework of accounting? Also
discuss whether a conceptual framework is necessary and what an alternative system mig
-ht be.
ii. Discuss what is meant by understandability,
relevance and reliability and describe the qualities that enhance these characteristics.
Also discuss the importance of comparability to users of financial Statements
iii. Distinguish between changes in accounting policies and changes in accounting estimates
and describe how accounting standards apply the principle of comparability where an en
tity changes its accounting policies.
iv. Define what is meant by ‘recognition’ in financial statements and discuss the recogni-
ion criteria. Also apply the recognition criteria to:
a. assets and liabilities
b. income and expenses.
v. Explain the following measures and compute amounts using:
a. Historical cost

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 b. Fair value/current cost
c. Net realizable value
d. Present value of future cash flows.
vi. Apply the principle of substance of over form to
the recognition and de-recognition of assets and liabilities.
vii. Recognize the substance of transactions in general, and specifically account for the f
ollowing types of transaction:
a. goods sold on sale or return/consignment stock
b. sale and repurchase/leaseback agreements
c. factoring of debtors.
viii. Describe the advantages and disadvantages of the use of historical cost accounting.
ix. Discuss whether the use of current value accounting overcomes the problems of historic
al cost accounting.
x. Distinguish between a principles-based and a rules-based framework and discuss whether
they can be complementary.

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APPENDIX 1.1
International Accounting Standards

No Name Issued

IAS 1 Presentation of Financial Statements 2007

IAS 2 Inventories 2005

Consolidated Financial Statements

IAS 3 1976
Superseded in 1989 by IAS 27 and IAS 28

Depreciation Accounting
IAS 4
Withdrawn in 1999

Information to Be Disclosed in Financial Statements

IAS 5 1976
Superseded by IAS 1 effective 1 July 1998

Accounting Responses to Changing Prices

IAS 6
Superseded by IAS 15, which was withdrawn December 2003

IAS 7 Statement of Cash Flows 1992

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 2003

Accounting for Research and Development Activities

IAS 9
Superseded by IAS 39 effective 1 July 1999

IAS 10 Events After the Reporting Period 2003

IAS 11 Construction Contracts 1993

IAS 12 Income Taxes 1996

Presentation of Current Assets and Current Liabilities

IAS 13
Superseded by IAS 39 effective 1 July 1998

IAS 14 Segment Reporting 1997

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 Superseded by IFRS 8 effective 1 January 2009

Information Reflecting the Effects of Changing Prices

IAS 15 2003
Withdrawn December 2003

IAS 16 Property, Plant and Equipment 2003

IAS 17 Leases 2003

IAS 18 Revenue 1993

Employee Benefits
IAS 19 1998
Superseded by IAS 19 (2011) effective 1 January 2013

IAS 19 Employee Benefits (2011) 2011

Accounting for Government Grants and Disclosure of

IAS 20 1983
Government Assistance

IAS 21 The Effects of Changes in Foreign Exchange Rates 2003

Business Combinations
IAS 22 1998
Superseded by IFRS 3 effective 31 March 2004

IAS 23 Borrowing Costs 2007

IAS 24 Related Party Disclosures 2009

Accounting for Investments

IAS 25
Superseded by IAS 39 and IAS 40 effective 2001

IAS 26 Accounting and Reporting by Retirement Benefit Plans 1987

IAS 27 Separate Financial Statements (2011) 2011

Consolidated and Separate Financial Statements

IAS 27 Superseded by IFRS 10, IFRS 12 and IAS 27 (2011) effective 1 2003
January 2013

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IAS 28 Investments in Associates and Joint Ventures (2011) 2011

Investments in Associates
IAS 28 Superseded by IAS 28 (2011) and IFRS 12 effective 1 January 2003
2013

IAS 29 Financial Reporting in Hyperinflationary Economies 1989

Disclosures in the Financial Statements of Banks and Similar

IAS 30 Financial Institutions 1990
Superseded by IFRS 7 effective 1 January 2007

Interests In Joint Ventures

IAS 31 2003
Superseded by IFRS 11 and IFRS 12 effective 1 January 2013

IAS 32 Financial Instruments: Presentation 2003

IAS 33 Earnings Per Share 2003

IAS 34 Interim Financial Reporting 1998

Discontinuing Operations
IAS 35 1998
Superseded by IFRS 5 effective 1 January 2005

IAS 36 Impairment of Assets 2004

IAS 37 Provisions, Contingent Liabilities and Contingent Assets 1998

IAS 38 Intangible Assets 2004

Financial Instruments: Recognition and Measurement

IAS 39 2003
Superseded by IFRS 9 effective 1 January 2015

IAS 40 Investment Property 2003

IAS 41 Agriculture 2001

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APPENDIX 1.2
International Financial Reporting Standards

No Name Issued

IFRS 1 First-time Adoption of International Financial Standards 2008

IFRS 2 Share-based Payment 2004

IFRS 3 Business Combinations 2008

IFRS 4 Insurance Contracts 2004

Non-current Assets Held for Sale and Discontinued

IFRS 5 2004
Operations

IFRS 6 Exploration for and Evaluation of Mineral Assets 2004

IFRS 7 Financial Instruments: Disclosures 2005

IFRS 8 Operating Segments 2006

IFRS 9 Financial Instruments 2010

IFRS 10 Consolidated Financial Statements 2011

IFRS 11 Joint Arrangements 2011

IFRS 12 Disclosure of Interests in Other Entities 2011

IFRS 13 Fair Value Measurement 2011

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