One of the outcomes on the Paper FA2 syllabus is ‘Explain generally accepted accounting principles and concepts’. This outcome seems to cause difficulties for some candidates. These difficulties may arise because the outcome is, unlike the majority of the syllabus, theoretical.
This is the first of two articles that will discuss the two subparts of the outcome – ‘underlying principles’ will feature in this article, while ‘qualitative characteristics’ will be the focus of a second article.
Another theoretical outcome, ‘The principles and process of bookkeeping’, refers to the meaning of the accounting equation, assets, liabilities and capital. These topics will be covered in a third article.
Principles and characteristics
The differentiation between principles and characteristics is clearly set out in the Study Guide, so it’s fair to assume that this isn’t something that will cause much difficulty for candidates. Therefore, it is important for candidates to ensure that attention has been directed to each of the individual items listed on the Study Guide. What candidates need to know about each of these is:
- how it is defined, and
- how it should be applied.
Thus, the items dealt with in this article are:
- going concern
- double entry
- business entity
- historical cost
Each of these principles is considered below. In each case, where a formal definition is provided by the Conceptual Framework for Financial Reporting (‘the Framework’), that definition is given, followed by an elaboration of the key points of that definition that candidates need to understand.
Definition: ‘Financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.
The basic point about the going concern principle is that it is assumed that the entity will continue to operate for the foreseeable future. For Paper FA2, candidates do not need to consider the time period that might be regarded as the ‘foreseeable future’. This is an advanced issue that will be considered in later papers. The same can be said of issues such as:
- circumstances in which the going concern assumption might not apply
- what different basis could be used and
- who decides whether the going concern assumption should apply.
What is relevant to this paper is that there are two key consequences of the going concern assumption being applied. These are set out in the Framework as:
- the entity will not be liquidated, and
- in the (foreseeable) future, the scale (ie size and nature) of the entity’s operations will not be materially different to the recent past.
This touches on the principle of materiality, which is considered below.
A further point to bear in mind is that, while an awareness of what might be meant by ‘a different basis’ might be expected (for example, break up basis), candidates would not be expected to apply that basis to calculate values.
The Framework actually refers to ‘accrual accounting’ as opposed to ‘accruals’ (the term that is more widely used in everyday language – and the Study Guide).
Definition: ‘Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.’
This is perhaps a more theoretical definition than is given for going concern. However, it can also be understood by paraphrasing the wording into a more straightforward format.
Essentially, what accrual accounting means is that the date on which cash is paid or received is not treated as the date on which the transaction took place. The date is that on which the transaction took place. Although the definition might seem a little impenetrable at first reading, this is essentially a simple idea. If Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to pay for the goods, accrual accounting requires that the transaction is recorded. Thus, the transaction is recorded on 25 January.
Accrual accounting means that the accounting records will include balances for receivables (amounts that the entity expects to receive in the future as a result of past transactions) and payables (amounts that the entity expects to pay out in the future as a result of past transactions). When preparing final accounts (or, to use an alternative term, financial statements) it will be necessary to recognise any costs that have been paid, but not yet consumed (prepayments), as well as costs that have been consumed, but not paid (accrued expenses).
Accrual accounting is closely linked to the definitions of ‘assets’ and ‘liabilities’ and the accounting equation. These will be considered in a future article.
At this stage it is worth remembering that, while a number of the theoretical aspects of the syllabus are linked in the same way as has been noted above, candidates should ensure that they understand the key points of each principle or concept in isolation first of all. Once a good understanding has been developed at an individual level, it will be easier to make the links between the various concepts and principles.
Definition: ‘The use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.’
In essence, consistency is a straightforward principle. It is intended to enhance financial reporting by making it easier for users to make comparisons. In that sense it contributes to the achievement of comparability (which is considered in the second article).
By requiring similar items to be treated in the same way (‘the use of the same method’ as stated in the Framework), it is fairly obvious that this contributes to making comparisons more meaningful.
The two key points to note is that consistency should be applied in two ways:
- ‘from period to period’ – ie by a single entity, and
- ‘across entities’ – ie across entities (in the same period).
It is highly probable that this is one of the major hurdles that any candidate has to overcome. Double entry is often easier to do than to explain. For that reason, candidates would be wise to complete as many practice questions as possible before taking the exam,. It is also the reason why the topic can only be touched on in a relatively brief article such as this.
There is no definition of double entry in the Framework – although it is probably fair to say that this is the most fundamental underpinning principle in accounting. In the absence of a formal definition, it is probably best to start by noting that double entry arises from the fact that every transaction has a dual aspect (sometimes referred to as ‘duality’). The dual aspect means that each party in a transaction is affected in two ways by the transaction, hence:
every transaction gives rise to both a debit entry and a credit entry.
Given that the value of the debit entries is the same as the value of the credit entries it follows that, when a number of transactions have been recorded, the total value of the debit entries will be the same as the total value of the credit entries. This is the basis of the accounting equation (which will be considered in a future article).
All of this might best be explained by considering the transaction that was included in the discussion on accruals. This was Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to pay for the goods.
This straightforward example allows a key point about double entry to be made. Clearly there are two parties involved in the transaction. While both parties will record the transaction, that is not what is meant by double entry. It is important to remember that when preparing accounting entries, we are only dealing with a single entity. Double entry is not related to the fact that two parties are involved in a transaction.
From Andrea’s point of view the dual aspect is:
- she has obtained goods
- she has also incurred the responsibility to pay for the goods at a later date.
In a real-life situation (and in an exam question), it will be clear whether the goods have been bought with the intention of selling them at a profit, or if they have been bought for consumption within the business. For the moment, let’s assume that Andrea has bought the goods for resale. That means we can now identify the two accounts in which entries will be made:
- goods for resale (or ‘purchases’ as is more often used to describe this account)
The next step is to decide which account will have the debit entry and which will have the credit entry. One way of doing this is to use a memory AID. The upper case letters have been used because the word itself is the AID – Asset Increase Debit.
This AID reminds us that, if an asset has been increased, then a debit entry is required. The AID can be expanded by changing one element within it at a time to the opposite state, leading to the opposite entry:
|Asset decreased (or reduced)||Credit|
It can therefore be deduced that:
|Liability decreased or reduced||Debit|
Using this logical approach, it should be possible to, first of all, identify which accounts will be affected and then how they will be affected.
Of course, this discussion also requires knowledge of the nature of assets and liabilities. As noted above, it is best to deal with one issue at a time, so the connection between double entry and the accounting equation will be considered in the third article.
Thus, if Andrea has incurred the responsibility to pay for the goods, she has clearly increased a liability. That means a credit entry is required in her payables account. It follows that the entry in her purchases account will be a debit.
The business entity principle simply means that, for the purpose of maintaining accounting records, the business is treated as a separate entity from the owner(s) of the business.
As Paper FA2 only relates to unincorporated businesses (sole traders and partnerships), this might seem like an unrealistic differentiation. Candidates should avoid getting too concerned about this and simply deal with transactions from the perspective of the business.
In our example, Andrea has been identified as the owner of the business. As she is a sole trader (ie her business is unincorporated), there are some important legal points to be noted. The first is that there is no legal differentiation between Andrea and her business. Following from that, Andrea will be personally responsible for any debts that the business incurs, and her personal assets may be used to settle business debts.
However, her personal assets are not included in the business records. In addition, if Andrea withdraws money for personal expenses, the nature of the expense is not recorded. All that is necessary is to record the fact that Andrea withdrew funds – with a debit entry in the drawings account and credit entry in the bank account.
Definition: ‘Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity.’
There are some key issues within this definition that candidates should be aware of.
The first is that materiality is different to accuracy. An example from the ACCA website may help to explain this:
‘ACCA is the global body for professional accountants with 162,000 members and 428,000 students.’
Anyone who is considering becoming an ACCA student will recognise that it is highly unlikely that there are exactly 162,000 members and exactly 428,000 students. However, those numbers (or a paraphrase of the combined total into the statement ‘over half a million members and students’) convey the important and useful information that ACCA is a very large and influential organisation.
We can also see this in the published financial statements of large businesses. These often report values in $000 or $m. While the exact values are not communicated, the essential information is provided as an aid to decision making.
This leads to the second issue – materiality is related to the fact that the purpose of financial statements is to provide information so that it can be used to make decisions about whether to undertake transactions with a particular business.
The final issue is that materiality is affected both by (i) whether information is included or omitted from financial statements and (ii) whether it is sufficiently informative.
Candidates in Paper FA2 will not be required to make a decision on an appropriate cut off level for materiality. This is a more advanced issue, which requires the exercise of professional judgment.
Theoretically, there are a number of bases that could be used to derive the value at which transactions are recorded. However, historical cost is the only one of these that needs to be considered in the context of Paper FA2.
Definition: Assets are recorded at the amount of cash… paid… to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation….’
(Some elements of the definition provided by the Conceptual Framework have been omitted as they are beyond the scope of the Paper FA2 syllabus.)
In simple terms this means that, for Paper FA2, assets and liabilities will continue to be recorded at the value at which they were initially recorded – and that value will be based on the cash value at the date of the transaction.
By ensuring that the key points of each of these principles are understood, candidates should be better prepared to answer questions that might arise in the exam.
Written by a member of the Paper FA2 examining team