One of the outcomes of the FA2 syllabus is to ‘Explain generally accepted accounting principles and concepts’. This outcome seems to cause difficulties for some candidates. These difficulties may arise because the outcome is more theoretical in nature than the majority of the syllabus and also tends to be examined in narrative style questions.
Principles and characteristics
It is important to note that the ‘principles of accounting’ are distinct from the ‘qualitative accounting characteristics’ and this differentiation between principles and characteristics is clearly set out in the Detailed Study Guide (‘the study guide’).
It is important for candidates to ensure that attention is 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.
This article relates solely to the ‘principles of accounting’ and, therefore, we will consider the following principles from the study guide:
- going concern
- accruals
- consistency
- double entry
- business entity
- materiality
- historical cost
- prudence
Each of these principles is considered below. In each case, where a formal definition is provided by the Conceptual Framework for Financial Reporting (the Conceptual Framework), that definition is given, followed by an elaboration of the key points of that definition that candidates need to understand.
Going concern
Definition: ‘Financial statements are normally prepared on the assumption that the reporting 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 enter liquidation or to cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.
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 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 exams. 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.
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 in the FA2 exam.
Accruals
The Framework actually refers to ‘accrual accounting’ as opposed to ‘accruals’ (the term that is more widely used in everyday language and in 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 often not necessarily the same as the date that the actual transaction takes place. In transactions between businesses, it is common for payment not to be made on the same date that an order is made or that goods are transferred.
Although the definition might seem a little complicated 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 actually pay for the goods, accrual accounting requires that the transaction is recorded when the sale/purchase takes place rather than when cash changes hands. Thus, the initial sale and purchase 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 yet paid for (accrued expenses).
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.
Consistency
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 one of the qualitative characteristics of useful financial information.
By requiring similar items to be treated in the same way (‘the use of the same methods’ as stated in the Conceptual Framework), this contributes to making comparisons more meaningful.
The two key points to note are that consistency should be applied in two ways:
- ‘from period to period’ – ie by a single entity; and
- ‘across entities’ – ie between entities in the same period.
In practical terms, this means that consistency helps to achieve comparability. For instance, it should be possible for users to understand how a business has performed in the year by comparing it to the results of the previous year. This is only possible if the figures and information are prepared using consistent methods across each year. Consistency across entities also means that it should be possible to compare one business’s performance with a competitor and therefore make informed investment decisions.
This does not mean that everything in the accounts needs to be treated the same by every entity.
Double entry
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 briefly in a relatively short article such as this.
There is no definition of double entry in the Conceptual 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 and that every transaction gives rise to both a debit entry (Dr) and a credit entry (Cr).
Given that the value of the debit entries is the same as the value of the credit entries for any given transaction, it follows that when a number of transactions have been recorded, the total value of the debit entries will still be the same as the total value of the credit entries. This is the basis of the accounting equation.
All of this might best be explained by considering the transaction that was included in the discussion on accruals. This was that 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 – either Andrea or Brian. 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, and
- 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/use 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), and
- payables.
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: