Accounting theory for Stage 2 exam

The Accounting Conceptual Framework

This framework is set by the International Accounting Standards Board. The role of the framework is to ensure that consistent accounting concepts and standards can be developed that ensure best-practice accounting is used throughout the world.

Accounting Standards

Any accountant who belongs to one of the Australian professional accounting bodies MUST follow accounting standards as part of their professional obligations. However, all accountants SHOULD follow accounting standards as they result in accounting information being faithfully representative of the affairs of the business.

Accounting Concepts and Conventions

Accounting concepts and conventions are like rules and guidelines that accountants use when recording, reporting and interpreting financial information. Their aim is to provide a degree of consistency and faithful representation in the processing of financial information.

Accrual Accounting

The accrual basis of accounting recognises transactions and events when they have an economic impact on the entity rather than when the associated cash flows occur. Revenue is  recognised when it is earned, and expenses are recognised when they are incurred.

Realisation

The realisation concept looks at when the earning of revenue can be said to have occurred. Accounting standards state that revenue can only be recognised once the goods or services associated with the revenue have been delivered or rendered. Thus, revenue is not recognised until it has actually been earned.

Contrast the concepts of the accounting entity and the legal entity.

An accounting entity is any organisational unit for which accounting records are kept and about which accounting reports are prepared.

A legal entity is an organisational unit that is seen by the law as having its own separate legal status. Companies and incorporated associations have separate legal entity status, but sole proprietorships and partnerships do not. From a legal perspective, for sole proprietorships and partnerships the business is seen as being the same legal entity as the owner(s).

Thus, all businesses are separate accounting entities, but only companies and incorporated associations are separate legal entities.

Accounting Period (the reporting period)

The life of the business is split into arbitrary time periods (accounting periods) to facilitate periodic reporting. Common lengths of periods are annual or monthly, although any period length can actually be used.

Consistency

The concept of consistency states that accountants should apply the same accounting methods from one period to the next.

Duality

The accounting concept of duality refers to the fact that every transaction has at least two effects on the accounting equation, and the impact on the accounting equation is equal of both sides.

Duality relates to the accounting equation: ASSETS = LIABILITIES + OWNERS EQUITY

Going Concern (also known as continuity)

Financial reports are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.

Materiability

The Accounting Conceptual Framework describes materiality as an ‘entity-specific aspect of relevance. In other words, what is deemed to be material for a business will depend on the size and nature of the business.

Faithful Representation

It is important that the financial statements are ‘true and fair’ (free from bias and undue error, and not misleading). They must accurately reflect the financial performance and position of the business.

Stakeholders must be given all the useful and relevant information in a reliable, comparable, and understandable manner so that they can be in a position to make the most informed and best decisions they can.

Prudence

Accountants must use care and caution in the valuation of assets and the measurement of profit when preparing financial statements. This principle serves so as not to overstate amounts when reporting the assets and revenue or not to understate the liabilities and expenses of a business.

Internal Users of Accounting Information

Internal users are those who utilise the accounting information so as to be able to make management decisions within an organisation.

• Management

External Users of Accounting Information

External users are those outside of management who utilise the financial information about an entity. There are a wide range of different purposes for which they may use this information, such as:

• investors

• employees

• lenders

• suppliers (creditors)

• customers

• governments and their agencies

• the general public

Sole Proprietorship (also known as sole trader)

A sole proprietorship is simply a business that is owned by one individual.

Advantages of a Sole Proprietorship

·      The owner has full control over the way the business operates

·      All profits belong to the owner

·      The owner has the satisfaction of developing his/her own ideas, turning them into success (hopefully)

Disadvantages of a Sole Proprietorship

 

·      As the business is not a separate legal entity, the owner has unlimited liability for the debts of the business. If these debts cannot be fully met from the business’ assets, the owner’s personal assets may be at risk

·      The owner is personally responsible for all losses of the business

·      Finance is limited to the owner’s personal wealth plus any borrowings they can arrange

Partnership

A partnership may be defined as an association of two or more persons to co-own a business with a view to making a profit.

Advantages of a Partnership

·      The running of the business is shared; this may allow the scope for people with various skills and talents to concentrate on those particular areas of management.

·      More finance may be able to be raised; both from having more owners contribute and also from having greater access to potential loans, as the ability to repay them is greater.

·      Both the workload and decision-making can be shared, lightening the burden that there would likely otherwise be under a sole proprietorship.

Disadvantages of a Partnership

 

·      As with a sole proprietorship, a partnership is not a separate legal entity, meaning that the partners have unlimited liability for the debts of the business. If these debts cannot be fully met from the business’ assets, the owners’ personal assets may be at risk.

·      All partners are responsible for the actions of other partners in the business, unless specified otherwise in the partnership agreement. As such, if one partner cannot meet their share of the debts of the business, the other partners must cover it.

·      Although shared decision-making can be advantageous, it is not always so. Sometimes, disagreements can occur making the partnership unworkable or at least leading to difficulties within it.