(72)-ACCOUNTING POLICIES & ESTIMATES

Accounting Policies & Estimates

Accounting policies

An accounting policy is concerned with the,

• Recognition
• Selection of measurement base and
• Presentation

Of assets, liabilities, gains and losses of an entity

The most appropriate accounting policy should be selected in order give a true and fair view. Two points should be noted about this approach.

1. Accounting policies must confirm to the relevant accounting standards. They can be changed only where standard allows choice.
2. Accounting policies should not be chopped and charged on an ad hock basis. A balance must be struck to achieve consistency and reliability.

Accounting estimates

An accounting estimate is the method used to establish the monetary value of assets, liabilities, gains and losses using the measurement base selected base selected by the accounting policy.

Accounting estimates involve the use of judgment when applying an accounting policy.

(71)-SUBSTANCE OVER FORM & PERIODICITY CONCEPT

Substance over Form & Periodicity Concept

Substance over form

Substance over form means that transactions should be accounted for and presented in accordance with their economic substance, not their legal form.

An example of substance over form is that of assets acquired on hire purchase. Legally the purchaser does not own the asset until the final installment has been paid. However, the accounting treatment is to record a fixed asset in the accounts at the start of the hire purchase agreement. The substance of the transaction is that the business owns the asset. The same could be said of assets acquired under long term lease.

The time interval concept (Periodicity concept)

The activities of an entity are conveniently split up into blocks of time, be these days, months, quarters or years. The activities continue to occur but the intervals are placed so as to record activities between two points in time. The time intervals under consideration are usually of equal length to facilitate comparison, but this does not need to be the case. Therefore accounts are usually prepared annually.

(70)-REVENUE RECOGNITION CONCEPT

Revenue Recognition Concept

Accruals accounting is based on the matching of costs with the revenue they generate. It is crucially important under this convention that we can establish the point at which revenue may be recognized so that the correct treatment can be applied to the related costs.

For example, the costs of stock should be carried as an asset in the balance sheet until such time as it is sold; they should then be written off as a charge to the trading account.

Therefore accountants must be clear be clear at what moment the sale of the item takes place. The decision has a direct impact on profit since under the prudence concept it is unacceptable to recognize the profit on sale until a sale has taken place.

Revenue is generally recognized as earned at the point of sale, because at that point four criteria will generally have been met.

1. The product or service has been provided to the buyer.
2. The buyer has recognized his liability to pay for the goods or services provided and the seller has recognized that ownership of goods has passed from himself to the buyer.
3. The buyer has indicated his willingness to hand over cash or other assets in settlement of his liability.
4. The monetary value of the goods or services has been established.

At earlier point of business cycle there will not in general be firm evidence that the above criteria will be met. Until work on a product is complete, there is a risk that some flaw in the manufacturing process will necessitate its writing off; even when the product is complete there is no guarantee that is will find a buyer.

At later points in the business cycle, for example when cash is received for the sale, the recognition of revenue may occur in a period later than that in which the related costs were charged. Revenue recognition would then depend on fortuitous circumstances, such as the cash flow of a company’s debtors, and might fluctuate misleadingly from one period to another.

(69)-STABLE MONETARY UNIT AND OBJECTTIVITY CONCEPTS

Stable Monetary Unit Concept

The financial statements must be expressed in terms of a monetary unit,

For example in the USA the $

It is assumed that the value of this unit remains constant.
In practice, of course, the value of the unit is not usually constant and comparisons between the accounts of the current year and those of previous years may be misleading.

Objectivity (neutrality) concept

Objectivity means that accountants must be free from bias. They must adopt a neutral stance when analyzing accounting data.

An accountant must show objectivity in his work. This means he should try to strip his answers of any personal opinion or prejudice and should be as precise and as detailed as the situation warrants. The result of this should be that any number of accountants will give the same answer independently of each other.

In practice, objectivity is difficult. To accountants faced with the same accounting data may come to different conclusions as to the correct treatment. It was to combat subjectivity that accounting standards were developed.

The Realization Concept

The realization concept means that revenue and profits are recognized when realized.

(68)-THE HISTORICAL COST CONVENTION

The Historical Cost Convention

Historical cost means transactions are recorded at the cost when they occurred.
A basic principal of accounting is that resources are normally started in accounts at historical cost, i.e. at the amount which the business paid to acquire them. An important advantage of this procedure is that there is usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an expense.

In general, accounts prefer to deal with costs, rather than with values. This is because valuations tend to vary according to what the valuation is for. For example, suppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a balance sheet and has to decide what monetary amount to attribute to the asset.

Numerous possibilities might be considered,

• The original coat (historical cost) of the machine
• Half of the historical cost, on the ground that half of its useful life has expired
• The amount the machine might fetch on the secondhand market
• The amount it would cost to replace the machine with an identical machine
• The amount it would cost to replace the machine with a more modern machine incorporating the technological advances of the previous two years
• The machines economic value, i.e. the amount of the profits it is expected to generate for the company during its remaining life

All of these valuation have something to commend them, but the great advantage of the first two is that they are based on a figure (the machines historical cost) which is objectively verifiable. The subjective judgment involved in the other valuations. Particularly the last is so great as to lessen the reliability of any accounts in they are used.

(67)-THE MATERIALITY CONCEPT

The Materiality Concept

Only items material in amount or in their nature will affect the true and fair view given by a set of accounts.

An error which is too trivial to affect anyone’s understanding of the accounts is referred to as immaterial. In preparing accounts it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive details.

Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb.

For example to define material items as those with a value greater than 5% of the net profit disclosed by the accounts.

However some items disclosed in accounts are regarded as particular sensitive and even a very small misstatement of such an item would be regarded as material.

An example in the accounts of a limited company might be the amount of remuneration paid to directors of the company.

The assessment of an item as material or immaterial may affect its treatment in the accounts.
For example, the profit and loss account of a business will show the expenses incurred by the business grouped under suitable captions; but in the case of very small expenses it may be appropriate to lump them together under a caption such as “sundry expenses” because a more detailed breakdown would be inappropriate for such immaterial amounts.

In assessing whether or not an item is material, it is not only the amount of the item which needs to be considered. The context is also important.

(66)-THE SEPARATE VALUATION PRINCIPLE

The Separate Valuation Principle

The separate valuation concept states that, in determining the amount to be attributed to an asset or liability in the balance sheet, each component item of the asset or liability must be determined separately.

These separate valuations must then be aggregated to arrive at the balance sheet figure.

For example, If a company’s stock comprises 50 separate items, a valuation must be arrive at for each item separately; the 50 figures must then be aggregated and the total is the stock figure which should appear in the balance sheet.