Accounting Conventions and Policies

CIMA-BA3 · Chapter 23

Accounting Conventions and Policies

Financial statements rest on a few basic concepts. IAS 1 requires fair presentation, the going concern basis, the accruals basis and consistency. The Conceptual Framework says what makes information useful: it must be relevant and a faithful representation (the two fundamental characteristics), and it is more useful if it is comparable, verifiable, timely and understandable. Most items are measured at historical cost, although other valuation bases exist. Businesses choose accounting policies and make accounting estimates, and must apply them consistently.

1 Introduction

There are many accounting conventions and concepts underlying the preparation of financial statements.

In this chapter we will explain the main conventions and concepts.

YouTube video

Three points where the lecture uses older ideas. It lists ‘reliability’, which the Conceptual Framework has replaced with ‘faithful representation’. It describes prudence in its traditional form (recognise losses at once, profits only when realised); the Framework now describes prudence as caution when making judgements under uncertainty, without deliberately understating assets or profits — the inventory example in the lecture still holds. And its example of substance over form uses a leased machine; leases are not part of BA3, so take it only as an illustration of the idea.

2 The fundamental accounting concepts

These are contained in IAS 1 Presentation of Financial Statements, and must be followed.

Concept	Meaning
Fair presentation	Financial statements should be ‘fairly presented’: they should show the effects of transactions honestly, as they really are, without trying to make the results look better or worse. Following IFRS is presumed to achieve fair presentation.
Going concern	It is assumed that a business will continue to operate for the foreseeable future. If it were about to close, its assets would be valued at what they would fetch in a forced sale, which may be far below their carrying amounts.
Accruals	Assets, liabilities, equity, income and expenses are recognised when they occur, and not when cash is received or paid. This is the accruals (or matching) concept of Chapter 4: income and expenses are recognised in the period in which they are earned or incurred, not in the period in which the cash happens to be received or paid.
Consistency	Items should be treated in the same way from one period to the next, unless there is a significant change in the nature of the operations. Similar items should also be treated in the same way within a period — for example, all the cars in a fleet depreciated by the same method.

Going concern is the underlying assumption of the Conceptual Framework: unless management intends to close the business, or has no realistic alternative, the financial statements are prepared on a going concern basis. It is why, for example, inventory is normally valued at cost: a business that expects to carry on trading expects to sell its goods for more than they cost.

IAS 1 is due to be replaced by IFRS 18 Presentation and Disclosure in Financial Statements for accounting periods beginning on or after 1 January 2027; the concepts in this section stay the same.

3 Other accounting concepts and qualitative characteristics

The Conceptual Framework sets out the qualitative characteristics that make financial information useful. Qualitative means they describe the quality of the information, not amounts. There are two fundamental characteristics, which information must have, and four enhancing characteristics, which make useful information more useful.

Qualitative characteristic	Meaning
Fundamental
Relevance	The information is capable of making a difference to the decisions users make, because it helps them predict the future or confirm or correct their past expectations. Do not give information just for the sake of it.
Faithful representation	The information represents what it claims to represent: it is complete, neutral and free from error.
Enhancing
Comparability	Users can identify similarities and differences between items, between periods and between entities. This is why the previous year’s figures are shown alongside this year’s.
Verifiability	Different knowledgeable, independent observers could agree that the information is a faithful representation.
Timeliness	The information is available to users in time to influence their decisions.
Understandability	The information is classified and presented clearly and concisely, for users who have a reasonable knowledge of business and are willing to study it.

The other concepts in the list below support these characteristics:

Concept	Meaning
Materiality	Information is material if omitting, misstating or obscuring it could reasonably be expected to influence users’ decisions. Materiality depends on size and nature: $1,000 may be material to a small business but not to a large oil company. Material items are shown separately; immaterial ones may be combined. Materiality is an aspect of relevance.
Reliability	An older name: users must be able to rely on the figures. The Conceptual Framework now uses faithful representation instead.
Substance over form	Transactions are accounted for according to their economic substance, not merely their legal form. Faithful representation requires it.
Neutrality	The information is without bias: it is not slanted to make the position look better or worse than it is. Neutrality is part of faithful representation.
Prudence	Caution when making judgements under uncertainty, so that assets and income are not overstated and liabilities and expenses are not understated. It does not allow deliberate understatement either, which would breach neutrality. Valuing inventory at the lower of cost and net realisable value (Chapter 9) is an example.
Completeness	Everything needed to understand the position has been included; nothing has been left out. Completeness is part of faithful representation.
Business entity	The business is accounted for separately from its owner (the separate entity concept of Chapter 1); the owner’s personal assets and spending are not in the business’s accounts.

3.1 The elements of financial statements

The Conceptual Framework also defines the five elements of financial statements (Chapter 2 gives the same definitions):

Element	Formal definition
Asset	A present economic resource controlled by the entity as a result of past events
Liability	A present obligation of the entity to transfer an economic resource as a result of past events
Equity (capital)	The residual interest in the assets of the entity after deducting all its liabilities
Income	Increases in assets, or decreases in liabilities, that result in increases in equity, other than contributions from the owners
Expenses	Decreases in assets, or increases in liabilities, that result in decreases in equity, other than distributions to the owners

3.2 Accounting policies and accounting estimates

Accounting policies are the principles, bases, conventions and rules a business chooses to apply in preparing its financial statements — for example, whether inventory cost is found by FIFO or average cost (Chapter 9), or whether property is held under the cost model or the revaluation model (Chapter 6). Under the consistency concept a policy is changed only if a standard requires it or the change gives more relevant information; a change of policy is then applied as if the new policy had always been used, so the previous year’s figures are restated and stay comparable.

Accounting estimates are amounts that cannot be measured exactly and so need judgement — for example, the useful life and residual value of an asset and its depreciation (Chapter 5), the allowance for receivables (Chapter 8), the net realisable value of inventory (Chapter 9), an accrual for an unbilled expense (Chapter 4) and a provision for a liability of uncertain timing or amount, such as a product warranty (Chapter 25). When better information arrives, the estimate is revised and the change affects the current and future periods; earlier periods are not restated.

4 Alternative Valuation Bases

Valuation basis	Meaning
Historical cost	The original cost of the asset (for a non-current asset, less accumulated depreciation). This is the basis normally used.
Replacement cost	What it would cost now to replace the asset with an equivalent one.
Net realisable value	What the asset could be sold for, less the costs of selling it.
Economic value	The present value of the future cash the asset is expected to earn for the business.

Financial statements are prepared under the historical cost convention: assets are normally shown at their original cost less accumulated depreciation. The other bases are used only in particular cases — inventory is written down to net realisable value when that is lower than cost (Chapter 9), and property, plant and equipment may be revalued (Chapter 6).

Historical cost is objective and easy to verify, but it gets out of date. In times of high inflation it undervalues assets in the statement of financial position, because they are still shown at what they cost years ago. It also overstates profit, because depreciation is based on that old, lower cost.

5 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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