1.4 Accounting Concepts, Assumptions & Principles

Underlying Assumption: Going Concern

The Conceptual Framework identifies one underlying assumption for the preparation of financial statements: the going concern assumption.

Financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future (usually considered to be at least, but not limited to, 12 months from the end of the reporting period).

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 (e.g., a break-up basis, where assets are valued at what they would sell for in a forced sale), and if so, the basis used must be disclosed.

The Accruals Basis of Accounting

While going concern is the underlying assumption, the accruals basis is the fundamental accounting concept that dictates when transactions are recorded.

Under the accruals basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid), and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.

For example:

• If a company sells goods on credit in December, the revenue is recognized in December (when the transaction occurred and control transferred), even if the cash is not received until January.
• If a company uses electricity in December but pays the bill in January, the expense is recorded in December.

This is in contrast to cash accounting, which only records transactions when cash changes hands.

Key Accounting Concepts

In addition to the qualitative characteristics, several key concepts govern how transactions are treated:

Substance Over Form

Faithful representation requires that transactions are accounted for and presented in accordance with their substance and economic reality, and not merely their legal form.

For example, if a company 'sells' an asset to a bank but signs an agreement to buy it back in six months at the original price plus interest, the legal form is a sale. However, the economic substance is that the company has taken out a loan secured against the asset. Accounting standard requires it to be treated as a loan, not a sale.

Prudence

Prudence is the exercise of caution when making judgments under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated, and liabilities and expenses are not understated.

However, the Conceptual Framework (2018) clarifies that prudence does not allow for the deliberate overstatement of liabilities/expenses or understatement of assets/income, as this would violate the neutrality characteristic. Prudence simply means being cautious and unbiased when dealing with uncertainty.

Measurement Bases

Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and profit and loss account. The Conceptual Framework describes two broad measurement categories:

1. Historical Cost

Historical cost measures an asset or liability based on the transaction price at the time it was acquired or incurred, plus transaction costs. It does not reflect changes in value over time (except for impairment or depreciation).

• Advantage: It is highly verifiable and objective.
• Disadvantage: It may lack relevance, especially in times of high inflation or rapidly changing asset values.

2. Current Value

Current value measures reflect the conditions at the measurement date. There are three main current value measurement bases:

• Fair Value: The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. (An exit price).
• Value in Use (for assets) / Fulfilment Value (for liabilities): The present value of the cash flows, or other economic benefits, that an entity expects to derive from the use of an asset and from its ultimate disposal. Fulfilment value is the present value of the cash flows expected to be incurred to satisfy a liability.
• Current Cost: The cost of an equivalent asset at the measurement date, comprising the consideration that would be paid at the measurement date plus the transaction costs that would be incurred at that date. (An entry price).