10 Regulatory Framework 10 Regulatory Framework Examining accounting conventions, together with the role of audit

10 Regulatory 10 Regulatory Framework Framework

Examining accounting conventions, together with the role

of audit

JAN 2010 CIMA C2 YUAN LI 2

TopicsTopics

ConventionsAccounting regulationsRoles of auditor and management


Learning OutcomesLearning Outcomesidentify the underlying assumptions, policies and

changes in accounting estimates; identify the basic methods of valuing assets on c

urrent cost, fair value and value to the business bases and their impact on profit measures and statement of financial position values;

explain the influence of legislation (e.g. Companies Acts) and accounting standards on the production of published accounting information for organisations;


Learning OutcomesLearning Outcomesidentify the requirements for external audit

and the basic processes undertaken; explain the purpose and basic procedures

of internal audit; explain the meaning of fair presentation

(or ‘ true and fair view ’ ); explain the purpose of audit checks and

audit trails.


Introduction Introduction Guidance on how to prepare F/S

Ways in which accountants take decisions on methods of acctg & valuation for some items

judgment ……

opinion ……..

Role of auditors


10.2 Accounting 10.2 Accounting conventionsconventions10.2.1 The business entity convention

10.2.2 The money measurement convention

10.2.3 The historical cost convention

10.2.4 The objectivity convention

10.2.5 The dual aspect convention

10.2.6 The realisation convention

10.2.7 The periodicity convention


10.2 Accounting 10.2 Accounting conventionsconventions10.2.8 The accruals and matching conventions

10.2.9 The materiality convention

10.2.10 The stable monetary unit convention

10.2.11 The going concern convention

10.2.12 The consistency convention

10.2.13 The prudence convention


Business entity convention Business entity convention

the business is separate from its owners

sole trader or partnership

the entity is viewed as a vehicle through which the owner(s) engage in economic activity with a view to profit

Company

having a separate identity with its own objectives, the owners merely being other interested parties having claims against the entity


Money measurement Money measurement convention convention

all events are expressed in money terms


Historical cost Historical cost convention convention

transactions are recorded at cost

Historical cost is objective


ObjectivityObjectivity convention convention is the need to avoid bias

Ideally, any two accountants would produce the same figure

but judgments involved

Financial statements which are objective should be reliable


Dual aspect Dual aspect convention convention the double effect of transactions


RealisationRealisation conventionconvention items are included in financial statements

when realised Sales revenue when goods or services have been supplied and invoice i

ssued

Receivable invoice raised

Goods sold on a ‘sale-or-return’ basis(recognize sold until deadline for return has passed)


Periodicity convention Periodicity convention

assumes transactions can be allocated to a period of time

enables comparisons to be made between one period and the other


implies that expenses are matched to income

Accruals and matching Accruals and matching conventions conventions

arise from

periodicity convention

need to identify transactions with particular accounting


expenditure incurred in a particular accounting period should be accounted for in that period

irrespective of whether or not it has been

invoiced or paid for

Accruals convention Accruals convention


match the revenue earned in a period with the expenses consumed in earning that revenue

e.g.goods purchased that remain unused at the end of

the periodClosing inventory

Matching convention Matching convention


Prudent view

Matching convention Matching convention

expenses

revenue

only where they can be reasonably identified with future earning potential that they are carried forward to future periods, and so most expenses are charged to the income statement for the period in which they were incurred

Even money received, but order not fulfilled, not revenue of this period


Materiality convention Materiality convention the practice of revealing

significant items to users of accounts

Depending on

Judgment

value nature of the item effect on the results

Size of the organisation

Judgment

value nature of the item effect on the results

Size of the organisation


Materiality conventionMateriality conventioncan be applied to

items as ‘ revenue expenditure ’

‘ aggregation ’

‘ offsetting ’


inflation is ignored

10.2.10 The stable monetary unit convention


the business will continue into the foreseeable future (at least 1 year)

10.2.11 The going concern convention

Important for valuing assets


treating similar items the same way from 1 period to the next

Applying to groups of similar items

e.g. Method of valuing inventoriesDepreciation method for similar types non-current

assets

10.2.12 The consistency convention


Caution be applied when exercising judgment about uncertainties

reflects the view that prevents profits/assets being overstated and expenses/liabilities being understated

10.2.13 The prudence convention


10.3 Accounting policies and estimation techniques

Accounting Policies

principles, conventions, rules used when calculating the assets and liabilities, revenue and expenses, in the financial statements


Estimation techniquesEstimation techniques

Specific methods of making estimates when applying policies, e.g. straight line depreciation 25%


Values based on original costs

Can lead to overstating profits and understating assets in times of inflation

Accounting conventionsAccounting conventionsHistorical cost accounting Historical cost accounting


note note

You should be able to explain these conventions including their impact on profit and balance sheet values. Consider inventories bought at the beginning of the year at $100 and what the implication is of 10% rise in that price.


10.4.1 Capital Capital maintenance maintenance

earnings can be realized only after an organization's capital has been maintained at a predetermined level

Assumes the need to maintain sufficient capital to support the desired level of activity


10.4.2 Current purchasing power (CPP)

accounting restatement of items using Retail Price Index to reflect

monetary gains/losses. Monetary items would suffer losses/gains whilst non-monetary items do not

measures changes in the prices of goods and services bought for household consumption in the UK , published monthly.

Retail price index


10.4.3 Current cost accounting

revaluation of items using specific price charges that affect that particular business, i.e. separate inflation rates for each item


10.4.4 Fair value

Non-current assets may also be valued at their fair value

Fair value involves the revaluation of items to what they could be sold for

Advantages: provides relevant and up-to-date information

Disadvantages: not reliable


10.4.5 value to the business10.4.5 value to the business

Value to the business

Replacement cost Recoverable amount

Value in useFair value less costs

to selland

is the higher of

is the lower of

and


Value in useValue in use

future benefit derived from an asset in today’s terms


10.4.6 The valuation of intangible assets

patents; trademarks; goodwill;research and development costs; intellectual capital (the value of employee

s ’ knowledge and skills)


R & DGeneral R & D costs (not lead to a specific

new product or method of production) written off to I/S (expenses)

Capital expenditure, if they are directed towards the development of a

specific product or production method;the outcome of the research is known with

reasonable certainty; the future revenue is likely to exceed the costs.


10.5 Regulations in accounting

Company law

European Union Directives

Accounting profession

Accounting standards

IASB “Framework”


10.5.1 Company law format and layout of company accounts

and other guidance and principles

Often states which companies are required to have their financial statements audited by a registered auditor


10.5.2 The accountancy profession

Accounting profession and members qualified by examinations and practical experience


10.5.3 International accounting standards

IFRS, IAS


10.5.4 The IASB Frameworkunderlies all accounting standards and futu

re standards

● The objective of financial statements

● Underlying assumptions and qualitative characteristics

● The elements of financial statements

● The measurement of profit and capital maintenance


10.6 Role of auditor10.6 Role of auditorto ascertain that the financial statements

are properly prepared in accordance with company law and accounting standards


10.6.1 Fair presentation or true and fair

accounts fairly reflect the position of the business

not contain any significant errors (materiality convention)


10.6.1 Fair presentation or true and fair

Compliance tests = checks on procedures Substantive tests = checks on transactions and

balancesExternal auditor forms opinion on financial

statements (not necessarily look for fraud)Internal auditor = carry out checks for management

and advise on systems VFM audit = investigation of effectiveness,

efficiency and economy


10.6.2 The role of the external auditor

External auditor forms opinion on financial statements (not necessarily look for fraud)

1. testing the reliability of the systems and procedures used (compliance testing);

2. testing specific transactions to ensure that they have been accounted for accurately (substantive testing).


10.6.3 The role of the internal auditor

carry out checks for management and advise on systems

● advising on accounting systems;

● carrying out tests on the accounting records and internal management reports.


10.6.4 The value-for-money audit

VFM audit = investigation of effectiveness, efficiency and economy, either by internal or external auditors


10.7 Role of management 10.7 Role of management Safeguard assetsAct as stewards to the owners


Practice questionsPractice questions1. Match the following conventions with the scenario.

Convention scenario

A. Materiality 1. A company includes in inventories goods received before the year end, but for which invoices are not received until after the year end

B. Accruals 2. The owner of a business takes goods from inventories for her own personal use

C. Consistency 3. non-current assets are valued at cost, less accumulated depreciation, rather valued at saleable value in an enforced sale

D. Prudence 4. Business entities do not place a value on their employees

E. Separate entity 5. Sales revenue is not recognised when a customer places an order

F. Realisation 6. A company has a policy of always including the wages of production employees in the cost of goods manufactured

G. Going concern 7. A company buys a computer printer for $100 and charges this to office renewals, rather than to office equipment

H. Money measurement

8. Inventories are valued at the lower of cost and net realisable value


Practice questionsPractice questions2. The historical cost convention:A. Values all assets at their cost to the business, without

any adjustment for depreciationB. Has been replaced in accounting records by a system

of current cost accounting C. Fails to take account of changing price levels over

timeD. Records only past transactions

Answer: C


Practice questionsPractice questions3. In times of rising prices, the historical cost

convention has the effect of:A. Overstating profits and understating balance

sheet asset valuesB. Valuating all assets at their cost to the businessC. Understating profits and overstating balance

sheet asset valuesD. Recording goods sold at their cost price, even if

they are worth less than that cost

Answer: A


Practice questionsPractice questions4. The capital maintenance convention implies that:

A. A business should invest its profits in the purchase of capital assets

B. The capital of a business should be kept intact by not paying out dividends

C. Profit is earned only if the value of an organisation’s net assets have increased during an accounting period

D. Non-current assets should be properly maintained Answer: C


Practice questionsPractice questions5. Which THREE of the following statements are correct?

A. external auditors report to the directors

B. External auditors are appointed by the directors

C.External auditors are required to give a report to shareholders

D.External auditors correct errors in financial statements

E. Internal auditors should not liaise with external auditors

F. Internal audit is part of internal control

G.Internal audit should be independent of the activities it audits

Answer: CFG

Documents

10 Regulatory Framework 10 Regulatory Framework Examining accounting conventions, together with the role of audit