Evaluación Económica

A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing $100.

During the year he sells 17 machines at $150 each. How should the remaining machines be valued at

If the going concern assumption is not followed, that fact must be disclosed, together with the following information.

(a) The basis on which the financial statements have been prepared.

(b) The reasons why the entity is not considered to be a going concern.

3.2.3 Accruals basis of accounting Definition

In the accruals basis of accounting, items are recognised as assets, liabilities, equity, income and expenses (the elements of financial statements) when they satisfy the definitions and recognition criteria for

those elements in the Framework. (IAS 1)

Entities should prepare their financial statements on the basis that transactions are recorded in them, not as the cash is paid or received, but as the revenues or expenses are earned or incurred in the accounting period to which they relate.

According to the accruals assumption, profit is computed as the surplus / (deficit) of revenue and expenses.

In computing profit, revenue earned must be matched against the expenditure incurred in earning it.

This is also known as the matching convention.

3.2.4 Example: Accruals

Emma prints 20 T-shirts in her first month of trading (May) at a cost of $5 each (purchased on credit terms). She then sells all of them for $10 each. Emma has therefore made a profit of $100, the surplus of revenue ($200) earned over the cost ($100) of acquiring them.

If, however, Emma only sells 18 T-shirts, it is incorrect to charge her income statement with the cost of 20 T-shirts, as she still has two T-shirts in inventory. If she sells them in June, she is likely to make a profit on the sale. Therefore, the profit is $90, the surplus of sales revenue ($180) over the purchase cost of 18 T-shirts ($90).

Her statement of financial position will look like this.

$

Proprietor's capital (profit for the period) 90

Accounts payable (20 × $5) 100

190 However, if Emma had decided to give up selling T-shirts, then the going concern assumption no longer applies and the value of the two T-shirts in the statement of financial position is break-up valuation, not cost. Similarly, if the two unsold T-shirts are unlikely to be sold at more than their cost of $5 each (say, because of damage or a fall in demand) then they should be recorded on the statement of financial position at their net realisable value (i.e. the likely eventual sales price less any expenses incurred to make them saleable, i.e. say, $4 each) rather than cost. This shows the application of the prudence concept, which we will discuss shortly.

In this example, the concepts of going concern and accrual are linked. Since the business is assumed to be a going concern, it is possible to carry forward the cost of the unsold T-shirts as a charge against profits of the next period.

3.3 Further concepts

3.3.1 Faithful representation

Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the

transactions or finding an appropriate method of measurement or presentation. Where measurement of the financial effects of an item is so uncertain, entities should not recognise such an item, e.g. internally generated goodwill.

3.3.2 Substance over form

Faithful representation of a transaction is only possible if it is accounted for according to its substance and economic reality, not solely based on its legal form.

Definition

Substance over form. The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. (Framework)

For instance, one party may sell an asset to another party and the sales documentation may record that legal ownership has been transferred. However, if agreements exist whereby the party selling the asset continues to enjoy the future economic benefits arising from the asset, then in substance no sale has taken place.

An example of substance over form is found in accounting for finance leases. A finance lease is one in which the risks and rewards of ownership are transferred to the lessee (the party who physically holds the asset). In a finance lease arrangement, the lessee never obtains legal title to the asset so does not own that asset. However, they have all the risks and rewards of ownership, such as the right to use the asset for most, if not all, of its useful life and they must bear the costs of ownership such as insurance and maintenance. For this reason, the asset is capitalised in the lessee’’s accounts and treated as an owned asset, following the substance of the transaction. This accounting treatment will ensure that the financial statements show the true financial position of the entity, and does not hide assets and liabilities from the statement of financial position.

In accounting for the finance lease above, if the legal form was followed, the asset and the finance lease liability would not be recognised which would make the financial statements look better than they actually are. This has the effect of improving the gearing ratio, as the liability is not recorded, it also improves the return on capital employed, as the asset base is lower. Hence following substance over form is key in showing a fair presentation of the financial statements of an entity.

3.3.3 Neutrality

Information must be free from bias to be reliable. Neutrality is lost if the financial statements are prepared so as to influence the user to make a judgment or decision in order to achieve a predetermined outcome.

3.3.4 Prudence

Uncertainties exist in the preparation of financial information, e.g. the collectability of doubtful

receivables. These uncertainties are recognised through disclosure and through the application of prudence.

Prudence does not, however, allow the creation of hidden reserves or excessive provisions, understatement of assets or income or overstatement of liabilities or expenses.

3.3.5 Completeness

Financial information must be complete, within the restrictions of materiality and cost, to be reliable.

Omission of information may cause information to be misleading.

4 Setting of International Financial Reporting

LO 4.5

LO 4.6

4.1 Due process

The due process in developing an accounting standard has six stages as follows:

Step 1