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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
JAN 2010 CIMA C2 YUAN LI 3
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;
JAN 2010 CIMA C2 YUAN LI 4
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.
JAN 2010 CIMA C2 YUAN LI 5
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
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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
JAN 2010 CIMA C2 YUAN LI 7
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
JAN 2010 CIMA C2 YUAN LI 8
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
JAN 2010 CIMA C2 YUAN LI 9
Money measurement Money measurement convention convention
all events are expressed in money terms
JAN 2010 CIMA C2 YUAN LI 10
Historical cost Historical cost convention convention
transactions are recorded at cost
Historical cost is objective
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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
JAN 2010 CIMA C2 YUAN LI 12
Dual aspect Dual aspect convention convention the double effect of transactions
JAN 2010 CIMA C2 YUAN LI 13
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)
JAN 2010 CIMA C2 YUAN LI 14
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
JAN 2010 CIMA C2 YUAN LI 15
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
JAN 2010 CIMA C2 YUAN LI 16
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
JAN 2010 CIMA C2 YUAN LI 17
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
JAN 2010 CIMA C2 YUAN LI 18
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
JAN 2010 CIMA C2 YUAN LI 19
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
JAN 2010 CIMA C2 YUAN LI 20
Materiality conventionMateriality conventioncan be applied to
items as ‘ revenue expenditure ’
‘ aggregation ’
‘ offsetting ’
JAN 2010 CIMA C2 YUAN LI 22
the business will continue into the foreseeable future (at least 1 year)
10.2.11 The going concern convention
Important for valuing assets
JAN 2010 CIMA C2 YUAN LI 23
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
JAN 2010 CIMA C2 YUAN LI 24
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
JAN 2010 CIMA C2 YUAN LI 25
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
JAN 2010 CIMA C2 YUAN LI 26
Estimation techniquesEstimation techniques
Specific methods of making estimates when applying policies, e.g. straight line depreciation 25%
JAN 2010 CIMA C2 YUAN LI 27
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
JAN 2010 CIMA C2 YUAN LI 28
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.
JAN 2010 CIMA C2 YUAN LI 29
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
JAN 2010 CIMA C2 YUAN LI 30
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
JAN 2010 CIMA C2 YUAN LI 31
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
JAN 2010 CIMA C2 YUAN LI 32
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
JAN 2010 CIMA C2 YUAN LI 33
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
JAN 2010 CIMA C2 YUAN LI 34
Value in useValue in use
future benefit derived from an asset in today’s terms
JAN 2010 CIMA C2 YUAN LI 35
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)
JAN 2010 CIMA C2 YUAN LI 36
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.
JAN 2010 CIMA C2 YUAN LI 37
10.5 Regulations in accounting
Company law
European Union Directives
Accounting profession
Accounting standards
IASB “Framework”
JAN 2010 CIMA C2 YUAN LI 38
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
JAN 2010 CIMA C2 YUAN LI 39
10.5.2 The accountancy profession
Accounting profession and members qualified by examinations and practical experience
JAN 2010 CIMA C2 YUAN LI 41
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
JAN 2010 CIMA C2 YUAN LI 42
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
JAN 2010 CIMA C2 YUAN LI 43
10.6.1 Fair presentation or true and fair
accounts fairly reflect the position of the business
not contain any significant errors (materiality convention)
JAN 2010 CIMA C2 YUAN LI 44
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
JAN 2010 CIMA C2 YUAN LI 45
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).
JAN 2010 CIMA C2 YUAN LI 46
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.
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10.6.4 The value-for-money audit
VFM audit = investigation of effectiveness, efficiency and economy, either by internal or external auditors
JAN 2010 CIMA C2 YUAN LI 48
10.7 Role of management 10.7 Role of management Safeguard assetsAct as stewards to the owners
JAN 2010 CIMA C2 YUAN LI 49
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
JAN 2010 CIMA C2 YUAN LI 50
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
JAN 2010 CIMA C2 YUAN LI 51
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
JAN 2010 CIMA C2 YUAN LI 52
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
JAN 2010 CIMA C2 YUAN LI 53
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