Sample Accounting Essay Paper on Accounting Theory and Applications

Accounting Theory and Applications

Application of the principles of Conceptual Framework

  1. In explaining the definition and recognition criteria of an expense

According to the principles of the conceptual framework, the definition of an expense is met if it is done as per the elements of the financial statement. In this case, an expense refers to the outflow of business resources. It can also be referred to as the utilization of assets or the increase of a liability or the combination of the two for the use of delivering, producing goods or providing services. However, here the increase of liabilities should not be that associated with resources distributed to owners such as dividends that result in a reduction in equity. Thus, an expense is recognized when a net change in assets and earning of revenues occurs, meaning that the recognition of an expense is tied to recognition of revenues (Henderson et al., 2013).

According to this explanation, the definition of an expense has been met by the ABC Company. This is because the provision of future expansion of $100,000 that is set aside in each of the next five years results in a reduction in assets and an increase in liabilities. This amount has been set aside for increasing the capacity of the company enabling it to meet its rising product demand. The definition of an expense has therefore been met because the amount set aside results to a net change in assets and the revenues that ABC will earn. The rising demand is met after expansion leading to an increase in revenues.

The principles of the conceptual framework dictate that the recognition criteria for an expense are met when four criteria are satisfied that include definition, measurability, relevance, and reliability. In definition, the expense should be described as per the elements of financial statements. To be measurable, the item should have an attribute that is relevant and can be measured with sufficient reliability. In relevance, the item should be in a position to make a difference in the decisions of the user. In reliability, the information given about the expense should be representative, faithful, neutral and is verifiable (Kaminski, & Carpenter, 2011).

Moreover, expenses are recognized in the financial statement, if there is a potential loss of future economic benefit due to the decrease of an asset or increase in liability that affects the financial results determined in the period being reported. Secondly, it is possible to measure the consumption or loss of the future economic benefits in a reliable manner. The matching principle is also very essential in recognition of expenses and their presentation in the financial statements. In this case, there are general rules applicable whereby, if an expense will result in future economic benefits, it is presented as an asset, and if it results in current benefits, it is an expense (Loftus et al., 2016)

The expense for ABC Company has met the recognition criteria for a number of reasons. Firstly, it has met its definition as explained above. Secondly, it is measurable as it provides the attribute of the total costs amounting to $500,000 that will be required for the expansion to take place after five years and a provision of $100,000 in every year. The expense has met the relevance criteria because the projected increase in demand is supported by the expansion and it will lead to a higher projection of expected revenue. The reliability criteria have been met because it is expected that the product demand will be meet when an expansion is carried out in the next five years at a cost of $500,000.

  • In explaining whether the preference shares should be considered as equity or a liability

Equity refers to the interest obtained from assets of a company after deducting all the liabilities. Thus, it is essential that assets and liabilities be conceptually identified recognized and measured first since equity is considered as the balancing figure or the function of an entity’s assets and liabilities. It is affected by the profitability of an entity and the contributions made by owners.  It is also the claim to the net assets of a company in the event of winding up the company (Deegan, 2014). Equity consists of the capital originally introduced by company owners that include share capital and share premium. Secondly, the company accumulated retained profits that include the retained earnings and gains from unrealized assets or revaluation reserves. The non-controlling interest (NCI) in group accounts is also referred to as equity interest. Other forms of equity are the changes in NCI as a result of its increase or decrease, convertible loan stock element, differences in a group foreign exchange and shares that are issuable contingently (Deegan, 2014).

A liability refers to the current obligations of a business resulting from past occurrences that when they are paid, there is an outflow of resources of the business, representing a sacrifice of future economic benefits.  A recognizable liability does not have to be the obligation that is due on demand; instead, it is only necessary that it is a present obligation. An obligation means that there is the involvement of two different parties, namely an external party to the business and the business. The obligation arises from contractual agreements such as money borrowed, money owed for purchased assets, money owed for services rendered or obligation to offer goods and services to parties who have paid for them in advance in a reciprocal transaction (Loftus et al., 2016).

Liability and equity are differentiated from one another in that both are determined by their legal status and the priority given to the two types of claims. Liabilities are claimed for an amount that is already stated in the entity’s records but equity does not.  This is because owners of equity can either enjoy the rewards of the business or bear the losses that arise based on their holding interest in the business. Additionally, liabilities are paid on demand and at a specified date or upon the occurrence of an event. Contrary, a company is not obligated to transfer its assets to the owners except when it plans to make a distribution like in the case where dividends are declared, or net assets are being distributed in winding up of the company (Loftus et al., 2016). The preference shares in ABC Company are therefore considered as equity. This is because the fixed dividend of 3% is only paid if profits are earned in a year or if net assets are positive. The preference shares are redeemable after three years; during this time, the company will use its profits to buy them back after deducting all its liabilities.

Measurement Issues

Measurement refers to the process, through which information concerned with a company’s incomes and expenses, assets, liabilities and equity are quantified in monetary terms. A measure is obtained by applying a measurement basis in measuring the elements of financial statements. The feature of the item being measured such as historical costs, fulfillment value or fair value is referred to as the measurement basis. Measurement is one of the important aspects of financial reporting, but it is one of the areas with various issues in terms of the guidance it provides to preparers and users of financial statement (Henderson et al., 2013). 

The framework of the International Accounting Standards Board (IASB) published an Exposure Draft (ED) entitled “Exposure Draft (ED)/2015/3 Conceptual Framework for Financial Reporting” whose purpose is to collect comments. Chapter six of the ED raises various issues that are associated with measurement in financial reporting. One of the measurement issues raised covers the various bases of measurement, the information provided by these bases and the advantages and disadvantages associated with them. The other issues raised is concerned with the factors that need to be considered while selecting a measurement basis. The measurements bases have been categorized in the ED as historical cost and current value. The current value is further categorized as fair value, and the value applied to assets and the value that is used in fulfillment of liabilities (IASB, 2015).

The specific concerns with the measurement basis are whether the IASB has made the correct identification of the basis whose description should be in the conceptual framework. If not so, the draft seeks to find out the measurement basis that should be included and the reasons why they should be included. The other concern is whether the information provided for each measurement basis is described in a proper manner and whether both advantages and disadvantages have been appropriately given on each base. In addition, the draft highlights that it is important to be aware of the factors that need to be considered when selecting a measurement basis. This is because there are given factors that have a significant effect on the selection of a basis including the qualitative characteristics of helpful financial information and cost constraint. Thus, the concern is whether the IASB has identified the factors to consider when selecting a measurement basis in a proper manner. There is also the concern of under which situations it is necessary to use more than one measurement basis in order to provide information concerning income, expense, asset or liability (IASB, 2015).

The ED elaborates that, under the framework of the IASB there are two approaches under which more than one measurement basis can be used. Firstly, in most scenarios, the use of one measurement to give information is the most understandable in the statement of financial position as well as the statement of financial performance while the other measurement will be used for disclosure only. Secondly, it states that the current value measurement basis is used in some cases to provide information that is more relevant in the statement of financial position while a different basis will be used to determine the incomes or expenses that are related to the profit or loss statement. The issue here is whether the provided approaches by IASB on the use of more than one relevant measurement basis are agreeable (IASB, 2015).

A wide range of issues related to the measurement concerns that have been raised in the Exposure Draft for comment have been raised by other Financial Reporting bodies and different authors. In the identification of the correct basis of measurement in order to provide their description in the conceptual framework, there are various issues that are related to it. The first thing to consider is that unlike other measurements in daily life, financial reporting measurement may be liable to many controversies. Other measurements are associated with the physical characteristics of physical objects like weight, temperature, height and others such that the use of accurate tools in measurement ensures that the information obtained is objective and not controversial. However, in financial reporting, subjects of measurement are abstract concepts that have uncertain meaning such as incomes and net assets, making the measurements potentially controversial (Cohn, 2015).

The measurements are also in monetary terms, and thus, they are said to be the measurement of value. However, a value is considered to have different meanings such that an asset may be valued at historical cost, market value or replacement cost, but none of these measurements can be considered as the one and only value that is correct for the asset. Each of the values will be correct if the measurement is done correctly on the basis that is employed. Different attributes of assets and liabilities are therefore used to give different values for measurement. These attributes include the historical costs, market value or replacement cost. Moreover, the diversity of the aim for which information in a financial report is needed for implies that the basis of measurement employed for one purpose may not be appropriate for other purposes (ICAEW, 2006).

The consequences of double entry bookkeeping also have an effect on the measurements basis in financial reporting. It is not possible to measure one item such as a liability or expense without measuring a different item at the same time on the other side of entries. Careful considerations should be made to ensure that unfortunate results are not obtained on either side of the entries because of the use of different basis of measurements (Gleeson-White, 2012). Another difficulty that is associated with identifying a measurement basis is the fact that it aims at capturing business activities that are in a continuous process. A business is always in the middle of various activities that are yet to be completed. For instance, services that are in the course of being delivered to customers or raw materials that are yet to be converted to work in progress (ICAEW, 2006).

The process of capturing such incomplete activities and monetarily expressing them is to some extent an arbitrary process. It can only be carried out in a judgmental and conventional manner that entails dealing with four basic problems. Firstly, making predictions of how incomplete activities will turn out is challenging. Secondly, making a determination of what separable assets will be measured is hard. Third, the problem of allocating values to different assets that are separable and to different accounting periods in the past and future. Fourth, the identification issues of the markets and other sources of values that can be employed in the measurement of business activities, which are yet to be completed. These fundamental problems have effects on the identification of the bases of measurement available since most of them are likely to be subjective and judgmental when measuring some items (Kaminski, & Carpenter, 2011).

All the measurement basis are forms of accrual accounting, meaning that the incomes are measured at the moment it is earned, and costs are measured once they are incurred. Judgment on whether the information provided concerning a measurement basis and its advantages and disadvantages is appropriately provided can only be made based on whether their cost effectiveness or fitness for purpose is well explained. There are characteristics that help to argue the quality of measurement basis. Relevance and reliability are some of the key characteristics used in assessing the quality of a measurement basis as well as other qualitative characteristics that may have some issues. Therefore, to start with, one factor that need to be considered in selecting a measurement basis for measuring the elements of the financial statement is that it must be relevant and represent what it purports to represent in a faithful manner. Moreover, the information needs to be comparable, timely, verifiable and understandable. The cost constraint is also significant such that the basis must sufficiently justify the cost of provided information.

An issue that affects the relevancy of information given by measurement basis is that there may be a level of uncertainty of measurement in estimates of the given information. This level may be so high such that a different measurement basis is needed to provide relevant information, or it may be inappropriate to recognize the asset or liability. Another issue is that a basis may fail to represent in a faithful manner the position of an entity due to measurement inconsistencies that arise from the use of different measurement basis to measure assets or liabilities that are almost similar. Enhancement of qualitative characteristics of verifiability, understandability, comparability also has an effect on the selection of a basis. For instance, if the number of measurement basis used for a given set of financial statement is increased, then the amount of information that results from this is complex and hence less understandable (W Sangster, 2012).

Definitions and elaborations of the advantages and disadvantages of different measurement basis highlight various issues associated with each of them. Measuring the value of an asset using historical costs implies that the amount that was paid for it is taken as its cost while for a liability; the amount that has been received in its respect is taken as the cost. This is understood to be the recoverable historical cost, and it is higher than the realizable value and its value in use. The issues with historical costs in reliability are that it can only be reliable if it is based on actual transactions only and it is subjective when based on predictions and allocations, for instance in depreciation of assets. In relevance, historical costs are based on measurements that are out of dates, it ignores gains that have not been realized and measures some major assets and liabilities such as intangibles at zero. The measurement basis of the value of the business in case of an asset seeks to answer the question of how much a business would lose if it lacks it and the answer is given by the replacement cost if the asset. In liabilities, value of business measurement seeks to find out how better the business will perform if they are settled. The basis is reliable when there are markets for comparing replacement of assets, and it becomes subjective when the markets and technologies used for predictions and allocations change. In relevancy, the basis helps in showing costs of entry for new business entrants and indicates when the capability of the business to operate is maintained. However, it has a disadvantage in that investors’ main priority is not the maintenance of operating capacity, and the perspective of new entrants is not relevant for the existing investors. Fair value basis is reliable when based on active markets and subjective when reliable market values do not exist. In relevancy, the basis shows the gross value of sales and thus the opportunity cost, it shows the projected value of future cash flows adjusted for risk for some assets. Some financial analysts also consider it as the only information that is relevant in financial decision-making. However, it shows measurement based on the alternatives rejected and shows the values of assets at a suboptimal level of aggregation (Kaminski & Carpenter, 2011).

Resolving of the myriad measurement issues is very important from the perspective of setting the reporting standards. This is because there are various economic consequences that arise from the accounting standards set to assist in preparation and interpretation of financial information.  The standards have a huge impact on the various stakeholders such as shareholders, investors, suppliers, competitors, customers who use the financial reports prepared and interpreted on the basis of the standards. Therefore, it is essential that standard setters resolve the issues related to measurement, the correct basis of measurement are identified to solve the various challenges of measurement in financial reporting. They have a responsibility of ensuring the types of standards employed in financial reporting are evidence-based and supported by credible accounting theory. Continuous evaluation, discussions and comments from various stakeholders should be encouraged by standard setters to resolve existing issues. In this case, they should also work towards ensuring adequate information is provided on all basis identified, their advantages, disadvantages and factors in selecting a basis appropriately explained. The standard setters’ initiative will thus play the role of eliminating negative economic consequences that may be experienced due to various measurement issues (Loftus et al., 2016).

References

Cohn, M 2015, ‘IASB Proposes Enhancements to ConceptualFramework’, Accountingtoday.Com, p. 1

Deegan C., 2014. Financial Accounting Theory, 4th ed., McGraw-Hill.

Gleeson-White, J., 2012. Double Entry. Allen &Unwin: Australia.

Henderson, S., Peirson, G., Herbohn, K., Artiach, T. and Howieson, B., 2013.Issues in financial accounting. Pearson Higher Education AU.

IASB, 2015, Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting.

ICAEW, Financial Reporting Faculty, 2006, Measurement in Financial Reporting, Information for better market initiative, London.

Kaminski, K, & Carpenter, J 2011, ‘Accounting Conceptual Frameworks: A Comparison Of FASB And IASB Approaches’, International Journal Of Business, Accounting, & Finance, 5, 1, p. 16.

Loftus, J., Leo, K., Boys, N., Daniliuc, S., Luke, B., Hong, A., Byrnes, K., 2016. Financial

Reporting, Wiley

W Sangster, A., 2012. The Genesis of Double Entry Bookkeeping. The Accounting Review.