Topic
X
2
Accounting
Standards,
Assumptions
and Principles
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Describe the main functions of the accounting bodies in Malaysia;
2.
Discuss the purpose of accounting standards;
3.
Explain the assumptions and principles in accounting;
4.
Apply the concepts and principles in accounting; and
5.
Differentiate between types of business and ownership;
X INTRODUCTION
Imagine the world without traffic law and enforcement! There will be havoc, as
people will drive as fast as they want, beat traffic lights as they please or park
their car anywhere they like. To ensure our safety on the road, we have rules and
drivers need license before they can drive. Now, can you imagine the accounting
profession without rules and regulations?
You have learned earlier that external users rely on the accounting information
produced by business to make decisions. How can users be assured that the
information presented is reliable? After all, the financial statements are prepared
by the companyÊs accountant. Knowing that to prepare financial statements, the
accounting profession have to follow certain rules and regulation increased the
reliability of information provided by the financial statement. But who regulates
the accounting profession?
24
X TOPIC 2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
This section begins with the introduction to the various accounting bodies in
Malaysia that govern the accounting profession. The main functions of these
bodies will be described.
We have to follow certain guidelines called accounting standards in preparing
the financial statements. You will learn why it is important to have such
standards; this article below proves the consequence of not doing so!
Accountant Held Liable for Interest Expense from Tax Error
Accounting WEB.com - 26th June 2006 - The South Dakota Supreme Court last
week upheld a Circuit Court decision allowing a jury to award damages to
Doug OÊBryan Contracting Inc. for interest expense on underpayment of taxes
that resulted from an error made by his accountant. The stateÊs high court had
not previously allowed recovery of interest expense in lawsuits against tax
advisers, the Associated Press reports.
Bruce Ashland, a certified public accountant, understated OÊBryanÊs income for
1995. The well-drilling company, located in Martin, South Dakota, incorporated
in April 1995, and Ashland used the wrong method to calculate income for the
first quarter of the year. When the error was discovered several years later,
OÊBryan owed an additional $239,933 in taxes and about $50,000 in interest.
Source: http://www.accountingweb.com/cgibin/item.cgi?id=102293&d=815
&h=0&f=0& dateformat=%o%20%B%20%Y
2.1
ACCOUNTING BODIES IN MALAYSIA
It is important that you know the accounting bodies that exist in Malaysia. The
accounting profession in Malaysia is governed by these bodies. Thus, the
accounting profession has to follow certain guidelines and rules set by the
bodies.
2.1.1
Malaysian Institute of Accountants (MIA)
Established under the Accountants Act (1967), MIA is an authoritative body
regulating the accounting profession. The main functions of MIA are to:
(a)
Determine the qualifications for members;
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ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES W
25
(b)
Provide training and continuing professional education to existing and
potential practitioners; and
(c)
Control the accounting practice in Malaysia.
(S
Source: www.mia.org.my, 17/08/06, 12.00pm)
2.1.2
The Malaysian Institute of Certified Public
Accountants (MICPA)
The Malaysian Institute of Certified Public Accountants (MICPA) was formed as
a professional body in 1958 under the Companies Act 19401946. The functions
and objectives of MICPA are to:
(a)
Advance the theory and practice of accountancy in all its aspects;
(b)
Recruit, educate, train and assess a body of members skilled in these areas;
(c)
Preserve at all times the professional independence of accountants;
(d)
Maintain high standards of practice and professional conduct by all its
members; and
(e)
Develop the accounting profession in relation to public practice, industry,
commerce, education and the public service.
2.1.3
Malaysian Accounting Standard Board (MASB)
Established under the Financial Reporting Act 1997 as an independent authority
to develop and issue accounting and financial reporting standards in Malaysia,
the main functions and authority of MASB are to:
(a)
Issue new accounting standards [Financial Reporting Standards (FRS)] as
approved accounting standards;
(b)
Review, revise or adopt existing accounting standards;
(c)
Issue statements of principles for financial reporting;
(d)
Sponsor or undertake development of possible accounting standards;
(e)
Conduct public consultation as necessary; and
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X TOPIC 2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
(f)
Develop a conceptual framework for the purpose of evaluating proposed
accounting standards.
(S
Source: www.masb.org.my,17/08/06, 3.00pm)
2.1.4
Financial Reporting Foundation (FRF)
The Financial Reporting Foundation (FRF) is established under the Financial
Reporting Act 1997 (Act) together with MASB. The FRF comprises representation
from all relevant parties in the standard setting process, including preparers,
users, regulators and the accountancy profession.
The FRF has responsibility for the oversight of the MASB's performance, financial
and funding arrangements and as an initial source of views for the MASB on
proposed standards and pronouncements. It has no direct responsibility with
regard to standard setting.
You may visit, http://www.mia.org.my and http://www.micpa.com.my to
further enhance your understanding on the role played by these bodies. Further,
for
more
information
on
MASB
and
FRF,
you
can
access
http://www.masb.org.my. If you are keen on financial reporting standards, they
can be found at http://www.masb.org.my/masbstd_appas2.htm.
2.2
ACCOUNTING STANDARDS
Accounting standards are guidelines that need to be adhered by the
accounting profession in preparing and reporting of the financial statements.
Rules and guidelines will definitely increase the work quality of accounting
professionals. How can we be assured that companies will follow the prescribed
guidelines?
The Companies Act 1965 requires companies to comply with approved
accounting standards. Section 166A of the Companies Act 1965 requires directors
of companies incorporated under the Act to ensure accounts are prepared in
accordance with the applicable accounting standards to the extent that the
accounts give a true and fair view.
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27
In Malaysia, the approved accounting standards comprise of the followings:
(a)
Financial reporting standards issued by MASB;
(b)
International accounting standards issued by International Accounting
Standard Board (IASB); and
(c)
Technical pronouncements published by MASB.
These accounting standards are developed from guidelines, practices, and rules
that are acceptable by the accounting profession and known as Generally
Accepted Accounting Principles (GAAP). The standards are established so that
the accounting practised is standardised and this increases the reliability and
comparability of financial statements.
2.2.1
Generally Accepted Accounting Principles (GAAP)
In preparing the financial statements, accountants have to follow certain
standards, guidelines, practices, and rules which are known as Generally
Accepted Accounting Principles (GAAP). This is to ensure that the financial
information provided to external parties to the business is prepared according to
a uniform set of assumptions and principles.
To prepare, use and interpret financial statements effectively we need to
understand these assumptions and principles. There are a number of
assumptions and principles. However, this module will only introduce selected
assumptions and principles.
GAAP, the common set of accounting principles, standards and procedures that
companies use to compile their financial statements. GAAP are a combination of
authoritative standards (set by policy boards) and simply the commonly
accepted ways of recording and reporting accounting information.
Source: http://www.investopedia.com/terms/g/gaap.asp
ACTIVITY 2.1
Eventhough GAAP principles has been in practice for a long time,
why do you think that unscrupulous accountants do still distort
figures?
28
X TOPIC 2
2.3
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
ACCOUNTING ASSUMPTIONS
LetÊs now look at the four assumptions used to facilitate the preparation of
financial statements.
2.3.1
Assumption 1: Separate Entity
For accounting purposes, the business is considered as a separate entity from the
owner. Both the owner and the business are two separate accounting entities. An
accounting entity is an economic unit that controls its own resources. Activities
of each entity must be separated from its owner.
For example, Kak Long owns three different businesses: a restaurant, a
laundrette, and a grocery store. Imagine, if only one account is prepared for all
business, would she be able to identify which business is profitable or not? For
accounting purpose there are four separate accounting entities: Kak Long, the
restaurant, the laundrette and the grocery store. It means each entity will need to
keep a separate accounting record. Separation of accounts will enable the owner
to know the financial position and performance of each entity.
Figure 2.1: Separate accounting entity
It is important to note that accounting entity is not the same as legal entity.
Business that is registered as a company is recognised as a legal entity. While for
sole proprietorship and partnership the law does not differentiate the business
and its owner.
TOPIC 2
2.3.2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES W
29
Assumption 2: Going Concern
An entity is assumed to be continuing its operations in the foreseeable future and
will not cease operations. This has important implication in valuing assets and
liabilities of a company.
Suppose Mak & Anak Bakery, owned a unique bread making machine costing
RM100,000. If Mak & Anak Bakery decides to close down, the machine is
worthless, as nobody else wants to use the bread making machine.
Therefore in order to report the bread making machine as asset worth
RM100,000, we have to make an assumption that Mak & Anak Bakery will
continue operating.
ACTIVITY 2.2
Syarikat Jojo has been making big profits for the past ten years of
operation. However, it will only continue to exist for the next two
years. Will you consider investing your money in Syarikat Jojo?
Justify your claim.
2.3.3
Assumption 3: Monetary Unit
All transactions can be measured in monetary units. In Malaysia the monetary
unit is Ringgit Malaysia (RM). Items that cannot be measured in monetary unit
will not be reported in the financial statements but disclosed as notes.
Transactions in foreign currency will be converted in RM for recording purposes.
2.3.4
Assumption 4: Accounting Period
This assumption states that the life of a business entity can be divided into
periodic intervals. This enables financial statements to be prepared periodically.
The accounting year of a 12 month period has been established as the normal
period for reporting. This enables the comparison of present and past
performance to be made for each accounting period.
Accounting year or fiscal year can start at any period but normally it is from 1st
January until 31st December, or it starts from 1st July and ends on 30th June the
next year.
30
X TOPIC 2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
Interim reports can be produced for a period of less than a year; monthly,
quarterly and semi-annually reports. These reports are produced to meet the
requirements of users for timely information.
2.4
BASIC ACCOUNTING PRINCIPLES
SELF-CHECK 2.1
You purchased a new Ferrari for RM500,000 to be used in your
business. The day after, a tree fell onto your new Ferrari. Once
repaired, the insurance company valued the Ferrari at RM300,000.
Can you record the value of the Ferrari at RM300,000? Why?
The four basic assumptions have resulted in the following principles:
2.4.1
Principle 1: Historical Cost
This principle states that all transactions must be recorded and accounted for
according to their historical cost, in other words, the original cost incurred at the
time of transactions as agreed by both buyer and seller.
2.4.2
Principle 2: Revenue Recognition
This principle states that revenue must be recognised when they are earned.
Earned commonly refers to the act of providing goods or services to customers.
Recognising revenue means the amount is recorded in the account.
This principle indicates that although cash has not been received, but goods have
been delivered or services have been performed, and thus revenue should be
recognised. The opposite also applies, if you have received cash in advance but
have not performed any service or provided any goods to your customer, you
cannot record the amount of cash received as revenue. In other words, revenue is
recognised when earned rather than when cash is received. This notion of
recognising revenue when it is earned and not when cash is received is called
accrual accounting. You will learn more about this in Topic 5.1.2.
The same applies to the recognition of expenses, where expenses should be
recognised when it is incurred not when cash changes hand. If you have received
the goods or services, although payments are to be made in the future, expense
must be recognised at that time.
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31
Figure 2.2: Relationship between revenues and expenses
2.4.3
Principle 3: Matching
To determine profit for the accounting period, the revenues of that period must
be matched with the expenses for the same period. As long as the revenue is
earned and expenses are incurred during the period, it must be taken into
account.
Take note that revenues can be cash or non cash, and expenses can be cash or
non-cash as well. Hence, profit (revenues minus expenses) is not the same as
cash. You can make a large profit but might have liquidity problem; in other
words you do not have enough cash to pay your creditors.
Use the time line diagram to help you learn the matching concepts and later
the calculation of revenue and expenses.
All Revenues for Year 1
match with
Year 1
Year 2
All Expenses for Year 1
Profit for Year 1 = Total Revenue in Year 1 - Total Expenses in Year 1
2.4.4
Principle 4: Full Disclosure
This principle states that all relevant and material information must be
adequately disclosed either in the financial statements or as notes accompanying
the statements.
32
X TOPIC 2
2.5
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
FORMS OF BUSINESS
Relationship between Business and Accounting
Business deals with a great numbers of decision making. Decisions include
pricing of products, deciding on investment, borrowing money, hiring
employees and expanding the business. To make decisions properly, managers
need useful information. Accounting information plays an important role in
this decision-making process. Business may be classified according to the types
of activities they are involved in and by the types of ownership. Different types
of business have different reporting requirements.
2.5.1
Types of Business
Business organisation can be categorised into several types according to their
main activities.
(a)
Merchandising/Retailing/Trading
The business main activities involve purchasing goods which are then sold
to customers. Examples are supermarkets, departmental stores, wholesalers
and grocery stores. These merchandisers buy various goods at a price (cost
or purchase price) and sold them to customers at a higher price (sale price).
One such example is Giant, the leader in MalaysiaÊs retail sector.
Figure 2.3: Giant, well known retailer for its cost effective goods.
You will learn in detail on the accounting for merchandiser in Topic 6.
TOPIC 2
(b)
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES W
33
Manufacturing
Manufacturing firms convert raw materials into finished goods. Examples
are oil refinery, car manufacturing company and toy manufacturing
company. A car manufacturing company purchased tyres, windshield as
their materials (parts) and hire labours to assemble this material into
finished products (cars). The cost of all materials, labour and other expenses
used to manufacture the car is the cost of manufacturing. The finished
product is then sold at a higher price than the manufacturing cost.
One example of a local car manufacturer is PERODUA. Its subsidiary,
Perodua Manufacturing Sdn Bhd, is responsible for the manufacturing of
the Perodua vehicles and selected vehicle component parts.
You will learn the accounting for manufacturing in the management
accounting subject.
(c)
Services
This business provides services to its customers. Examples are lawyers,
photocopying service, hotel, car rental and education. Lawyer provide legal
services or consultation services, they earned fees for services rendered to
customers.
Figure 2.4: Types of business organisations
ACTIVITY 2.3
Can you name specific business that you have encountered in the
following sectors?
(a)
Services;
(b)
Merchandising; and
(c)
Manufacturing.
34
X TOPIC 2
2.5.2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
Types of Ownership of Business
Types of ownership will have an impact on the accounting practices and
procedures of an organisation. Formats and information contained in the
financial statements are slightly different. Therefore you must understand the
different characteristics among the three types of ownership. There are three
basic forms of ownership: sole proprietorship, partnership and company.
(a)
Sole Proprietorship/Sole trader
As indicated by the name, the ownership belongs to any one individual.
Think of the „goreng pisang‰ seller at the corner of the street. The
formation of this type of business is relatively easy as there are only a few
legal requirements required before starting the business. For accounting
purposes, the owners are considered a separate entity from the business,
however for legal purposes the owner and the business are one entity.
The advantages of sole proprietorship are as follows:
(i)
Sole proprietorship is easy to set up.
(ii)
Owner has full control over the business decisions and activities.
(iii) Income of the business belongs to owner, and not shared with other
people.
(iv) Compared to other form of business organisations, it has less legal
requirement.
The disadvantages of sole proprietorship:
(i)
Difficult to expand as expertise and capital might be limited.
(ii)
Owner bears all the risks.
(iii) Unlimited liabilities.
(b)
Partnership
This type of business is owned by two or more individuals, called partners.
Just like the sole trader the formation requires no or little legal
requirements. The „goreng pisang‰ seller might want to expand his
business to include „nasi lemak‰. As such, he might invite an expert in
making „nasi lemak‰ to become his partner. However, an agreement must
exist between partners normally on how the profit or losses should be
shared. Similar to sole trader, no distinction is made between partners and
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ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES W
35
business for legal purposes. Therefore, all partners are responsible for the
business liabilities.
The advantages of partnership are as follows:
(i)
Higher sources of capital as owners are more than one.
(ii)
Partners might have additional skill and expertise to strengthen the
business partnership.
(iii) Unlike companies, partnership is not required to disclose business
information to an external party.
The disadvantages of sole partnership:
(i)
Unlimited liabilities
(ii)
Conflicts among partners will lead to instability in the management of
business
(iii) Lack of continuity; partnership will dissolve if one partner dies, or pulls
out of the partnership, or is declared bankrupt.
(c)
Company (Corporation)
Companies like Coca Cola and Maxis are owned by many people called
shareholders. Shareholders are people who own shares in the company. A
company is a separate legal entity from the owners, in other words an
„artificial person‰ that can conduct business in its own name, unlike sole
trader and partnerships.
The advantages of companies are as follows:
(i)
Limited liabilities.
(ii)
Easy to expand as they can issue shares and debentures to generate
funds as capital.
(iii) Continuity.
(iv) Shares can be transferred from one person to another easily.
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X TOPIC 2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
The disadvantages of companies are as follows:
(i)
Subjected to rules and regulations of the government
(ii)
Ownership is separate from the management
(iii) Set up cost is high compared to other forms of business
Figure 2.5: Types of business ownership
ACTTIVITY 2.4
If you plan to open up a gift store in the Midvalley Megamall, what
form of business and type of ownership will you choose? Give your
reasons.
The following tables summarises the differences between the various types of
ownership in a business entity.
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ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES W
37
Table 2.1: Comparison of Types of Ownership in a Business Entity
Proprietorship
Partnerships
Company
1.
Owner (s)
Proprietor
Partners
Shareholders
2.
Life
of
organisation
Limited
Limited
Indefinite
3.
Liabilities
Unlimited
Unlimited
Limited
4.
Accounting
status
Business
is
separate from the
proprietor.
Business
is
separate from the
partners
Business is separate
from the shareholders
5.
Legal status
None
None
A separate legal entity
6.
Formation
Relatively easy
Relatively easy
Complex
7.
Management
Normally by the
owner
Normally by the
partners
Managers/Directors
8.
Tax
Proprietor
pays
tax on business
profit
Each partner pays
tax on his share of
the profits
Companies pay tax on
the business profit and
shareholders pay tax
on the amount of
dividend they receive.
(Double Taxation)
The accounting profession has to follow standards, rules and guidelines
known as the generally accepted accounting principles to ensure uniformity
in preparing and reporting the accounting information.
The standards are established so that the accounting practised is standardised
and comparability of financial statements is increased.
There are four assumptions used to facilitate the preparation of financial
statements.
(i)
Separate entity assumption;
(ii)
Going concern assumption;
(iii) Monetary unit assumption; and
(iv) Time period assumption.
38
X TOPIC 2
ACCOUNTING STANDARDS, ASSUMPTIONS AND PRINCIPLES
The basic principles in accounting are:
(i)
Historical cost principles;
(ii)
Revenue recognition principles;
(iii) Matching principles; and
(iv) Full disclosure principles.
Business can be divided into three main categories: merchandising
(retailing/trading), manufacturing and services.
Business organisation can be formed as sole proprietorship (sole trader),
partnerships and companies.
Accounting Entity Assumption
Generally
Accepted
Principles (GAAP)
Historical cost accounting
Accounting Matching concept
Revenue recognition
Going concern concept
1.
Match the following accounting bodies with the main function listed below.
MIA
2.
MICPA
MASB
(a)
________________
publishes accounting standards.
(b)
________________
provides training to accountants.
(c)
________________
controls the accounting practice in Malaysia.
(d)
________________
issues statements of principles for financial
reporting.
Can a company ignore the accounting standards in the preparation and
reporting of its financial statements?
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39
3.
Malaysian Airline (MAS) revenues come from a number of different
sources: ticket sales, holiday packages, rentals of planes and advertisings.
Take for example, ticket sales; normal tickets sold are fully refundable until
24 hours of flight cancellation. However, tickets sold on super saver plan
are not refundable. At what point of time will MAS recognise the revenue
from these situations?
4.
Classify the following businesses according to their type of business.
Business
Car Rental
Car Dealership
Tuition Centres
Batik Factory
Tailor
Clothing Stores
1.
2.
Type of Business
Explain the following accounting assumptions:
(a)
Separate entity;
(b)
Going concern;
(c)
Monetary units; and
(d)
Accounting Period.
Explain the following accounting principles:
(a)
Historical Cost;
(b)
Revenue Recognition;
(c)
Matching; and
(d)
Full disclosure.
3.
Identify three types of business ownership.
4.
Explain the characteristics of each of the business ownership identified in 3
above.