6.1 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. ACCOUNTING Financial and Organisational Decision Making Chapter 6 Underlying assumptions of the historical cost accounting system Slides written and designed by Tony Van Eekelen

Chapter 6: Underlying assumptions of the historical cost accounting system 6.2 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Learning Objectives In this chapter you will be introduced to –how a general theoretical framework can help with choosing between alternatives –a theoretical framework in terms of objectives, assumptions, principles and rules –the difference between an inductively and deductively derived framework

Chapter 6: Underlying assumptions of the historical cost accounting system 6.3 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Learning Objectives –how the objectives, assumptions and principles impact on the recording and reporting of accounting information –how the assumptions relate to the objectives of historical cost accounting –the elements of historical cost accounting reports

Chapter 6: Underlying assumptions of the historical cost accounting system 6.4 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. The problem of choice Should the event be included in the accounting system? How will the accounting equation be affected by this event? These two choices exist throughout accounting and thus it is necessary to establish some principles to guide the process of decision making.

Chapter 6: Underlying assumptions of the historical cost accounting system 6.5 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. A general framework for design Objectives Assumptions Principles Rules

Chapter 6: Underlying assumptions of the historical cost accounting system 6.6 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. A general framework to aid decision making Objectives –set the purpose for why we are making the decisions Assumptions –are statements accepted by the designer as self- evident facts without argument –are varied by degree of certainty –regard all assumptions with caution

Chapter 6: Underlying assumptions of the historical cost accounting system 6.7 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. General framework Principles –must be justified entirely by logical argument within the framework Rules –application of principles –are more specific and narrower than principles

Chapter 6: Underlying assumptions of the historical cost accounting system 6.8 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Deductive vs. Inductive The above model of objectives, assumptions, principles and rules can be derived in two ways. The deductive approach is to start with the objectives and work your way down. Thus the rules and principles are deduced from the objectives and assumptions

Chapter 6: Underlying assumptions of the historical cost accounting system 6.9 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Deductive vs. Inductive An alternative approach is to look at what system already exists This method of inductive research involves observing the current practice and inducing the principle and objectives Historical cost accounting developed this way

Chapter 6: Underlying assumptions of the historical cost accounting system 6.10 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Deductive vs. Inductive ObjectivesAssumptionPrinciplesRules Empirical inductive approach Deductive approach

Chapter 6: Underlying assumptions of the historical cost accounting system 6.11 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. The objectives of historical cost accounting system The objective of an accounting system involves the production of relevant and reliable information to aid the users of this information in their decision making process. Problem: trade-off between reliability and relevance

Chapter 6: Underlying assumptions of the historical cost accounting system 6.12 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. The assumptions of the historical cost accounting system Assumptions have been derived to achieve the objective of reliability and relevance Objectives Usefulness of information for decision making requiring RelevanceReliability

Chapter 6: Underlying assumptions of the historical cost accounting system 6.13 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Accounting entity –Separation distinguishes between the affairs of the owners and the entity in smaller firms (sole traders and partnerships) the separation is more difficult as by law the two accounting entities are one. Not so for companies. –Viewpoint procedures relate to the entity owner is an external party

Chapter 6: Underlying assumptions of the historical cost accounting system 6.14 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Ownership and economic resources –Accountants have the task of measuring only those resources that have economic value –Two types of value value in exchange value in use –resources must be scarce economic resources = creditors claims + owners claims

Chapter 6: Underlying assumptions of the historical cost accounting system 6.15 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Money measurement –the unit of measurement is important –money as a medium of exchange is assumed to be the unit of measurement –use national currency $ –Problems inflation exchange rates time value of money

Chapter 6: Underlying assumptions of the historical cost accounting system 6.16 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Accounting period –requirement for information at regular intervals –problems cut-off date may result in incomplete venture thus measurement problem valuing of inventory, value of asset

Chapter 6: Underlying assumptions of the historical cost accounting system 6.17 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Continuity or going concern –the entity is assumed to continue in operation into the foreseeable future –at end of accounting period this assumption of continuity assumes that incomplete ventures will be completed in the future –assets are placed in the balance sheet to show the future economic benefit

Chapter 6: Underlying assumptions of the historical cost accounting system 6.18 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Relevance assumptions Capital maintenance and profit –no dividends can be paid except out of profits –profits are defined as the growth in net assets over a period of time after owners contributions are taken into account $100,000 Capital $100,000 Increase $20,000 Net assets beginning Net assets end

Chapter 6: Underlying assumptions of the historical cost accounting system 6.19 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Reliability assumptions For information to be reliable it must not contain bias or errors Faithful representation –financial statements faithfully represent all the transactions and events in the accounting period –historical cost system does this well

Chapter 6: Underlying assumptions of the historical cost accounting system 6.20 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Verifiability –similar measures or conclusions would be reached if two or more qualified persons examined the same data –again historical cost performs this well Reliability assumptions

Chapter 6: Underlying assumptions of the historical cost accounting system 6.21 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. The broad principle of historical cost accounting Using the objectives of reliability and relevance and the assumptions, principles can now be derived Two main principles are –primary transaction basis –dollar measurement

Chapter 6: Underlying assumptions of the historical cost accounting system 6.22 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Primary transactions basis No primary entry may be entered into the accounting system unless it is evidenced by a past external transaction involving the entity external event involving the transfer of something of value between two entities evidence includes all documents secondary entries do exist –essentially reallocation of amounts from primary entries

Chapter 6: Underlying assumptions of the historical cost accounting system 6.23 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Events vs. transactions External transactions All economic events affecting entity Data processing Reports on entity

Chapter 6: Underlying assumptions of the historical cost accounting system 6.24 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Dollar measurement Every transaction or event recorded in the accounts shall be measured in dollars Follows from the money measurement assumption

Chapter 6: Underlying assumptions of the historical cost accounting system 6.25 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Statement elements Assets –are economic resources controlled by the entity for the purpose of providing future benefits to that entity –Related assumptions are resources offering future benefits through use or exchange - ownership & economic resources under the control of the entity - entity, ownership and economic resources It must have been acquired in a past, external transaction - primary transaction principle

Chapter 6: Underlying assumptions of the historical cost accounting system 6.26 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Statement elements Liabilities –regarded as an obligation and meets the following A claim on the entity involving a future sacrifice of economic resources - ownership and economic resources the resources are to be sacrificed by the entity to an external entity - entity assumption Must arise out of a past external transaction - primary transactions principle

Chapter 6: Underlying assumptions of the historical cost accounting system 6.27 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Statement elements Owners equity –Interest of owners in the net asset of an entity at any time –Owners equity = assets - liabilities –Capital changes due to contributions or withdrawals not profits –Profits is the change in net assets after capital changes

Chapter 6: Underlying assumptions of the historical cost accounting system 6.28 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Statement elements Revenue –are accomplishments of the earning process of a business enterprise during a period –usually represent cash inflows that have occurred or will probably eventuate –will be as a result of the entitys operations during the period –Capital contributions are not revenue

Chapter 6: Underlying assumptions of the historical cost accounting system 6.29 PPS t/a Carnegie et al; Accounting: Financial and Organisational Decision Making © 1999 McGraw-Hill Book Co. Aust. Statement elements Expenses –maybe regarded as expired assets –as economic resources that have been consumed during the period resources consumed must have been acquired in a past transaction - primary transaction basis resources that have expired during the period - ownership and economic resources Withdrawals by owners are not expenses but capital reduction - capital maintenance –Problem - when a resource has been consumed and how much has been consumed?