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by Phil Todd 01 Apr 2000 Diploma in Financial Management Relevant to All Papers

To appreciate, and therefore be able to interpret a set of Financial Statements, it is necessary to have an understanding of the fundamental principles upon which they are based. Phil Todd, lecturer at Financial Training Company writes

Interpretation of financial statements
Indeed, all the detailed accounting rules and regulations contained in the SSAPs and FRSs have their origin in these basic tenets.

For the examination, particularly paper 1, Interpretation of Financial Statements, it is necessary not only to know what these principles are, but also to be able to explain what they mean in simple layman’s terms and be able to illustrate them with examples. The purpose of this article is to enable you to achieve this threefold objective.

SSAP 2
Our starting point must be SSAP 2, which contains four of these fundamental principles. The four concepts covered by SSAP 2 are:

• going concern;
• consistency;
• accruals;
• prudence.

It should be noted that when the last major Company Law overhaul was performed in the early 1980s, the significance of these principles was accepted by their inclusion in statute - as part of what is now the Companies Act 1985. It is therefore the case that in preparing Financial Statements, which adhere to these concepts, the directors of a company are not only following best accounting practice, but also complying with statute.

Before looking at each of the SSAP 2 concepts in more detail, it must be appreciated that these four do not provide an all-inclusive list. Indeed, for the examination, any question requiring a discussion of ‘the fundamental concepts’ would undoubtedly expect candidates to consider the matter more widely than just SSAP 2. We shall return to these other issues later.

The going concern concept
Perhaps the most straightforward of the concepts, but no less important as a result. The going concern concept simply means that the Financial Statements have been prepared on the assumption (or perhaps expectation) that the company will remain in operational existence for the foreseeable future. In this context, the foreseeable future is taken to be the next twelve months, unless the Financial Statements stipulate some shorter period of time. It is readily apparent how important this concept is, both to the preparation of the Profit and Loss Account and the Balance Sheet.

If it were not the case, and the company was to be wound up, the assets of the company would be included at their realisable value (in a forced sale) net of any taxation implications which might arise. In a ‘normal’ situation where the going concern concept is applicable, such assets are included at their original cost, net of any required depreciation. By having this as one of our fundamental concepts, it becomes implicit that any set of financial statements relates to a company, which will continue in operational existence for the foreseeable future, unless the contrary is stated.

The consistency concept
As we study accountancy, we very quickly appreciate those things we once thought of as absolutes are in fact not so in practice. For example, whereas we may once have believed that a company’s profit for the year was a matter of fact, we now know that it is at the mercy of a whole range of accounting policy choices. This can be something as simple as the way it charges depreciation on its fixed assets or as complex as the way it recognises revenue on its long-term contracts. In either case, a decision needs to be taken and adhered to, if the accounts are to make sense. In other words, there must be a consistent application of accounting policies, both within an accounting period and from one period to the next.

Without consistency we cannot have comparability; and without comparability, financial reporting is rather meaningless. For example, a profit for the year of £100m may initially be perceived as good, but can only really be assessed by comparison with last year and/or budget for this year.

Finally, it must be noted that the consistency concept does not preclude changes being made. Clearly, as time goes by, new accounting practices will develop. However, as these are adopted two things must happen. First, they must be fully disclosed as a change in accounting policy. And second, the comparative figures for the previous year must be restated under the new policy so as to facilitate comparison.

The accruals concept
Also known as the matching concept, because of the way it strives to match costs against the revenues generated by incurring those costs, the accruals concept is in many ways the most significant of all. Its basic tenet is that revenues should be recognised (i.e. included in the Profit & Loss Account) in the period in which they are earned, not necessarily when they are received in cash. Thus, for example, a sale made to a customer on credit just before the year-end would be included in that year's Profit & Loss Account, even though the cash may not be received until the following year.

In the same way, expenses are recognised according to the period to which they relate, and not when they are paid. For example, an electricity bill not paid by the year-end would still be charged in that year's Profit & Loss Account whereas rates paid in advance would be held back and not charged until the next year.

The previous examples of how to apply the accruals concept are comparatively straightforward. However, the concept is all-pervasive and does provide guidance in many more complex scenarios.

The depreciation of fixed assets
This is a classic example of the accruals concept at work (and certainly one worth remembering to give in the exam).

Fixed assets are bought to provide benefit to the company i.e. help generate revenue, over several accounting periods. The accruals concept therefore requires us to estimate the net cost of the asset (i.e. cost less residual value) and charge it to the periods expected to benefit from its use (i.e. its useful economic life). In other words, we are matching the cost of using the asset with the revenue it helps to generate.

It goes even further. If we expect the revenue patterns to be other than even, we would charge depreciation in such a way as to charge more where revenues are greater and less where they are smaller.

Long-term contracts
Where a company undertakes, for example, large civil engineering contracts, which take several years to complete it is the accruals concept which helps determine how the revenue should be recognised.

Imagine building a new shopping complex for a price of £500m, which will take five years to complete. How should the company account for the revenue in its Profit & Loss Account? Again it is the accruals concept which provides the guidance.

Since the revenue is earned as the complex is built (irrespective of the cash received) it should be recognised a little each year over the five-year period.

Of course, precisely how much should be regarded as earned each year is open to debate; the accruals concept simply provides us with the principle.

Life-time subscriptions
A gymnasium or golf club may offer their members the opportunity to take out lifetime subscriptions, rather than the normal annual ones. Clearly this is good news for the cash flow of the club and represents income/revenue. However, the question is raised as to when this income should be recognised in the accounts. There is no uncertainty surrounding it - it’s all been received. Again, it is the accruals concept which provides guidance in this respect. Since the members will enjoy the benefits of club membership over several future periods, and the club will incur costs associated with that membership over the same period, the revenue should be deferred and taken to Profit & Loss over that same period - i.e., matched.

It should, however, be noted that a significant exercise of judgement would still be required to determine the period of time over which the revenue will be spread. In other words, the concept of accruals provides the basic approach but not the detailed mechanics. Since this will be different in every case, it would be impossible for any concept to be that specific.

The prudence concept
This is the concept which means that revenues and profits should not be anticipated, rather they should only be included once their realisation in cash is reasonably certain. Conversely, provision should be made for all known liabilities. Thus, a conservative approach is adopted in determining profits. Indeed, wherever a conflict arises between the application of the accruals and prudence concepts, it is prudence, which prevails. The following examples illustrate this conflict:

Research and development costs
Following the accruals concept, any money spent by a company on research into new products would be deferred to the future and matched against the revenue generated by the new product. However, as there is no certainty that the research will lead to the successful development of such a product, the prudence concept would require the research costs to be written off as incurred. As stated earlier, the prudence concept prevails - as detailed in SSAP 13.

Long-term contracts
We saw under the discussion on the accruals concept that revenue on a long-term contract should be recognised over the life of the contract, as contract activity progresses. However, particularly in the earlier years, it may be difficult to determine whether or not the contract will actually make a profit overall. Whilst this is the case, the prudence concept would prohibit recognising any profit in the Profit and Loss Account. In other words, since a chunk of revenue is being recognised, it would need to be matched with an equivalent amount of cost to reveal no net profit.

Unfortunately, recent years have seen some accountants hide behind the prudence concept in creating Financial Statements which show the company in a favourable light, but which destroy the ‘True & Fair’ view. The Stock Exchanges like to see companies producing steady, growing profits. The nature of the real world, however, is that profits tend to be a bit more erratic than they would like.

By creating provisions in the good years, in the name of ‘Prudence’, and releasing them in the bad years, accountants have been able to smooth out this effect. Such practices are now much harder to achieve following the advent of FRS 12, but the price we may have to pay is much more volatile reported profits.

FRS 5
This accounting standard deals with another fundamental accounting concept, namely that of ‘Substance over Form’. The fact that this was not included in SSAP 2 should not in any way be thought of as diminishing its importance. Indeed, it has always been a fundamental concept of the greatest importance which must be followed in order for accounts to show a ‘True and Fair’ view. So what does it mean?

The concept requires that when reflecting transactions in Financial Statements, we should look to the commercial substance rather than the strict legal form. This can best be illustrated by example.

A hire purchase (HP) agreement has the legal form of a hire agreement during its life, with legal title only passing at the end. If we were to account for this according to the strict legal form, the asset would only be capitalised at the end of the HP agreement and during the agreement’s life, the ‘HP charges’ would simply be charged to Profit and Loss Account. However, the substance of this transaction is that the buyer obtains the use of the asset from the outset of the agreement and this should be reflected in the accounting treatment adopted. In short, we should treat the asset as if it was bought outright at the start.

The major reasons for applying substance are twofold. First, to ensure that we have comparability between companies whose activities are essentially the same, but who achieve this in slightly different ways - as in the example above.

However, there is a somewhat more sinister reason. As discussed under ‘prudence’, some accountants/directors are quite prepared to take whatever steps they can to produce Financial Statements, which show their companies in the best possible light. By allowing them to hide behind the strict legal form of certain transactions, this process could be made easier.

The following are further examples of the application of the concept of substance over form:

• accounting for groups;
• consignment stock;
• sale and repurchase agreements.

Looking at each in turn:

Accounting for groups
Some companies grow by doing so organically i.e., from within.

However, by far the more common approach is to grow by acquisition.

This then produces what is known as a ‘group of companies’ comprising the original company, which is doing the acquiring (the parent), and one or more companies which have been bought (the subsidiaries). The strict legal form here is that each company remains a separate legal entity and as such must prepare its own accounts. However, the substance of the situation is that the group is effectively a single operating unit. We therefore apply ‘substance over form’ and produce a single set of accounts for all the companies combined - which are known as the ‘Consolidated Accounts’. Thus they provide a ‘True and Fair’ view of the affairs of the group as a whole.

Consignment stock
A common situation where a manufacturer sends goods to a dealer who then sells them. A problem can arise at the year-end when goods remain at the dealer unsold. The question arises as to who’s stock it is and therefore in which set of accounts it should appear. Normally, the fact that the goods are at the dealer would suggest that he had bought them and that they should therefore be regarded as his stock. However, we apply substance over form and look at which of the two parties has control over the stock, rather than simple legal title.

Sale and repurchase agreements
A simple example will best illustrate the problem.

XYZ plc has stock worth £25m, which it sells to ABC plc for £30m cash just before the year-end. On the face of it, this produces profit of £5m for XYZ, increases its current assets by £5m and improves its non-stock current assets by £30m. This does wonders for its profitability and liquidity ratios.

However, an agreement is signed giving XYZ the right to buy the goods back, or ABC the right to sell back, just after the year-end for £33m. Although the legal form is a sale, the substance of the transaction is that of a loan from ABC to XYZ of £30m, repayable with interest of £3m.

FRS 5 requires this substance of the transaction to be recorded rather than the legal form.

Conclusion
It is easy to disregard the fundamental concepts of accounting practice in the light of all the detailed rules provided by the Companies Act 1985, the SSAPs and the FRSs. However, this would be a mistake. These concepts not only underpin the solutions provided by many of these accounting regulations but they also provide the framework for dealing with just about every accounting problem which exists. Their importance today is as significant as ever.

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