Accounting Concepts, Recognition and Measurement

The Conceptual Framework tells you what useful information looks like. This topic shows how the ideas work on actual figures. It covers when an item enters the statements (recognition) and leaves them (derecognition), the bases on which amounts are measured, and the accounting concepts that guide day-to-day decisions: going concern, accruals, materiality, offsetting, consistency, prudence, substance over form, the business entity and fair presentation.

This is some of the most reliably examined theory in the paper. A written question asking you to explain several concepts, each for 2 marks, appears in five of the 20 diets reviewed, and Section A regularly asks which concept applies to a stated situation. Read the topics on FRC Nigeria, bases of accounting and elements of financial statements and on the Conceptual Framework and qualitative characteristics first.

Duality, the concept behind double entry, is taught in the double entry topic.

Recognition and derecognition

Recognition is the process of including in the statement of financial position or the statement of financial performance an item that meets the definition of an element. It has two parts: describing the item in words and giving it a monetary amount. The amount at which an asset, liability or equity item is shown in the statement of financial position is its Carrying amount.

Recognition is linked across elements, so recognising one item often means recognising or derecognising another. Revenue, for example, is recognised at the same time as the receivable (Conceptual Framework, paragraph 5.1).

Recognition criteria

An item is recognised only if it meets two tests (Conceptual Framework, paragraph 5.6).

1. It meets the definition of an asset, liability or equity for the statement of financial position, or of income or expenses for the statement of financial performance.
2. Recognising it gives users useful information, meaning information that is relevant about the item and about any resulting income, expenses or changes in equity, and a faithful representation of them.

Recognition may not be appropriate if there is significant uncertainty that the asset or liability exists, or if the probability of an inflow or outflow of economic benefits is low. The ability to represent the item faithfully can also be limited by a high degree of measurement uncertainty or by other factors.

The current framework differs from the older one. Under it, an item was recognised if it met the definition, if it was probable that benefits would flow in or out, and if its cost or value could be measured reliably. The International Accounting Standards Board (IASB) now treats probability as a point for measurement and relevance and not as a separate criterion. The practical effect is small.

Derecognition

Derecognition is the removal of an item from the statements when it no longer meets the recognition criteria, often because the risks and rewards have passed to someone else. An asset is derecognised when the entity loses control of it, which means it can no longer direct its use or obtain its benefits. A liability is derecognised when the obligation is discharged, cancelled or expires (Conceptual Framework, paragraph 5.26).

Example. A company buys a delivery van for ₦8,500,000. The van is a resource the company controls from which it expects benefits, and its cost is known, so it is recognised as an asset. When the van is sold the company loses control of it and derecognises it.

Measurement bases

Measurement is the basis on which an element is recognised and reported. The choice of basis considers relevance and faithful representation, measurement uncertainty and the cost constraint. There are four bases, and each standard says which applies in which circumstances.

Background. The 2018 Conceptual Framework groups measurement bases as historical cost (paragraph 6.4) and current value (paragraph 6.10 onwards), with current cost, fair value and value in use among the current value measures. The four-basis list below follows the questions set in past papers, so use it for the examination.

Historical cost is the most used basis but it is often modified. Inventory, for instance, is measured at the lower of cost and net realisable value. The first two bases are the Historical cost and current cost conventions named in the syllabus.

Accounting concepts at a glance

Accounting concepts are the broad principles and assumptions that sit under the preparation of financial statements. Some come from the framework and others from International Accounting Standard (IAS) 1. The table gives a one-line meaning of each, and the sections that follow develop the ones that carry the most marks.

Materiality and aggregation

IAS 1 requires that each material class of similar items is presented separately in the statements (IAS 1, paragraph 29). Information is material if omitting or misstating it could influence the decisions users make from the report of a specific entity. An error so small that it does not affect users’ understanding is Immaterial. No absolute test applies to every business. There is no rule that an item above 5% of profit is material. Judgement considers magnitude, nature or both.

• Magnitude. Whether a given amount is material depends on its size against the figure it affects. The same error of ₦60,000 is 0.4% of non-current assets of ₦15,000,000 and not material, but 20% of a profit of ₦300,000 and material.
• Nature. Some items are material whatever their size because the law or a standard requires them to be disclosed. Presenting two large amounts as one small net figure is also a material misstatement, even if the net is arithmetically right, because users cannot judge the risk in each.

Offsetting

IAS 1 says that assets and liabilities must not be offset against each other, and neither may income and expenses (IAS 1, paragraph 32). Each is reported separately. A Net figure results from combining a positive and a negative amount. The exceptions are where:

• a standard or an interpretation requires or permits offsetting; or
• offsetting reflects the economic substance of the transaction. IAS 1 gives the example of reporting a gain or loss on disposal of a non-current asset as the sale proceeds less the carrying amount and the related selling expenses.

Suppose a business owes Mr Ade ₦2,400,000 and is owed ₦2,150,000 by Mr Ben. It must show a liability of ₦2,400,000 and an asset of ₦2,150,000. It must not show a single net liability of ₦250,000, because that hides the risk that Mr Ben may not pay.

Consistency of presentation

Comparable information needs consistent presentation. IAS 1 requires items to be presented and classified the same way from one year to the next (IAS 1, paragraph 45). There are two exceptions. The first is when, after a significant change in operations or a review of the statements, a different presentation or classification would be more appropriate. The second is when a new standard or an interpretation requires a change.

Consider a manager promised a bonus if gross profit rises by more than 10%. Last year the cost of sales included production costs of ₦28,000,000 and warehousing costs of ₦6,000,000. This year the manager moves warehousing to other expenses.

Net profit is the same at ₦7,000,000, but gross profit jumps from 32% to 44% of sales (22 ÷ 50) only because of the change in classification. That could mislead the person deciding the bonus. If the new classification is right, last year’s figures must be restated on the same basis.

Prudence and the other concepts

Prudence means allowing for caution in preparing the statements, with reasonable and sensible allowances to avoid overstating assets or income and avoid understating expenses or liabilities. Prudence is no longer set out in the framework, but standards still rely on it. One general rule that comes from it is that an asset is not shown at more than the cash it will generate.

If it would be, it is written down. A company with receivables of ₦8,000,000 that expects 3% not to be collected makes an allowance of ₦240,000 and shows net receivables of ₦7,760,000. The ₦240,000 is also an expense in the statement of profit or loss. An allowance of 10% would be excessive and not prudent. Bad and doubtful debts have their own topic.

• Going concern. Unless stated otherwise, the entity is assumed to continue for the foreseeable future with no intention or need to liquidate or curtail its operations significantly.
• Accruals. Income is recognised when earned and expenses when incurred, whatever the cash timing. This produces prepayments and accrued expenses. Prepaid expenses and amounts owed by customers are assets. Income received in advance and amounts owed to suppliers are liabilities.
• Substance over form. Transactions are often governed by legal rules, but they are accounted for according to their economic reality. Without that, the statements would not represent faithfully what happened. Sale and repurchase agreements, lease contracts and consignment of goods are examples.
• Business entity. Business income and costs are kept separate from the private income and costs of the owner. If an owner pays a personal electricity bill from the business bank account, the amount is the owner’s drawings and not an expense of the business. The concept underlies proper double entry.

Fair presentation

Statements are said to give a true and fair view, or to present fairly. IAS 1 requires fair presentation of the financial position, performance and cash flows (IAS 1, paragraph 15). The framework does not define true and fair, but it says that an entity that complies with IFRS and whose information has the qualitative characteristics should convey what is generally understood as a true and fair view.

IAS 1 describes fair presentation as the faithful representation of the effects of transactions, other events and conditions according to the framework’s definitions and recognition criteria.

Faithful representation goes beyond making the amounts materially correct. It means showing the substance and economic reality of transactions, not hiding important information through poor classification or inadequate disclosure, and not misleading users. Where legal form and economic substance conflict, the statements must show the substance. An entity whose statements comply fully with IFRS must say so, and it must not claim compliance unless it meets every applicable standard.

Sometimes fair presentation needs more than compliance, so the spirit of a standard matters as well as its wording.

The ideas in more depth

Accruals and cash

The accruals concept is the reason the statement of financial position holds receivables, payables, prepayments and accrued expenses. If you remember that every accrual or prepayment is a result of this one concept, the later topics on adjustments become easier to follow.

Recognition links the elements

Recognising a sale creates revenue and a receivable together. Paying a supplier removes a liability and cash together. Because double entry always has two sides, recognition always involves at least two elements, which is why the topic on double entry follows from this one.

Choosing the measurement basis

Historical cost is objective and checkable, since the cost is in the invoice. Current cost is more relevant when prices have moved, but it needs estimates. Realisable value is the only sensible basis when the business is closing. Present value suits long-term items where the timing of cash matters. Lower of cost and net realisable value is a mix of two bases, applied to inventory.

Materiality, aggregation and offsetting together

Aggregation lets a statement show a manageable number of lines, and materiality decides which items must be shown on their own. Offsetting is the opposite risk: merging items so that important amounts disappear. All three serve the same aim, which is statements that users can understand and rely on.

Prudence is not permission to understate

Prudence asks for reasonable caution. Deliberately making excessive allowances would also mislead users, so it conflicts with neutrality and faithful representation.

Sources and references

• IASB, Conceptual Framework for Financial Reporting (March 2018): paragraphs 5.1 and 5.6 (recognition), paragraph 5.26 (derecognition), and paragraphs 6.4 and 6.10 (measurement bases).
• IAS 1 Presentation of Financial Statements: paragraph 15 (fair presentation), paragraphs 25 and 26 (going concern), paragraphs 27 and 28 (accrual basis), paragraphs 29 to 31 (materiality and aggregation), paragraphs 32 to 35 (offsetting) and paragraphs 45 and 46 (consistency of presentation).

Worked example: concepts applied at Oriental Foods

1. Inventory. Measured at the lower of cost and net realisable value. ₦420,000 is lower than ₦480,000, so inventory is carried at ₦420,000 and ₦60,000 is written off as an expense.
   Check: ₦480,000 − ₦420,000 = ₦60,000.
   The concept is Prudence.
2. Machine. On the going concern basis it stays at historical cost less depreciation, starting from ₦2,000,000. Current cost is ₦2,600,000. Realisable value of ₦1,400,000 would apply only if the business were being closed.
3. Amounts with one supplier. The business must show a liability of ₦1,800,000 and an asset of ₦1,550,000. Netting to a liability of ₦250,000 is Offsetting, which is not allowed here.
   Check: ₦1,800,000 − ₦1,550,000 = ₦250,000.
4. Receivables.
   Allowance = 2% × ₦5,000,000 = ₦100,000, so net receivables are ₦4,900,000.
   The concept is prudence.
5. Personal rent. The ₦120,000 is the owner’s Drawings and not a business expense. The concept is the Business entity concept. If it were wrongly charged as rent, profit would be understated by ₦120,000.

Common mistakes in the exam

• Defining a concept in a sentence without saying how it affects the accounts. The question usually asks for the accounting treatment.
• Confusing accruals, which governs timing, with the cash basis.
• Using the break-up basis or realisable value for a going concern.
• Saying materiality has a fixed percentage.
• Offsetting a receivable and a payable with the same party without noting that IAS 1 forbids it.
• Treating consistency as a rule that a policy can never change, and forgetting its two exceptions.
• Calling prudence permission to understate profit. It means reasonable caution.
• Treating the owner’s private payments from the business as expenses instead of drawings.

Quick revision

• Recognition: meets the definition of an element and gives relevant, faithful information. Derecognition: control lost or liability ended.
• Four measurement bases: historical cost, current cost, realisable value, present value. Realisable value for non-going concerns.
• Inventory: lower of cost and net realisable value.
• Materiality: size or nature, no fixed threshold. Show material classes separately.
• Offsetting: not allowed unless a standard permits or substance requires it.
• Consistency: same presentation each year, with two exceptions.
• Prudence: reasonable caution, no overstating assets or income.
• Fair presentation: faithful representation, compliance with IFRS, substance over form.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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