The conceptual framework
In Australia, the AASB Framework provides guidance on the following:
– Which entities must make their financial statements publicly
– The purpose of external financial reporting.
– Qualities that the financial statements should have.
– The elements of accounting (from lecture 1).
AASB - Australian Accounting Standards Board
• The ‘Conceptual Framework’ provides characteristics that general
purpose financial information should have if it is to be useful for decision
• Fundamental characteristics:
– relevance and reliability (faithful representation) (the latter is
proposed to replace the current qualitative characteristic of
• Enhancing characteristics:
Who must report?
• ‘Reporting Entities’.
• These are entities that are considered to have external users relying on
their financial information to make decisions.
• Statement of Accounting Concepts 1 (SAC1) defines a ‘Reporting Entity’ as
any entity in which it is reasonable to expect the existence of users who
depend on general-purpose financial statements for information to enable
them to make economic decisions.
• The key factor is dependence.
• Many entities have users, but they are not all dependent users.
• If the only users related to an entity are those who can command
information when needed, they are not dependent, therefore the entity is
not a reporting entity.
• The users must not be in a position to command information, they are
Owner’s Equity = Assets – Liabilities
Assets = Liabilities + Owner’s Equity Income
“… increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that
result in increases in equity, other than those relating to contributions from
• An increase in economic benefits
• Assets or Liabilities
• Result in an increase in equity, but
• Excludes owner’s contributions of equity
“…decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrence of liabilities that
result in decreases in equity, other than those relating to distributions to
• A decrease in economic benefits
• Assets or Liabilities
• Result in a decrease in equity, but
• Exclude distributions to owners
Recognition Criteria for the elements
We have discussed the definitions of the elements, but there are two
‘recognition criteria’ for the elements as well:
– Probable Occurrence
– Reliable Measurement
An item cannot be recorded in the entity’s accounts unless it satisfies
both of these recognition criteria.
• Probable occurrence requires that there be a greater than 50% chance of
the increase or decrease in economic benefits occurring.
• Reliable measurement requires that to be recorded in the accounts, the
item must have a cost or value that can be measured reliably.
• To fully justify how a particular item should be recorded in the accounts
requires an explanation of the element(s) affected, their definitions and
recognition criteria. Extended accounting equation
Assets = Liabilities + Equity + Income – Expenses - Drawings
• Income is shown as a positive addition to owner’s equity, since income
contributes to profit.
• Expenses are shown as a deduction from owner’s equity, since expenses
Assets + Expenses + Drawings = Liabilities + Owner’s Equity + Income
Assets, Expenses and Drawings are treated
in the same way:
Liabilities, Income and Capital are treated
in the same way: Cash-basis accounting
• Records income when it the cash has been received (regardless of
whether the income has been earned).
• Records expenses when they have been paid (regardless of whether the
expense has been incurred).
• The profit (loss) is based on what was actually received/paid from
income/expense related items.
• Under cash-basis accounting:
Profit/Loss = cash receipts for income items – cash payments for expense items.
• Entities produce financial statements for a period of time, usually 12
• Cash accounting can cause transactions to be recorded in a different
period from when the economic substance of the transaction actually took
place, as it focuses on recording the cash flow.
• This approach can be problematic if advance payments of cash or delays
in payment of cash occur.
• Records income when it has been earned (regardless of whether the cash
has been received).
• Records expenses when they have been incurred (regardless of whether
the cash has been paid).
• The profit (loss) for a period is based on what was actually
earned/incurred during a period regardless of the cash received or paid.
This better reflects the business performance for the period than cash-
• Most entities use accrual-basis accounting as it produces more relevant
information about business performance.
• An accrual-based accounting system manages transactions by recording
‘temporary’ asset or liability accounts to deal with the timing of the cash
receipt or payment being different from the timing of the earning of
revenue or incurring of expenses.
Effects of accrual-basis accounting on financial reporting
• Accrual-basis accounting records transactions when income is earned or
expenses incurred, and ignores whether there has been a corresponding
exchange of cash.
• The accrual-basis income statement, showing profit or loss for a period,
will not necessarily have a direct relationship to the cash received or paid
during that same period.
Chart of accounts
• A Chart of Accounts is used to number accounts, and assist the
accountant in locating ledger accounts and posting correctly.
• The chart of accounts should show accounts used in the business,
grouped according to the element to which they belong.
• Each element must begin with a new number to avoid confusion with
• The numbers chosen should be flexible to allow for more accounts to be
added at a later date. Ledger accounts
• An account is an individual accounting record of increases and decreases
in a specific asset, liability, owner’s equity, income or expense item.
• There are separate accounts for all of the items used in transactions such
as cash, salaries expense and accounts payable.
Debit side Credit side
Trial Balancehe account on which the ‘normal
• The Trial Balance is a list of accounts and their balances at a given date
(‘as at …’).
• The primary purpose of a trial balance is to prove debits equal credits in
ledgers after posting.
• If debits and credits do not agree, the trial balance can be used to uncover
errors in journalising and posting.
errors: trial balance may ‘balance’, the accounting system may still contain
1. A transaction posted to the wrong account.
2. A transaction recorded at an incorrect amount.
3. A transaction omitted.
Inventory • One of the most valuable assets for a trading firm.
• Usually the primary source of income.
• Accurate records must be kept relating to inventory purchased, sold, on
• It must be safe-guarded to minimise loss, theft, damage, obsolescence.
Income for a retailer
The primary source of income is from the sale of inventory, known as
‘sales revenue’ or ‘sales’.
Expenses for a retailer
1. Cost of sales (COS) = total cost of inventory sold during the period.
2. Other expenses = expenses incurred in the process of earning sales revenue.
‘Gross profit’ is sales revenue less COS, and this is shown in the entity’s income
• Represents the difference between cost price and selling price.
• Gross profit is the ‘mark-up’ on goods either manufactured or purchased
• Gross profit must be sufficient to cover all other expenses of the entity
and leave a profit.
Perpetual Inventory System
• Maintains detailed records of the cost of inventory purchased and sold.
• Recording is made easier with the use of bar codes and optical scanners.
• COS is determined at the time a sale occurs.
The alternative recording system is known as the ‘periodic’ system
Apr 1 Inventory (110) 38,000
Accounts Payable (200) 38,000
(To record goods purchased on credit
from Music Imports)
Purchase returns and allowances
• A purchase return is the return of goods by the purchaser because …
• Goods are damaged or defective.
• Goods are of inferior quality.
• Goods do not meet purchaser’s specifications.
• The purchaser will receive a refund in the form of either credit or
cash depending on how the goods were initially purchased.
• A purchase allowance occurs where the seller keeps the goods and a
reduction in price is granted.
Apr 4 Accounts Payable (200) 700
Inventory (110) 700
Recording sales of inventory • Sales revenue is recorded when earned (under accrual accounting and the
income recognition princi