Wednesday, 5 June 2013


This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).

Value accounting has created numerous debates surrounding the trade-offs of the concepts of relevance and reliability. Relevance and reliability are both critical for the quality of the financial information, but both are related such that an emphasis on one will hurt the other and vice versa. Hence, we have to trade-off between them. Accounting information is relevant when it is provided in time, but at early stages information is uncertain and hence less reliable. But if we wait to gain while the information gains reliability, its relevance is lost.

Under the AASB accounting policies of March 1999:

Reliability is defined in the following sections: 

4.1.5 Reliable financial information faithfully conveys to users the underlying transactions and other events that have occurred.

4.1.6 For financial information to be reliable, it needs to be free from bias. Reliable financial information does not lead users to conclusions that serve particular needs, desires or preconceptions of the prepares of financial reports.

Paragraph 4.1.7 goes on to explain that "To be reliable, financial information also needs to be free from undue error..."

A good example of what happens when reliability fails can be found here. 

Timeliness of Accounting

Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time to fulfill their decision making needs. 

Timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users while conversely, delay in provision of information tends to render it less relevant to the decision making needs of the users. Timeliness principle is therefore closely related to the relevance principle.

Timeliness is important to protect the users of accounting information from basing their decisions on outdated information. Imagine the problem that could arise if a company was to issue its financial statements to the public after 12 months of the accounting period. The users of the financial statements, such as potential investors, would probably find it hard to assess whether the present financial circumstances of the company have changed drastically from those reflected in the financial statements.

Going Concern

Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realise its assets and settle its obligations in the normal course of the business. 

The auditor evaluates an entity’s ability to continue as a going concern for a period not greater than one year following the date of the financial statements being audited. The auditor considers such items as negative trends in operating results, loan defaults, denial of trade credit from suppliers uneconomical long-term commitments, and legal proceedings in deciding if there is a substantial doubt about an entity’s ability to continue as a going concern. If so, the auditor must qualify the audit report with a statement about the problem. 

The Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.

Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings.

The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the balance sheet.

Money Measurement Concept

Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and events that are capable of being measured in monetary terms are recognized in the financial statements.

On the balance sheet:

All transactions and events recorded in the financial statements must be reduced to a unit of monetary currency. Where it is not possible to assign a reliable monetary value to a transaction or event, it shall not be recorded in the financial statements.

However, any material transactions and events that are not recorded for failing to meet the measurability criteria might need be disclosed in the supplementary notes of financial statements to assist the users in gaining a better understanding of the financial performance and position of the entity.

The recognition criteria defined by IASB and FASB require that the elements of financial statements (i.e. assets, liabilities, income and expense) must only be recognized in the financial statements if its cost or value can be measured with sufficient reliability. Therefore, an entity shall not recognize an element of financial statement unless a reliable value can be assigned to it.

In many cases however the preparers of financial statements are unable to arrive at a precise amount to be recognized in the financial statements and must resort to the use of reasonable estimates in arriving at an approximate value. The use of reasonable estimates is a very important component in the preparation of financial statements and as long as forming estimates do not involve a high degree of subjectivity and uncertainty they do not undermine the reliability of financial information.

Where a significant element of financial statement is not recognized because of the inability to measure its monetary value with sufficient reliability, it may be disclosed in the supplementary notes of financial statements to enhance the users' understandability and completeness of the presented financial information.

For example: IAS 38 Intangible Assets and ASC 350 Intangibles - Goodwill and Other require that internally generated goodwill shall not be recognized as an asset in the balance sheet. This is due to the difficulty in identifying and measuring the cost of internally generated goodwill as distinct from the cost of running the day to day operations of the business. 

Goodwill Definition

Definition of 'Goodwill'

Generally speaking in accounting terms this is the amount paid over and above during a company acquisition. 

An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company is purchased by another company.

In an acquisition, the amount paid for the company over book value usually accounts for the target firm's intangible assets.

The goodwill is seen as an intangible asset on the balance sheet because it is not a physical asset like buildings or equipment. Goodwill typically reflects the value of intangible assets such as a strong brand name, good customer relations, good employee relations and any patents or proprietary technology.

Tuesday, 4 June 2013

The Debt/Equity Ratio: Solvency on the balance sheet or personal finances

The debt/equity ratio is a a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. The name says it all. It indicates what proportion of equity and debt the company is using to finance its assets.

Total Liabilities/Shareholders Equity

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as corporate ones.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

This can be used in stock picking strategies, which will come later in the series of posts. 

Quick Ratio: The Balance Sheet Liquidity - Inventories

An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.

Quick Ratio = (Current Assets - Inventories) / Current Liabilities

In bookkeeping, the acid test or quick ratio evaluates your company’s current assets and liabilities, but it’s a stricter test of cash flow than the similar current ratio. Many lenders prefer the acid test ratio when deciding whether to give you a loan because of that strictness; it doesn’t include the inventory account in the calculation. In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength. 

The current ratio: Balance sheet liquidity

The current ratio is a short term liquidity test to see if a company has the "cash" to pay its obligations. 

In book keeping the current ratio compares the current assets to the current liabilities of a company. The current ratio is one way lenders test your cash flow when they consider loaning you money. Lenders usually look for current ratios of 1.2 to 2, so any financial institution would consider this example’s current ratio of 2.36 to be a good sign. A current ratio under 1 is considered a danger sign because it indicates that the company doesn’t have enough cash to pay its current bills.


Current assets of $56000
Current Liabilities of $26000
= a current ratio of 2.1

Also known as "liquidity ratio", "cash asset ratio" and "cash ratio".

Current and Noncurrent Liabilities: The Balance Sheet Continued

International Accounting Standard 1: Presentation of Financial Statements or IAS 1 is an international financial reporting standard adopted by the International Accounting Standards Board (IASB) gives clear requirements on the classification of Liabilities.

IAS 1 paragraph 60 stipulates that an entity should present current and non-current liabilities as separate classifications in its statement of financial position, except when a presentation based on liquidity provides more relevant and reliable information. Whatever the method of presentation, an entity should disclose the amount expected to be settled after more than 12 months and less than 12 months.

Paragraph 69a–d of IAS 1 states that liabilities are to be classified as current if any one of four specified conditions is met. The conditions are:

a) It expects to settle the liability in its current operating cycle

b) It holds the liability primarily for trading

c) The liability is due to be settled within 12 months

d) It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period.

So in terms of classification of current liabilities on the balance sheet they are liabilities the company expects to settle within 12 months of the date on the balance sheet. Settlement comes either from the use of current assets such as cash on hand or from the current sale of inventory. Settlement can also come from swapping out one current liability for another.

Noncurrent or long-term liabilities are ones the company reckons aren’t going anywhere soon! In other words, the company doesn’t expect to be liquidating them within 12 months of the balance sheet date.

Examples of Current Liabilities include:

  • Short term notes payable: Notes due in full less than 12 months after the balance sheet date are short term. For example, a business may need a brief influx of cash to pay mandatory expenses such as payroll. A good example would be a working capital loan, a loan to be paid back in the short term after revenue is earned. 
  • Accounts payable: the account showing the amount payable to a companies lenders. 
  • Dividends payable
  • Current portion of long term notes payable: i.e. the loan amount due in the next 12 months. 
Examples of Noncurrent liabilities include:
  • Long term leases
  • Extended warranties on products
  • Bonds payable: long term amounts due outside the normal 12 months.