Chapter 1
Accounting concepts also known as accounting principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. Since financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial statements are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles. In order to ensure compliance with the accounting concepts, major accounting standard-setting bodies have incorporated them into their reporting frameworks such as the International Accounting Standard Board framework.
Going concern concept
Going concern is one of the fundamental assumptions in accounting which forms the basis of preparing financial statements. 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 restrict its operational activities. It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity shall be prepared on a non-going concern basis. This means thatassets will be recognised at amount which is expected to be realised from their sale (net of selling costs) rather than their net book value. Liabilities shall be stated at amounts that are likely to be paid.
Matching or Accrual concept
Financial statements are prepared under the matching concept which requires revenues and cost to berecognised in the financial statements of the accounting periods to which they relate rather than on a cash basis.
Under accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognised in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be recognised in the subsequent accounting period during which the services or obligations in respect of the prepaid income will be performed.
Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognised in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be charged to income statement in the next accounting periodwhen they arise.
A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets. Depreciation results in a systematic charge of the cost of a non-current asset to the income statement over several accounting periods spanning the asset's useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of non-current assets is not charged to the income statement at once but is 'matched' against economic benefits derived from the asset's use over several accounting periods.
Prudence concept or conservatism
Conservatism requires that profits should not be anticipated or overstated. However provision should be made for all possible losses whether they are known with certainty or is a best estimate in the light of the information available.Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies and significant estimates such that the assets and income of the entity are not overstated whereas liability and expenses are not understated.
The rationale behind prudence is that a company should not recognise an asset at a value that is higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid.
There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by management whereas liabilities and expenses are more likely to be understated. The risk arises from the fact that companies often benefit from better reported profitability and lower gearing in the form of higher share price and cheaper source of finance. Hence the choice of accounting policies and use of estimates may result in bias in the preparation of the financial statements aimed at improving profitability and financial position through the use of creative accounting techniques. Prudence concept helps to ensure that such bias is countered by requiring the exercise of caution in arriving at estimates and the adoption of accounting policies.
Writing off bad debts, valuation of inventory and recording of provision for doubtful debts and depreciation are examples of the application of the prudence concept.
Consistency concept
Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity’s financial performance and position overtime. Comparability is enhanced when there is consistency of accounting treatment for similar items within an accounting period and from one period to another. For example if the reducing balance method of depreciation has been used to depreciate a motor van then the same method should be used with all other vehicles and in the future periods as well.
IAS 8 (Change in Accounting Policy) allows an entity to change its accounting policy in order to improve the reliability and relevance of financial statements and may also imposed it as a result of a change in an accounting standard or enactment of a new standard.
Business entity concept or Accounting entity concept
Financial accounting is based on the principle that the transactions of a business are to be accounted for separately from its owners. The business entity concept claims that the business is separate and distinct from its owners. It requires the affairs of the business to be kept separate from the affairs of the owners. Only transactions relating to the business must be recorded in the books of the business. Any private transaction of the owner not related at all to the business must not be recorded. Hence any personal expense incurred by owners of a business will not appear in the books of the business. However if the personal expense are paid out of business bank account then it will be treated as drawings in the same way as cash drawings.
The business entity also explains why owners’ capital account has a credit balance in the same way as liabilities. For instance capital contributed by a soletrader represents a form of liability to the business since it is money owing by the business to the owner.
Money measurement concept
Money measurement concept requires that only those transactions and assets which can be expressed in monetary terms should be recognised in the accounts. Where it is not possible to assign a reliable monetary value to a transaction or an asset, it should not be included in the financial statements. The following are examples of items that would not be included in the accounts of a business as a result of the money measurement principle:
- customers' satisfaction with his business
- the benefits of staff training
- the effect of new laws
- the value of the skills of its managers
- extra skills gained by the employees during training
- better staff morale following redecoration of premises
- improved public roads resulting in added value to the business property
Historical cost concept
The principle of accounting requires a transaction to be initially recorded at its historical cost, that is, the amount involved at the time the transaction took place. For example a business has bought a vehicle for $10 000 in January and omits to record it. After 3 month the omission is discovered and the transaction is being recorded, but at the time of recording, the price of the vehicle is $13 000. Which amount should be used for recording the vehicle bought, $10 000 or 13 000? The amount to be recorded is obviously $10 000, this being the actual amount of the transaction.
Dual aspect concept or Duality
The double entry system of accounting rest on the principle of duality whereby there must be two entries for each transaction; one entry should be on the debit side and the second corresponding entry should be on the credit side.
Materiality concept
Information is material if its omission or misstatement could influence the economic decisions of users. Materiality therefore relates to the significance of transactions, it defines the cut-off point after which financial information becomes relevant and critical to the decision making needs of users. Materiality is relative to the size and specific circumstances of a business. A direct consequence of this concept is that it allows identical items in different businesses to be treated differently depending of their significance to each business. For example there are two businesses A and B whereby A is a small soletraderwhereas B is a very big company and each bought the same type of equipment. Materiality allows the soletraderto treat it as a non-current asset whereas the company may treat it as an expense. Another example could be that a business decides to record inventory of stationery as an asset only if the value is over $100.
Consider the following example. A sole trader purchased the following items from an office supplier.
$
calculator 10
computer system 2000
document shredder 25
stapler 5
Applying the accounting principle of materiality, which would be recorded as revenue expenditure?
Answer
calculator, document shredder and stapler
Realisation concept
This concept deals with the issue as to when should income considered as beingrealised. Generally revenue is said to be realised when the ownership and the associated risks and reward are transferred to the buyer, the goods are being delivered to the customer and the latter accepts the liability. (refer to IAS 18 chapter 14 for further details)
Substance over form
Substance over form requires that if the substance of a transaction differs from its legal form, then such transaction should be accounted for in accordance to its commercial substance and financial reality.This means that a transaction should be recorded according to the real intention in the mind of those undertakingthe transaction although it contradicts the content of the written agreement. The existence of this concept is mainly to deal with off balance sheet finance.An example is where an item bought on hire purchase is recorded in the buyer’s book as a non-current asset although the seller is the legal owner until the last installment is paid. The rationale behind this is that information contained in the financial statements should represent the business essence of transactions not merely their legal aspects in order to provide a true and fair view. Substance over form concept entails the use of judgment on the part of preparers of financial statements in order for them to derive the business sense from the transactions and to present them in a manner that best reflects their true essence.
Practice Questions
1 Donald is in business and it has a financial year ended 31 December 2007. He is unsure how to deal with the following transactions in the accounts of the business.
- On 1 December 2007, Donald started an agreement to rent additional premises. On this date he paid $7 200 by cheque to cover the rent for the period 1 December 2007 to 31 May 2008. He intends to charge all of this payment to his income statement for the year ended 31 December 2007. An equal amount is charged for rent each month.
- During the year ended 31 December 2007, Donald’s general expense account showed that he paid $15 000. This includes an amount of $2 500 for the family holiday which has been paid out of the business bank account.
- In December 2007, Donald was negotiating a sale of goods to the value of $10 000. He was fairly certain that during January 2008, the client would sign the contract to purchase the goods. He planned to include this amount in the sales figures for the year ending 31 December 2007.
- Donald feels that his management team is an asset to the business and wants to include the team at a value of $50 000 on the balance sheet of the business.
REQUIRED
a)Advise Donald how he should deal with each of the above transactions in his financial statements, identifying and applying appropriate accounting concepts.
b)The following ledger accounting entries to record transactions (i) and (ii) above for the year ended 31 December 2007, showing (where appropriate) the transfers to the financial statements.
i)Rent.
ii)General expenses.
2 In each of the following, identify which accounting concept should be followed and briefly explain why it is applied.
- The owner of a business has taken goods from inventory for his own personal use. The goods originally cost $500.
- A business has good industrial relations and wishes to record this in the accounts at a value of $20 000.
- A business has bought two door mats costing $3 each. These are expected to last many years and have been recorded under non-current assets.
- Goods to the value of $1 500 were received in the final month of the financial year. The invoice for these goods has not yet been received and no entry made in the accounts at the financial year end.
Multiple Choice Questions
1There is great uncertainty about the continuance of a business. This has caused the proprietor to make a large reduction in the valuation of the year-end inventory. Which accounting concept does this illustrate?
Agoing concernBmatchingCmaterialityDsubstance over form
2The treasurer of a club has decided not to include subscriptions owing by members in the statement of financial position at the year-end.
Which accounting concept is being applied?
AaccrualsBgoing concernCmoney measurementDprudence
3Accountants prefer the commercial reality of a transaction to a strictly legal approach. This is an example of
Aconsistency.Bmateriality.C prudence.Dsubstance over form
4 A sole trader pays private expenses from the business bank account and records them as drawings.
Which accounting principle is applied?
A business entityB going concernC matchingD prudence
5 A business values obsolete inventory at net realisable value. Which accounting principle has been applied?
A consistencyB going concernC materialityD prudence
6 A pocket calculator costs $9.50 and has a useful life of 5 years. The bookkeeper has decided to treat the purchase of the calculator as revenue expenditure. Which accounting concept has been applied?
A accrualsB materialityC prudenceD substance over form
7 What does the ‘going concern’ principle mean?
A a business is profitable
B a business will continue to operate for the foreseeable future
C the assets of a business exceed its liabilities
D the assets of a business should be valued at disposal value
8 When a businessman introduces capital into his business, the transaction is debited in the Cash Book and credited to his Capital account. Of which accounting principle is this an example?
A entityB going concernC matchingD prudence
9 A company does not include the value of skills gained by its employees from training programmes in its financial statements.
Which accounting principle is being applied?
A consistencyB materialityC money measurementD substance over form
10 Of which concept is the writing off of a bad debt an example?
A going concernB matchingC prudenceD substance over form
11 A company purchases machinery on hire purchase over four years but does not own the machinery until the final payment has been made. At the end of year 1 the company shows the machinery in its statement of financial position as a non current asset and also records the liability for the amount still owed. Which accounting principle is being applied?
A consistencyB materialityC prudenceD substance over form
12 Businesses anticipate losses but not profits in preparing their annual accounts. Which accounting concept is being applied here?
A accrualsB consistencyC going concernD prudence
13 What is an example of the application of the concept of accounting for substance over form?
A accounting for inventory losses
B recording an asset acquired under a hire purchase agreement as a non current asset
C recording the premium on the issue of ordinary shares in a share premium account
D writing off a debt from a customer in liquidation
14 A business sells its freehold property to a bank and agrees to repurchase them in five years’ time. The business continues to use the property on lease from the bank. The property remain in the statement of financial position of the business. What is the reason for this accounting treatment?
A the asset must be treated in the same way from year to year
B the commercial reality of the transaction is that the business still owns the asset
C the cost of the asset must be matched with the periods expected to benefit from its use
D the income from the sales proceeds must not be anticipated
15 A company excludes from its statement of financial position machinery for which spare parts are no longer obtainable.
Which concept is being applied by the company?
A going concernB materialityC prudenceD substance over form
16 Which accounting policies illustrate the matching principle?
1 charging depreciation on non-current assets
2 revaluing non-current assets on a regular basis
3 using the reducing balance method of depreciation
A 1, 2 and 3B 1 and 2 onlyC 1 and 3 onlyD 2 and 3 only
17 An item of inventory originally cost $5000, but has deteriorated badly and is written down to its estimated net realisable value of $2000. Which accounting principle has been applied?
A consistencyB materialityC prudenceD substance over form
18 A company changes from the straight-line method of depreciation to the reducing balance method.
Which accounting principle has not been applied?
A consistencyB going concernC historic costD materiality
19 What should a company prepare to forecast its state as a going concern at the end of next year?
A cash budgetC forecast statement of financial position
B cash flow statementD forecast income statement
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