Accounting Concept (1)

7/28/2019 Accounting Concept (1)

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Accounting Conceptsand Principles


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Introduction Actually there are a number of accounting

concepts and principles based on which weprepare our accounts

These generally accepted accountingprinciples lay down accepted assumptionsand guidelines and are commonly referred

to as accounting concepts


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Users of Financial Statements

Investors Need information about the profitability, dividend yield

and price earnings ratio in order to assess the qualityand the price of shares of a company

Lenders Need information about the profitability and solvency of

the business in order to determine the risk and interestrate of loans

Management Need information for planning, policy making and

evaluation

Suppliers and trade creditors Need information about the liquidity of business in order

to access the ability to repay the amounts owed to them


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Government Need information about various businesses for statisticsand formulation of economic plan

Customers Interested in long-tem stability of the business and

continuance of the supply of particular products Employees

Interested in the stability of the business to provideemployment, fringe benefits and promotion opportunities

Public Need information about the trends and recent

development


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Limitations of conventional

financial statements Companies may use different

methods of valuation, cost calculationand recognizing profit

The balance sheet does not reflectthe true worth of the company

Financial statements can only showpartial information about thefinancial position of an enterprise,instead of the whole picture


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Accounting Concepts


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Accounting Concepts Business entity Money Measurement/stable

monetary unit Going Concern Historical Cost

Prudence/conservatism Materiality


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Objectivity

Consistency

Accruals/matching

Realization

Uniformity

Disclosure Relevance


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Business Entity Meaning

The business and its owner(s) are two

separate existence entity Any private and personal incomes and

expenses of the owner(s) should not betreated as the incomes and expenses of

the business


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Business Entity


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Examples Insurance premiums for the owners

house should be excluded from theexpense of the business

The owners property should not beincluded in the premises account of thebusiness

Any payments for the owners personalexpenses by the business will be treatedas drawings and reduced the ownerscapital contribution in the business


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Money Measurement


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Money Measurement Meaning

All transactions of the business arerecorded in terms of money

It provides a common unit ofmeasurement

Examples Market conditions, technological

changes and the efficiency ofmanagement would not be disclosed inthe accounts


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Going Concern


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Going Concern Meaning

The business will continue in operationalexistence for the foreseeable future

Financial statements should be preparedon a going concern basis unlessmanagement either intends to liquidatethe enterprise or to cease trading, orhas no realistic alternative but to do so


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Example Possible losses form the closure of

business will not be anticipated in theaccounts

Prepayments, depreciation provisionsmay be carried forward in theexpectation of proper matching againstthe revenues of future periods

Fixed assets are recorded at historicalcost


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Accounting CostConcept


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Accounting Cost Meaning

Assets should be shown on the balancesheet at the cost of purchase instead of

current value Example

The cost of fixed assets is recorded atthe date of acquisition cost. The

acquisition cost includes all expendituremade to prepare the asset for itsintended use. It included the invoiceprice of the assets, freight charges,

insurance or installation costs


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Dual Aspect Concept


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Every transaction has dual effects Assets of a business are always equal

to the claims of owners and outsiders Every transaction has an equal impact

on assets and liabilities in such a waythat total assets are always equal to

total liabilities.


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Fundamental Accounting

Equation


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Realization Cost

Concept


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Realization Meaning Revenues should be recognized only when

it is realized. Realization means creation of legal rights

to receive money Sales are recognized when the goods are

sold and delivered to customers orservices are rendered


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Recognition of revenue Revenue is said to have been realized when cashhas been received or right to receive cash on saleof goods or services or both has been created

The concept provides that revenues arerecognized when it is earned, and not when moneyis received

A receipt in advance for the supply of goodsshould be treated as prepaid income under

current liabilities Since revenue is a principal component in the

measurement of profit, the timing of itsrecognition has a direct effect on the profit


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Example Goods sent to our customers on sale or

return basis This means the customer do not pay for

the goods until they confirm to buy. Ifthey do not buy, those goods will returnto us

Goods on the sale or return basis willnot be treated as normal sales andshould be included in the closing stockunless the sales have been confirmed bycustomers


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Exceptions to rule of salesrecognition1. Long-term contracts

Owning to the long duration of long-termcontracts, part of the total profit estimatedto have been arisen from the accounting

period should be included in the profit andloss account

2. Hire Purchase Sale Hire purchase sales have long collection

period. Revenue should be recognized whencash received rather than when the sale(transfer of ownership) is made

The interest charged on a hire purchase sale

constitutes the profit of transaction


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3. Gold Revenue from gold is said to be

recognized during the period when

its production is completed and notwhen it is sold, as sale is certain.


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4. Accounts maintained on cash basis

Professionals like doctors, advocates,

etc recognize revenue only when theamount of fee is received in cash.


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Prudence/Conservatism


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Prudence/Conservatism Meaning

Revenues and profits are not anticipated.Only realized profits with reasonablecertainty are recognized in the profitand loss account

However, provision is made for all knownexpenses and losses whether the amountis known for certain or just anestimation

This treatment minimizes the reportedprofits and the valuation of assets


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Example Stock valuation sticks to rule of the

lower of cost and net realizable value

The provision for doubtful debts should

be made Fixed assets must be depreciated over

their useful economic lives


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Materiality


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Materiality Meaning

Immaterial amounts may be aggregated

with the amounts of a similar nature orfunction and need not be presentedseparately

Materiality depends on the size and

nature of the item


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Example Small payments such as postage,

stationery and cleaning expenses shouldnot be disclosed separately. They should

be grouped together as sundry expenses The cost of small-valued assets such as

pencil sharpeners and paper clips shouldbe written off to the profit and loss

account as revenue expenditures,although they can last for more than oneaccounting period


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Objectivity


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Objectivity Meaning

The accounting information should be

free from bias and capable ofindependent verification

The information should be based uponverifiable evidence such as invoices or

contracts


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Example The recognition of revenue should be

based on verifiable evidence such as thedelivery of goods or the issue of

invoices


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Consistency


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Consistency Meaning

Companies should choose the mostsuitable accounting methods andtreatments, and consistently apply themin every period

Changes are permitted only when thenew method is considered better andcan reflect the true and fair view of thefinancial position of the company

The change and its effect on profitsshould be disclosed in the financialstatements


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Examples If a company adopts straight line

method and should not be changed toadopt reducing balance method in otherperiod

If a company adopts weight-average

method as stock valuation and shouldnot be changed to other method e.g.first-in-first-out method


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Matching Concept


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Matching Concept Meaning

For determining income of a year only

that expenses which have been incurredto earn that revenue should be takeninto account.

The net income for the period is

determined by subtracting expensesincurred from revenues earned


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Example

Expenses incurred but not yet paid incurrent period should be treated asaccrual/accrued expenses under currentliabilities

Expenses incurred in the followingperiod but paid for in advance should betreated as prepayment expenses undercurrent asset

Depreciation should be charged as partof the cost of a fixed asset consumedduring the period of use


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Problems in the

recognition of expenses Normally, expenses represents

resources consumed during the

current period. Some costs maybenefit several accounting periods,for example, developmentexpenditures, depreciation on fixedassets.


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Recognition criteria for

expenses Association between cause and effect Expenses are recognized on the basis of a

direct association between the expenses

incurred on the basis of a direct associationbetween the expenses incurred and revenuesearned

For example, the sales commissions should be

accounted for in the period when the productsare sold, not when they are paid


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Systematic allocation of costs When the cost benefit several accountingperiods, they should be recognized on the basisof a systematic and rational allocation method

For example, a provision for depreciation

should be made over the estimated useful lifeof a fixed asset

Immediate recognition If the expenses are expected to have no

certain future benefit or are even without

future benefit, they should be written off inthe current accounting period, for example,stock losses, advertising expenses andresearch costs


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Disclosure


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Disclosure Meaning Financial statements should be prepared

to reflect a true and fair view of the

financial position and performance ofthe enterprise

All material and relevant informationmust be disclosed in the financial

statements


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Uniformity


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Uniformity Meaning

Different companies within the sameindustry should adopt the sameaccounting methods and treatments forlike transactions

The practice enables inter-company

comparisons of their financial positions


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Relevance


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Relevance Meaning

Financial statements should be preparedto meet the objectives of the users

Relevant information which can satisfythe needs of most users is selected andrecorded in the financial statement

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Accounting Concept (1)