Acct Concepts HRB

8/11/2019 Acct Concepts HRB

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ACCOUNTING

Conceptual FrameworkAccounting Concepts and

Principles

Ch Hamad Rasool Bhullar

FCMA, FCIS, FPA, Mphil, M.Com, DCMA, PGD (Islamic Fin)


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Areas in AccountingProfession

Financial accounting

Cost accounting

Managerial accounting

Tax accounting

Auditing Accounting systems

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Importance of Framework

A conceptual framework underlyingfinancial accounting is important

because it can lead to consistentstandards and it prescribes thenature, function, and limits offinancial accounting and financialstatements.

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Introduction Actually there are a number of

accounting concepts, assumptions,conventions and principles basedon which we prepare our accounts

These generally acceptedaccountingprinciples(GAAPs) laydown accepted assumptions andguidelines and are commonly

referred to as accountingconcepts


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Users and Stakeholders of FS

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Users of Financial Statements Investors (Current and Potential)

Need information about the profitability, dividend yieldand price earnings ratio in order to assess the qualityand the price of shares of a company

Lenders (Bankers, Insurance Cos etc)

Need information about the profitability and solvency ofthe business in order to determine the risk and interestrate of loans

Management Need information for planning, policy making and

evaluation, for continuation and new projects

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 Authorities and Planners Need information about various businesses for statistics

and formulation of economic plan

Customers and Consumers Interested in long-tem stability of the business and

continuance of the supply of particular products

Employees and Employees Union

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

General Public Need information about the trends and recent

development

Taxation Departments For assessments of right amount of taxes (Income Tax,

Excise, Customs, Sales Tax..etc)


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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

ConceptsEnd of Confusion,Frustration, and

Failure


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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 Full Disclosure

Relevance


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Business Entity

Meaning The business and its owner(s) are

two separate entities

Any private and personal incomesand expenses of the owner(s)should not be treated as theincomes and expenses of the

business Capital account reflects the

transactions with owners


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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 Meaning

All transactions of the business arerecorded in terms of common unit of valuei.e. money

It provides a common unit of measurement,so such items which are not measurable inmoney are neithe recorded nor reported

Examples

Market conditions, technological changesand the efficiency of management wouldnot be disclosed in the accounts


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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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Historical 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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Prudence/Conservatism

Meaning Revenues and profits are not anticipated.

Only realized profits with reasonablecertainty are recognized in the profit

and loss account However, provision is made for all known

expenses and losses whether the amountis known for certain or just an

estimation This treatment minimizes the reported

profits 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 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 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 ofinvoices


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Consistency Meaning Continuity from year toyear Companies should choose the most

suitable accounting methods andtreatments, and consistently apply themin every period

Changes are permitted only when the newmethod is considered better and can

reflect the true and fair view of thefinancial position of the company The change and its effect on profits

should be disclosed in the financial

statements


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Consistency

Examples If a company adopts straight line

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

If a company adopts weight-averagemethod as stock valuation and should

not be changed to other method e.g.first-in-first-out method


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Accruals/Matching

VsCash Basis of Accounting


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Accruals/Matching Meaning

Revenues are recognized when they areearned, but not when cash is received

Expenses are recognized as they are

incurred, but not when cash is paid The net income for the period is

determined by subtracting expensesincurred from revenues earned

Cash basis of Accounting fails to measurethe Economic performance of an Entity sogives Incomplete information


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Example

Expenses incurred but not yet paid incurrent period should be treated asaccruals/accrued expenses, so taken ascurrent liabilities

Expenses to be used in future periodsbut paid for in advanceshould betreated as prepaid expenses and takenas current assets

Depreciationshould 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 adirect association between the expenses

incurred on the basis of a direct associationbetween the expenses incurred and revenuesearned out of the usage thereof

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 accounting

periods, they should be recognized on the basisof a systematic and rational allocation method

For example, a provision for depreciationshould 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 withoutfuture benefit, they should be written off inthe current accounting period, for example,stock losses, advertising expenses andresearch costs


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RealizationMeaning Revenues should be recognized when

the major economic activities havebeen completed Sales are recognized when the goods

are sold and delivered to customers

or services are rendered


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Recognition of revenue The realization concept develops rules forthe recognition of revenue

The concept provides that revenues are

recognized when it is earned, and not whenmoney is received A receipt in advance for the supply of

goods should be treated as prepaid incomeunder current liabilities

Since revenue is a principal component inthe measurement of profit, the timing ofits recognition has a direct effect on theprofit


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Recognition criteria for

revenues The uncertain profits should not beestimated, whereas reported profits mustbe verifiable

Revenue is recognized when1. The major earning process has substantially

been completed2. Further cost for the completion of the earning

process are very slight or can be accuratelyascertained, and

3. The buyer has admitted his liability to pay forthe goods or services provided and theultimate collection is relatively certain


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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 returnbasis willnot be treated as normal sales andshould be included in the closing stockunless the sales have been confirmed bycustomers


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Problems in the

recognition of revenue Normally, revenue is recognized whenthere is a sale

The point of sales in the earning process is

selected as the most appropriated time torecord revenues However, if revenue is earned in a long and

continuous process, it is difficult todetermine the portion of revenue which isearned at each stage

Therefore, revenue is permitted to berecorded other than at the point of sales


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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. Receipts from subscriptions- A publisher receives subscriptions before itsends newspapers or magazines to itscustomers

- It is proper to defer revenue recognition untilthe service is rendered.

- However, part of subscription income can berecognized as it is received in order to matchagainst the advertising expenses incurred


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Full 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 financialstatements


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Uniformity Meaning

Different companies within the same

industry should adopt the sameaccounting methods and treatments forlike transactions

The practice enables inter-company

comparisons of their financial positions


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Relevance Meaning

Financial statements should be prepared

to meet the objectives of the users Relevant information which can satisfy

the needs of most users is selected andrecorded in the financial statement


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Integrity, Objectivityand Ethics of Reporting

The financial accounting and reportingfailures of BIG Companies like Enron,WorldCom, Tyco, Xerox etc shocked

the investors. The disclosure that someof the largest and best-knowncorporations had overstated profits

and misled investors, raised thequestion: Where were the Auditors?

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Accountancy is a


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Accountancy is aResponsible Profession

The shockwave led to: Global changes in regulations 2002

Prohibition on Non-Auditing serviceson Auditors and their firms

Penalties for the reporting ofmisleading financial statements

Restrictions on insider trading andInformation sharing

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Congratulations

For Learning with Patience

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Acct Concepts HRB