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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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Historical Cost
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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
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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 ofinvoices
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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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Accruals/Matching
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Accruals/Matching Meaning
Revenues are recognized when they are
earned, 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
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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 adirect 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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Realization
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Realization Meaning 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 profitsmust be verifiable
Revenue is recognized when1. The major earning process has substantiallybeen completed
2. Further cost for the completion of theearning process are very slight or can be
accurately ascertained, and3. The buyer has admitted his liability to payfor the 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. If
they 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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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 it
sends 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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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 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
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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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