Accounting

Concepts and
Principles

1
 Introductio
•nActually there are a number of
accounting concepts and principles
based on which we prepare our
accounts
• These generally accepted accounting
principles lay down accepted
assumptions and 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 quality and 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 interest rate 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
statistics and 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 provide
employment, fringe benefits and promotion
opportunities
• Public
– Need information about the trends and
recent development

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Accounting
Concepts

5
 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 be treated as the
incomes and expenses of the
business

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Business
Entity

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• Examples
– Insurance premiums for the
owner’s house should be
excluded from the expense of
the business
– The owner’s property should not be
included in the premises account of
the business
– Any payments for the owner’s
personal expenses by the business
will be treated as drawings and
reduced the owner’s capital
contribution in the business
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Money
Measurement

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 Money
•Measurement
Meaning
– All transactions of the business
are recorded in terms of money
– It provides a common unit
of measurement
• Examples
– Market conditions, technological
changes and the efficiency of
management would not be
disclosed in the accounts
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Going
Concern

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 Going
•Concern
Meaning
– The business will continue in
operational existence for the
foreseeable future
– Financial statements should be
prepared on a going concern basis
unless management either intends
to liquidate the enterprise or to
cease trading, or has no realistic
alternative but to do so
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• Example
– Possible losses form the closure of
business will not be anticipated in
the accounts
– Prepayments, depreciation
provisions may be carried forward
in the expectation of proper
matching against the revenues of
future periods
– Fixed assets are recorded at
historical cost

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Historical
Cost

1
6
 Historical
•Cost
Meaning
– Assets should be shown on the
balance sheet at the cost of
purchase instead of current value
• Example
– The cost of fixed assets is recorded
at the date of acquisition cost. The
acquisition cost includes all
expenditure made to prepare the
asset for its intended use. It
included the invoice price of the
assets, freight charges, insurance or 1
7
Prudence/
Conservatism

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 Prudence/
•Conservatism
Meaning
– Revenues and profits are not
anticipated. Only realized profits with
reasonable certainty are recognized
in the profit and loss account
– However, provision is made for all
known expenses and losses whether
the amount is known for certain or
just an estimation
– This treatment minimizes the
reported profits and the valuation 19
of assets
• 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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Materiali
ty

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 Materialit
•y Meaning
– Immaterial amounts may be
aggregated with the amounts of a
similar nature or function and need
not be presented separately
– Materiality depends on the size
and nature of the item

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• Example
– Small payments such as postage,
stationery and cleaning expenses
should not be disclosed separately.
They should be grouped together as
sundry expenses
– The cost of small-valued assets such
as pencil sharpeners and paper clips
should be written off to the profit
and loss account as revenue
expenditures, although they can last
for more than one accounting period 23
Objectiv
ity

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Objectivity
• Meaning
– The accounting information should
be free from bias and capable of
independent verification
– The information should be based
upon verifiable evidence such
as invoices or contracts

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• Example
– The recognition of revenue should be
based on verifiable evidence such as
the delivery of goods or the issue of
invoices

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Consiste
ncy

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 Consistenc
•y Meaning
– Companies should choose the
most suitable accounting
methods and treatments, and
consistently apply them in
every period
– Changes are permitted only when
the new method is considered better
and can reflect the true and fair view
of the financial position of the
company
– The change and its effect on 28
profits should be disclosed in the
• Examples
– If a company adopts straight line
method and should not be changed
to adopt reducing balance method
in other period
– If a company adopts weight-
average method as stock
valuation and should not 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
expenses incurred from revenues 31
earned
• Example
– Expenses incurred but not yet paid in
current period should be treated as
accrual/accrued expenses under
current liabilities
– Expenses incurred in the following
period but paid for in advance
should be treated as prepayment
expenses under current asset
– Depreciation should be charged as
part of the cost of a fixed asset
consumed during 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 may
benefit several accounting
periods, for example,
development expenditures,
depreciation on fixed assets.

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Realizati
on

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 Realizatio
•nMeaning
• Revenues should be recognized
when the major economic
activities have been 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
for the recognition of revenue
• The concept provides that revenues are
recognized when it is earned, and not
when money is received
• A receipt in advance for the supply of
goods should be treated as prepaid
income under current liabilities
• Since revenue is a principal
component in the measurement of
profit, the timing of
its recognition has a direct effect on
the profit 36
Disclos
ure

37
 Disclosur
•eMeaning
– Financial statements should be
prepared to reflect a true and fair
view of the financial position and
performance of the enterprise
– All material and relevant
information must be disclosed in
the financial statements

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Uniformi
ty

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 Uniformit
•y Meaning
– Different companies within the
same industry should adopt the
same accounting methods and
treatments for like transactions
– The practice enables inter-company
comparisons of their financial
positions

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Relevan
ce

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 Relevanc
•eMeaning
– Financial statements
should be prepared to
meet the
objectives of the
users
– Relevant information which can
satisfy the needs of most users is
selected and recorded in the 42
financial statement