C hapter 12: Accounting concepts and

principles
Contents of chapter
This chapter covers the concepts and principles that govern how we enter transactions in our accounting
records.

Notes for teachers

Examination questions on this topic will probably give students more trouble than those in any other
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chapters.

Accounting students, by and large, do not like answering any type of essay questions in accounting. They
prefer to do computational questions.

Make certain they read the questions carefully and do what is required. For instance:
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‘Define the going concern concept and give an example to illustrate its application.’

Many students would attempt the definition part, but forget to give an example.

Stock valuation gives many illustrations of concepts and principles. See notes for teachers points 3, 4,
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5 and 6 in Chapter 3 in this teacher’s manual.

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 Answers to MCQs and exercises
12.1 B 12.2 A 12.3 C 12.4 B 12.5 A

12.6
(a) Business entity
For example, the owner’s personal expenses, such as life insurance expenses, should not be included in the
business profit and loss account.

(b) Accrual
For example, proposed dividends by a limited company, even though unpaid, should be included in the profit
and loss appropriation account for the period.

(c) Prudence
For example, discounts allowed to debtors should be anticipated and provided for.

(d) Materiality
For example, different petty cash expenses need not be disclosed separately in the profit and loss account. They
can be grouped together as sundry expenses.

12.7
(a) (i) Accrual
Revenues are recognised when they are earned, not when they are received in cash. Expenses are
recognised when they are incurred, not when they are paid in cash.
For example, accruals should be added to the expenses paid while prepayments should be deducted, before
posting to the profit and loss account.

(ii) Consistency
Once an accounting method has been adopted, similar items should be treated in the same way in future.
For example, a company has adopted a policy of providing a full-year depreciation on all fixed assets held at
the year end. This policy should be followed in future. If the policy needs to be changed, the reasons and
the effects will have to be disclosed.

(b) (i) The business entity concept is violated. The business is treated as a separate entity from the owner. The
profit from private investment should not be recorded in the business profit and loss account. However, if it
is contributed to the business, it should be recorded as additional capital.

(ii) The prudence concept is violated. It is not prudent to record the unrealised gain in the market value of stock
in the books.

12.8X (Brief answers – but teachers can expand them.)

(a) Materiality.
(b) Prudence. His father may not die soon and you cannot be certain that he would inherit a fortune.
(c) Going concern concept. The business is not expected to have to sell its stock very quickly, but would instead sell
at the normal speed of sales.
(d) Prudence. Profits should not be overstated.
(e) Historical cost concept says he should show it at $75,000. The other values are not taken into account for fixed
assets.

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12.9X (No set answer, but something like the following:)

(a) Money measurement concept

It is the accounting custom NOT to charge anything in a sole trader’s profit and loss account for services
rendered by him/her to his/her business. This is due to the fact that the value of his/her services cannot be
measured in units of money objectively.

(b) Matching concept

Depreciation is provided to write off the cost of a fixed asset consumed over the period of its life.

(c) Business entity concept

A business is treated as a separate entity from its owner. The business resources taken out by the owner for his
personal use should thus be treated as drawings.

12.10
(a) Accrual concept. An interest expense is recorded when it has been incurred, i.e. even if it is not paid.
(b) Machinery will eventually be put out of use no matter how well it is maintained. Because of wear and tear, rot,
decay, obsolescence, inadequacy and so on, depreciation is needed to reflect the utilisation of the assets.
(c) Historical cost concept and prudence concept would not allow it anyway.
(d) Prudence concept.
(e) Carriage inwards are costs of delivery directly related to the cost of purchases of goods and are shown in the
trading account. Carriage outwards are distribution expenses, not part of cost of goods sold, and therefore are
shown in the profit and loss account.

12.11
(a) According to the accrual concept, revenue is recognised in the period in which it has been earned, not when they
are received; expenses are recognised in the period in which they are incurred, not when it is paid. Revenue and
expenses match with one another so far as their relationships can be established. Revenue and profits dealt with
in the profit and loss account are matched with associated costs and expenses for the same period.
The proposed reversal of the year-end bonus would be inconsistent with the accrual concept. Although the year-
end payment has not been made, the expenses have been incurred up to 30 September 20X0, and hence the
expenses should be accrued for the financial year ended 30 September.

(b) The money measurement concept states that accounting is only concerned with those facts that can be
measured in units of money with a fair degree of objectivity.
The valuation and inclusion of loyalty of the staff in the balance sheet would be inconsistent with the money
measurement concept since the value of staff loyalty cannot be measured with a fair degree of objectivity, that is,
the valuation would be quite subjective.

(c) The consistency concept states that the same accounting treatment should be applied consistently to similar
items within each accounting period and from one period to the next.
The change of the accounting method for depreciation would be inconsistent with the consistency concept.
Once the reducing balance method for depreciation is selected, it should not be changed. Constantly changing
the accounting methods would lead to a distortion of the profits calculated from the accounting records.

(d) According to the prudence concept, revenue and profits should not be anticipated but are recognised in the
profit and loss account only when realised in cash or other assets where the ultimate cash realisation of those
assets can be assessed with reasonable certainty. Provision, however, has to be made for all known liabilities
(expenses and losses) whether their amount is known with certainty or is just an estimate in view of the
information available.
The prudence concept requires that the possible losses, e.g. bad debts, be provided for even if the losses have
not been actually incurred during the financial year. Hence, the proposed provision for bad debts is consistent
with the prudence concept.
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