Accounting theory

Accounting Concepts

Accounting theory

Accounting concepts Accounting bases Accounting policies

Accounting standards

Accounting Theory

Concepts

Fundamental assumptions underlying the preparation of financial statements

Bases

Methods developed to apply the concepts to specific transactions

Policies

Specific to a particular organization Chosen on the basis of suitableness

Accounting theory
Accounting Policies specific to a firm

Accounting bases methods Accounting Concepts broad principles

Accounting Theory
CONCEPT Matching principle BASES Methods of depreciation (application of matching principle in accounting for non-current assets) POLICY Specific choice of method: straight line or reducing balance

Accounting Concepts
Business entity concept.

The business is a separate entity distinct from its owners or managers. This concept requires the careful separation of the financial affairs of the business from its owners and other businesses.

Accounting Concepts
Going concern

An enterprise is normally viewed as a going concern, that is, as continuing in operations for the foreseeable future.
It is assumed that the enterprise has no intention to curtail the scale of its operations.

Accounting Concepts
Historical cost

Assets should be recorded initially at cost.

Main limitation of using historical cost:

In times of inflation, historical costs figures lack relevance and can mislead users of financial information. In order to overcome this limitation, revaluation of assets is allowed as an alternative to historical cost accounting.

Accounting Concepts
Advantages of using historical cost:

Historical costs are perceived to be more reliable because they can be verified. The use of historical cost is cost-effective.

To use current market value means spending money each time an asset is revalued

Accounting Concepts
Accrual basis of accounting Income is recognized when earned and not when it is received in cash;

Expenses are recognized when incurred and not when they are paid in cash.

Matching concept Revenue earned must be matched against the expenditure incurred in generating it.

Accounting Concepts
Revenue realization concept.

A sale should be recognized when:

the event from which it arises has taken place;

Sale is recognized when goods are delivered, or when invoice is prepared. Sale is not recognized when an order is received.

the receipt of cash is reasonably certain.

Sale on credit should be recognized as income even if cash has not yet been received.

Accounting Concepts
Materiality.

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statement.

Accounting Concepts
Prudence

Where alternatives exist, one should select the alternative that gives the most cautious presentation of the financial position or result of the business.
Assets and profits should not be overstated, but a balance must be achieve to prevent the material overstatement of liabilities and losses. Where a loss is foreseen, it should be anticipated and taken immediately into account.

Accounting Concepts
Monetary principle

Accounting will deal only with those items to which a monetary value can be attributed.
Financial statements do not reflect factors that cannot be measured in monetary terms: good management, hardworking members of staff, etc.

Accounting Concepts
Consistency

The items in the financial statement should be presented and classified in the same manner from one period to the next Except under the following cases:

There is a significant change in the nature of the operations of the business A review of its financial statement presentation demonstrates that relevance is better achieved by presenting items in a different way A change is required by a new accounting standard.

Accounting Concepts
Substance over form.

Some transactions have a real nature that differs from their legal form. Whenever it is legally possible, the real substance should prevail over the legal form.

An example is a hire purchase transaction.

Legal ownership of an asset on a hire purchase does not pass until the last instalment is paid, but it could be misleading to present a balance sheet in which such assets did not appear until the end of the contract.

Illustration
In preparing the accounts of your company for the year end March 31, 1999, you are faced with the following problems:

The managing director wishes the companys good industrial relations to be reflected in the accounts. The long term future success of the company is extremely uncertain. Although the sales have not yet actually taken place, some reliable customers of the company have placed several large orders that are likely to be extremely profitable.

Illustration
In preparing the accounts of your company for the year end March 31, 1999, you are faced with the following problems:

One of the owners of the company has invested his drawings in some corporate bonds and shares. At the year end, an amount is outstanding in respect of electricity bills. During the year the company purchases Shs200,000 worth of stationery. These were still in use at the end of the year.

Illustration

The company had a poor trading year and the owners believe that a more balanced result could be presented if a LIFO stock valuation method was adopted instead of the present FIFO method. A debtor who owes a large amount of money is rumoured to be going into liquidation. The company owns some shares in a quoted company which the auditors think are worthless.

Explain how you would treat each of the above cases and give reasons for the treatment.

Explain how you would treat each of the above cases and give reasons for the treatment.
Structure of the answer:

State the accounting principle that should be applied. (1 mark) Explain the principle briefly.(1 mark) Apply the principle to the case given and state your answer. (1 mark).

Example: The managing director wishes the companys good industrial relations to be reflected in the accounts.

Step 1: State the accounting principle that should be applied. (1 mark) This case should be evaluated using the MONETARY PRINCIPLE.

Step 2: Explain the principle briefly.(1 mark) The monetary principle states that financial statements should only reflect events that can be measured in monetary terms.

Step 3: Apply the principle to the case given and state your answer. (1 mark). In this particular case, the managing director would be mistaken to reflect the fact that the business has good relations with the clients as this event cannot be quantified in terms of money. (1 mark)

This point can be further elaborated using the concept of non-purchased goodwill.

Example: The long term future success of the company is extremely uncertain.

Step 1: State the accounting principle that should be applied. (1 mk) This case should be evaluated using the GOING CONCERN PRINCIPLE.

Step 2: Explain the principle briefly.(1 mk) The going concern principle states that a business entity is expected to operate for an indefinite period of time. It is assumed that the owners are not intending to close it down in the foreseeable future. This means that assets will be continue to be valued at cost and not at their selling prices.

Step 3: Apply the principle to the case and state your answer. (1 mk) In this particular case, the going concern principle should be applied. The financial reports should continue to reflect the results of the operations of the business (profit/loss for the year) and the balance sheet should reflect the assets at cost price.

The factors that could affect its future operations could be disclosed in the notes to financial statements.

Example: Although the sales have not yet actually taken place, some reliable customers of the company have placed several large orders that are likely to be extremely profitable.

This case should be evaluated using the REALISATION PRINCIPLE.

The realisation principle is a principle used in the recognition of income. When should income/revenue be recognized in the books? It states the goods are considered sold when: a. When they have been delivered to customers; or b. When the invoice has been prepared (credit sale), i.e., even if cash has not yet been received.

In this case the receipt of an order does not constitute a sale as yet. Therefore the value of the goods ordered should not be shown as sales.

Example:

One of the owners of the company has invested his drawings in some corporate bonds and shares.

The principle that is applicable to this case is the BUSINESS ENTITY principle. It states that the business is a separate entity from the owner. The personal affairs of the owner should not be reflected in the books of the business and vice versa.

In this case, the drawings of the owner should be recorded as a business transaction, i.e., as a withdrawal of capital.

But the investment constitutes a personal transaction of the owner and should not be reflected in the books of the business.

Example: At the year end, an amount is outstanding in respect of electricity bills. During the year the company purchases Shs200,000 worth of stationery. These were still in use at the end of the year.

In both cases, the principle that should be applied is the accruals concept. The accruals concept is used in the recognition of income and expenses. According to this concept, an income should be recognized when it is earned and not when it is received in cash. An expense should be recognized when incurred and not when it is paid in cash.

In the case of the electricity bill, an expense should be recognized for the electricity consumed during the month even if it is still not paid. A liability should be recognized for the outstanding amount. In the case of the stationery, the value of the unused stationery should be deducted from the expense for the year. An asset should be recognized for the value of the unused stationery, ie. Prepaid expense.

Example: The company had a poor trading year and the owners believe that a more balanced result could be presented if a LIFO stock valuation method was adopted instead of the present FIFO method.

The principle that should be applied is the CONSISTENCY PRINCIPLE.

It states that items in the financial statement should be presented and classified in the same manner from one period to the next. This is important so that meaningful comparisons can be made between two accounting periods or between two firms.

In this case, the company is not allowed to change its method of valuing stock to show higher profits.

One could add the reasons when one is allowed to implement these changes: when required by a new accounting standard, when there is a change in the nature of the business, etc.

Example: A debtor who owes a large amount of money is rumoured to be going into liquidation. The company owns some shares in a quoted company which the auditors think are worthless.

Both cases should be analyzed using the prudence concept. Where alternatives exist, one should select the alternative that gives the most cautious results of the business. Assets and profits should not be overstated; losses should be anticipated and taken into account. The recognition of contingent liabilities is governed by IAS 37.

In the first case, an estimated bad debt expense should be recognized in the books (provision for bad debts).
In the second case, the value of the investment in the balance sheet should be written off from the books and a loss should be declared in the P/L.