Accounting Principles

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Accounting Principles
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Learning Outcome

• State the meaning of the concepts and principles.
• Discuss the importance and functions of the
  concepts and principles.
• Discuss the shortcomings or limitations of the
  concepts and principles.

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Accounting concepts and principles

• Business entity
• Going concern
• Historical cost
• Accrual
• Matching
• Consistency
• Objectivity
• Materiality

4
Accounting concepts and principles

• Stable monetary unit
• Prudence
• Realisation
• Uniformity
• Relevance
• Timeliness
• Disclosure
• Substance over form

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Business entity

• The business and its owner(s) are two separate
  entities. Any transactions related to the
  business should be recorded properly in the books
  of the business. Any private transactions related
  to the owners only should not be treated as the
  transactions of the business.

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Business entity

• Importance
• - defines the areas of interest of the financial
  statement
• - what should be included and disclosed in the
  financial statements

7
Going concern

• An enterprise is on a going concern and will
  continue in operation for the foreseeable future.
  It is assumed that the enterprise has neither the
  intention nor the need to liquidate or curtail
  materially the scale of its operations. All fixed
  assets should be valued at historical cost.

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Going concern

• Importance
• - enables the enterprise to carry out plans
• - enables the enterprise to make contracts with
  others
• - expenditure can be deferred over future periods

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Going concern

• Shortcomings
• - no business can continue forever
• - assets valued at historical cost may be
  misleading unless they are valued at current
  prices
• - financial statements may be misleading if the
  business is going to close shortly after the
  balance sheet date

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Historical cost

• All transactions and events should be measured in
  terms of the acquisition cost.

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Historical cost

• Importance
• - historical cost is objective and verifiable
• - minimize manipulation
• - is consistent with going concern, consistency
  and prudence concepts

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Historical cost

• Shortcomings
• - does not show the market value of the assets
  which is more relevant to users
• - with an increase in price level, the profits
  may be overstated
• - the profit is a combination of holding gain and
  operating gain

13
Accrual

• Financial statements are prepared on the accrual
  basis of accounting.
• Expenses are recognised when they incurred and
  not when cash was paid.
• Revenues are recognised when they earned and not
  when cash was received.

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Accrual

• Importance
• - more accurate to show the expenses and income
  for the period

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Accrual

• Shortcomings
• - the calculations become more complicated
• - the calculations can be manipulated

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Matching

• The revenue or income for the period should be
  matched with the expenses for that period to
  assess the profit made.

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Matching

• Importance
• - actual profit is ascertained
• - profit will not be overstated as expenses
  should be matched against the revenue

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Consistency

• In preparing the accounts of a business, like
  items must be treated consistently in the
  accounts from period to period.
• Changes can still be made if they provide a
  better way of presenting the accounting data.
• Such changes should be disclosed in the financial
  statements.

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Consistency

• Importance
• - more reliable for comparison of the results of
  different periods
• - similar items can be followed accordingly

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Objectivity

• Those who are responsible for the preparation of
  the final accounts and the books should avoid
  personal bias.
• The transactions recorded should be based on
  verifiable evidence. (e.g. invoice)

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Objectivity

• Importance
• - minimize the possibility of subjective
  judgments
• - avoid manipulations

22
Objectivity

• Shortcomings
• - to find a verifiable evidence will take time,
  the information may not be relevant
• - estimations are necessary in preparing accounts

23
Materiality

• Each material item should be presented separately
  in the financial statements.
• To be material, accounting information must be
  able to affect the decisions of the users.
• Immaterial amounts may be added with the amounts
  of a similar nature and need not be presented
  separately.

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Materiality

• Importance
• - serves as a guide what should be disclosed in
  the financial statements
• - proper accounting treatments are applied to
  material items only

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Materiality

• Shortcomings
• - what is material depends on the size and nature
  of the company, it may reduce the comparability
  of different companies if their definitions on
  material are different
• - it may affect the objectivity of the financial
  statements

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Stable monetary unit and Money measurement

• All transactions of the business are recorded in
  terms of money.
• Only those facts that can be measured in terms of
  money are recorded.
• The purchasing power of the dollar is stable.

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Stable monetary unit and Money measurement

• Importance
• - provides a common unit of measurement
• - transactions / items can be easily verified
• - enables comparisons

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Stable monetary unit and Money measurement

• Shortcomings
• - items that cannot be measured in terms of money
  are excluded, but they are good for the business
• - the purchasing power can never be stable

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Prudence

• Under this concept, revenues and profits are not
  anticipated. Only realized revenue and profits
  are recognized in the profit and loss account.
  Provision is made for all known liabilities
  whether the amount is known with certainty or is
  a best estimate in light of the information
  available.

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Prudence

• Importance
• -  It reduces the chance that the users be misled
  by relying on the over-optimistic results.

31
Prudence

• Shortcomings
• -  Prudence asserts that stock should be valued
  at the lower of cost and net realizable value.
  This conflicts with the historical cost concept.
• -  It also violates the consistency convention if
  stock is valued at net realizable value instead
  of cost.

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Realisation

• Revenues should be recognized when the major
  economic activities have been completed.

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Realisation

• Importance
• - It develops rules for the recognition of
  revenue.
• - It provides a base to accurately compute
  profits.

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Uniformity

• Different companies within the same industry
  should adopt the same accounting methods and
  treatments for like items.

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Uniformity

• Importance
• -    It enables inter-company comparisons of the
  financial positions and performances.

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Uniformity

• Shortcomings
• -   It reduces the flexibility of the enterprise
  to choose its own accounting policies and
  methods.
• -   The requirement will reduce the need for
  professional judgment and the accounts may not
  give a true and fair view.
• -    Even if the companies use the same
  accounting method, difference in accounting
  estimates may also reduce the comparability of
  the financial reports.

37
Relevance

• To be useful, information must be relevant to the
  decision-making needs of users. Financial
  statements should be prepared to meet the
  objectives of the users. Relevance relates to the
  influence of the information on the users
  evaluation of past, present or future events or
  confirming or correcting their past evaluation.

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Timeliness

• Financial statements are prepared on a timely
  basis. If there is undue delay in the reporting
  of information it may lose its relevance.

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Timeliness

• Importance
• -  Financial statements are prepared regularly.
• -  It facilitates the comparison of the
  performance of the business in different periods.

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Timeliness

• Shortcomings
• - If information is provided on a timely basis,
  reports will be made before all aspects of a
  transaction or other event are known, and this
  will impair reliability.
• - it may be too costly if reports are prepared
  for a very short period of time
• - information may not be relevant if it takes a
  long time to disclose on the financial statements

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Disclosure

• The concept asserts that adequate disclosure of
  information is required. All the material and
  relevant information must be disclosed in the
  financial statements.
• Any changes in accounting policies and other
  disclosures governed by the Companies Ordinance
  should be disclosed in the final accounts in
  order to give a true and fair view of the
  reported financial statements.

42
Disclosure

• Importance
• - ensure reliability
• - enable comparability

43
Disclosure

• Shortcomings
• - To disclose all relevant information will be
  time-consuming.

44
Substance over form

• The legal form of a transaction can differ from
  its real substance.
• Accounting should show the transaction in
  accordance with its real substance. That is how
  the transaction affects the economic situations
  of the business.

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Substance over form

• Importance
• - The substance of the transaction has taken
  precedence over the legal form of the transaction.