2.1 - Accounting Concepts

Question 1

Accounting Entity

Answer 1

The accounting entity concept states that the personal financial affairs of (owners name), the owner, must be kept separate and distinct from the financial affairs of (business name), the business, as they are separate entities. Therefore,

• ($___) of the (good purchased/used) will be reported as an expense in the income statement for (business name) as it is a business expense.
• ($___) of the (good purchased/used) will be reported as drawings-as a direct reduction in equity in the statement of financial position for (business name). The (good purchased/used) will not be reported in the income statement, as it is a personal expense of (owners name) and not a business expense for (business name), as it is a distribution to (owners name).
• If this was not followed, and (owners name) included any of their own income or expenses in (business name)’s income statement, the profit figure being reported would not accurately represent the actual profit of the business and the profit may be understated, due to (owners name) including their personal expenses.

Question 2

Meeting the characteristics of an asset and being recognized

PPE

Answer 2

• The (asset name) which (business name) owns meets the characteristic of an asset because (owners name) purchased the (asset name) in a past transaction. (business name) has present control over the benefits expected to flow from the asset, as it is only able to be used by staff of (business name) to (purpose) to earn income and bring money into the business. In the future, there will be an inflow of economic benefit in the form of cash, when the (asset name) will be used to (purpose) and earn income, resulting in cash being received into the business and increasing the bank asset for (business name). (asset name) will also allow (business name) to continue operating efficiently and effectively in order to provide its (name of goods/service)
• (business name) has a purchase invoice/receipt that provides a reliable measure of the cost of the (asset name), because the invoice faithfully represents a market transaction, agreed between (suppliers name) and (business name), which is complete, neutral and free from error.

Question 3

Meeting the characteristics of a liability and being recognized

Answer 3

• The (liability name) which (business name) owes meets the characteristic of a liability because (owners name) acquired the debt from a past transaction. (business name) is under the present obligation to repay the (liability name) to the supplier for the (asset name), and there is a contract between them and (suppliers name) which states they must repay the debt acquired. In the future, there will be an outflow of economic benefit in the form of cash, when the (liability name) ($__) will be paid back to (___), decreasing the bank asset for (business name).
• It is probable that (business name) will pay back (suppliers name), as they want to be able to purchase on credit again in the future and need to maintain a good credit rating.
• (business name) has an invoice that provides a reliable measure of the amount owing of the (liability name), because the invoice faithfully represents a market transaction, agreed between (suppliers name) and (business name), which is complete, neutral and free from error.

Question 4

Meeting the characteristics of an income and being recognized

Answer 4

• The money received for (income name) is an increase in economic benefits by being an inflow of assets, as money is coming from a (cash/credit) sale, which will increase the asset of (bank/accounts receivable) for (business name).
• (income name) will increase the profit for (business name) and therefore increase its equity. The (income name) is being received from customers and not from (owners name), the owner, as a contribution.

Question 5

Meeting the characteristics of an expense and being recognized

Answer 5

• The money paid for (expense name) is a decrease in economic benefits by being an outflow of assets, as money is leaving from a (cash/credit) sale, which will decrease the asset of (bank/accounts receivable) for (business name).
• (expense name) will decrease the profit for (business name) and therefore decrease its equity. The (expense name) is paid to (___) and not a distribution to (owners name), the owner, for their personal use, as drawings.

Question 6

Capital expenditure

Answer 6

The (item name) which (owners name) has purchased for ($___) is an example of capital expenditure. This is because it is a one-off cost, (with a one-off nature) which will be reported as a non current PPE asset on the statement of financial position. The (item name) will benefit (business name) beyond the current accounting period when it will used to generate income as customers… (function of PPE in context to the business).

Question 7

Revenue expenditure

Answer 7

The (item expense name) which (owners name) has purchased for ($___) for the (PPE name) is an example of revenue expenditure. This is because it is a day-to-day cost, (with a recurring nature) which will be purchased regularly (each ___) in order to (purpose of expense). This will decrease (business name) bank asset when paid monthly as an expense listed on the income statement for (business name). The (item expense name) will only affect (business name) within the current accounting period as it will used for the monthly maintenance of (PPE name), and more will be required to be purchased next year. The ($ amount of expense) will decrease the profit of (business name).

Question 8

Depreciation

Answer 8

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

• For (business name), this means the ($___) cost of the (asset name) should be spread over its useful life. The (asset name) is expected to last (___) years so it will be depreciated by ($___) each year.
• This will be reported as an expense called depreciation on (asset name), on the (business name) income statement.

Question 9

Monetary measurement

Answer 9

The (statement name) for (business name) illustrates the monetary measurement concept, as it has been prepared using the single common currency (unit of measure), of New Zealand dollars.

• Therefore, the cost of the new (item purchased) which is ($___ cost in foreign currency) must be converted into New Zealand dollars before it is reported in the financial statements.
• The (item purchased) will be reported at the converted value on the statement of financial position as a non current asset for (business name).

OR

• In the income statement for (business name), the columns have $NZD indicating that the income and expenses are measured in terms of $NZD.

Question 10

Historical cost

Answer 10

The historical cost concept states that all transactions must be reported at the amount of cash paid or payable at the time of transaction, meaning that (business name) must report the (item purchased) at the original purchase price of ($___) on the (statement name) as a (account name group).

Question 11

Going concern

Answer 11

• Going concern means that (business name) will continue to operate into the foreseeable future.

Asset

• (business name) will use the (asset name) to produce (goods in context to business) which they will sell to earn revenue. As the (asset name) will benefit the business beyond the next accounting period, it will be reported in the statement of financial position as a non-current asset.
• Reporting the (asset name) as a non-current asset demonstrates the going concern concept, as (owners name) is indicating that they intend to continue to operate (business name) into the foreseeable future, beyond the next accounting period; and that the business will continue to grow in the future and sell (goods/service name), so there is no intention to liquidate or make significant changes to the business within the next 12 months because of this.

Liability

• (business name) will pay back the (liability name) over the next (___) years until (year), when the loan is due. As the (liability name) will affect the business beyond the next accounting period, it will be reported in the statement of financial position as a non-current liability.
• Reporting the (liability name) as a non-current liability demonstrates the going concern concept, as (owners name) is indicating that they intend to continue to operate (business name) into the foreseeable future, beyond the next accounting period; and that the business will continue to grow in the future, so there is no intention to liquidate or make significant changes to the business within the next 12 months because of this.

Question 12

Period reporting

Answer 12

The period reporting concept has been applied by diving the economic life of (business name) into time periods of equal length, which in this case are for one year (eg. 2018, 2019, 2020). This enables (owners name) to measure the financial performance and position of (business name) so that comparisons can be made from one year to the next.

Question 13

Accrual basis

Answer 13

The accrual basis concept states that (business name) must recognise transactions and other events when they occur and report their effects in the financial statements for the period to which they relate.

Question 14

Accrual basis

Accrued income

Answer 14

• This will mean that the (income name) owed of ($___) will be added to the (income group name) on the income statement for the period ended 31 March (year), because they relate to the current accounting period as the (work done name) was done during this year.
• (business name) will also create a current asset called accrued income worth ($___) on the statement of financial position for (business name), which will recognise the future gain of economic resource when the (income name) is received in the next accounting period.

Question 15

Accrual basis

Accrued expense

Answer 15

Work done, Money not paid

• This will mean that the (expense name) owing of ($___) will be added to the (expense group name) on the income statement for the period ended 31 March (year), (debit the expense (expense name)) because they relate to the current accounting period as the (work done name) was done during this year.
• (business name) will also create a current liability called accrued expenses worth ($___) on the statement of financial position for (business name), (credit accrued expenses), as (business name) have an obligation to pay (expense name) ($ amount) in the next accounting period, and this will recognise the future loss of economic resource when the (expense name) is paid.

Question 16

Accrual basis

Income in advance

Answer 16

Money received, work not done

• This will mean that the (income name) received of ($___) will be deducted from the (income group name) on the income statement for for the period ended 31 March (year), (debit the (income name)), because they do not relate to the current accounting period as the (income name) belong to next year.
• (business name) will also create a current liability called income in advance worth ($___) on the statement of financial position for (business name) (credit income in advance), as (business name) have an obligation to provide the (goods/service name) ($ amount) in the next accounting period, and this will recognise the future loss of economic resource when the (service name) is provided or a refund of money is given if they cannot (service given).

Question 17

Accrual basis

Prepayment

Answer 17

• This will mean that the (expense name) paid of ($___) will be deducted from the (expense group name) on the income for the period ended 31 March (year), because they do not relate to the current accounting period as (expense name) belong to next year.
• (business name) will also create a current asset called prepayments worth ($___) on the statement of financial position for (business name), which will recognise the future gain of economic resources when the (service received) is received in the next accounting period.

Question 18

Purposes, components and limitations of the statement of accounting policies

Answer 18

The purpose of the statement of accounting policies for (business name) is to inform users of the measurement bases used for reporting the assets, liabilities, expenses and incomes. It is important for users to know how (account type) have been measured so they understand the numbers reported for (account type) in the financial statements. For example, when (owners name) looks at their statement of financial position, they need to know that the investments (and other assets) are stated at their cost to the business, and not their market value, as this will make a difference to how (owners name) understands the statement of financial position.

The limitation of the statement of accounting policies for (business name) is that terminology used in the statement may not be understood by all users (eg. Accural Basis of Accounting).

Question 19

Purpose of the income statement

Answer 19

The purpose of the income statement for (business name) is to show the income, expenses and profit/loss for the year ended (___) each year. This will allow (owners name), the owner to see how (business name) is performing and make comparisons between years.

Question 20

Purpose and limitations of the statement of financial position

Answer 20

The purpose of the statement of financial position for (business name) is to measure the assets, liabilities and equity as at (___) each year. This will allow (owners name), the owner, to see the position of (business name) in terms of how much it owns compared to how much it owes, as capital.

Limitations

• Does not include non-financial information (eg. state of assets, ability of staff and quality of location) that can not be given monetary measurement. For example, the poor state of (asset name) may mean that customers will not hire/use them, thus reducing future profitability or meaning that a significant investment must be made by (owners name) to upgrade them if (decision).
• Assets are recorded at historical cost which may be outdated.
• Accumulated depreciation and allowance for doubtful debts are based on estimates, which means that the carrying amount may not reflect the current market value of the assets and could therefore affect the amount (owners name) pays for (decision).

Question 21

Purpose of the cash budget

Answer 21

The purpose of the cash budget for (business name) is to show the future estimated cash receipts, future estimated cash payments and the expected bank balance for the business. This will allow (owners name), the owner, to predict the bank balance and ensure they have enough cash on hand to pay off any forthcoming payments in the next 4-6 weeks. (owners name) could use the information on the cash budget, such as the future estimated cash payments, to decide if they have enough cash to cover them or if they need to seek further outside financing, such as a loan from the bank.

Question 22

Purposes, components and limitations of the statement of cash flows

Answer 22

The purpose of the statement of cash flows for (business name) is to determine where cash came from, what it was spent on during the year, and whether there was a net increase or decrease in cash to explain any changes in the bank balance for the year.

The limitations of the statement of cash flows for (business name) are that it only shows the money coming into and going out of the business, and does not show what amounts are still owing to and owed by (business name), which means that (owners name) would not know if there would be enough money in the bank or money expected to be received to cover any future payments that introducing the (asset name) may bring. It also does not show any credit transactions (eg. credit sales), it does not include non cash items (eg. bad debts, depreciation), and there is no correlation between net increase/decrease in cash and the net profit/loss (i.e. cash transactions do not reflect the operating performance of (business name).

Question 23

Summary of income

Answer 23

• Increases economic benefits by inflow/enhancement/increase of assets OR decrease in liabilities
• Increases equity by increasing profit
• Not a contribution from the owner
• Probable increase in economic benefits has occurred
• A transaction document provides a reliable measure

Question 24

Summary of expenses

Answer 24

• Decreases economic benefits by outflow/depletion/decrease of assets OR increase in liabilities
• Decreases equity by decreasing profit
• Not a distribution to the owner (drawings)
• Probable decrease in economic benefits has occurred
• A transaction document or business knowledge provides a reliable measure

Question 25

Qualitative characteristic of relevance

Answer 25

• Information is relevant when it has predictive or confirmatory value which influences the economic decisions of users by helping them to evaluate past, present or future events, or correct past evaluations.
• In this example, the (information) represented by this is relevant, because it will help (owner name) (more accurately predict the economic benefit used/remaining or confirm decisions made).

Question 26

Qualitative characteristic of materiality

Answer 26

• Materiality requires information to be disclosed separately if its omission or misstatement (size or nature) could influence the economic decisions of users taken on the basis of the financial statements.

Size
- In this example, the amount of ($ amount) for the (purchased good) is material because it is a significant amount, thus it is important that the (account name 1) is reported separately from the (account name 2). The size of ($ amount) will show how much of an impact the new products have had on the total (account type). To omit (account name 1) as a separate piece of information would make it difficult to see how much it has contributed to the total (account type) of (business name), and therefore make it difficult for (owners name) to make future decisions as to wether to continue to offer this (good/service).

Nature
- In this example, it is important that the (account name 1) are reported separately from the (account name 2), as the nature of the new product/service is important. Thus, the impact of (account name 1) must be shown separately from (account name 2). To omit (account name 1) as a separate piece of information would make it difficult to see how much it has contributed to the total (account type) of (business name), and therefore make it difficult for (owners name) to make future decisions as to wether to continue to offer this (good/service).

Question 27

Recognition criteria of probable economic outflow for liability/expense

Answer 27

It is probable that (business name) will have cash flow from the business to pay for the (expense name), as they will want to maintain a good credit history with the (expense provider name), in case they want further (expense name).

Question 28

Recognition criteria of probable economic outflow for assets

Answer 28

• It is probable that (business name) will continue to use the (asset name), as…
• It is necessary to (purpose) in providing its (name of goods/service).
• (owners name) will have ensured they could meet their customers needs by purchasing inventory that they are likely to buy from (business name).

Therefore, it is probable that the (asset name) will provide future economic benefit in the form of cash from customers when the (goods/service) are completed.

Question 29

Qualitative characteristic of timeliness

Answer 29

Timeliness requires information to be received in a time period that makes it useful for decision making. Otherwise, it will lose its relevance. Looking at the older Cash Flow Statements does not meet the qualitative characteristic of timeliness, as the information contained in them is no longer relevant to (owners name)’s current situation, as they now have different cash receipts and payments. (owners name)’s business has grown recently, so any figures in previous statements cannot be used to help them decide if growing the business further is a good idea. Only the most recent statement would provide timely information.

Question 30

Qualitative characteristic of verifiability

Answer 30

• ($ amount) cost of the (account name) is verifiable because it is supported by documentation (an invoice/receipt) providing proof of the amount, that any independent party (eg. accountant) would agree to as the amount to be reported in the (statement name).

Question 31

Recognition criteria of probable economic outflow and reliable measure for depreciation

Answer 31

It is probable that there will be a decrease in the (asset name), as it will have been used for a year for (purpose) and therefore some of its economic benefit will have been used up.

The depreciation is a reliable measure, as it is based on an appropriate depreciation method and rate that is based on (assumption from depreciation method). Therefore, the depreciation expense faithfully represents the transaction.

Question 32

Why a liability and asset will be reported in the statement of financial position as a non-current

Answer 32

Liability
- The (liability name) will be reported in the Statement of Financial Position as a non-current liability, as (business name) will not pay back the (liability name) within the next accounting period (1 year), as any liability that is settled within 1 year is current, and the liability will not be settled for (_) years.

Asset
- The (asset name) will be reported in the Statement of Financial Position as a non-current asset, as (business name) has no intention to turn (asset name) into cash in the next 12 months, so they will continue to use it for (function of asset in context to the business) to earn income over the next few years.

Question 33

Qualitative characteristic of comparability

Answer 33

• (owners name) is able to readily compare the performance and position of (business name) over the three year period from (financial statement) and are therefore able to identify that (fact 1 from data given) and (fact 2 from data given). This is important, as it indicates to (owners name) that (business name) is making sufficient profit to repay the loan obligation and interest on loan.
• Comparability has been enabled through the consistent measurement and display of the financial effects of transactions and other events. For example, the accounting policies employed in the preparation of financial statements, any changes made and the effects of these changes. This allows for corresponding information for the preceding periods to be shown.

Question 34

Units of use depreciation method definition and appropriateness

Answer 34

Units of use depreciation calculates depreciation under the assumption that the loss of future service potential of (asset name) is based on how much it is used.

The depreciation method used should closely match with the using up of future economic benefit of the (asset name).

Units of use is an appropriate depreciation method for the (asset name) because it is not likely to become ‘out of date’, meaning that the (asset name) will be the same for a number of years. It will only suffer wear and tear, and subsequent loss of useful economic life when it is used by customers. Therefore, depreciating (asset name) using the units of use method for the (kilometers driven) is most appropriate.

Question 35

Faithful representation of accounting entity

Answer 35

Faithful representation requires transactions to be reported in a way that is complete, neutral and free from error. By reporting this personal expense as drawings and not as an expense of (business name), it is ensuring that the information is neutral and not biased towards (owners name)’s personal gain.

Question 36

Qualitative characteristic of understandability

Answer 36

• Financial statements are prepared under the assumption that (owners name) has a reasonable knowledge of (business name) and of the information contained in the statement. Therefore, they would understand how to use the statement when making their decision to (decision and how information was used).

Question 37

Limitations of the income statement

Answer 37

• It does not include non-financial information (eg. state of assets, ability of staff, quality of location), which do not have monetary measurement, but could have a significant impact on (business names)’s (profitability/reliability to repay the loan).
• Some components such as depreciation and doubtful debts expenses are shown only as estimates. This means that the impact of the competitor on income and expenses may not accurately reflect the actual impact. Therefore, decisions might be made to reduce expenses that are not necessary.

Question 38

Recognition criteria of the income statement

Answer 38

It is probable that (income name) will flow into (business name) because it is likely that customers will pay their account as they will want to have a good credit history and continue to buy on credit in the future. The amount of ($ amount) will be measured reliably by invoices issued to the credit customers.

Question 39

Diminishing value depreciation method definition, appropriateness and limitations

Answer 39

Diminishing value depreciation calculates depreciation under the assumption that the loss of future service potential of the (asset name) is highest in the earliest years of the assets useful economic life.

The depreciation method used should closely match with the using up of future economic benefit of the (asset name).

Diminishing value is an appropriate depreciation method for the (asset name) because technology changes quickly, and new advances in computing can replace the existing technology almost on a yearly basis. Therefore, depreciating (asset name) using the diminishing value method is most appropriate.

Question 40

Limitation of depreciation

Answer 40

Depreciation spreads the historical cost of the (asset name) over its useful life. It is an estimate of the loss of future economic benefit of an asset, and therefore unlikely to exactly replicate the loss. As a result, the depreciation applied to the (asset name) may underestimate the loss of benefit and therefore the asset may be reported too highly and overstate the value of the assets of (business name).

Question 41

Qualitative characteristic of faithful representation

Answer 41

• The reporting of the (liability name) will have the qualitative characteristic of faithful representation, as (business name) will have a loan agreement that is complete, neutral, and free from error. This loan agreement will have been prepared by a third party (not ((owners name)) and will show that the loan will not be paid back in the next 12 months, as any liability that is settled within 12 months is current and this loan has a maturity date of (loan due date). This agreement faithfully represents an arms-length market transaction between independent parties ((business name) and (asset provider name)).

Question 42

Recognition criteria of an asset

Answer 42

• It is also probable that cash will flow to the business, as (business name) would intend to (function of PPE in context to the business) to earn income.

Question 43

Straight line depreciation method definition, appropriateness and limitations

Answer 43

Straight line depreciation calculates depreciation under the assumption that the loss of future service potential of the (asset name) is the same amount each year, and is therefore spread evenly over the assets useful economic life.

The depreciation method used should closely match with the using up of future economic benefit of the (asset name).

Straight line is an appropriate depreciation method for the (asset name) because its use does not change and its economic benefit is consumed the same year after year.

Question 44

Reliable measure

Answer 44

(business name) can recognise the (account group name), as the ($ amount) cost of the (account name) can be reliably measured, as (business name) will have a
receipt/invoice from when they issued/received it from (transaction), that is complete, neutral and free from error.

Question 45

Recognition of elements

Answer 45

Elements should be recognised if…

• It is probable that any future economic benefit associated with the item will flow to or from the entity
• The item has a cost or value that can be measured reliably

Question 46

Expenses being recognized

Answer 46

• Expenses are recognized in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen, that can be measured reliably.

Question 47

Incomes being recognized

Answer 47

• Incomes are recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen, that can be measured reliably.
• (business name) can recognise the (income name) as income, because it is probable that the cash for the (income name), will flow to (business name), resulting in an increase in future economic benefits, as customers are likely to pay their accounts. This is because they have a legal obligation, and will want to have good credit history in order to continue to buy on credit in the future.