3.1 Accounting Theories / Concepts Flashcards
1. Define each accounting theory 2. Identify the accounting theory applied in a given scenario 3. Explain how each accounting theory affects the preparation and presentation of financial statements.
What are accounting theories?
General guidelines for carrying out the accounting process. These guidelines are generally accepted by accounting professionals to help them prepare financial reports that are fair and objective.
What does the “Accounting Entity Concept” or “ Business Entity Concept” state?
The activities of a business are separate from the actions of the owner. All transactions are recorded from** the **point of view of the business. OR
The business is a separate entity from its owner, and all transactions are recorded from the point of view of the business. Accounting records the business activities and not the personal activities of the business owner.
What does the “Monetary Concept” state?
Only business transactions that can be measured in monetary terms are recorded.
OR
Only business activities that have monetary values are recorded, i.e. only business activities that can be measured in monetary terms are recorded.
What does the “Prudence Concept” state?
The accounting treatment chosen should be the one that least overstates assets and profits and least understates liabilities and losses.
OR
The business must report and adjust for losses that are likely to incur, even though the losses may not be confirmed yet. However, the business does not record profits that are likely to occur. Profits are recorded when they are actually earned.
What does the “Historical Cost Concept” state?
Transactions should be recorded at their original cost. The original cost is the amount reflected in the source documents.
What does the “Objectivity Concept” state?
Accounting information recorded must be supported by reliable and verifiable evidence so that financial statements will be free from opinions and biases.
Transactions are recorded based on information that is reliable and verifiable (i.e. supported by source documents or evidence). Note: Accountants have to estimate the values of some transactions. Some estimates are considered objective if two independent accountants make similar estimates using the same information provided.
What does the “Going Concern Concept” assume?
A business is assumed to have an indefinite economic life unless there is credible evidence that it may close down.
OR
The going concern concept assumes that the business has an indefinite economic life. or Unless there is evidence showing that the business will be closed down in the foreseeable future, it is assumed that the business has an indefinite economic life. Note: As a going concern, the business will buy assets (for example, equipment, buildings, etc) to help it carry out its operations in the long term. These assets are not expected to be sold off soon after they are acquired / bought / purchased. Hence, they are usually recorded at historical cost (i.e. the price at which they were bought). If there is evidence indicating that the business may close down in the foreseeable future, these assets have to be valued at the value that they can be sold for and no longer at historical cost.
What does the “Accounting Period Concept” state?
The life of a business is divided into regular time intervals.
OR
Businesses prepare financial statements at regular intervals (i.e. regular financial periods or regular accounting periods), such as at the end of each month, each quarter, each half-year or each year. or The Accounting Period Concept refers to the practice of breaking up the life of a business into regular time intervals.
Why does the accountant need to report profit for regular periods of time?
Because it is in accordance with the accounting period concept.
What does the “Accrual Basis of Accounting” state?
Business activities that have occurred, regardless of whether cash is paid or received, should be recorded in the relevant accounting period.
OR
Income is recorded in the financial period that it is earned, regardless of when it is received. Similarly, expenses are recorded in the financial period that they are incurred, regardless of when payment is made.
What does the “Matching Concept” state?
Expenses incurred must be matched against income earned in the same period to determine the profit for that period.
OR
For a given financial period, only the income earned and the expenses incurred during the period should be recorded. Income earned and expenses incurred before or after the financial period should not be included. The business must also identify all the expenses incurred to generate the income earned during the financial period.
What does the “Consistency Concept” state?
Once an accounting method is chosen, this method should be applied to all future accounting periods to enable meaningful comparison.
OR
The accounting methods used by the business must be consistent from period to period so that its financial performance can be meaningfully compared across financial periods. Inconsistency in the use of accounting methods may result in misleading figures in the financial statements. However, a business may change its accounting methods if new methods provide more accurate information about its transactions.
Why must the accounting methods used by the business be consistent from period to period?
In order that it adheres to / observes the consistency concept. The financial performance of the business can then be meaningfully compared across financial periods. Inconsistency in the use of accounting methods may result in misleading figures in the financial statements.
Can a business change its accounting methods?
Yes, if new methods provide more accurate information about its transactions.
What does the “Materiality Concept” state?
Relevant information should be reported in the financial statements if it is likely to make a difference to the decision-making process.
OR
A transaction or an item is considered material (i.e. important or significant) if it makes a difference to decision-making. The value of the transaction or item is usually compared to the size and nature of the business, in terms of the income, profit, assets or equity of the business.
