Accounting principles or concepts Flashcards
What are principles or concepts
-Basically, concepts are assumptions that are applied when recording and summarizing financial transactions.
-To bring about consistency within the accounting
profession
-Important for the credibility of the accountants, and for
the reliability of the financial results that they report.
KEY ACCOUNTING CONCEPTS
- Business entity
- Money measurement
- Historic cost
- Realisation
- Duality
- Consistency
- Materiality
- Accruals
- Prudence
- Going concern
- Substance over form
Business entity concept
-Accounts are kept for entities and not the people who own or run the company.
-The idea here is that the financial transactions of one
individual or a group of individuals must be kept separate from any unrelated financial transactions of the business owned by those same individuals.
Money measurement concept
- For an accounting record to be made it must be able to be expressed in monetary terms.
- Any item which cannot be expressed in money terms are therefore not accounted for.
- Consider a situation where there is a labor strike or the business owner’s health is failing; these situations have a huge impact on the operations and financial security of the company but this information is not reflected in the financial statements.
Realization concept
- Revenues are recognized when they are earned or realized.
- Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services.
- For instance, if a company is awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided overtime according to the work actually being done.
Duality concept
-This concept is the basis of the fundamental
accounting equation:
Assets = Capital + Liabilities
-All accounting transactions must keep this
equation balanced.
-Hence all transactions are recorded twice (a
debit and a corresponding credit entry).
Consistency concept
-Transactions and valuation methods are treated the
same way from year to year, or period to period.
-Users of accounts can, therefore, make more
meaningful comparisons of financial performance from
year to year.
-Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
Materiality concept
-Only events that are significant enough to justify the
usefulness of information are recorded
-Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased but this transaction is not worth accounting for.
-An amount may be considered material in the accounts if its inclusion in, or omission from the financial statements would affect the way people would read or interpret those financial statements
Accruals (Matching) concept
-Revenues should be recognized (i.e. included in Income Statement) in the period in which they are earned, not necessarily when they are received in cash.
-Example: a sale made to a customer on credit just
before the year-end would be included in that year’s
Income Statement, even though the cash may not be
received until the following year.
-In the same way, expenses are recognised according to the period to which they relate (i.e. when they are incurred), and not when they are paid.
-For example, an electricity bill not paid by the year-end would still be charged in that year’s Income Statement whereas rates paid in advance would be held back and not charged until the next year.
Prudence concept
- Prudence is about profits and assets not being overstated and
- Losses and liabilities being provided for as soon as they are recognised
- The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible.
- The reasons for accounting in this manner are so that financial statements do not overstate the company’s financial position.
Going concern concept
-When preparing financial statements, management
should make an assessment of an enterprise’s ability
to continue as a going concern.
-Financial statements should be prepared on a going
concern basis unless management either intends to
liquidate the enterprise or to cease trading, or has no
realistic alternative but to do so.
-The going concern concept thus assumes that the
firm will continue to operate and not close down in the foreseeable future.
Substance over form
-It can happen that the legal form of a transaction can
differ from its real substance.
-When this happens, accounting should show the
transaction in accordance with its real substance which
is, basically, how the transaction affects the economic
situation of the business.
-This means that accounting in this instance will not
reflect the exact legal position concerning the
transaction.
Historical cost concept
-A transaction is recorded at the amount actually paid for it.
-Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company.
-The cost concept does recognize that assets generally
depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.)
Capital and revenue expenditure
Expenses are the use or consumption of goods and services in the process of obtaining revenues.
Expenditure is usually of two types
Capital Expenditure
-Capital expenditure consists of expenditure, the benefit of which is not fully enjoyed in one accounting period but spread over several accounting periods.
-It includes assets acquired for the purpose of earning income or increasing the earning capacity of the business. These are not meant for sale.
-Expenditure incurred for improving assets and extending an existing asset is also capital expenditure.
The sum of invoice price, freight and insurance charges, installation and custom duty etc. will be capitalized, i.e., they appear on the assets side of Balance Sheet.
