Chapter 5 - Trial Balance and Financial Statements (continued) Flashcards
Use of Financial Statements and the Impact in the accounting concepts
Income Statement main financial source of information: gross profit calculation
Statement of Financial Position main financial source of information are the net capital and the capital/equity figures.
Use of Financial Statements and the Impact in the accounting concepts
Enable users to
- Assess the firm’s performance with confidence
- make accurate comparisons with previous years and other years
- make reliable decisions about investment or trading activities
Accounting Concepts and Conventions
Duality / Dual Aspect Concept
Because the financial transactions involve an exchange of goods or services, and they will mostly between the firm and a 3rd party.
Therefore one party will give the monetary value and the other will receive it. So every financial transactions is recorded twice.
Accounting Concepts and Conventions
Business Entity Concept
Financial transactions of a business are treated as separate from the non-business activities of the owner of the business.
So only the business transactions are recorded, not the owner’s.
The owner’s invested capital is an identifiable investment in the business.
Accounting Concepts and Conventions
Going Concern Concept
Financial Statements are prepared with the idea that a company will continue to operate as a viable commercial venture in the foreseeable future, with no reduction in its operational scale, and not likely going into liquidation.
Assets will have an accurate depreciation calculation.
If the company is unlikely to continue as Going Concern, has to stop trading, and its assets have to be liquidated, the market value of those assets may be significantly lower than what shown in the firm’s accounts. Directors will then write down the amounts to the amounts they would realise they would be in a forced sale, and readjust liabilities.
‘Going Concern’ statements give reassurance to users that the company’s assets are likely to be worth the value they carry in the books.
Accounting Concepts and Conventions
Accruals (matching) concept
Ensures revenue relating to year is matched against the related expenses of the year. In order to match the income of one period to the expenditure of the same period, adjusting relevant unpaid expense payables.
There is a subjectivity in estimating the ‘accrued payables’ and ‘prepaid receivables’, the accruals matching report is a more objective way of measuring profit than a cash basis.
It gives a clearer view of the assets and liabilities in the Statement of Financial Position,
Accounting Concepts and Conventions
Consistency Concept
Different asset valuations can change the level of profits, therefore a consistent method is crucial.
Changing methods will provide different figures, making comparisons with previous years inaccurate.
It’s only acceptable changing methods if the circumstances change radically, where the quality of the financial statements would improve.
Directors must disclose when methods have been changed. In larger companies, auditors may have to approve it.
The change should be highlighted in the in the accounts, as well as comparative figures (before and after) the change, so that comparisons continue to be valid.
Accounting Concepts and Conventions
Prudence Concept
There are a number of estimates and predictions that need to be made, and there is a tendency to be over-optimistic about profits and financial position.
The prudence concept prescribes being cautious when making judgements.
When there are 2 figures, the accountant should always be cautious where there is uncertainties.
Revenues and profits should only recognised when there is certainty about them.
It prevails over the Accruals concept, if the 2 ever conflict.
Prudence is exercised when bad debt provision is calculated, and when write offs are done as soon as they are realised as such.
Not exercising prudence will prevent a fair view of the firm’s activities.
Accounting Concepts and Conventions
Materiality Concept
This is a concept of common sense. That is, if the concerned items are of low monetary value, it is probably not reasonable to be too stringent with the accounting rules, specially if it outweighs the benefit to the users of the accounts.
If items are immaterial for the business profit and its financial position.
Adjustments to Monetary Value in Financial Statements: Accrued Payables and Prepaid Receivables
The Accrual concept states that all income and expenditure for the year will be charged to the Income Statement of the year in which it occurred, not when cash is paid or received.
Which means that there may be a need to adjust the figures in the trial balance before they are put in the financial statements.
Adjustments to Monetary Value in Financial Statements: Accrued Payables and Prepaid Receivables
Accrued Payable
Is an expense that was incurred in the current year, but unpaid by the end of the year.
Even though it is unpaid, the accruals concept states it needs to be charged to the Income Statement for that year.
Example, an electricity invoice for December that is only received in January (that is the following financial year).
Although it will only be physically paid that new current year, it refers to the previous financial year.
Some other examples are: utilities and wage/overtime adjustments
Adjustments to Monetary Value in Financial Statements: Accrued Payables and Prepaid Receivables
Prepaid receivable
An expense that has been paid in the current year, but relates to goods or services where the benefits are intended for the following year.
Although the expense was paid in advance, it must be taken into next year’s Income Statement.
Example: firm prepaid insurance for the months of January to March the following year. This payment will be carried forwarded and included in the next year’s financial statement.
Other examples of expenses that may be prepaid: rent, rates, insurance, advertising,
Adjusting a figure from the trial balance
When there needs to be an adjustment to the Trial Balance, from a note, the double entry principle still needs to be applied.
The rule is: one item goes in the Income Statement and other on the Statement of Financial Position.
Adjusting a figure from the trial balance
Example and how it will show in Income Statement
Trial Balance Debit Credit
Advertising 14,600
Wages and Salaries 36,500
Business Rates 12,000
Note 1) accrued payable of £3,000 due in wages and salaries to show actual cost for that year.
Note 2) Prepaid receivable which was only due the following year, so £1,500 must be deducted from business rates to show the actual cost incurred for that year.
Income Statement
DR CR Gross Profit 162,750
Less Expenses
Advertising 14,600
Wages and Salaries 39,500
Business Rates 10,500
(64,600)
Net Profit 98,150
Accruals and Prepayments
Accrual - the amount needs to be added to the relevant expense in the Income Statement.
Prepayment - the amount needs to be deducted from the expense
Whilst these amounts are added and the deducted to the total in the trial balance to be added to the Income Statement.
the figures themselves need to be entered in the Statement of Financial Position as accruals and prepayments.
