Concepts (advanced)

Question 1

Accounting Entity

Answer 1

The financial affairs of the entity are kept separate and distinct from the financial affairs of the owner

When preparing accounting records of a business we only include the business transactions and exclude those of the owner.

When preparing the Income Statement only Business income and expenses are included. Owner’s personal income and expenses are recorded as Drawings in the Equity Section of the Statement of Financial Position

When preparing the Statement of Financial Position only Business assets and liabilities are included. Owners personal assets and liabilities are recorded as Drawings in the Equity section of the Statement of Financial Position.

Question 2

Reporting Period

Answer 2

The lifetime of the business is divided into nominated time periods of equal length, usually a year.

This allows users to make comparisons of financial performance and position of a business from one period to another. Users can identify financial trends to assist in decision-making.

Question 3

Going Concern

Answer 3

The financial reports are prepared on the assumption that the life of the business is expected to continue to operate into the foreseeable future.

Hence assets, particularly Plant Property and Equipment, are valued at historical cost in the Statement of Financial Position.

The Historical Cost Concept is applied in conjunction with the Going Concern Concept.

Users will know for certain what they were purchased for. They can make their own decisions on their market value.

The market value of assets is not relevant, as the business does not intend to sell the Plant Property and Equipment in the foreseeable future, as the business is not closing down. The business will continue to use them to generate future income in the years ahead.

If the business is not a Going Concern then the Historical Cost Concept does not apply. Assets must be valued at Market Value. All the assets will all be classified as Current Assets. There will be no Non-Current Assets, as the business will close very soon and stop trading – well within a year.

Question 4

Historical Cost

Answer 4

Transactions are recorded at the amount of cash paid or payable at the time of the transaction

This means that assets are recorded at their original price when acquired.

The Historical Cost concept only applies if the business is a Going Concern. It is not a going concern then assets must be recorded at market value.

Question 5

Monetary Measurement

Answer 5

Financial transactions must be measured in a common currency such as NZ$ for New Zealand businesses.

Therefore if a transaction cannot be expressed in money values, backed up with a source document, it will not be recorded in the accounting records. For example the number of years operating or the location of the business will not appear in the Financial Statements of the business.

This is a limitation of the Financial Statements – they do not record non-financial information.

Question 6

Accrual Basis

Answer 6

Transactions are recognised when they occur and are recorded and reported in the financial reports of the period to which they relate

This concept is needed due to the Period Reporting concept

It is important that only Income and Expenses that relate to the current accounting period are reported in the Income Statement. This allows users to revise Income Statements for previous periods to compare and contrast to allow decision making to happen.

In the Statement of Financial Position it is important to record all assets and liabilities accurately at the end of each accounting period. This allows users to assess the financial stability of the entity for decision-making.

Applying the Accrual Basis concept to all transactions allows this to happen.