Accounting Principles

Accounting Principles

Learning Outcome • State the meaning of the concepts and principles. • Discuss the importance and functions of the concepts and principles. • Discuss the shortcomings or limitations of the concepts and principles.

Accounting concepts and principles • Business entity • Going concern • Historical cost • Accrual • Matching • Consistency • Objectivity • Materiality

Accounting concepts and principles • Stable monetary unit • Prudence • Realisation • Uniformity • Relevance • Timeliness • Disclosure • Substance over form

Business entity • The business and its owner(s) are two separate entities. Any transactions related to the business should be recorded properly in the books of the business. Any private transactions related to the owners only should not be treated as the transactions of the business.

Business entity • Importance • - defines the areas of interest of the financial statement • - what should be included and disclosed in the financial statements

Going concern • An enterprise is on a going concern and will continue in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations. All fixed assets should be valued at historical cost.

Going concern • Importance • - enables the enterprise to carry out plans • - enables the enterprise to make contracts with others • - expenditure can be deferred over future periods

Going concern • Shortcomings • - no business can continue forever • - assets valued at historical cost may be misleading unless they are valued at current prices • - financial statements may be misleading if the business is going to close shortly after the balance sheet date

Historical cost • All transactions and events should be measured in terms of the acquisition cost.

Historical cost • Importance • - historical cost is objective and verifiable • - minimize manipulation • - is consistent with going concern, consistency and prudence concepts

Historical cost • Shortcomings • - does not show the market value of the assets which is more relevant to users • - with an increase in price level, the profits may be overstated • - the profit is a combination of holding gain and operating gain

Accrual • Financial statements are prepared on the accrual basis of accounting. • Expenses are recognised when they incurred and not when cash was paid. • Revenues are recognised when they earned and not when cash was received.

Accrual • Importance • - more accurate to show the expenses and income for the period

Accrual • Shortcomings • - the calculations become more complicated • - the calculations can be manipulated

Matching • The revenue or income for the period should be matched with the expenses for that period to assess the profit made.

Matching • Importance • - actual profit is ascertained • - profit will not be overstated as expenses should be matched against the revenue

Consistency • In preparing the accounts of a business, like items must be treated consistently in the accounts from period to period. • Changes can still be made if they provide a better way of presenting the accounting data. • Such changes should be disclosed in the financial statements.

Consistency • Importance • - more reliable for comparison of the results of different periods • - similar items can be followed accordingly

Objectivity • Those who are responsible for the preparation of the final accounts and the books should avoid personal bias. • The transactions recorded should be based on verifiable evidence. (e.g. invoice)

Objectivity • Importance • - minimize the possibility of subjective judgments • - avoid manipulations

Objectivity • Shortcomings • - to find a verifiable evidence will take time, the information may not be relevant • - estimations are necessary in preparing accounts

Materiality • Each material item should be presented separately in the financial statements. • To be material, accounting information must be able to affect the decisions of the users. • Immaterial amounts may be added with the amounts of a similar nature and need not be presented separately.

Materiality • Importance • - serves as a guide what should be disclosed in the financial statements • - proper accounting treatments are applied to material items only

Materiality • Shortcomings • - what is material depends on the size and nature of the company, it may reduce the comparability of different companies if their definitions on ‘material’ are different • - it may affect the objectivity of the financial statements

Stable monetary unit and Money measurement • All transactions of the business are recorded in terms of money. • Only those facts that can be measured in terms of money are recorded. • The purchasing power of the dollar is stable.

Stable monetary unit and Money measurement • Importance • - provides a common unit of measurement • - transactions / items can be easily verified • - enables comparisons

Stable monetary unit and Money measurement • Shortcomings • - items that cannot be measured in terms of money are excluded, but they are good for the business • - the purchasing power can never be stable

Prudence • Under this concept, revenues and profits are not anticipated. Only realized revenue and profits are recognized in the profit and loss account. Provision is made for all known liabilities whether the amount is known with certainty or is a best estimate in light of the information available.

Prudence • Importance • - It reduces the chance that the users be misled by relying on the over-optimistic results.

Prudence Shortcomings • - Prudence asserts that stock should be valued at the lower of cost and net realizable value. This conflicts with the historical cost concept. • - It also violates the consistency convention if stock is valued at net realizable value instead of cost.

Realisation • Revenues should be recognized when the major economic activities have been completed.

Realisation • Importance • - It develops rules for the recognition of revenue. • - It provides a base to accurately compute profits.

Uniformity • Different companies within the same industry should adopt the same accounting methods and treatments for like items.

Uniformity • Importance • - It enables inter-company comparisons of the financial positions and performances.

Uniformity • Shortcomings • - It reduces the flexibility of the enterprise to choose its own accounting policies and methods. • - The requirement will reduce the need for professional judgment and the accounts may not give a ‘true and fair view’. • - Even if the companies use the same accounting method, difference in accounting estimates may also reduce the comparability of the financial reports.

Relevance • To be useful, information must be relevant to the decision-making needs of users. Financial statements should be prepared to meet the objectives of the users. Relevance relates to the influence of the information on the user’s evaluation of past, present or future events or confirming or correcting their past evaluation.

Timeliness • Financial statements are prepared on a timely basis. If there is undue delay in the reporting of information it may lose its relevance.

Timeliness • Importance • - Financial statements are prepared regularly. • - It facilitates the comparison of the performance of the business in different periods.

Timeliness • Shortcomings • - If information is provided on a timely basis, reports will be made before all aspects of a transaction or other event are known, and this will impair reliability. • - it may be too costly if reports are prepared for a very short period of time • - information may not be relevant if it takes a long time to disclose on the financial statements

Disclosure • The concept asserts that adequate disclosure of information is required. All the material and relevant information must be disclosed in the financial statements. • Any changes in accounting policies and other disclosures governed by the Companies Ordinance should be disclosed in the final accounts in order to give a true and fair view of the reported financial statements.

Disclosure • Importance • - ensure reliability • - enable comparability

Disclosure • Shortcomings • - To disclose all relevant information will be time-consuming.

Substance over form • The legal form of a transaction can differ from its real substance. • Accounting should show the transaction in accordance with its real substance. That is how the transaction affects the economic situations of the business.

Substance over form • Importance • - The substance of the transaction has taken precedence over the legal form of the transaction.

Accounting Principles