Paper 1.1
Chapter 2
The Accounting Concepts – Part 1 (The Summary)
Just a basic summary of those little things that we always tend to forget.
The Going Concern Concept implies that a business is a going concern, i.e. that
there is no reason to expect the liquidation of assets. Thus, the business may be
valued at its historical, or current cost, rather than its break-up or replacement
value. A further example to illustrate the application of the Going Concern concept,
may be clearly seen, when stock is valued. It is a practice to value stock at the lower
of its net realizable value or cost of purchase, this is because the going concern
concept implies that the stock is held to be sold at a future date.
The Accruals Concept is based on several ‘ideas’ or practices, which may be clearly
illustrated, if summarized in the following form:
1. Revenue and Costs must be recognized as they are earned or incurred.
2. Revenues must be matched with costs, and vice versa, and dealt with in the profit
and loss account of the period to which they relate.
It is for this reason, that we actually disclose the value of the creditors in the Balance
Sheet, and the value of debtors. Furthermore, although we may have paid rent of
BD 1000, for the next two years for example, we may only note the amount relevant
to this year’s profit and loss account, and the remaining balance, as a prepayment in
the Balance Sheet.
Furthermore, this is the reason why it is required to account for sales and purchases
when made, even though on credit, rather than when they are paid for.
As well as this, the figure for closing stock is also deducted from the figure of
purchases because the figure of closing stock relates to the opening stock figure of
next year’s accounts.
The Prudence Concept
1. a) Where there are alternative procedures
b) Or alternative valuations
c) The one selected should be the one which gives the most cautious
presentation of the business’s financial position or results.
2. a) Revenues and profits are not anticipated but are related to the period in
which they occur. E.g. when a sale is made.
b) Provision is made for all known expenses or losses whether these are known
for certain or just estimates.
What definition means in layman’s terms is simply, if the company is in doubt about
an expense or a liability that it may have, it should create a provision for it
immediately, and if the company anticipates any future gains or profits, from a future
sale for example, it should ignore it, unless realized.
Examples:
1. Provisions for Bad & Doubtful Debts
2. Stock should be valued at the lower of net realizable value or cost
Sales Revenue could be realized, if the following circumstances apply:
1. The transaction is for a specific quantity of goods at a known price.
2. The sales transaction is completed or it is known for certain that it will be
completed.
3. Cash is received for a purchase, or it is virtually certain that cash will eventually be
received.
Consistency Concept states that similar items within a single set of accounts, should
be similarly accounted for, and that they are treated the same from one period to
another.
The Entity concept states that a business must be regarded as a separate entity
distinct from its owners or managers.
Money Measurement, states that accounts will only deal with those items to which a
monetary value can be attributed, which means that subject matter such as staff is
ignored.
Separate Valuation Principle refers to the amount/cost attributable to an asset /
liability, since the valuation should deal with each component separately. E.g. an
independent valuation should be obtained for each item of stock, and their net
realizable values should then be aggregated to obtain the total value of stock.
The Materiality Concept refers to the following:
Only items material in amount or in their nature affect the true & fair view given by a
set of accounts. In other words, immaterial items are not paid that much attention.
But this is obviously based on a subjective judgment in deciding whether an item is
immaterial or not. Either way, the amount of the item and its context must be
considered.
Historical Cost Convention states that transactions should be recorded at their cost.
Stable Monetary Unit states that the Financial Statements must be expressed in
terms of a monetary unit, e.g. $.
Objectivity Concept states that accounts must be free from bias or subjectivity as
much as possible.
Time Interval, states that the activities of an entity must be split up into blocks of time,
e.g. daily, monthly or annually.
Substance Over Form, refers to a transaction in two distinct ways, ‘subject’ and
‘form’. Thus, the transaction should be accounted for and presented in accordance
with their economic ‘substance’ not their legal ‘form’. E.g. assets required on a hire
purchase are not legally owned by the buyer even though the substance of the
transaction refers to the buyer as the owner.
The Realization Concept states that revenues and profits are recognized when they
are realized. Basically the Realization Concept refers the question of when does an
entity realize a profit or a gain?
Simply, revenue may be recognized at the point of sale, when the following
conditions are satisfied:
1. The product or service has been provided to the buyer
2. The buyer recognized his liability to pay for the goods
3. The ownership of the goods has passed from the seller to the buyer.
4. The buyer has indicated his willingness to pay.
5. The monetary value of the goods has been established.
Revenue or profits may also be recognized at other situations even if a sale hasn’t
been established, such as:
1. Longterm Contracts, where profits/revenues are recognized when the production
on a section of the total contract is complete, rather than when the entire project is
complete.
2. Retail & Hire Purchase, where an actual sale isn’t made unless the buyer finishes
all of his installments. In this case, profit would be the interest added to the cost of
the asset sold.
