GAAP CONCEPTS Lesson

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Learning Outcomes and Assessment Standards

Learning Outcome 1: Financial Information The learner is able to demonstrate knowledge, understanding and the application of financial information according to generally accepted accounting practice and concepts. Assessment Standards: We know this when the learner is able to: Define and explain accounting concepts for a sole trader up to the financial statements. Within the context of the accounting cycle, identify and complete source documents, record the information in the subsidiary journals (books of first entry), post to the ledgers and draw up the trial balance of a sole trader manually and/or by using an accounting package. Analyse and show the effect of transactions on the accounting equation of sole traders. Prepare final accounts and financial statements of a sole trader.

Overview
In this lesson, we look at the rules governing the accounting process, in particular as determined by generally accepted accounting practice (GAAP).

Lesson

DVD

The nature of GAAP GAAP may be defined as the body of knowledge, consisting of the written and unwritten rules of accounting, which guides accountants in their duty of financial reporting. GAAP consists of various accounting concepts that will be further discussed below. The need for GAAP The application of GAAP ensures that financial statements are:

Understandable Useful Relevant Reliable Timely Verifiable Neutral Comparable and consistent.

The business entity concept The financial affairs of a business are kept entirely separate from the financial affairs of its owner. A business has a life distinct from that of its owner the owners personal expenses or income should not be recorded in the books of the business, e.g. if the owner wins money in a casino, this forms part of his or her personal income and not that of the business. Should personal income/expenses be recorded in the books, confusion will arise and the financial statements will not represent a true state of affairs. The historical cost concept This concept is based on the rule that assets will be valued at historical cost, i.e. the amount which was originally paid for them (cost price). Land and buildings which were acquired in 1990 for R90000 will still be reflected in the financial statements as R90 000 in the year 2000, even though the value may

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have doubled or even trebled since the purchase. The reason for this is that if accountants were allowed to place any subjective value on assets, this could result in manipulation of financial statements financial results could either be overstated or understated to suit their own purposes. The going-concern cost concept Financial statements are prepared on the assumption that a business will continue operating for the foreseeable future. If a business had to suddenly close down, it would be forced to value its assets at less than the values reflected in the books assets would realise a far lower value than their historical cost owing to the forced closure of the business. The matching concept This concept has a two-sided effect:

expenses and income must be recorded in the correct time period, and if an expense has been incurred with the effect of producing income, then these two items must be matched against each other in the same set of financial statements.

At financial year-end (e.g. 28 February 20.4) all transactions up to and including this date must be reflected in the financial statements on 28 February 20.4. This would include expenses which have not yet been paid and income which has not yet been received up to and including 28 February 20.4. This concept therefore implies that income and expenses are recorded when they are incurred and not when they are actually received or paid. The reason for this is to ensure that financial statements are comparable from one year to the next year and from one business to another. The prudence concept This concept is based on the assumption that financial results are presented in a conservative manner, possibly even in a pessimistic manner. An accountant will not consider any expected income, but will make provision for anticipated losses even if he or she is not entirely certain of the exact amount. An accountant would understate rather than overstate profits in the event of uncertainty. The concept of materiality This concept covers the disclosure of items which are of importance to readers of financial statements only material items are shown in the financial statements. The reason for this is to assist the readers of financial statements in their understanding of the figures provided. Financial statements are not cluttered with long lists of figures only the relevant information is shown. The other details are usually shown separately as a note to the financial statements. In preparing the financial statements, it is necessary to adjust figures at the end of the financial period. Consider the table below. Required You are required to match the examples in the left-hand column with the appropriate concepts in the right-hand column.

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Table:
Examples of year-end adjustments Appropriate principle applied A.  Damages payable to a client will be finalised next year. An estimated amount of R9 000 is 1. Business entity principle recorded this year. B.  Interest on overdraft is shown as a separate amount to Interest on loan. C.  An owner owes his sister R5 000 for costs incurred on holiday. This is not reflected in the financial statements of the business. 2. Historical cost principle 3. Going-concern principle

D.  When a debtor settles his or her account, the discount granted must be recorded at the 4. Matching principle same time. E.  Land and buildings are shown in the financial statements at R400 000, even though an estate agent says the property is worth twice that amount. F.  Trading stock is still shown at the cost price of R20 000, even though it could only be sold immediately for R15000 on a flea market or auction. 5. Principle of prudence

6. Principle of materiality

State the concept applied in each of the following cases: Interest on overdraft is shown separately from bank charges in the income statement. The financial period is 01 March 20.4 28 February 20.5. Part of the shop is let at a monthly rental of R12000 per annum, but the tenant has not yet paid the rent for February 20.5. R12000 was recorded in the income statement on 28 February 20.5. The owner won the National Lotto. He did not record this as income in the income statement of his business. Land and buildings of a business are reflected in the balance sheet at R250000, yet the owner has been offered R450000. Consumable stores have been ordered in the current financial year, but will only be delivered early in the next financial year. Obsolete computers are valued at R15000 in the balance sheet even though the business could only get R5 000 if it were to sell these to its staff immediately. Stock of merchandise worth R25 000 and consumables worth R5000 are reflected in the balance sheet as inventory at R30000. The break-down is shown separately as a note to the financial statements. An amount in respect of damages is owing to a customer. The amount will be finalised in the next financial year. The accountant estimated the damages at R20000 and recorded it in the current financial year. The interest on the loan for the current year amounted to R5000. Only R3000 was paid. The income statement for the current year reflected an amount of R5000 in respect of the interest. Stationery, consumables and repairs have been grouped under Sundry expenses. Year-end accounting procedures After all posting to the general ledger has been processed, a trial balance is drawn up. This is done to verify that the double-entry principle has been adhered to and all posting has been done correctly. The trial balance does not indicate how profitable the business is it merely consists of a list of balances of the various ledger accounts in the general ledger. In order to determine the profitability of a

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business, a new set of accounts needs to be prepared, namely the trading account and the profit and loss account. Although a business is run as a going concern, it is essential to prepare final accounts for a stated period, e.g. 01 March 20.4 28 February 20.5. This period is called the financial year or accounting period. It should be noted that a business does not have to follow the calendar year, i.e. 01 January 20.4 31 December 20.4. Most businesses use the financial period of 01 March 20.4 28 February 20.5, mainly for tax reasons. Before final accounts are drawn up, it is necessary to take adjustments into account. Adjustments consist of entries which were not considered when the trial balance was drawn up. Examples of these adjustments are dealt with below. Adjustments are made to ensure that the matching concept is complied with expenses and income are matched for the same time-frame. The double-entry principle applies to adjustments. Adjustments are recorded by means of journal entries. Postings are done to the relevant accounts and an adjusted trial balance is drawn up. This trial balance is called the post-adjustment trial balance. The trial balance that is drawn up before adjustments have been considered, is called the pre-adjustment trial balance.
YEAR END PROCEDURES:

Pre-adjustment trial balance Journal entries for adjustments Post to the ledger

Post-adjustment trial balance

Activity 1
Match each concept mentioned in the left-hand column with an example of its application in the right-hand column. N.B. In your answer book, record the concepts on the left with the correct responses in the right-hand column.
CONCEPTS (A) Business entity concept (B) Historical cost concept (C) Going-concern concept APPLICATION (1) Damages payable to a client will be finalised next year. An estimated amount of R15 000 is recorded this year. (2) Interest on overdraft is shown as a separate amount in the income statement. (3) An owner of a business wins R1 000 in a competition. This is not reflected in the income statement of the business.

INdividUaL
FORMATIVE ASSESSMENT

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(D) Matching concept (E) Prudence concept

(F) Concept of materiality

(4) Whenever a debtor settles an account, discounts should be recorded at the same time. (5) Land and buildings are shown in the balance sheet at R105 000, even though an estate agent says that they could be sold for R250 000. (6) Trading stock is shown in the balance sheet at R80 000, even though the business would get only R50 000 if the stock was sold at a flea market the next day.

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