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ACCOUNTING CONCEPTS and CONVENTIONS

Slide 1 Candy1
Fung Ka Pui, 8/9/2006

‡ Accounting is a social science has its concepts and principles that used in applying the accounting cycle to achieve accounting functions and objectives.

ACCOUNTING CONCEPTS
Accounting concepts refer to the nature of the economic environment in which accounting operates . Recording has been based on certain assumptions.

Classification

ASSUMPTIONS 1. Economic entity 2. Going concern 3. Monetary unit 4. Periodicity

PRINCIPLES 1. Historical cost 2. Revenue recognition 3. Matching 4. Full disclosure

CONSTRAINTS 1. Cost-benefit Cost2. Materiality 3. Industry practice 4. Conservatism

Accounting Concepts
1. 2. 3. 4. 5. 6. 7. 8. Money measurement concept The going concern concept The business entity concept The realisation concept Accrual /Matching concept Historical Cost Concept Periodicity Dual Aspect

Accounting Conventions
1. 2. 3. 4. Materiality Concept Prudence/Conservatism Concept Consistency Concept Disclosure

Money measurement concept
‡ It can be measured in money ‡ Most people will agree to the money value of the transaction. ‡ Assumes that the value or purchasing power of money is constant, ignoring the effects of inflation or deflation.

‡

Monetary Unit - money is the
common denominator.

Money measurement concept
‡ e.g. ‡ Accounting doesn¶t tell how good the quality of employees¶ skills are although this is important for the success of a business.

The Going concern concept
‡ This concept implies that the business will continue to operate for the foreseeable future. ‡ This is why we use the historical cost concept and ignore the current market value in asset valuation.

‡ Going Concern

- company to last long enough to fulfill objectives and commitments.

The Going concern concept
‡ e.g. ‡ Fixed assets are shown at cost less accumulated depreciation.

The Business entity concept
‡ This concept implies that the affairs of a business are to be treated as being quite separate from the non-business activities of its owners. ‡ Personal transactions of the owner should not be included.

‡ Economic Entity

² company keeps its activity separate from its owners and other businesses.

The Business entity concept
‡ e.g. ‡ A director¶s private car should not be included in the fixed assets of the company.

The Realisation concept
‡ This concept holds to the view that profit can only be taken into account when realisation has occurred. ‡ Generally, sales revenue arising from the sale of goods is recognised when the goods are delivered to the customers.
‡

- generally occurs (1) when realized or realizable and (2) when earned.
Revenue Recognition

The Realisation concept
‡ e.g. ‡ Profit is earned when goods or services are provided to customers. Thus it is incorrect to record profit when order is received, or when the customer pays for the goods.

Accrual concept
‡ The accrual concept says that net profit is the difference between revenues and expenses. ‡ Determining the expenses used up to obtain the revenues is referred to as matching expenses against reveues. ‡ Income and costs are recognised as they are earned and incurred but not as they are received or paid.

Matching

- efforts (expenses) should be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so. ´Let the expense follow the revenues.µ

Expense Recognition

Accrual concept
‡ e.g. ‡ Expenses have to take into account of amounts payable at the end of an accounting year even though the cash has not yet been paid.

Historical Cost concept
‡ Assets are normally shown at their original costs of acquisition. ‡ Any changes in the market value after the purchase are ignored. ‡ Historical cost is the most objective measure of the value of an asset. However, it cannot reflect the current value of an asset.

Historical Cost concept
‡ E.g. ‡ A fixed asset acquired at a cost of Rs.100,000 would be recorded at this amount in the books. Even if its market value may have gone up or down in future, it should be recorded at its original cost Rs.sssssss100,000.

Periodicity ± Time Period Assumption

‡ The life of an entity is divided into short economic time periods on which reporting statements are fashioned.

‡ Periodicity - company can divide its
economic activities into time periods.

Dual Aspect
‡ Transaction has two fold effect: Debit & Credit. ‡ Accounting Equation: A = C / E + L ‡ Assets = Liabilities

Conventions

Materiality
‡ Financial statement should separately disclose significant items for they would influence decisions of users. ‡ Accounting does not serve a useful purpose if the effort of recording a transaction in a certain way is not worthwhile. ‡ In other words do not waste your time in the elaborate recording of trivial items.

Materiality
‡ e.g. ‡ A stock of stationery worths $10 should be treated as an expense when it was bought.

Prudence/Conservaitsm
‡ The accountant should always be on the side of safety. ‡ The prudence concept means that normally he will take the figure which will understate rather than overstate the profit. ‡ Provision is made for all known liabilities.

Prudence/Conservaitsm

‡ E.g. ‡ Provision for doubtful debts should be deducted from debtors in balance sheet.

Consistency
‡ When a firm has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way. ‡ Frequent changes in the accounting methods would lead to misleading profits calculated from the accounting records. ‡ It states that when a firm has chosen a method for the accounting treatment of an item, all similar items should be treated in the same way.

Consistency
‡ E.g. ‡ Depreciation method of certain fixed assets once adopted should be used in the following years.

Disclosure
‡ The financial statements of a firm must include all information necessary for the formation of valid decisions by the users. Any information that might be relevant to an investor or creditor should be disclosed, either in the body of the financial statements or in the notes attached thereto.

‡

Exercises

Assumptions
Brief Exercise : Identify which basic assumption of accounting is best described in each item below.
(a) The economic activities of FedEx Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.

Periodicity Monetary Unit Going Concern Economic Entity

Contd.
Brief Exercise Identify which basic principle of accounting is best described in each item below.
(a) Norfolk Southern Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater.

Revenue Recognition

Matching Full Disclosure Historical Cost

Constraints
Cost Benefit Materiality
² the cost of providing the information must be weighed against the benefits that can be derived from using it. - an item is material if its inclusion or omission would influence or change the judgment of a reasonable person. - the peculiar nature of some industries and business concerns sometimes requires departure from basic accounting theory.

Industry Practice

Conservatism ² when in doubt, choose the solution that will be least
likely to overstate assets and income.

Constraints
Brief Exercise What accounting constraints are illustrated by the items below? (a) Zip·s Farms, Inc. reports agricultural crops on its balance sheet at market value. (b) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000. (c) Wildcat Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it. (d) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired. Industry Practice Conservatism

CostCost-Benefit

Materiality

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