Unit 1a.

– Accounting Review

The Accounting Cycle

The accounting cycle is the process by which companies produce their financial statements. For any
organization the first accounting step is to open the accounts. After the company has operated for
one period (i.e. month, quarter or year) some of the account balances carry over to the next period.
Hence, the accounting cycle starts with the beginning asset, liability and owners’ equity account
balances left over from the preceding period.

FLOW OF DATA IN THE ACCOUNTING CYCLE

Specific preliminary and intermediary records are used for certain activities in the accounting
system. Among these are:

RETURN RETURN
ACTIVITY SALES INWARDS PURCHASES OUTWARDS ASSET CASH
Preliminary Invoice Credit Note Invoice Debit Note Invoice Voucher,
Bill,
Cheque
Intermediary Sales Return Purchases Return General Cashbook
Journal Inwards Journal Outwards Journal
Journal Journal
Personal Sales Sales Purchases Purchase
Accounts Ledger Ledger Ledger Ledger
General Sales Return Purchases Return Asset Cash or
Accounts Accoun Inwards Account Outwards Account Bank
t Account Account Account
Trial Balance (adjusted and unadjusted)
Final Income Statement and Balance Sheet
Accounts

The Application of concepts in the preparation of final accounts

The historical cost of conversion

The reason for using the convention
Assets and expenses are recorded in ledger accounts at the actual amounts expended on these items
because this has the virtue of being objective, that is, beyond dispute. In most cases, the actual cost of
goods or services is ascertainable from invoices, contracts and in some instances, by a firm’s costing
records if its own workforce has been used to build or install its plant or machinery.

An alternative to recording assets and expenses at cost is to record them at a valuation. This
introduces subjectivity into the accounting records as it is likely that no two people may agree on the
value of the assets in ledger accounts.

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The concept of money measurement
Only transactions which can be expressed in money terms are recorded in ledger accounts.
Some of the benefits enjoyed by a firm’s may arise from expenditure which it has incurred but may
be incapable of being evaluated in money terms.

Example
A firm may incur expenditure in providing safe and pleasant working conditions for its staff and
generally looking after their welfare. The management treat the staff well and pay for them to be
properly trained; they consult them on many matters to do with of the firm. As a result, it has a loyal,
highly motivated staff, but it is not possible to express staff morale and motivation in money terms
and record in in financial accounts.
Other items which cannot be measured in monetary units are:
The competence of management;
The skill of the workforce;
The existence of a full or growing order book;
The attitude of local residents to the existence of a factory in the neighborhood (it provides
employment for local people, or it pollutes the atmosphere, etc.).

The concept of realization

Revenue should not be recorded in the accounts before it has been realized. A sale is deemed to take
place when the goods which are the subject of the sale have been replaced by cash or a debtor for the
sale.

Revenue should not be overstated by sales which have not been realized. A promise by a potential
customer to purchase goods at a future date does not amount to a sale. Goods sent on sale or returned
remain the property of the seller until the consignee intimates, or does some act to imply, that he has
accepted the goods.

The matching concept

The purpose of this concept is to ensure that revenue, other income and expenses are recognized in
the financial period in which they accrue or are incurred. This is necessary if the financial statements
are to state fairly the profit or loss for a given period and the state of the business at the period end.

Revenue should be recognized in the period in which it arises. Sales which have not been realized in
a period should not be credited in the trading account of that period. Sales which have been realized
should be credited in the trading account even if cash has not been received in respect of the sales. As
the recognition of sales is not restricted to those made on a cash basis, trade debtors at the period end
are shown on the balance sheet.

Expenses must be accounted for in the profit and loss account as incurred and not on the basis only of
payments made in the period. Expenses which have been incurred but not paid must be accrued, and
the accrual shown on the balance sheet. Expenses which have been paid but which relate to a later
period should not be debited in the profit and loss account covering the period in which payment was
made but should be shown as prepayments on the balance sheet.

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 The concept of materiality
This concept permits the normally accepted treatment of transactions of any particular kind to be
disregarded if the amount (or substance) involved is insignificant in the context of business as a
whole.
The concept does require that all items which are sufficiently material to affect evaluations or
decisions should be disclosed.
Two factors to be considered in deciding on materiality are:
a. Will the cost of adhering strictly to form be greater than the benefit obtained? If it is going to
cost an additional $10,000 in staff salaries to ensure that they year-end stock is $50,000 and
not $48,000, it is clearly not worth the cost.
b. Will disclosure or non-disclosure of the item in financial statements influence the evaluations
or decisions of persons reading the statements?

The consistency concept

The purpose of this concept is to enable sensible comparisons to be made of the results of a business
and its financial position from one year to another. To this end, all items of a similar nature should be
treated in a similar manner both within the same accounting period and from one period to the next.

The methods of depreciating fixed assets should be applied consistently from one year to the next. If
the straight line method is selected for a type of asset when it is first acquired, the basis should be
used for that asset in all future years; it would not be acceptable to change to the reducing balance
method in a subsequent year in order to manipulate profit. (A change of method would only be
permissible if it could be shown that the new method will give a fairer presentation of the results and
of the financial position of the business.)

The prudence concept

The prudence concept is concerned with ensuring the capital of a business is not depleted by
overstatement of profit. If an owner’s drawings exceed his profits, the capital of the business is
depleted. If the process is carried too far, the point will be reached when the business is seriously
undercapitalized to the extent that insufficient funds are available to pay creditors or to replace worn
out assets. Unless new capital can be introduced, the business is finished.
Prudence is about
i. Profits not being overstated;
ii. Losses being provided for as soon as they are recognized.

The application of this concept requires that:

a) Revenue is not anticipated before it has been realized;
b) All costs of earning revenue brought to account in the period are charged against that revenue

Prudence is an overriding concept; if, in a given situation, the application of another concept would
conflict with prudence, prudence takes precedence over that other concept.

The going concern concept

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The going concern concept is concerned with the amounts at which assets are shown in the balance
sheet. It requires that business accounts shall be prepared on the assumption that a business is a going
concern. If there is any intention to discontinue the business, or to substantially curtail its scope of
operations in the foreseeable future, the effect of any such action should be reflected in the balance
sheet.

If a business is a going concern, its fixed assets will normally be shown in the balance sheet at cost
less aggregate depreciation to date, i.e. at net book value. Stock should be shown at cost or net
realizable value, whichever is the less. If a business is not a going concern, the assets should be
shown in the balance sheet at the amount they may be expected to realize when sold, bearing in mind
that, in an enforced sale, the proceeds may be lower than expected. The effect of writing assets down
in this way will increase the amounts charged normally for depreciation in the profit and loss
account.

Trial Balance
A trial balance is a list of all balances existing on ledger accounts at a given date. Always describe it
as a ‘trial balance at (date)’.

The trial balance distinguishes between those accounts with debit balances and those with credit
balances. If the total of the debit balances equals the total of the credit balances, the ledger accounts
are, on the face of it, aromatically correct.

Practice Questions
1. Identify and explain the concept that is involved in each of the following :

a. A case of food poisoning occurred in a restaurant. The owner is being sued by a number of
clients who were affected. The estimated cost of the loss the restaurant is likely to suffer from
this lawsuit is not yet ascertained. However, a provisional amount is being recorded now as an
expense.

b. A hotel has traditionally depreciated its fixed assets using the straight line method. However
this year it has decided to use the reducing balance method.

c. The company has two motor vehicles which were acquired on hire purchase. Although these
have not yet been paid for, they were shown as fixed asset items in the balance sheet.

d. Several minor expenses have been paid for, and classified as miscellaneous expenses. However
there is no receipt for them.

e. A number of reams of paper and boxes of pencil are in stores at the end of the year. These were
not included in the closing stock. Instead they were written off as office expense

f. The production manager thinks that it is a waste of time to be preparing financial statements
every year

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g. Several clients have either enquired about our service or has promised to place substantial
orders, but we have not yet negotiated any business

h. The managing director wished that the excellent working conditions and worker relations be
reflected in the accounting statements

i. Most of the assets were bought a long time ago, and would worth much more than the books
show today.

Conversion of list of balances into trial balance

2. The following list of balances were extracted from Quincey’s ledger at 31 December 1992
$
Sales 36,000
Purchases 25,000
Return Inwards 820
Return Outwards 400
Stock at 1.1.1992 2,500
Wages 4,000
Rent and Rates 1,600
Carriage Inwards 750
Carriage outwards 925
Interest Income 600
Premises 20,000
Provision for depreciation of premises 2,000
Motor Vehicles 8,000
Provision for depreciation of motor vehicles 4,000
Trade debtors 4,500
Trade creditors 1,250
Provision for doubtful debts 200
Balance at bank 1,225
Capital 30,750
Drawings 5,880
Required:
Prepare a trial balance for Quincey’s as at 31 December 1992

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3. Colombo is an inexperienced accounts assistant and has prepared the following trial balance at
31.12.1999:

DR CR

Premises 80,000

Plant and Machinery 65,000

Office Furniture 15,000

Provision for Depreciation: Plant and
Machinery 35,000

Provision for Depreciation: office furniture 10,000

Stock at 1.1.1999 6,000

Stock at 31.12.1999 7,200

Debtors 5,500

Creditors 2,700

Purchases 47,000

Carriage Inwards 1,200

Carriage outwards 2,100

Sales 90,000

Return inwards 2,600

Return outwards 1,400

Provision for doubtful debts 500

Selling and distribution expenses 20,800

Administration expenses 15,400

Discounts received 2,000

Discounts allowed 1,800

Drawings 12,600

Capital 133,400
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 306,600 250,600

Required
Prepare a corrected a trial balance for Colombo as at 31 December 1999