Lecture 3

Accounting assumptions and concepts

Welcome

Todays quote
Genius is one per cent inspiration and ninety-nine per cent perspiration- by Thomas Edison

 Specific Objectives Students should be able to 1.Explain the definition of accounting

Accounting Definition
The process of accumulating, analyzing, quantifying, classifying, recording, summarizing, Interpreting and reporting data relating to the economic resources of an enterprise to all interested parties

Accounting Concepts
Accounting principles are built on the foundation of a number of basic concepts that accountants regard as self evident When such concepts are followed unquestionably for generations they are called conventions In order to understand accounting as it now exists, one must understand what the underlying concepts, assumptions and principles are These concepts , assumptions and principles called Generally Accepted Accounting Principles)GAAP

Accounting Concepts
Accrual BasisAlso known as the Matching Concept The effects of transactions and other events are recognized in the accounts when they occur and not when the cash or its equivalent is received or paid. It means that revenue must be matched the costs, expenses incurred against earning .

 Historical Cost Concept The assets are normally shown at cost price and it is the basis for valuation of the assets.

In other words, all values are based on the historical costs incurred

Historical Cost continued

There are exceptions such as inventories of finished goods, raw materials and market securities which are shown in the balance sheet at cost or net realizable value whichever is lower. This implies that there are two aspects of accounting, one represented by the assets of the business and the other by the liabilities or claims against them. The concept states that these two aspects are always equal to each other. In other words, this is the alternate form of the accounting equation; Assets = Capital + Liabilities

 Going concern concept The financial statements of an enterprise are prepared on the assumption that it will continue in operation for the foreseeable future.

Example- Going Concern

Let us suppose, a business is preparing its financial statements at 31st December 2008. Normally, historical using the cost concept, the assets would be shown at a total value of $100,000. It is known that the business will be forced to close down in February 2009, only two months later and the assets are expected to be sold for $60,000. In this case, it would not make sense to keep to the going concern concept and so we can reject the historical cost concept for asset valuation purposes. In the Balance sheet at 31st December 2008, the assets will be shown at the figure of $60,000

 The business entity concept It implies that the affairs of a business are treated separate from the non business activities of its owners. The items recorded in the books of the business are restricted or limited to the transactions of the business. Example, owner starts business with $500,000, the owner becomes a long term creditor of the business, in other words the business owes the owner $500,000.

The money measurement concept Accounting information has traditionally been concerned only with those facts covered by the following: It can be measured in monetary units Most people will agree to the monetary value of the transaction This limitation is referred to as the monetary measurement concept and it means that accounting can never explain everything about a business

The Time Interval or Period concept The financial statements are prepared at regular intervals of one year.
Companies which publish financial statements between their annual ones are called interim statements

Realization concept
It states that revenues should be recorded in the period when the goods are delivered to the customer or when the services are rendered

Amount recognized is the amount that the customer has a legal obligation to pay

 Prudence This is the inclusion of a degree of caution in the exercise of the judgment needed in making estimates required under conditions of uncertainty so that assets and income are not overstated and liabilities and expenses are not understated. Accountant should always exercise caution when dealing with uncertainty while at the same time ensuring that the financial statements are neutral - gains and losses are neither overstated nor understated Revenue are recognized only when they are reasonably certain, whereas expenses are recognized as soon as they can be reasonably estimated

Qualitative Characteristics of Financial Statements

There are four (4) qualitative characteristics known understandability, relevance, reliability and comparability

1. UnderstandabilityInformation in financial statements should be readily understandable by users

 (2)Relevance Information in financial statements must be relevant to the decision making needs of users. To be relevant, information must influence the economic decisions of users by assisting them to evaluate past, present or future or confirming or correcting their past evaluation

 (3) MaterialityInformation is material if its omission or misstatement could influence the economic decisions of users. Material if its disclosure is likely to lead the users of the accounting information to act differently or to come to a different conclusion if it were not disclosed Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement

 (4) Reliability
To be useful information should be on the following1. Faithful representation a Balance Sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the entity at the reporting date.

 Substance over form Definition

Transactions and other events must be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

Example I will be using a hire purchase transaction in respect to a non current asset, car, to illustrate this condition. What is hire purchase? Use Stewarts Motor Ltd - car 1. From a legal point of view, the car does not belong to the business until all installments are made that is only when the final payment is made 2. From an economic point of view, business will have used the car for business purposes. The car bought on hire purchase will be shown in its ledger accounts and balance sheet, as a non current asset, as though it is legally owned by the business as well as a liability showing separately the amount owed for the car. 3. In this way, the substance of the transaction has taken precedence over the legal form of the transaction

Neutrality Information in financial statements must be free of bias

Prudence (Conservatism)
This is the inclusion of a degree of caution in the exercise of the judgment needed in making the estimates required under conditions of uncertainty such that assets and income are not overstated and liabilities and expenses are not understated. Accountant should always exercise caution when dealing with uncertainty while at the same time ensuring that the financial statements are neutral that gains and losses are neither overstated nor understated

 Jamaica scenario Do you think with we are living in a time of uncertainty?

Completeness- To be reliable, information in financial statements must be complete within the bounds of materiality and cost

 Comparability To be reliable, comparability requires consistency. Users must be able to compare the financial statements of an enterprise over time to identify trends in the financial position and performance The measurement and display of the financial effect of similar transactions and other events must be done in a consistent way throughout an entity and over time for the entity as well as for other entities.

 Asset A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the enterprise. Examples- Building, Plant,Machinery known as non current assets Current assets assets that used for the trading purposes of a business Examples- inventory, debtors, cash

 Liability- Non current liabilities and current liabilities 1.An entitys present obligation arising as a result of past transactions or events. 2.Examples- Bank Loan over one year or 12 months known non current liability Current Liabilities 1.Liabilities to be settled within 12 months 2.Examples- bank overdraft, creditors

 Equity- known as CAPITAL The residual interest in the assets after deducting all liabilities from Total Assets.

 Students -Reflection on todays lesson

Summary of the days lesson

Next week lecture

 Read Chapters 1 and 10, Frank Wood Business Accounting Text Book, eleventh edition

 THE END