ACCOUNTING: Concepts & Conventions

Candy1

 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

PRINCIPLES

CONSTRAINTS

1.

1.

Historical Histor Historica icall cost cost

1.

2. Going Goin Going g conce concern concern rn

2.

Revenue

2. Materiality Mate Materi rial alit ity y

3. Monetary Monet Monetary ary unit unit

3. Matching Match atchin ing g

3. Industry Indus Industry try practice prac practic tice e

4. Periodicity Peri Period odic icit ity y

4. Full Full disclosure disclo disclosur sure e

4. Conservatism Cons Conser erva vati tism sm

Economic Econ Econom omic ic entity enti entity ty

recognition

CostCost-benefit -benefit

 Accounting Concepts 1.

2. 3. 4. 5. 6. 7. 8.

Money mea measur suremen ment con concep cept The going co concer cern con concep cept The busi busine ness ss enti entity ty con concept cept The realisat sation con concep cept Accr ccrual /M /Matching co concept Histo storical Cost Concept Periodicity Dual Aspect

 Accounting Conventions 1.

Mater ateria ialility ty Conc Concep eptt 2. Prud Prudenc ence/ e/Co Conse nserv rvat atism ism Conce Concept pt 3. Cons Consis iste tenc ncy y Conc Concep eptt 4. 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. 

ney is is the the  Monetary Unit - money 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 historica l cost concept and ignore the current market value in asset valuation.

 Going Concern

- comp compan anyy to to la last st 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 realisat realisation ion has occurr occurred. ed. Generally, sales revenue arising from the sale of goods goods is recogn recognised ised when when the goods are delivered to the customers.

- gene general rally ly occu occurs rs (1) (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 efforts (expenses) (expenses) should be matched 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.sssssss 100,000.

Periodic Peri odicity ity ± Time Peri Period od Assu Assumpti mption on



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

company any ca cann divi divide de its its  Periodicity - comp 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 when a firm has chosen chos en a method for the accounting treatment of an item, 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 

fy whi ch ch basi c assumption o  : Identi fy ssumption  o f accountin g is  best  des cr cri bed bed in  each it em  belo w. w. Brief Exercise

(a) The economi c acti viti es  o f FedEx Co rpo ra ration  are di vi ded ded into  12-mont h p er erio ds  fo r t he he pu rpos e o f issuin g annu al al repo rts .

Periodicity

s  not  adjust  (b) So lec lect ron  Co rpo ra ration, In c. c. do es not  in  its  fin an ci al amounts  in its  al st at em ents  fo r t he he ts  o f in fla effects o  flation .

Monetary Unit

(c) Walgreen  Co . repo rts  cu rre rrent  an d non cu rre rrent  in  its  balan ce classi fi ca cations  in its  ce s hee heet .

Going

(d) The economi c acti viti es  o f Gen eral eral Elect ri c its  su bsi di ar an d its su  ari es  are m erged erged fo r accountin g an d re po rtin g pu rpos es .

Economic Entity

Concern

Contd . ify which basic prin ciple ciple o f Id ent ify acco unt in g is best d  escribed  in  each it em em belo w. w. t  d escribe n  Co rp (a) No rf rfo lk lk So ut her hern Co  rpo ra rat ion  repo rt s reven ue ue in  it s in co me me st at eme ement  when  it  is earn ed  in st ea ead  o f n  t he when t  he cash is co llec llect ed . Brief Exercise

Revenue Recognition

(b) Yahoo, In c. c. reco gn izes izes d eprecia epreciat ion  expen se se fo r od  d uri a machin e o ver ver t he he 2-year period d  urin g which t ha hat  machin e helps t he he co mpa mpan  y earn  reven ue. ue.

Matching

(c) Oracle Co rp rpo ra rat ion  repo rt s in fo rma rmat ion  abo ut  n  t he pend in g lawsuit s in t  he not es es to  it s fin an cial cial st at eme ement s. s.

Full Disclosure

(d ) East ma man  Kod ak ak Co mpa mpan  y repo rt s land  on  it s balan ce ce sheet  at t  he amo unt  paid  to  acquire it, even  t  t he t ho ugh ugh t he he est ima imat ed  fair market  value is great er. er.

Historical Cost

C onstraints onstraints Cost Benefit ² the cost of providing the information must be weighed against the benefits that can be derived from using it.

Materiality

- an item is material material if its its inclusion or omission would influence or change the judgment of a reasonable person.

Industry Practice

- the peculiar nature of some industries industries and business concerns sometimes requires departure departure from basic accounting theory.

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

Constraints What accounting constraints are illustrated by the items below? (a) Zip·s Farms, Inc. reports agricultural crops Industry Practice on its balance sheet at market value. Brief Exercise

(b) Crimson Tide Corporation does not accrue a contingent lawsuit gain of $650,000.

Conservatism

(c) Wildcat Company 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.

CostCost -Benefit

(d) Sun Devil Corporation expenses the cost of wastebaskets in the year they are acquired.

Materiality