PRINCIPLE OF ACCOUNTING

PRINCIPLE OF ACCOUNTING - CHAPTER 1 1

 Contents
Chapter 1: Overview of Accounting

Chapter 2: The Accounting equation

Chapter 3: Recording financial transactions

Chapter 4: The use of ledger entry

Chapter 5: Trial balance

Chapter 6: The basic financial statements

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 CHAPTER 1: OVERVIEW OF ACCOUNTING

OBJECTIVES PRINCIPLE ACCOUNTING

The purpose of this chapter is to show you that accounting is the system used to
provide useful financial information.

After studying this chapter, you should be able to:

- Introduction of accounting
- Accounting assumptions and principles
- Qualitative Characteristic of financial information

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CHAPTER 1
 CHAPTER 1: OVERVIEW OF ACCOUNTING

1.1. Introduction of accounting

1.2. Accounting assumptions and principles

1.3. Qualitative Characteristic of financial information

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CHAPTER 1
 1.1. OVERVIEW OF ACCOUNTING

1.1.1. Definition of accounting

1.1.2. Types of accounting

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1.1.1. Definition of accounting

- Accounting is the systematic and

comprehensive recording of financial
transactions pertaining to a business
- Accounting is a way of recording,
analyzing and summarizing transaction of
an entity

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 1.1.1. Definition of accounting
What is accounting?
Accounting is a way of recording, analysing and
summarising transactions of an entity (a term we shall use to
describe any business organisation)

The activities of the accounting process

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CHAPTER 1
 TYPES OF ACCOUNTING

FINANCIAL ACCOUNTING

MANAGERIAL ACCOUNTING

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 1.1.2. TYPES OF ACCOUNTING
FINANCIAL ACCOUNTING

Financial accounting is concerned

with reporting information to
users external to an entity in
order to help them to make
sound economic decisions about
t h e entity’ s p e rf o rma n c e a n d
financial position. 9
 1.1.2. TYPES OF ACCOUNTING

MANAGERIAL ACCOUNTING

Management accounting (also referred

to as managerial accounting) is that
area of accounting concerned with
providing financial and other
information to all levels of
management in an organisation to
enable them to carry out their
planning, controlling and
decision‐ making responsibilities.10
 Users of accounting information
HM Revenue
& Customs
Management
(HMRC)
Owners
Trade contacts

Finance User of financial statement Bodies

provider
Financial
Employees analysts &
advisers
The public Government
agencies

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 TYPES OF ACCOUNTING

External Users Internal Users

Managerial accounting provides

Financial accounting provides external
information needs for internal decision
users with financial statements.
makers.

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 USERS OF ACCOUNTING INFORMATION

External Users Internal Users

•Lenders • Consumer Groups •Managers • Sales Staff

•Shareholders • External Auditors •Officers/Directors • Budget Officers
•Governments • Customers •Internal Auditors • Controllers

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 The purpose of accounting information

• Managers of the company: They need information about the company's financial
situation as it is currently and as it is expected to be in the future. This is to
enable them to manage the business efficiently and to make effective decisions
• Shareholders of the company: They want to know how profitable the company's
operations are and how much profit they can afford to withdraw from the
business for their own use
• Trade contacts: Suppliers want to know about the company's ability to pay its
debts; customers need to know that the company is a secure source of supply and
is in no danger of having to close down
• Financial analysts and advisers need information for their clients or audience. For
example, stockbrokers need information to advise investors. Credit agencies want
information to advise potential suppliers of goods to the company. Journalists
need information for their reading public

ACCOUNTING I- FINANCIAL
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ACCOUNTING DEPARTMENT- TMU
• Others
– Regulatory agencies
– Tax authorities
– Customers
– Labor Unions
– Economic planners
 Earning enough? Compare to competition?

Will the company be able to pay bills when due?

TYPES OF ACCOUNTING
Internal Users ask

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 1.1.3. THE NEEDS OF FINANCIAL ACCOUNTING
The objective of financial
statements

The ultimate goal of accounting is to

provide information that is useful for
decision-making. Financial accounting
is used to generate information for
stakeholders outside of an organization,
such as owners, stockholders, lenders,
and governmental entities.

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1.1.3. THE NEEDS OF FINANCIAL ACCOUNTING
The objective of financial
statements

A business should produce

information about its activities
because there are user groups who
want or need to know that
information in order to make
decisions relating to providing
resources to the entity.
PRINCIPLE OF ACCOUNTING - 20
CHAPTER 1
1.2 ACCOUNTING ASSUMPTIONS AND PRINCIPLES

1.2.1 Accounting assumptions

1.2.2 Accounting principles

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 ACCOUNTING ASSUMPTIONS
Accounting is the underlying
concepts and assumption for financial
convention framework
GOING
CONCERN

BASIS FOR
PREPARING
FS

ACCRUAL
BASIS

is not an underlying
assumption, but FS should be
prepared on an accrual
basis.
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 ACCOUNTING ASSUMPTIONS
Going concern concept
Concept assumes  The entity is
reviewed as continuing in operation for the Preparing a
foreseeable future. It is assumed that the normal set of
entity has neither the intention nor the accounts
necessity of liquidation or ceasing to trade

Unless:
(i) the entity is being liquidated or has
ceased trading, or BREAK-UP
(ii) the directors either intend to BASIS
liquidate the entity or to cease
trading
(iii) Scale down operations in a material Must disclosure: The basic on which
way. FS are prepared
The reasons why the entity not
consider to be a going concern 23
 ACCOUNTING ASSUMPTIONS
Going concern
Practice question:
A business on 1 January and buys 20 washing machines, each
costing £100. During the year he sells 17 machines at £150 each.
Requirement
How should the remaining machines be valued at 31 December in
the following circumstances?
a. He is forced to close down his business at the end of the year
and the remaining machines will realise only £60 each in a
forced sale.
b. He intends to continue his business into the next year.

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 ACCOUNTING ASSUMPTIONS

Monetary Unit Assumption

The monetary unit assumption

requires that companies include in
the accounting records only
transaction data that can be
expressed in money terms. This
assumption enables accounting to
quantify (measure) economic events.
The monetary unit assumption is
vital to applying the historical cost
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 ACCOUNTING ASSUMPTIONS

Monetary Unit Assumption

The monetary unit assumption requires that

companies include in the accounting records
only transaction data that can be expressed in
money terms. This assumption enables
accounting to quantify (measure) economic
events. The monetary unit assumption is vital
to applying the historical cost principle.

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 ACCOUNTING ASSUMPTIONS
Economic Entity Assumption
The business entity concept

A business is a separate entity from its owner.

that accountants regard a business as a separate
entity, distinct from its owners or managers.
The concept applies whether the business is a
limited liability company (and so recognised
in law as a separate entity), a sole trader or a
partnership (in which case the business is not
legally recognised as separate from its owners).
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 ACCOUNTING ASSUMPTIONS
Economic Entity Assumption
An economic entity can be any organization or unit in
society.

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 ACCOUNTING ASSUMPTIONS

The accounting period concept

The accounting period concept states that

the life of a business can be divided into
artificial periods and that useful reports
covering those periods can be prepared for
the business.

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 ACCOUNTING ASSUMPTIONS
Accounting concepts and convention
Accrual basic:
The effects of transactions and other events are recognized when they occur
(and not as cash or its equivalent is received or paid) and they are recorded
in the accounting records and reported in the FSs of the periods to which
they relate.

Entities  record when revenues or expenses are earned or incurred in the

accounting period, to which they relate, not as the cash is paid or received

Accrual assumption  profit/revenue earned must be matched against the

expenditure incurred in earning it. This is the matching convention

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 CONCEPTUAL FRAMEWORK

Accrual basic
Worked example: Emma purchases 20 T-shirts in her first month
of trading (May) at a cost of £5 each on credit. She sells all of them
on credit for £10 each. Emma has therefore made a profit of £100,
by matching the income (£200) earned against the cost (£100) of
acquiring them.
If, however, Emma only sells 18 T-shirts, it is incorrect to charge
her statement of profit or loss with the cost of 20 T-shirts, as she
still has two T-shirts in hand. If she sells them in June, she is likely
to make a profit on the sale. Therefore, only the purchase cost of 18
T-shirts (£90) should be matched with her sales income (£1 80),
leaving her with a profit of £90.
Her statement of financial position will look like this at the end of
May: 31
 ACCOUNTING PRINCIPLES
Accounting concepts and convention
Materiality and aggregation:
• Omissions or misstatements of items are material if they could,
individually or collectively, influence the economic decisions of
users taken on the basis of the financial statements.
• Financial statements result from processing large numbers of
transactions or other events that are then aggregated into classes
according to their nature or function, such as 'revenue',
'purchases', 'trade receivables' and 'trade payables'.

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 ACCOUNTING PRINCIPLES
Accounting concepts and convention
Materiality and aggregation:
• Omissions or misstatements of items are material if they could,
individually or collectively, influence the economic decisions of
users taken on the basis of the financial statements.
• Financial statements result from processing large numbers of
transactions or other events that are then aggregated into classes
according to their nature or function, such as 'revenue',
'purchases', 'trade receivables' and 'trade payables'.

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 ACCOUNTING PRINCIPLES
Accounting concepts and convention
Consistency of presentation: the presentation and classification of
items in the financial statements should stay the same from one
period to the next, unless:
 There is a significant change in the nature of the operations,
or a review of the financial statements indicates a more
appropriate presentation.
 A change in presentation is required by an IAS.
Historical cost: Transactions are recorded at their cost when they
incurred.
 A basic principle of accounting is that the monetary amount at
which items are normally measured in financial statements is at
historical cost.

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 ACCOUNTING PRINCIPLES

Historical cost: Transactions are recorded at their

cost when they incurred.
 A basic principle of accounting is that the
monetary amount at which items are normally
measured in financial statements is at historical
cost.

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 ACCOUNTING PRINCIPLES
Historical cost Principle
Numerous possibilities can be considered, including:
• the original cost (historical cost) of the machine.
• half of the historical cost, on the ground that half of its useful life has
expired
• The amount the machine might fetch on the second hand market
(realisable value)
• the amount needed to replace the machine with an identical machine
(replacement cost) the amount needed to replace the machine with a more
modern machine incorporating the technological advances of the
previous two years.
• the machine’s economic value, ie, the amount of the profits it is expected
to generate for the company during its remaining life (present value)
All of these valuations have something to commend them, but the great
advantage of the first two is that they are based on a figure (the machine’s
historical cost) which is objectively verifiable. 36
 1.3 QUALITATIVE CHARACTERISTIC OF FINANCIAL INFORMATION

1.3.1 Fundamental Qualitative characteristic

1.3.2. Enhancing Qualitative characteristic

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1.3 QUALITATIVE CHARACTERISTIC OF FINANCIAL INFORMATION

- Qualitative characteristics are the qualities or attributes

that make financial accounting information useful to the
users

- The objective is to ensure that the information is useful

to the users in making economic decisions

- Financial information should be relevant and faithfully

represent what it purports to represent. The usefulness of
financial information is enhanced if it is comparable,
verifiable, timely and understandable. 38
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 1.3.1 Fundamental Qualitative characteristic

• Relevance – financial information is regarded as relevant if

it is capable of influencing the decisions of users.

• Faithful representation – this means that financial

information must be complete, neutral and free from error.

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 1.3.2. Enhancing Qualitative characteristic

- Comparability – it should be possible to compare an entity over time

and with similar information about other entities.

- Verifiability – if information can be verified (e.g. through an audit)

this provides assurance to the users that it is both credible and reliable.

- Timeliness – information should be provided to users within a

timescale suitable for their decision making purposes.

- Understandability – information should be understandable to those

that might want to review and use it. This can be facilitated through
appropriate classification, characterisation and presentation of
information.
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