Accounting Concepts

Prepared by: Hammad ur Rab

 Introduction
• The IASB (International Accounting Standards
Board) have published a document called the
Conceptual Framework.
• This document sets out the fundamental
concepts that provide a foundation for
financial reporting.
 Concepts / Terminologies
• Accruals basis
• Completeness
• True and fair view/faithful representation
• Materiality
• Prudence
• Going concern basis
• Substance over form
• Matching Concept
• Legal Entity
• Money Measurement Concept
 Accrual Basis (Matching Concept)
Accruals basis accounting (accruals accounting, the accruals
concept) depicts the effects of transactions and other events
and circumstances on a reporting entity’s economic resources
and claims in the periods in which those effects occur, even if
the resulting cash receipts and payments occur in a different
period.
• Revenue from sales and other income should be reported
in the period when the income arises (which might not be
the same as the period when the cash is received).
• The cost of sales in the statement of comprehensive
income must be matched with the sales. Income and
‘matching’ expenses must be reported in the same financial
period.
• Other expenses should be charged in the period to which
they relate, not the period in which they are paid for.
 Accrual Concept (contd.)
• A company prepares its financial statements to the
30 June each year. It sells goods for Rs. 50,000 to a
customer on 6 June, but does not receive a cash
payment from the customer until 15 August Year 2.
• A company starts in business on 1 September Year 1.
It acquires an office for which it pays one year’s rent
in advance, to 31 August Year 2. The cost of the
annual rental is Rs. 120,000. The company prepares
its financial statements for a financial period ending
on 31 December each year.
 Consistency
• The content of the financial statements must
be presented consistently from one period to
the next.
• The presentation can be changed only if
necessary to improve the quality of
information presented in terms of its
usefulness to the users or if a new rule
requires a change.
 Consistency (contd.)
A manager of a business has been promised a bonus if he can improve gross
profit to more than 10% above what it was last year. In the event the results
of the business have been exactly the same but the manager has prepared
the financial statements on a slightly different basis.

2012 2013
Sales 25,000 25,000
Cost of sales:
Production costs 10,000 10,000
Warehousing costs 10,000
(20,000) (10,000)
Gross profit 5,000 15,000
Less: Other expenses (4,000) (14,000)
Net profit 1,000 1,000
 Completeness
• The objective of financial reporting is to provide
useful information on which a person has to rely.
• To be reliable, information should be complete,
subject to materiality and cost. (There is no
need to include information if it is not material,
and greater accuracy is not required if the cost of
obtaining the extra information is more than the
benefits that the information will provide to its
users).
• Completeness refers to whether all transactions
that occurred during the period have been
recorded.
 Materiality
• Information is material if omitting it or misstating
it could influence decisions that users make on
the basis of financial information about a specific
reporting entity.
• There is no absolute measure of materiality that
can be applied to all businesses. In other words
there is no rule that says any item greater than
5% of profit must be material.
• Whether an item is material or not depends on
its magnitude or its nature or both in the context
of the specific circumstances of the business.
• Any information which is legally required,
omission of it is material misstatement regardless
of the size.
True and fair view (faithful representation)

Financial statements should give a true and fair

view of the financial position, financial
performance and changes in financial position of
an entity.
Financial statements should provide a faithful
representation of these.
This is achieved by following all the rules set out
in law and accounting standards.
 Faithful Representation
Faithful representation would have three
characteristics.
• complete – the depiction includes all information
necessary for a user to understand the phenomenon
being depicted, including all necessary descriptions
and explanations.
• neutral – the depiction is without bias in the
selection or presentation of financial information;
and
• free from error – where there are no errors or
omissions in the description of the phenomenon,
and the process used to produce the reported
information has been selected and applied with no
errors in the process.
 Materiality (contd.)
• Two similar businesses prepare financial
statements that show that A has non-current
assets of Rs. 10,000,000 and B has a profit for
the year of Rs. 100,000. Each business discovers
a Rs. 20,000 error.
• A business owes Mr A Rs. 1,000,000 and is owed
Rs. 950,000 by Mr B. Instead of showing an asset
of Rs. 950,000 and a liability of Rs. 1,000,000,
the business shows a single liability of Rs.
50,000.
 Prudence
• Financial statements must sometimes
recognise the uncertainty in business
transactions. For example, if a business is owed
Rs. 1,000,000 by a number of its customers,
there will be some uncertainty as to whether
all the money will actually be collected.
• Prudence involves allowing for some caution
in preparing financial statements, by making
reasonable and sensible allowances in order to
avoid overstating assets or income and to avoid
understating expenses or liabilities.
 Prudence (contd.)
• A company has receivables of Rs. 10,000,000. The
company knows from experience that about 2% of
its receivables will not be collected because of
customers being in financial difficulty. It is prudent
to make an allowance for doubtful debts to 2% of
receivables (but it would be inappropriate to make
an excessive allowance, say 10% of receivables).
• The company would recognise an allowance of Rs.
200,000 to set against the receivable in the
statement of financial position showing a net
amount of Rs. 9,800,000 (10,000,000 less 200,000).
The Rs.200,000 would also be recognised as an
expense in the statement of comprehensive
income.
 Going concern basis
• Financial statements are prepared on the
assumption that the entity will continue to operate
for the foreseeable future, and does not intend to
go into nor will be forced into liquidation.
• The going concern assumption is particularly
relevant for the valuation of assets. The going
concern basis of accounting is that all the items of
value owned by a business, such as inventory and
property, plant and equipment, should be valued on
the assumption that the business will continue in
operation for the foreseeable future.
• The business will not close down or be forced to
close down and sell off all its items (assets).
 Substance over form
To provide a faithful representation, financial
information must account for transactions and
other events in a way that reflects their substance
and economic reality (in other words, their true
commercial impact) rather than their legal form.
If there is a difference between economic
substance and legal form, the financial
information should represent the economic
substance.
 Substance over form
• Alpha rents (leases) an asset from Beta. The asset is
expected to be useful for 10 years after which it will
be scrapped. Alpha has a contract to use the asset for
10 years.

• The substance of the transaction is that Alpha has

bought the asset from Beta. Beta would only agree to
let Alpha use the asset for all of its useful life if the
rentals received from Alpha covered Beta’s costs of
buying the asset and gave Beta a financial return. This
is the same as Alpha borrowing money and buying
the asset. Alpha must recognise the leased asset as if
it owns it and also must recognise a liability to pay for
the asset.
 Substance over form
• Substance over form (sale and repurchase
agreements) Gamma sells an asset to Delta for
Rs. 1,000,000. There is a contract in place under
which Gamma must buy the asset back off Delta
for Rs. 1,100,000 in 12 months’ time. Gamma
continues to use the asset in exactly the same
way as before, even though Delta is now its legal
owner.
• The substance of the transaction is that Gamma
has not sold the asset to Delta but has borrowed
money from Delta. Gamma must recognise a
liability for Rs. 1,000,000.
 Legal Entity

• An association, corporation, partnership,

proprietorship, trust, or individual that has legal
standing in the eyes of law.
• A legal entity has legal capacity to enter into
agreements or contracts, assume obligations,
incur and pay debts, sue and be sued in its own
right, and to be held responsible for its actions.
 Historical cost principle
• It dictates that the companies record their assets
at cost.
• E.g. land initial cost Rs. 30 M, but after one year
it is Rs. 40 M.
• But in Historical cost it will be continued to be
reported at Rs. 30 M.
 Fair value principle
• It states that assets and liabilities should be stated at
fair value.
• The price received to sell an asset or settle a
liability.
• Some assets are required to be reported at fair value
e.g. investment.
• Factual nature of cost figures versus fair value.
• Assets are actively traded then fair value is
available.
• E.g. Toshiba inc. owns a building that is worth more
than cost. In order to give more relevant
information, it reported the building at fair value.
 Monetary unit assumption
• Include data which can be expressed in
monetary terms.
• Quantify economic events.
• Data which can not be quantified, may not be
included. E.g. morale of the employees.
 Economic entity assumption
• Activities of the entity be kept separate and
distinct from its owners and all other
economic entities.

• E.g. Mr. Roger, owner of Roger photography

records his personal expenses as the expense
of the business.
 IAS – 1 (Objective & Scope)
• Objective: To prescribe the basis for
presentation of general purpose financial
statements, to endure comparability both with
the entity’s financial statements of previous
periods and with the financial statements of
other entities.
• Scope: It applies to all general purpose financial
statements that are prepared and presented in
accordance with IFRS.
 Objective of Financial Statements
• The objective of general purpose financial
statements is to provide information about:
– the financial position (Assets, Liabilities and
Equity),
– Financial performance (Income, expenses)
– Cash flows
• This information is useful to a wide range of
users in making economic decision.
 Components of Financial Statements
A full set of financial statements would include the
following:
• A statement of comprehensive income or a
statement of profit or loss followed by a
statement of comprehensive income;
• A statement of financial position;
• Statements of changes in equity;
• Statement of cash flows
• Notes to the financial statements
 Exercise (True/False)

• The concept of separate entity is not

applicable to a partnership.
• The concept of going concern supposes that
the life of business entity will be more than 15
years.
• The ‘prudence’ concept allows a business to
build substantially higher reserves/allowances
than are actually required.
 Exercise - Identify relevant concept
• Inventories are valued on the same basis in each
accounting period.
• Assets are valued assuming there will be no
sudden stoppage in business.
• Assets and liabilities are valued with due caution
in times of uncertainty.
• Personal transactions should be distinguished
from business transactions.
• Cost of small calculators may be charged to
expenses instead of being capitalized.
 Exercise - Identify relevant concept

• The financial statements must disclose all the

relevant information.
• Income is not recognized when a fee is received
but when a service is rendered.
• Leased vehicles might be recorded as assets
although these are not owned by the
organisation.
• Income and all costs relating to earning such
income are accounted for in the same accounting
period.