Accounting Principles PDF

Accounting rules 10.1 Introduction Accounting has standard rules that everyone must follow to ensure financial information is consistent and understandable. Without these rules, it would be hard to compare the financial health of different businesses. This chapter explains key accounting principles...

Accounting rules 10.1 Introduction Accounting has standard rules that everyone must follow to ensure financial information is consistent and understandable. Without these rules, it would be hard to compare the financial health of different businesses. This chapter explains key accounting principles and how businesses should record capital and revenue expenditure, as well as capital and revenue receipts. It also covers how inventory should be valued, so all businesses follow the same procedures. 10.2 Accounting principles Accounting principles, often called concepts and conventions, are rules that guide how a business records its financial activities. A concept is a basic rule, while a convention is the accepted way of applying that rule in specific situations. These principles help ensure consistency (following the same methods or rules over time) and accuracy (being correct, precise, and free from errors.)in financial records. Business entity The business entity principle, also known as the accounting entity principle, states that a business is treated as separate from its owner. This means that the owner’s personal assets and spending do not appear in the business's accounting records. Only the business's assets, liabilities, and expenditures are recorded. If a transaction involves both the business and the owner, it is recorded in the business's accounts. For example, when the owner invests money into the business, it is credited to the capital account, showing the funds from the owner. This account reflects the amount the business owes the owner. Conversely, if the owner takes money out of the business, it is recorded as a debit in the drawings account, reducing the amount owed to the owner. Consistency in accounting, there are situations where multiple methods can be used, such as calculating the depreciation of non-current assets. When given a choice, it’s important to select the method that provides the most realistic results. Once a method is chosen, it must be used consistently in every accounting period, which is known as the consistency principle. This is essential for accurately comparing financial results over different years; inconsistent methods can (Change)distort a company's profit figures. If there’s a valid reason to change a method or valuation, it can be done, but the impact of that change should be clearly stated in the financial statements. Duality The principle of duality, also known as the dual aspect principle, states that every financial transaction has two sides: one that gives something and one that receives something. This means that when a transaction occurs, it is recorded in two places in the accounting records. This method is called double entry accounting. Going concern The going concern principle assumes that a business will continue to operate indefinitely and has no plans to close or significantly downsize. Because of this, the business's accounting records reflect non-current assets at their book value, which is the original cost minus depreciation, and inventory is shown at the lower of cost or its expected selling price. However, if there are indications that the business may close soon, the values of its assets in the financial statements will be adjusted to reflect their expected sale values, as these would be more relevant than the book values in that situation. Historic Value The historic cost principle states that all assets and expenses should be recorded at their actual purchase cost. This principle is related to the money measurement principle, as costs are verifiable facts. However, using this principle can make it hard to compare transactions over time because of inflation. To provide a more accurate value for non-current assets, depreciation is often applied, which reduces the recorded cost of these assets over time. Matching concept The matching principle, also known as the accruals principle, ensures that revenue and expenses are recorded in the same accounting period, regardless of when cash transactions occur. This principle extends the realization principle by including all income and expenses. By aligning the figures in an income statement with the period they represent—whether or not cash has actually changed hands—this principle allows for a more meaningful comparison of profits, sales, and expenses from year to year. Materiality Concept The materiality principle means that businesses can ignore certain accounting rules for items that are not very valuable. This is because the effort and cost of keeping track of these small items might be greater than the benefits gained from recording them. This principle recognizes that not all items need to be treated the same way, depending on their significance to the business. For example, a low-cost item like a pocket calculator may not be recorded as a non-current asset due to the complexity and cost of tracking its depreciation. Instead, it could be expensed in the year it’s purchased. What is considered material can vary by business size; a laptop may be immaterial for a large corporation but significant for a small business. Consequently, larger firms might set a threshold (e.g., non-current assets costing less than $1,000 are treated as expenses), while smaller businesses might use a much lower threshold. Additionally, minor expenses can be grouped into a single account (like "general expenses") rather than itemizing each small expense, and the total cost of office supplies can be recorded as an expense even if some remain at the end of the year Money measurement The money measurement principle states that only information that can be expressed in monetary terms can be included in accounting records. This principle uses money as a standard unit of measurement, making it factual and objective, rather than based on personal opinions. However, many important aspects of a business, like employee morale, the effectiveness of a good manager, and the benefits of staff training, cannot be measured in money. Therefore, these factors do not appear in accounting records. Similarly, events like the launch of a competing product or increased competition also cannot be recorded because their impact cannot be quantified in monetary terms. Prudence The prudence principle, also called the principle of conservatism, helps ensure that a business's financial records are realistic and trustworthy. It stops accountants from exaggerating profits or downplaying losses. The main idea is summed up in the saying: “never expect a profit before it’s certain, but always plan for potential losses.” This means that profits should only be recorded when it's clear they'll actually be received, while any possible losses should always be considered. This principle is very important in accounting. If using another rule would go against prudence, then prudence should be followed. For example, profits are usually counted when a sale happens, but if a customer doesn't pay on time, the prudence principle says that the uncollectible amount should be written off. Realization The realisation principle states that a profit should not be recorded until it is actually earned. This means that revenue is only recognized when ownership of goods or services transfers from the seller to the buyer, creating a legal obligation for the buyer to pay. When a customer places an order, no goods are exchanged, and therefore, no profit is recognized at that time. Profit is considered realized only when the goods are physically delivered to the customer, even if the sale is made on credit and the customer doesn’t pay right away. 10.3 International accounting standards International accounting standards establish consistent rules and guidelines for preparing financial statements across the globe. While the specifics of each standard are not covered here, the main goals of these standards are to protect users of financial statements and prevent any misinformation. The effectiveness of financial statements depends on the quality of information they provide, which can be evaluated based on four key factors: 1.Comparability: Financial statements should allow users to compare the financial performance of different companies. 2.Relevance: The information must be pertinent to the users' decision-making processes. 3.Reliability: The data presented should be trustworthy and accurate. 4.Understandability: Financial statements should be clear and easy to comprehend for users. Compatibility Financial statements are most helpful when you can compare them over time for the same business or with similar businesses. To make good comparisons, it's important to know if different accounting methods were used to prepare the statements and if there have been any changes to those methods. Understanding the similarities and differences between financial statements helps you better understand a business's financial performance and position. Relevance Financial statements show how well a business is doing and its overall financial health. This information is important for making decisions. It must be provided on time; if it’s late, it won’t be helpful. The information also needs to be relevant. This means it should help users check their past expectations and make better predictions about the future. Reliability Financial statements are considered reliable if they meet the following criteria: Dependable: Users can trust that the information accurately reflects the real transactions and events. Verifiable: The information can be checked and confirmed by others. Unbiased: The information is presented fairly without favoritism. Error-Free: There are no major mistakes in the data. Cautious Preparation: Care is taken in making any necessary judgments and estimates. Understandability Financial statements should be easy for users to understand. This clarity relies on both the information presented and the users’ ability to comprehend it. Users are generally expected to have a basic knowledge of business, economics, and accounting, and they should take the time to review the statements carefully. However, important information should not be left out just because it might be hard for users to understand. 10.4 Capital and revenue expenditure and receipts Capital expenditure refers to the money a business spends on buying and improving non-current assets. This includes costs like legal fees for purchases, delivery charges, and installation costs. These expenses are recorded as non-current assets in the business's financial statement rather than as immediate expenses, as they provide benefits over several years. The value of these non-current assets typically decreases over time due to depreciation, which will be accounted for against the annual revenue generated by the asset. Revenue expenditure Revenue expenditure is the money spent on the daily operations of a business. This includes costs like administrative expenses, selling expenses, financial expenses, and the maintenance of non-current assets. It also covers the purchase cost of goods intended for resale. These expenses are listed in the income statement and are matched against the revenue for that period. If revenue and capital expenditures are misclassified, it can lead to inaccurate profit reporting. For instance, if a machine repair is incorrectly recorded as an improvement, expenses will be understated, leading to overstated profits. Consequently, the non-current assets will appear overstated in the financial statement, which also inflates the capital due to the inaccurate profit figure. Capital receipt A capital receipt is money received by a business that comes from sources other than regular trading activities. Examples include: Money from the owner (capital contributions) Loans received Proceeds from selling non-current assets (like equipment or property) Capital receipts should not be included in the income statement. However, if there is a profit or loss from the sale of a non-current asset, that profit or loss is recorded in the income statement for the year when the asset is Revenue Receipts A revenue receipt is money that a business receives from its regular trading activities. Examples of revenue receipts include: Sales of goods Fees from clients Rent received Commissions received Discounts received Since these receipts come from the normal operations of the business, they are recorded in the income statement. 10.5 Inventory valuation At the end of each financial year, a business must value its inventory. Inventory is valued at the lower of cost or net realizable value to follow the principle of prudence, which helps prevent overvaluation of profit and assets. Cost of Inventory: This includes the actual purchase price and any extra costs (like shipping) to bring the inventory to its current condition. Net Realizable Value: This is the estimated amount the business expects to earn from selling the inventory, minus any costs needed to finish or sell the goods. Typically, the cost of inventory is lower than its net realizable value. However, if the goods are damaged or there’s a decline in demand (due to changes in taste or fashion), the net realizable value may be lower than the cost.  Scenario: A business has a batch of shoes that it purchased for $100 per pair. The business incurs an additional cost of $20 for shipping them to the store. Therefore, the total cost of the shoes is: Cost of Inventory: $100 (purchase price) + $20 (shipping) = $120 per pair. However, due to a change in fashion, the demand for these shoes has decreased. The business estimates that it can only sell them for $80 per pair. Additionally, it will incur $10 in selling expenses to sell the shoes. Estimated Selling Price: $80 per pair Selling Expenses: $10 per pair Now, we can calculate the net realizable value: Net Realizable Value (NRV)=Estimated Selling Price−Selling Expense (80-10)=70 In this example, the NRV of the shoes is $70 per pair. Since the cost of the inventory ($120) is higher than the NRV ($70), the business would value the inventory at $70 per pair for its financial statements. This reflects the principle of prudence, preventing overvaluation of the inventory on the balance sheet.