AFU4304 Unit 1 Session 01 Accounting Concepts PDF

Session 01 Accounting concepts and their application in financial accounting Session 01 Accounting concepts and their application in financial accounting Contents Introduction, p 1 1.1. Business entity concept, p 2 1.2. Money measurement concept, p 3 1.3. Accoun...

Session 01 Accounting concepts and their application in financial accounting Session 01 Accounting concepts and their application in financial accounting Contents Introduction, p 1 1.1. Business entity concept, p 2 1.2. Money measurement concept, p 3 1.3. Accounting period concept, p 3 1.4. Going concern concept, p 4 1.5. Realization concept, p 5 1.6. Accrual concept, p 6 1.7. Matching concept, p 7 1.8. Prudence concept, p 8 Review questions, p 10 Summary, p 11 Learning outcomes, p 11 Introduction Accounting concepts are ideas and assumptions that form a theoretical basis for financial accounting. The accounting concepts are applied when a business entity records its financial transactions and presents their results in its financial statements. The application of the accounting concepts brings 1 Unit 1: Intermediate Accounting consistency and uniformity in the accounting process, resulting a consistent set of financial information useful for economic decision making. In this session we shall learn about following accounting concepts with their meaning, significance and application in the financial accounting process. ▪ Business entity concept ▪ Money measurement concept ▪ Accounting period concept ▪ Going concern concept ▪ Realization concept ▪ Accrual concept ▪ Matching concept ▪ Prudence concept 1.1 Business entity concept This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the transactions of a business and personal transactions of its owners are considered separately. For example, when the owner invests money in the business, it is recorded as “capital” or “equity” in the business, giving the idea that the owner has contributed towards resources of the business. Suppose the total amount of resources (assets) of the business is worth Rs 1,600,000 and the owner has invested Rs 1,000,000. Then, the capital is Rs 1,000,000. This is the owner’s contribution towards the assets of the business. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not recorded as a business expense. It is considered as a decrease of the equity, in other words, a decrease of the owner’s contribution to the business. Accordingly, the accounting records are made from the point of view of the business and not as what the person owns in the business. 2  Session 01 Accounting concepts and their application in financial accounting This concept is significant when recording transactions and determining the profit of a business. It facilitates the recording and reporting of business transactions from the business’s point of view. Thus, it enables in determining the profit of the business as it records only the income and expenses of the business, and disregards the private transactions of the owner/s. Since the business is considered as a separate entity for financial accounting purpose, the financial statements are prepared in the name of the business, not in the name/s of its owner/s. 1.2 Money measurement concept This concept assumes that all business transactions are measurable in monetary terms (that is, in terms of the currency of the country in which the business operates). According to this concept, transactions that can be expressed in monetary terms are recorded in the books of accounts. For instance, sales of Rs 100,000, purchase of Rs 50,000 stock of raw material, and payment of Rs 40,000 salaries are transactions measurable in monetary terms, which, therefore, can be recorded in financial accounting. This concept facilitates in recording business transactions uniformly as they are recorded in terms of their monetary values, not in physical quantity or other measurement of value. Thus, it will be easy to compare financial statements of different businesses over different accounting periods. Accordingly, when preparing financial statements, it is required to mention the monetary unit used in recording transactions and preparing financial statements. 1.3 Accounting period concept According to this concept, the life time of the business is divided into parts, known as “accounting periods”. Profit or loss of business is determined for each period separately. An accounting period may be of one year, six months, three months, one month, or even a less time period. However, 3 Unit 1: Intermediate Accounting when preparing financial statements for the external use, one year is usually considered as an accounting period which is referred to as “financial year”. In practice, a financial year starts eighter on 1st January or 1st April in a calendar year. Since profit or loss is determined for an accounting period, all the transactions relating to the given accounting period are recorded separately. Accordingly, the statement of income is prepared for an accounting period, and the statement of financial position is prepared at the end of that accounting period. It facilitates the comparison of financial performance and position over different accounting periods when evaluating the business activities. 1.4 Going concern concept The going concern concept assumes that an entity will remain in business for the foreseeable future. In other words, it means that the entity does not have any intention to sell its assets to stop a major part of its operations or its entire operations in the near future. When this assumption is valid for a business, ▪ Assets can be classified as current assets and non-current assets. ▪ Non-current assets can be depreciated over their useful lives. ▪ Liabilities can be classified as current liabilities and non-current liabilities. ▪ Income and expenses can be recorded by following the accrual basis of accounting. Activity 1.1: Consideration of Going Concern assumption 1. Discuss a scenario or an event that might challenge the going concern assumption in a business organization. 2. Discuss how that situation is addressed when preparing financial statements. 4  Session 01 Accounting concepts and their application in financial accounting 1.5 Realization concept This concept states that income from a business transaction should be included in the accounting records only when it is realised. The term realisation means creation of right to receive money. The revenue from sale of goods is considered as realised when the right to receive cash for the goods sold is created, which usually happens upon the delivery of goods sold. The revenue from a service is considered as realized when the right to receive cash for the service given is established, which happens upon the completion of the service. The receipt of cash is not necessary to consider when determining the realization of income. For instance, a company received an order to supply stocks amounting to Rs 1,000,000. On 15th March 2024, it delivered Rs 550,000 worth of stocks to that customer. The remaining stocks are expected to be delivered in the month of April. By 31st March, the company received cash worth Rs 300,000 from the customer. As per the realization concept, the revenue is realized when the right to receive cash is created which is upon the delivery of stocks to the customer. Accordingly, the revenue realized during the year ended 31st March 2024 was only Rs 550,000. Thus, the revenue recognized in the statement of income for the year ended 31st March 2024 was Rs 550,000. Activity 1.2: Recognition of Revenue on Realization Concept The following transactions have taken place in AB PLC during the month ending 30 th April 2023. 1. AB PLC sold stocks of Rs.400,000 for cash in the month of March 2023. These stocks have been delivered during the month of April. 2. During the month of April, the stocks sold on credit was Rs.250,000. The stocks have been delivered in April, however the payment will be received in May 2023. 3. A payment of Rs 300,000 was received during the month of April to supply stocks to Y PLC. AB PLC was not able to complete the order by 30th April 2023. Discuss the recognition of revenue arising from the above transactions for the month ending 30th April 2023. 5 Unit 1: Intermediate Accounting 1.6 Accrual concept An accrual means something that becomes due. It involves an amount of money that is receivable or payable at the end of the accounting period. For example, an electricity bill amounting to Rs 10,000 was received on 27th September. It can be called as an accrual as it has become due now. According to this concept, income and expenses are recognized in the accounts when they become due. Accordingly, income is recognized when it becomes receivable (that is, the right to receive money is created), not when cash is received. Expenses are recognised when they become payable (an obligation to settle is created), not when cash is paid. Let’s study the following two examples to understand about the accrual concept. 1. The monthly rental of the office building is Rs 15,000. The rent has not been paid during the month. The rent becomes due at the end of the month whether it is paid or not. Thus, the rent expense of Rs 15,000 is recognized for that month. 2. An advance of Rs 340,000 was received for the supply of stocks worth Rs 400,000. The stocks have not yet been supplied. The revenue becomes receivable upon the delivery of stocks to the customer. Accordingly, the revenue is not recognized since the stocks have not yet been delivered. The receipts of the advance should be recognized as a liability. The examples discussed above highlight the fact that the accrual concept makes a distinction between the actual receipt of cash and the right to receive cash in relation to revenue, and actual payment of cash and obligation to pay cash in relation to expenses. 6  Session 01 Accounting concepts and their application in financial accounting Activity 1.3: Recognition of Income and Expenses on Accrual Concept The followings are certain transactions took place in Nimal’s business during the quarter ending 30th June 2023. 1. The electricity bill for the month of June was Rs 11,200. The amount paid during the month was Rs 5,000. 2. A fire insurance coverage was obtained on 1st April 2023 for a period of one year by paying Rs 120,000. 3. The monthly rental of the office building is Rs 15,000. The rent paid during the quarter was Rs 20,000. 4. An advance of Rs 150,000 was received on 15th June 2023 for the supply of stocks worth Rs 250,000. The stocks have not been supplied by 30th June 2023. Discuss whether the revenue and expenses relating to the above transactions are recognized for the quarter ending 30th June 2023. 1.7 Matching concept The matching concept states that the revenue, and the expenses incurred to generate the revenues have to be recognized in the same accounting period. For instance, suppose Rs 10,000 cost of stocks were sold and delivered for Rs 15,000. This transaction involves a sales income of Rs 15,000 and cost of sales (expense) of Rs 10,000, both of which have to be recognized during the same accounting period. According to this concept, the revenue recognized should be matched with the expenses incurred to earn the revenue when determining the profit for an accounting period. In the above transaction, by recognizing the revenue of Rs 15,000 and matching this with the cost of sales of Rs 10,000, a profit of Rs 5,000 is recognized. Thus, the matching concept guides how the expenses should be matched with revenue in determining exact profit or loss for a particular period. It is very helpful for the users of financial statements to know the exact amount of profit or loss of the business. 7 Unit 1: Intermediate Accounting Activity 1.4: Application of Matching Concept when determining Profit The following transactions have taken place in XY PLC during the month ending 31st January 2023. ▪ During the month of January, the stocks sold for cash and on credit were amounting to Rs 160,000 and Rs 240,000 respectively. Of the credit sales, Rs 30,000 stocks were just invoiced, but had not been delivered to the customers. ▪ The cost of the stocks sold and delivered to the customers during the month of January was Rs 180,000. ▪ The salaries for the month were Rs 80,000 which will be paid in the next month. ▪ The sales staff is entitled for commission of 5%. The commission paid during the month was Rs 10,000. ▪ The monthly rental for the office building is Rs 15,000, the payment of which will be made in the next month Calculate the profit earned by XY PLC during the month of January 2023. 1.8 Prudence concept Prudence is a fundamental principle in accounting that helps to ensure that financial statements are accurate, reliable, and trustworthy. It states that revenue should not be overstated and expenses should not be understated. Hence, by being prudent, the overstatement of profit can be avoided, which can otherwise create a false impression of financial health. The followings are some scenarios of applying the prudence concept in financial accounting; 1. The inventory is valued at the lower of cost and net realizable value. When the market value of the inventory is lower than its cost, the inventory should be valued at the lower market value. Thus, it avoids the overstatement of inventory value in the financial statements. For example, suppose the cost of the inventory as at the end of the financial year was Rs 560,000 and its net realizable value was Rs 8  Session 01 Accounting concepts and their application in financial accounting 500,000. According to the prudence concept, the inventory is valued at the lower of the cost and net realizable value. Since the net realizable value is lower than its cost, the inventory is written down to its net realizable value of Rs 500,000 by recognizing a loss of Rs 60,000. Accordingly, the inventory value recognized in the statement of financial position is Rs 500,000. 2. A provision for doubtful receivables is made against receivables balances to account for the impairment in their value in order that the receivables are not overstated in the financial statements. For example, the accounts receivable as at end of the year was Rs 220,000. After a review, it was found that the collectability of Rs 10,000 of these receivables is doubtful. In this situation, a provision of Rs 10,000 has to be made for the impairment of receivables. Accordingly, the accounts receivables should be recognized in the statement of financial position at Rs 210,000 (220,000 – 10,000). 3. If the value of a non-current asset has been impaired, the prudence concept requires that the impairment loss be recognized in the financial statements. Accordingly, the value of the asset should be written down to its recoverable amount, which is the maximum amount that the company expects to receive from the use or sale of the asset. For instance, suppose a machinery with the cost of Rs 750,000 and the accumulated depreciation of Rs 150,000 was found to be impaired. The estimated recoverable value of the machinery is Rs 430,000. In this case, the carrying value of the machinery was Rs 600,000 (750,000 – 150,000). Since the recoverable value is less than the carrying value, the value of the machinery should be written down to its recoverable amount of Rs 430,000 by recognizing an impairment loss of Rs 170,000. As a result, the machinery is recognized in the statement of financial position at its recoverable value of Rs 430,000. The impairment loss of 170,000 should be recognized as an expense. 9 Unit 1: Intermediate Accounting Activity 1.5: Application of Prudence Concept Consider the following information in relation to AS PLC as of 31st March 2023. 1. An equipment had a cost of Rs 800,000 and an accumulated depreciation of Rs 250,000. It is found that the recoverable value of the equipment is Rs 500,000. 2. The inventory as at 31st March 2023 had a cost of Rs 120,000 and net realizable value of Rs 100,000. 3. The accounts receivable as at 31st March 2023 was Rs 450,000. After a review, it was found that the collectability of Rs 30,000 of these receivables is doubtful. Discuss the relevant accounting adjustments for the above situations by applying the prudence concept. Review Questions 1. Explain the accrual concept and its importance in financial accounting? 2. How does the accrual concept differ from the cash basis of accounting? 3. What is the matching concept, and how does it relate to the accrual concept? 4. Provide an example of how the matching concept is applied in financial accounting. 5. Explain the prudence concept and its significance in financial accounting. 6. How does the prudence concept influence the treatment of uncertainties and risks in financial reporting? 7. Explain the going concern concept and its impact on the preparation of financial statements. 8. X PLC provided services for a value of Rs 80,000 by incurring a cost of Rs 60,000 in the month of December 2023. However, the payment will be received in January 2024. How should this transaction be recorded for the year ended 31st December 2023 in X PLC? Discuss it by referring to the relevant accounting concepts. 9. The inventory as at 31st March 2023 has been valued at Rs 100,000. Due to market trends, it is estimated that the realizable value of the inventory is Rs 80,000. How should this scenario be adjusted? Discuss it by referring to the relevant accounting concepts. 10. XY PLC, machine maintenance service provider, has received Rs 200,000 in advance for the services to be provided evenly over 5 months. Discuss how this transaction should be accounted for in the books of XY PLC by referring to the relevant accounting concepts. 10  Session 01 Accounting concepts and their application in financial accounting Summary Accounting concept refers to ideas and assumptions that forms a theoretical basis for financial accounting. The accounting concepts discussed in this session are business entity, money measurement, going concern, accounting period, realisation concept, accrual concept, and matching concept. Business entity concept assumes that the business and its owner/s are two separate entities for accounting purposes. Money measurement concept states that all business transactions are recorded in the books of accounts in monetary terms. Going concern concept assumes that a business firm will continue to carry on activities for the foreseeable future. According to the accounting period concept, all the business transactions are recorded in the books of accounts on the assumption that profit is to be determined for a specified time period. Realisation concept suggests that income should be included in the accounting records only when it is realized. Matching concept states that the revenue recognized should be matched with the expenses incurred to earn the revenue when determining the profit for an accounting period. The prudence concept helps to ensure that financial statements are accurate, reliable, and trustworthy. It states that revenue should not be overstated and expenses should not be understated. Learning Outcomes At the end of this session, you will be able to; ▪ Explain the term “accounting concept”. ▪ Explain the meaning of business entity, money measurement, going concern, accounting period, realization, accrual, matching, and prudence concepts. ▪ Discuss the significance of the accounting concepts in recognition and measurement of the elements of financial statements. ▪ Discuss the application of the accounting concepts in financial accounting. 11 Unit 1: Intermediate Accounting 12