DOC-20240718-WA0000.pdf

2. Accounting Concepts and Conventions Binguni Mabharana MSc Applied Finance (USJ) BBNS Banking and Finance & Financial Risks Management (AUS)  Accounting Concepts Generally Accepted Accounting Principles (GAAP) Basic assumptions and requ...

2. Accounting Concepts and Conventions Binguni Mabharana MSc Applied Finance (USJ) BBNS Banking and Finance & Financial Risks Management (AUS)  Accounting Concepts Generally Accepted Accounting Principles (GAAP) Basic assumptions and requirements that accounting is based on. These concepts are used to understand the way certain transactions are treated and the reason for it.  Accounting Concepts Money Measurement/ Accounting Business entity Going Concern Historical Cost stable monetary Period unit Prudence/ Dual Aspect Realization Matching Accrual Concept conservatism Materiality Objectivity Consistency Disclosure 1. Business Entity Concept  An entity is an organization where financial statements are prepared for. Business The business and the owner/s Entity are 2 independent parties. Concept Personal income of business is not considered to be the income of the owner/s.  Business Entity Concept Examples 1. Insurance premiums for the owner’s house should be excluded from the expense of the business. 2. The owner’s property should not be included in the account of the business. 3. Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business.  Business Entity Concept 1. Define business entity concept. 2. Suppose Tom and Anne have started a small retail shop by in front of Tom’s house. They have invested Rs. 100,000 into it. They bought the necessary equipment for cash and products to resell on credit basis. Also, Tom pays Rs.2000 to his monthly electricity bill of his personal house. a) Who are the owners of the business? b) What is the initial capital of the business? c) What is the impact of Tom’s electricity payment to their business? d) What happens if Tom took money from the business to pay his bill? 2. Money/ Financial Measurement Concept  In accounting, transactions and events are recorded only if they can be measured in monetary terms. Practices of Money Measurement Concept 1.Accounting items that can be measured in money terms. 2.Value of all the transactions are stated in money.  All transactions of the business are recorded in terms of money. Money It provides a common unit of Measurement measurement. Concept Inflation or deflation is not included in any asset value. Value of money is considered as stable. Weaknesses Not including the resources that cannot of Money be measured in monetary terms. For example, Measurement Abilities of management Concept Talents of employees Efficiency of employees  Money Measurement Concept Examples 1. Market conditions, technological changes and the efficiency of management would not be disclosed in the accounts 2. Value of all transactions are stated in monetary terms. 1. Define Money Measurement Concept. 2. Write 5 examples for business transactions. 3. Separately define monetary transactions and non-monetary transactions. 4. According to the money measurement concept what won’t be recorded from the below transactions. a) Taxes to the government b) Purchase from the creditors c) A company’s customer service d) Sales to the customers 3. Going Concern Concept  Going Concern Concept The business will Financial statements continue in should be prepared operational existence for the foreseeable on a going concern basis. future.  Going Concern Concept Examples 1. Classifying assets as current assets and non-current/fixed assets. 2. Classifying liabilities as current liabilities (bank overdrafts) and non-current liabilities.  Going Concern Concept 1. Define going concern concept. 2. Give 2 examples for Going concern concept. 3. Why do we classify assets and liabilities as current and non-current?  4. Accounting Period/ Periodic/ Periodicity Concept  Accounting Period Concept For measuring the financial results of a business periodically, the working life of an undertaking is split into convenient short periods called accounting period.  Accounting Period Concept Practices 1. Preparing financial statements to each accounting period 2. Mentioning the year on the top of financial statements 1. Define accounting period concept. 2. Name 2 practices of accounting period concept. 3. ‘Financial statements does not confirm accounting period concept.’ Is this true/ false? Why? 4. Which concept puts the foundation for accounting periodic concept? 5. Historical Cost Concept  Assets should be shown on the balance sheet at the cost of purchase instead of current value. Historical Known as the “Book Value” of Cost assets. Concept As items are not revalued, there will always be a source document to provide evidence.  Historical Cost Concept Example 1. For example, if a company's main headquarters, including the land and building, was purchased for $100,000 in 1925, and its expected market value today is $20 million, the asset is still recorded on the balance sheet at $100,000. 2. A company vehicle was bought for Rs. 2,000,000 in 2019. However, the current market value of it has been changed into Rs. 5,000,000. Despite of that, the value is recorded as Rs. 2,000,000.  Historical Cost Concept 1. Define Historical cost concept. 2. What is mean by “Historical cost”? 3. Name 2 practices of historical cost concept. 6. Prudence/ Conservatism  Revenues and profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and loss account. Prudence/ Conservatism However, provision are made for all known expenses and losses whether the amount is known for certain or just an estimation.  Prudence/ Conservatism Example 1. If a loyal client make an enquiry about purchasing materials, the sales accounts should not be updated until they pay you. 2. If a customer goes insolvent, relevant accounts for expected loss should be created. (Bad debt, Provision for bad debts)  Prudence/ Conservatism 1. Define prudence concept. 2. Mention whether we make provisions for probable profits and losses. 1. Name 3 practices of this concept. 7. Dual Aspect/ Double Entry Concept 7. Dual Aspect/ Double Entry Concept Isaac Newton → “Every action has an equal and opposite reaction” Luca Pacioli introduced the system first in 1494.  Dual Aspect Concept Every transaction This system of For every debit, there is should have a two- sided effect to the recording is known as a credit. “Double entry extent of same amount. system”.  Transactions Receiving Giving = (Debit) (Credit) Utilize it (Expense) Have to repay (liability) Waste it (Losses) Don’t have to repay = Save it (Asset) (income/gain) Expenses +Losses + Assets = Liabilities + Income/ Gain  For example: Cash sales of Rs.5,000. Debit (Receiving) Cash Account (Asset) Rs. 5,000 Dual Aspect Concept Credit (Giving) Sales Account (Income) Rs. 5,000  For example: Purchased From Arpico goods worth Rs. 10,000 and discount received Rs. 3,000. Debit (Receiving) Purchase Account(Asset) Rs. 10,000 Dual Aspect Credit (Giving) Concept Arpico Account Rs. 7,000 Discount received Rs. 3,000  Dual Aspect Concept 1. Define Dual aspect concept. 2. What is the name of the system that we use here? 3. What is the basis of Dual Aspect Concept? 4. What is the correct accounting equation? 1. Assets = Capital – Liabilities 2. Assets = Capital + Liabilities 3. Assets = Liabilities – Capital 4. Capital = Assets + Liability Expenses/ Assets /Capital/ Liabilities/ Income Debit (Receiving): Expense, Loss, Asset Credit (Giving) : Liability, Income Expense Asset Expense Capital Asset Income Income Asset Asset Liability Income Capital 8. Materiality  Materiality What matters to you → Material What doesn’t matters to you → Immaterial Financial Stakeholders (For Information statements decision making)  Materiality Information is material if the knowledge of it can influence the decisions made by stakeholders. Materiality is important because it affects reliability, completeness and relevance. For example Rs.100 is a material value for a small scale business with annual sales of Rs.1000. However, it is an immaterial amount for a business with annual sales of Rs. 100,000.  Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately. Materiality Materiality depends on the size and nature of the item.  Example 1. Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as Materiality sundry expenses.  Materiality 1. Define the concept of Materiality. 2. What are the factors which the materiality of information are decided on? 3. What do we do the immaterial information? 4. What is the criteria when presenting immaterial information collectively? 5. Name 2 examples for materiality concept. 9. Realization/ Revenue Recognition Concept  Realization Concept Revenues should be Sales are recognized recognized when the when the goods are major economic sold and delivered to activities have been customers or services completed. are rendered.  Current Liability : PREPAID INCOME (ADVANCE) Current Asset : DELAYED INCOME Realization Concept  Recognition of Revenue The realization concept develops rules for the recognition of revenue. Realization The concept provides that revenues are recognized when it is earned, and not when Concept money is received. Since revenue is a principal component in the measurement of profit, the timing of its recognition has a direct effect on the profit.  Examples 1. Advance payment for goods. A customer pays Rs.1,000 in advance for a custom- designed product. The seller does not realize the Rs.1,000 of revenue until its work on the Realization product is complete. Concept 2. Delayed payments. A seller ships goods to a customer on credit, and bills the customer Rs.2,000 for the goods. The seller has realized the entire Rs.2,000 as soon as the shipment has been completed. 1. Define realization concept. 2. When do we consider revenues into the accounts? 3. Give 3 practices of realization concept. 4. From the perspective of the business what are advance payments and delayed payments? 10. Matching Concept  Matching Concept The matching principle states that expenses should be recognized and recorded when those expenses can be matched with the revenues those expenses helped to generate. In other words, expenses shouldn't be recorded when they are paid.  Example 1. Mr. Sam is an agent of Autopal car company. He gets a 5% commission from a Matching car he sells. For the August 2021, he has sold Concept 10 cars which is worth of Rs.50,000 and he received his commission on September 2021. However, it will be recorded in the month of August due to the matching concept.  Matching Concept Therefore, matching concept ensures that financial statements do not overstate or understate the revenue or expenses of the company. 1. Define the matching concept. 2. Name 3 practices of matching concept. 3. What are the basic steps followed when ascertaining profit? 11. Accrual Concept  Revenues are recognized when they are earned, but not when cash is received Accrual Concept Expenses are recognized as they are incurred, but not when cash is paid  Example 1. ABC Company sells a table to Jane, and she promises to repay in 14 days. However, the Accrual accountant will not wait till they get the money from Jane. Instead, he will record the transaction Concept when issuing the table to Jane. 2. Western Ltd owes employees salary for December 2021. But it is paid on January 2022. However, the expense should be recorded in 2021 December. 1. Define accrual concept of accounting. 2. When are revenues considered? 3. When are expenses considered? 4. Suppose company X has bought a machinery from Maya enterprises on May. However, company has promised to pay in June. When should company X credit the expense to the account of Maya Enterprises? 12. Objectivity  Objectivity The accounting information should be free from bias and capable of independent verification The information should be based upon verifiable evidence such as invoices or contracts  Objectivity The whole business activities get suspicious when the financial statements are unreliable. Objectivity concept also helps in maintaining the reliability of the financial statements and every decision that revolves around it. Should be free from bias.  Example 1. The recognition of revenue should be based on Objectivity verifiable evidence such as the delivery of goods or the issue of invoices.  Objectivity 1. Define the concept of objectivity. 2. What is the main goal of objectivity? 3. Give an example for objectivity concept.  13. Consistency  Consistency Changes are permitted only Companies should choose when the new method is The change and its effect the most suitable considered better and can accounting methods and on profits should be reflect the true and fair disclosed in the financial treatments, and consistently view of the financial apply them in every period. statements. position of the company.  Advantages of Consistency Concept 1. Treatment for same product in different statements is similar. 2. Easy to compare the financial statements. 3. Convenient for users of financial statements. 4. Better decision making.  Examples 1. Ruwantha has a garment factory Consistency where he exports his products to Australia and Germany. He should not use different depreciation methods for same product even they are 2 separate branches.  Consistency 1. Define the concept of consistency. 2. What are the advantages of consistency concept. 3. What is the condition which we can switch to a another method? 14. Disclosure  Financial statements should be prepared to reflect a true and fair view of the financial position and performance of the enterprise. Disclosure All material and relevant information must be disclosed in the financial statements.  Financial information Accountant Stakeholders (Customers, Competitors, Management, n Creditors) Must not be misleading  Disclosure Information is not misleading if they have below qualities. 1. Not hiding any information 2. No ambiguity 3. Footnotes when necessary.* Not sharing “Trade secrets does not violate disclosure concept”.  Disclosure Example: In 2020, all the business entities had to fully and timely disclose the impact for their entities from the global COVID-19 pandemic, because it will help investors to overlook the true financial position of the company and to decide if they should further invest.  Disclosure Concept 1. What is disclosure concept? 2. What are the features of not misleading information? 3. What we don’t include under disclosure concept? 4. Name 3 practices of disclosure concept.  Users of Financial Statements Investors Lenders Management Suppliers Need information Need information Need information Need information about the about the for planning, policy about the liquidity profitability, profitability and making and of business to dividend yield and solvency to evaluation. assess the price earning ratio calculate the company’s ability to to assess the quality interest rate and repay the loans. and the quantity of risk of the loans. the company share.  Users of Financial Statements Government Customers Employees Public Need Interested in the Interested in the Need details information long-term stability of the about the trends about businesses stability of the business to and recent for various business and provide developments. statistics and continuing employments, economic plans. supply of certain fringe benefits products. and promotions.  Disadvantages of Conventional Financial Statements Financial statements are derived from historical costs. Financial statements are not adjusted for inflation. Financial statements do not contain some intangible assets. Financial statements only cover a specific period of time. Financial statements do not cover non-financial issues. Write the most appropriate accounting concept. Transaction/ Event Concept A customer goes insolvent, relevant accounts for expected loss should be created. Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses. Classifying assets as current assets and non-current/fixed assets. Employees are paid by their company every two weeks; they do not get paid at the end of each workday. Revenues and expenses in the same period should be matched. Preparing financial statements to each accounting period. The recognition of revenue should be based on verifiable evidence. Assets should be shown on the balance sheet at the cost of purchase instead of current value. All material and relevant information must be disclosed. For every debit, there is a credit. Thank You!!!