Accounting Concepts and Conventions Lecture Notes PDF

Summary

These lecture notes cover accounting concepts and conventions, including principles and guidelines, and generally accepted accounting principles (GAAP). The document also explores the relationship between accounting principles and guidelines, as well as accounting standard-setting bodies.

Full Transcript

LECTURE NOTE TWO ================ Study Session 2: Accounting Concepts and Conventions ==================================================== Introduction ------------ Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuab...

LECTURE NOTE TWO ================ Study Session 2: Accounting Concepts and Conventions ==================================================== Introduction ------------ Accounting follows a certain framework of core principles which makes the information generated through an accounting system valuable. Without these core principles, accounting would be irrelevant and unreliable. Thus, there are general rules and concepts that govern the field of accounting. These general rules are referred to as basic accounting **principles and guidelines**. These accounting **principles and guidelines** form the framework or basis on which more detailed, complex, and legalistic accounting rules are based. **Accounting principles are guidelines & standards, which have been accepted by the accounting profession in preparation and presentation of accounts of the business. It is approved and normally accepted by the government bodies & controlling authorities.** **Accounting principles are uniform in order to understand in the same sense by those using it. Also they are not rigid (i.e. inflexible) like principle of gravity but they are flexible. This is because mainly the account principles are social science. Accounting principles are not universal and permanent as they are not discovered but are developed by man from time to time. Thus the development of accounting principles is a continuous process.** In this study session, you will learn about the basic accounting principles and guidelines; Generally Accepted Accounting Principles (GAAP); the relationship between accounting principles and guidelines and the financial statement; as well as accounting standard-setting bodies Learning Outcomes for Study Session 2 ------------------------------------- On completion of this study session, you should be able to: 1. Define accounting principle 2. Discuss the features and rules of GAAP 3. Explain the basic accounting principles and guidelines 4. Discuss the influence of accounting principles and guidelines on the financial statement 5. Enumerate some accounting standard-setting bodies 2.1 Definition of Accounting Principle -------------------------------------- The word **'Principle'** has been differently viewed by different schools of thought. The American Institute of Certified Public Accountants **(AICPA)** has viewed the word principle as "a general law of rule adopted or professed as a guide to action; a settled ground or basis of conduct of practice" Thus, **Accounting Principles** refer to certain rules, procedures and conventions which represent a consensus view by those indulging in good accounting practices and procedures. Canadian Institute of Chartered Accountants **(CICA)** defined accounting principle as "the body of doctrines commonly associated with the theory and procedure of accounting, serving as an explanation of current practices as a guide for the selection of conventions or procedures where alternatives exist. Rules governing the formation of accounting axioms and the principles derived from them have arisen from common experiences, historical precedent, statements by individuals and professional bodies and regulations of Governmental agencies". ### 2.1.1 Features of Accounting Principles The following are some of the characteristics of accounting principles: **Figure 2.1: Features of Accounting Principle** **Relevance:** The accounting principle is considered to be relevant and useful to the extent that it increases the utility of the records to its readers. **Objectivity:** It is said to be objective to the extent that it is supported by the facts and free from personal bias. **Feasibility:** It is considered to be feasible to the extent that it is practicable with the least complication or cost. Though, accounting principles are denoted by various terms such as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates, etc., it can be classified into two groups, viz., accounting concepts and accounting conventions. **Figure 2.2: Classifications of Accounting Principle** However, these two classifications of accounting principles shall be discussed in details in the next study session. ### In-Text Questions 2.1 1. State briefly the three features of accounting principle. 2. Define briefly the principle of Accounting ### In-Text Answer 2.1 1. *a. Relevance* b. *Objectivity* c. *Feasibility* 2. *Accounting Principles refer to certain rules, procedures and conventions which represent a consensus view by those indulging in good accounting practices and procedures.* 2.2 Generally Accepted Accounting Principles (GAAP) --------------------------------------------------- Accounting principles are the building blocks that form the basis of more complex and specialized principles called Generally Accepted Accounting Principles (GAAP) such as **[Financial Accounting Standards Board (FASB)](http://www.accountingcoach.com/terms/F/financial-accounting-standards-board),** the International Financial Reporting Standards (IFRS), United State Generally Accepted Accounting Principles (US GAAP), etc. use the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards. The common set of accounting principles is the Generally Accepted Accounting Principles (GAAP). The rules and guidelines that companies must follow when reporting financial data are, Generally Accepted Accounting Principles (GAAP). To remain listed on many major stock exchanges in Nigeria, companies must file regular financial statements reported according to GAAP. However, Accounting principles differ around the world, and countries usually have their own, slightly different, versions of GAAP. If a company distributes its financial statements to the public, it is required to follow generally accepted accounting principles in the preparation of those statements. Further, if a company\'s stock is publicly traded, federal law requires the company\'s financial statements be audited by independent public accountants. Both the company\'s management and the independent accountants must certify that the financial statements and the related notes to the financial statements have been prepared in accordance with GAAP. ### 2.2.1 Relevance of GAAP GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of Generally Accepted Accounting Principles there, is an assumption that there is consistency from year to year in the methods used to prepare a company\'s financial statements. Although variations may exist, accountants can make reasonably confident conclusions when comparing one company to another, or comparing one company\'s financial statistics to the statistics for its industry. Over the years, the Generally Accepted Accounting Principles have become more complex because financial transactions have become more complex. ### 2.2.2 Rules of GAAP Generally Accepted Accounting Principles (GAAP) consist of three important sets of rules. i. The basic accounting principles and guidelines ii. The detailed rules and standards issued by FASB and its predecessor, the Accounting Principles Board (APB) iii. The generally accepted industry practices. However, for the purpose of this study session, only the basic accounting principles and guidelines shall be considered. 2.3 Basic Accounting Principles and Guidelines ---------------------------------------------- Accounting principles and guidelines are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these principles ensure that the users of financial information are not misled by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting principles and guidelines. In order to ensure application of the accounting principles and guidelines, major accounting standard-setting bodies have incorporated them into their reporting frameworks such as the International Accounting Standard Board (IASB) Framework. The following is a list of the ten main accounting principles and guidelines together with a highly condensed explanation of each. **Figure 2.3: Main accounting principles and guidelines** 1. **Economic Entity Assumption:** The accountant keeps all of the *business* transactions of a sole proprietorship separate from the business owner\'s *personal* transactions. For *legal* purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities. 2. **Monetary Unit Assumption:** Economic activity is measured in Naira value, and only transactions that can be expressed in Naira value are recorded. Because of this basic accounting principle, it is assumed that the Naira purchasing power has not changed over time. As a result, accountants ignore the effect of inflation on recorded amounts. For instance, naira from a 1960 transaction are combined (or shown) with naira from a 2013 transaction. 3. **Time Period Assumption:** This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2013, or the 5 weeks ended May 1, 2013. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For instance, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2012, the amount is known; but for the income statement for the three months ended March 31, 2013, the amount was not known and an estimate had to be used. It is therefore, *imperative* that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders\' equity, and statement of cash flows. 4. **Cost Principle:** From an accountant\'s point of view, the term \"cost\" refers to the amount spent (cash or the cash equivalent) when an item was *originally* obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as *historical* cost amounts. Because of this accounting principle, asset amounts are *not* adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect *any* type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today\'s market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) 5. **Full Disclosure Principle:** If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of \"footnotes\" are often attached to financial statements. A company usually lists its significant accounting policies as the first note to its financial statements. 6. **Going Concern Principle:** This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company\'s financial situation is such that the accountant believes the company will *not* be able to continue on, the accountant is required to disclose this assessment. The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods. 7. **Matching Principle:** This accounting principle requires companies to use the [**accrual basis of accounting**](http://www.accountingcoach.com/terms/A/accrual-basis-of-accounting). The matching principle requires that expenses be matched with revenues. For instance, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2013 revenues as a bonus on January 15, 2014, the company should report the bonus as an expense in 2013 and the amount unpaid at December 31, 2013 as a liability. (The expense is occurring as the sales are occurring.) Because it impossible to measure the future economic benefit of things such as advertisements (and thereby cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run. 8. **Revenue Recognition Principle:** Under the accrual basis of accounting (as opposed to the [**cash basis of accounting**](http://www.accountingcoach.com/terms/C/cash-basis-of-accounting)) [**revenues**](http://www.accountingcoach.com/terms/R/revenues) are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report N20,000 of revenue in its first month of operation but receive N0 in actual cash in that month. **Example 2.1** For instance, if Saka Consulting completes its service at an agreed price of N1,000, Saka should recognize N1,000 of revenue as soon as its work is done. It does not matter whether the client pays the N1,000 immediately or in 30 days. Do not confuse *revenue* with a **cash receipt**. 9. **Materiality:** Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial. **Example 2.2** A case study of an obviously immaterial item is the purchase of a N150 printer by a highly profitable multi-million naira company. Because the printer will be used for five years, the *matching* principle directs the accountant to expense the cost over the five-year period. But the **materiality** guideline allows this company to violate the matching principle and to expense the entire cost of N150 in the year it is purchased. The justification is that no one would consider it misleading if N150 is expensed in the first year instead of N30 being expensed in each of the five years that it is used. Because of materiality, financial statements usually show amounts rounded to the nearest naira, to the nearest thousand, or to the nearest million naira depending on the size of the company. 10. **Conservatism:** If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to \"break a tie.\" It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective. The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For instance, *potential* losses from lawsuits will be reported on the financial statements or in the notes, but *potential* gains will not be reported. Also, an accountant may write inventory *down* to an amount that is lower than the original cost, but will not write inventory *up* to an amount higher than the original cost. 2.4 How Principles and Guidelines Affect Financial Statements ------------------------------------------------------------- The basic accounting principles and guidelines directly affect the way financial statements are prepared and interpreted. The following are illustrations on how accounting principles and guidelines influence the balance sheet, income statement, and the notes to the financial statements. ### 2.4.1 Balance Sheet A **balance sheet** is a snapshot of a company\'s assets, liabilities, and owner\'s equity at one point in time. Because of the **economic entity assumption**, only the assets, liabilities, and owner\'s equity are specifically identified while personal assets of the owner are not included on the company\'s balance sheet. The assets listed on the balance sheet have a cost that can be measured and each amount shown is the original cost of each asset. **Example 2.3** For instance, if a tract of land was purchased in 1956 for N10,000. And the land is now appraised at N250,000. The **cost principle** requires that the land be shown in the asset account i.e. Land at its original cost of N10,000 rather than at the recently appraised amount of N250,000. If another piece of land is to be purchased, the **monetary unit assumption** dictates that the purchase price of the land bought today would simply be added to the purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as the total cost of land. The Supplies account shows the cost of supplies (if material, in amount) but have not yet been used. As the supplies are consumed, their cost will be moved to the Supplies Expense account on the income statement. This complies with the **matching principle** which requires expenses to be matched either with revenues or with the time period when they are used. The cost of the unused supplies remains on the balance sheet in the asset account supplies. The **cost principle** and **monetary unit assumption** prevent some very valuable assets from ever appearing on a company\'s balance sheet. Such companies that sell consumer products with high profile brand names, trade names, trademarks, and logos are not reported on their balance sheets because they were not purchased. For instance, Coca-Cola\'s logo is probably the most valuable asset of the company, yet it is not listed as asset on the company's balance sheet. Similarly, a company might have an excellent reputation and a very skilled management team, but because these were not purchased for a specific cost and cannot be objectively measured in Naira, they are not reported as assets on the balance sheet. If a company actually purchases the trademark of another company for a significant cost, the amount paid for the trademark will be reported as an asset on the balance sheet of the company that bought the trademark. ### 2.4.2 Income Statement An **income statement** covers a period of time (or time interval), such as a year, quarter, month, or four weeks. It is imperative to indicate the period of time in the heading of the income statement such as \"For the Half Year Ended September 30, 2019\". (This means for the period of January 1 through June 30, 2019.) If prepared under the **accrual basis of accounting**, an income statement will show how profitable a company was during the stated time interval. **Revenues** are the fees/incomes that were earned during the period of time shown in the heading. Recognizing revenues when they are earned instead of when the cash is actually received follows the **revenue recognition principle** and the **matching principle**. (The matching principle is what steers accountants towards using the accrual basis of accounting rather than the cash basis). **Gains** are a net amount related to transactions that are not considered part of the company\'s main operations. For instance, for a company that is into the farming, and not in the land development business. If such company should sell some land for N50,000 (where the actual cost of land as shown in the company\'s accounting records is N35,000). The company will report a **Gain on Sale of Land** of N 15,000. The N50,000 selling price will *not* be reported as part of the company\'s revenues. **Expenses** are costs used up by the company in performing its main operations. **The matching principle** requires that expenses be reported on the income statement when the related sales are made or when the costs are used up (rather than in the period when they are paid). **Losses** are a net amount related to transactions that are not considered part of the company\'s main operating activities. For instance, if a retail clothing company owns an old computer that is carried on its accounting records at N650. And the company sells that computer for N300, the company *receives* an asset (cash of N300) but it must also remove N650 of asset amounts from its accounting records. The result is a **Loss on Sale of Computer** of N350. The N300 selling price will *not* be included in the company\'s sales or revenues. ### 2.4.3 The Notes to Financial Statements Another basic accounting principle, the **full disclosure principle**, requires that a company\'s financial statements include disclosure notes. These notes include information that helps readers of the financial statements make investment and credit decisions. The notes to the financial statements are considered to be an integral part of the financial statements. 2.5 Accounting Standard and Institutions ---------------------------------------- Accountancy bodies are list of the various professional bodies and organizations that seek to provide regulation and oversight over individuals and firms operating in the accountancy industry. On the other hand, accounting standard-setting bodies are national or international organizations that have been delegated with the responsibility of setting Generally Accepted Accounting Principles by statute in a country or jurisdiction. **Box 2.1: Definition of accounting standard-setting bodies** Accounting standard-setting bodies are national or international organizations that have been delegated responsibility for setting Generally Accepted Accounting Principles by statute in a country or jurisdiction. ### 2.5.1 Some Accounting standard-setting bodies Below is a list of some accounting standard setting bodies with their country of domicile: **International:** The International Accounting Standards Board (IASB) issues IFRS; The International Federation of Accountants (with its International Public Sector Accounting Standards Board - IPSASB) issues IPSAS for Government/Public entities accounting; The IFRS Foundation **Albania**: Albanian National Accounting Council **Australia**: Australian Accounting Standards Board **Canada**: CICA\'s Accounting Standards Board \"AcSB\" **France**: Autorité des Normes Comptables (ANC) (formerly the Conseil National de la Comptabilité) **Germany**: Accounting Standards Committee of Germany (ASCG, in German: DRSC)\[3\] **India**: National Advisory Committee on Accounting Standards (NACAS) with the aide and advice of Institute of Chartered Accountants of India and Institute of Cost Accountants of India ### 2.5.2 Professional Bodies Professional bodies represent the interests of their members by lobbying governments, and provide the framework for self-regulation where this is permitted by statute. Professional bodies are also responsible for administering training and examinations for students and members. The primary bodies in each country are affiliated to the International Federation of Accountants. These bodies include: American Institute of Certified Public Accountants (AICPA) Association of Accountancy Bodies in West Africa (ABWA) Association of Accounting Technicians (AAT) Association of Chartered Certified Accountants (ACCA) Association of International Accountants (AIA) Association of National Accountants of Nigeria (ANAN) Canadian Institute of Chartered Accountants (CICA) Certified General Accountants Association of Canada (CGA) Chartered Accountants Australia and New Zealand (CAANZ) Chartered Institute of Cost & Management Accountants (CICMA) Chartered Institute of Management Accountants (CIMA) Chartered Institute of Public Finance and Accountancy (CIPFA) The Institute of Certified Commercial Professional Accountants and Internal Auditors (ICCPAIA) CPA Australia Guild of Industrial, Commercial and Institutional Accountants, Canada (ICIA) Hong Kong Institute of Certified Public Accountants Institute of Certified Public Accountants of Nigeria (ICPAN) Institute of Chartered Accountants in England and Wales (ICAEW) Institute of Certified Public Accountants in Ireland (CPA) Institute of Chartered Accountants in Ireland (ICAI) Institute of Cost Accountants of India (ICAI) Institute of Chartered Accountants of India Institute of Cost and Management Accountants of Bangladesh (ICMAB) Institute of Chartered Accountants of Nigeria (ICAN) Institute of Chartered Accountants of Pakistan (ICAP) Institute of Certified Public Accountants of Pakistan (ICPAP) Institute of Cost and Management Accountants of Pakistan (ICMAP) Society of Accounting Education (SOAE) Institute of Chartered Accountants of Scotland (ICAS) Institute of Chartered Accountants of Sri Lanka (ICASL) Institute of Chartered Accountants of Zimbabwe (ICAZ) Institute of Financial Accountants (IFA) Institute of Public Accountants (IPA) Institute of Singapore Chartered Accountants (ISCA) Malaysian Institute of Accountants The Malaysian Institute of Certified Public Accountants (MICPA) The Malta Institute of Accountants (MIA) South African Institute of Chartered Accountants (SAICA) ### 2.5.3 The Standard Setting Process International Financial Reporting Standards (IFRSs) are developed through an international consultation process, the \"due process\", which involves interested individuals and organisations from around the world. The due process comprises six stages, with the Trustees of the IFRS Foundation having the opportunity to ensure compliance at various points throughout: 1\. Setting the agenda 2\. Planning the project 3\. Developing and publishing the discussion paper 4\. Developing and publishing the exposure draft 5\. Developing and publishing the standard 6\. Issuing the standard Summary of Study Session 2 -------------------------- In this study session, you have learned the following: 1. Accounting Principles refer to certain rules, procedures and conventions which represent a consensus view by those indulging in good accounting practices and procedures. 2. To remain listed on many major stock exchanges in Nigeria, companies must file regular financial statements reported according to GAAP. 3. Generally Accepted Accounting Principles (GAAP) consist of three important sets of rules. That is, the basic accounting principles and guidelines; the detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB); and the generally accepted industry practices. 4. Basic Accounting Principles and Guidelines include; Economic entity assumption, Monetary unit assumption, Time period assumption, Cost principle, Full disclosure principle, Going concern principle, Matching principle, Revenue recognition principle, Materiality, and Conservatism 5. The basic accounting principles and guidelines directly affect the way financial statements (balance sheet, income statement, and the notes to the financial statements) are prepared and interpreted. **Accounting Principles** refer to certain rules, procedures and conventions which represent a consensus view by those indulging in good accounting practices and procedures. **AICPA** American Institute of Certified Public Accountants **Balance sheet** is a snapshot of a company\'s assets, liabilities, and owner\'s equity at one point in time. **CICA** Canadian Institute of Chartered Accountants **Income statement** is a statement showing how profitable a company is during a stated time interval. **Notes to financial statement** include information that helps readers of the financial statements make investment and credit decisions. **Principle** is a general law of rule adopted as a guide to action, a settled ground or basis of conduct of practice

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