FUNDAMENTAL CONCEPTS OF ACCOUNTING Accounting is the language of business and it is used to communicate financial information.

In order for that information to make sense, accounting is based on 12 fundamental concepts. These fundamental concepts then form the basis for all of the Generally Accepted Accounting Principles (GAAP). By using these concepts as the foundation, readers of financial statements and other accounting information do not need to make assumptions about what the numbers mean. For instance, the difference between reading that a truck has a value of $9000 on the balance sheet and understanding what that $9000 represents is huge. Can you turn around and sell the truck for $9000? If you had to buy the truck today, would you pay $9000? Or, perhaps the original purchase price of the truck was $9000. All of these assumptions lead to very different evaluations of the worth of that asset and how it contributes to the companys financial situation. For this reason it is imperative to know and understand the eleven key concepts.

ELEVEN KEY ACCOUNTING CONCEPTS

Entity Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate from those of the owner(s).

Money-Measurement
For an accounting record to be made it must be able to be expressed in monetary terms. For this reason, financial statements show only a limited picture of the business. Consider a situation where there is a labor strike pending or the business owners health is failing; these situations have a huge impact on the operations and financial security of the company but this information is not reflected in the financial statements. Going Concern Accounting assumes that an entity will continue to operate indefinitely. This concept implies that financial statements do not represent a companys worth if its assets were to be liquidated, but rather that the assets will be used in future operations. This concept also allows businesses to spread (amortize) the cost of an asset over its expected useful life. Cost An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the worth of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.) Look at the following example: Truck $10,000 purchase price of the truck Less depreciation $ 1,000 amount deducted as a depreciation expense Net Truck: $ 9,000 net book-value of the truck

The $9000 simply represents the book value of the truck after depreciation has been accounted for. This figure says nothing about other aspects that affect the value of an item and is not considered a market price. Dual Aspect This concept is the basis of the fundamental accounting equation:

Assets = Liabilities + Equity

1. Assets are what the company owns. 2. Liabilities are what the company owes to creditors against those assets 3. Equity is the difference between the two and represents what the company owes to its investors/owners. All accounting transactions must keep this equation balanced so when there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side. Objectivity The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices, receipts, bank statement, etc). This means that accounting records will initiate from a source document and that the information recorded is based on fact and not personal opinion.

Time Period
This concept defines a specific interval of time for which an entitys reports are prepared. This can be a fiscal year (Mar 1 Feb 28), natural year (Jan 1 Dec 31), or any other meaningful period such as a quarter or a month. Conservatism This requires understating rather than overstating revenue (income) and expense amounts that have a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible. The reasons for accounting in this manner are so that financial statements do not overstate the companys financial position. Accounting chooses to err on the side of caution and protect investors from inflated or overly positive results. Realization Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services. This concept is related to conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time when a contract is awarded. For instance, if a company is

awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided over time according to the work that is actually being done. Matching To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period. If you bill $20,000 of services in a month, in order to accurately represent the income for the month you must report the expenses you incurred while generating that income in the same month. Consistency Once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that same method for all subsequent events. This ensures that differences in financial position between reporting periods are a result of changed in the operations and not to changes in the way items are accounted for. Materiality Accounting practice only records events that are significant enough to justify the usefulness of the information. Technically, each time a sheet of paper is used, the asset Office supplies is decreased by an infinitesimal amount but that transaction is not worth accounting for. By understanding and applying these principles you will be able to read, prepare, and compare financial statements with clarity and accuracy. The bottom-line is that the ethical practice of accounting mandates reporting income as accurately as possible and when there is uncertainty, choosing to err on the side of caution.

Re: discuss accounting concepts and convention you know, laying emphasis on each of their limitations {20 pages} Answer #1 (a) Accounting Concepts Bases and Policies I) Concepts/conventions/principles Accounting Concepts are broad basic assumptions that underlie the periodic financial accounts of business enterprises. Examples of concepts include: i) The going concern concept: implies that the business will continue in operational existence for the foreseeable future, and that there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations. Financial statements should be prepared under the going concern basis unless the entity is being (or is going to be) liquidated or if it has ceased (or is about to cease) trading. The directors of a company must also disclose any significant doubts about the companys future if and when they arise. The main significance of the going concern concept is that the assets of the business should not be valued at their break-up value, which is the amount that they would sell for it they were sold off piecemeal and the business were thus broken up. ii) The accruals concept (or matching concept): states that revenue and costs must be recognized as they are earned or incurred, not as money is received or paid. They must be matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period to which they relate. Assume that a firm makes a profit of 100 by matching the revenue (200) earned from the sale of 20 units against the cost (100) of acquiring them. If, however, the firm had only sold eighteen units, it would have been incorrect to charge profit and loss account with the cost of twenty units; there is still two units in stock. If the firm intends to sell them later, it is likely to make a profit on the sale. Therefore, only the purchase cost of eighteen units (90) should be matched with the sales revenue, leaving a profit of 90.   The balance sheet would therefore look like this: Assets Stock (at cost, i.e. 2 x 5) 10

Debtors (18 x 10) 180 190 Liabilities Creditors 100 90 Capital (profit for the period)

90

If, however the firm had decided to give up selling units, then the going concern concept would no longer apply and the value of the two units in the balance sheet would be a break-up valuation rather than cost. Similarly, if the two unsold units were now unlikely to be sold at more than their cost of 5 each (say, because of damage or a fall in demand) then they should be recorded on the balance sheet at their net realizable value (i.e. the likely eventual sales price less any expenses incurred to make them saleable, e.g. paint) rather than cost. This shows the application of the prudence concept. (See below). In this example, the concepts of going concern and matching are linked. Because the business is assumed to be a going concern it is possible to carry forward the cost of the unsold units as a charge against profits of the next period. Essentially, the accruals concept states that, in computing profit, revenue earned must be matched against the expenditure incurred in earning it. iii) The Prudence Concept: The prudence concept states that where alternative procedures, or alternative valuations, are possible, the one selected should be the one that gives the most cautious presentation of the businesss financial position or results. Therefore, revenue and profits are not anticipated but are recognized by inclusion in the profit and loss account only when realized in the form of either cash or of other assets the ultimate cash realization of which can be assessed with reasonable certainty: provision is made for all liabilities (expenses and losses) whether the amount of these is known with certainty or is best estimate in the light of the information available. Assets and profits should not be overstated, but a balance must be achieved to prevent the material overstatement of liabilities or losses. The other aspect of the prudence concept is that where a loss is foreseen, it should be anticipated and taken into

account immediately. If a business purchases stock for 1,200 but because of a sudden slump in the market only 900 is likely to be realized when the stock is sold the prudence concept dictates that the stock should be valued at 900. It is not enough to wait until the stock is sold, and then recognize the 300 loss; it must be recognized as soon as it is foreseen. A profit can be considered to be a realized profit when it is in the form of: Cash Another asset that has a reasonably certain cash value. This includes amounts owing from debtors, provided that there is a reasonable certainty that the debtors will eventually pay up what they owe. A company begins trading on 1 January 20X2 and sells goods worth 100,000 during the year to 31 December. At 31 December there are debts outstanding of 15,000. Of these, the company is now doubtful whether 6,000 will ever be paid. The company should make a provision for doubtful debts of 6,000. Sales for 20x5 will be shown in the profit and loss account at their full value of 100,000, but the provision for doubtful debts would be a charge of 6,000. Because there is some uncertainty that the sales will be realized in the form of cash, the prudence concept dictates that the 6,000 should not be included in the profit for the year. iv) The consistency concept: The consistency concept states that in preparing accounts consistency should be observed in two respects. a) Similar items within a single set of accounts should be given similar accounting treatment. b) The same treatment should be applied from one period to another in accounting for similar items. This enables valid comparisons to be made from one period to the next. v) The entity concept: The concept is that accountants regard a business as a separate entity, distinct from its owners or managers. The concept applies whether the business is a limited company (and so recognized in law as a separate entity) or a sole proprietorship or partnership (in which case the business is not separately recognized by the law. vi) The money measurement concept: The money measurement concept states that accounts will only deal with those items

to which a monetary value can be attributed. For example, in the balance sheet of a business, monetary values can be attributed to such assets as machinery (e.g. the original cost of the machinery; or the amount it would cost to replace the machinery) and stocks of goods (e.g. the original cost of goods, or, theoretically, the price at which the goods are likely to be sold). The monetary measurement concept introduces limitations to the subject matter of accounts. A business may have intangible assets such as the flair of a good manager or the loyalty of its workforce. These may be important enough to give it a clear superiority over an otherwise identical business, but because they cannot be evaluated in monetary terms they do not appear anywhere in the accounts.   vii) The separate valuation principle: The separate valuation principle states that, in determining the amount to be attributed to an asset or liability in the balance sheet, each component item of the asset or liability must be determined separately. These separate valuations must then be aggregated to arrive at the balance sheet figure. For example, if a companys stock comprises 50 separate items, a valuation must (in theory) be arrived at for each item separately; the 50 figures must then be aggregated and the total is the stock figure which should appear in the balance sheet. viii) The materiality concept: An item is considered material if its omission or misstatement will affect the decision making process of the users. Materiality depends on the nature and size of the item. Only items material in amount or in their nature will affect the true and fair view given by a set of accounts. An error that is too trivial to affect anyones understanding of the accounts is referred to as immaterial. In preparing accounts it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive detail. Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb (for example to define material items as those with a value greater than 5% of the net profit disclosed by the accounts). But some items disclosed in accounts are regarded as particularly sensitive and even a very small misstatement of such an item would be regarded as a material

error. An example in the accounts of a limited company might be the amount of remuneration paid to directors of the company. The assessment of an item as material or immaterial may affect its treatment in the accounts. For example, the profit and loss account of a business will show the expenses incurred by he business grouped under suitable captions (heating and lighting expenses, rent and rates expenses etc); but in the case of very small expenses it may be appropriate to lump them together under a caption such as sundry expenses, because a more detailed breakdown would be inappropriate for such immaterial amounts. Example: a) If a balance sheet shows fixed assets of 2 million and stocks of 30,000 an error of 20,000 in the depreciation calculations might not be regarded as material, whereas an error of 20,000 in the stock valuation probably would be. In other words, the total of which the erroneous item forms part must be considered. b) If a business has a bank loan of 50,000 balance and a 55,000 balance on bank deposit account, it might well be regarded as a material misstatement if these two amounts were displayed on the balance sheet as cash at bank 5,000. In other words, incorrect presentation may amount to material misstatement even if there is no monetary error. ix) The historical cost convention: A basic principle of accounting (some writers include it in the list of fundamental accounting concepts) is that resources are normally stated in accounts at historical cost, i.e. at the amount that the business paid to acquire them. An important advantage of this procedure is that the objectivity of accounts is maximized: there is usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an expense. Historical cost means transactions are recorded at the cost when they occurred. In general, accountants prefer to deal with costs, rather than with values. This is because valuations tend to be subjective and to vary according to what the valuation is for. For example, s uppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a balance sheet and has decided what monetary amount to attribute to the asset. x) Objectivity (neutrality):An accountant must show objectivity in his work. This means he should try to strip

his answers of any personal opinion or prejudice and should be as precise and as detailed as the situation warrants. The result of this should be that any number of accountants will give the same answer independently of each other. Objectivity means that accountants must be free from bias. They must adopt a neutral stance when analysing accounting data. In practice objectivity is difficult. Two accountants faced with the same accounting data may come to different conclusions as to the correct treatment. It was to combat subjectivity that accounting standards were developed. xi) The realization concept: Realization: Revenue and profits are recognized when realized. The concept states that revenue and profits are not anticipated but are recognized by inclusion in the income statement only when realized in the form of either cash or of other assets the ultimate cash realization of which can be assessed with reasonable certainty. xii) Duality: Every transaction has two-fold effect in the accounts and is the basis of double entry bookkeeping. xiii) Substance over form: The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form e.g. a non current asset on Hire purchase although is not legally owned by the enterprise until it is fully paid for, it is reflected in the accounts as an asset and depreciation provided for in the normal accounting way. Example 3.1 It is generally agreed that sales revenue should only be realized and so recognized in the trading, profit and loss account when: a) The sale transaction is for a specific quantity of goods at a known price, so that the sales value of the transaction is known for certain. b) The sale transaction has been completed, or else it is certain that it will be completed (e.g. in the case of long-term contract work, when the job is well under way but not yet completed by the end of an accounting period). c) The critical event in the sale transaction has occurred. The critical event is the event after which: i) It becomes virtually certain that cash will eventually be received from the customer. ii) Cash is actually received. Usually, revenue is recognized

(a) When a cash sale is made. (b) The customer promises to pay on or before a specified future date, and the debt is legally enforceable. The prudence concept is applied here in the sense that revenue should not be anticipated, and included in the trading, profit and loss account, before it is reasonably certain to happen. Required Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might be recognized at the following stages of a sale. (a) Goods have been acquired by the business, which it confidently expects to resell very quickly. (b) A customer places a firm order for goods. (c) Goods are delivered to the customer. (d) The customer is invoiced for goods. (e) The customer pays for the goods. (f) The customers cheque in payment for the goods has been cleared by the bank. Answer (a) A sale must never be recognized before a customer has even ordered the goods. There is no certainty about the value of the sale, nor when it will take place, even if it is virtually certain that goods will be sold. (b) A sale must never be recognized when the customer places an order. Even though the order will be for a specific quantity of goods at a specific price, it is not yet certain that the sale transaction will go through. The customer may cancel an order, the supplier might be unable to deliver the goods as ordered or it may be decided that the customer is not a good credit risk. (c) A sale will be recognized when delivery of the goods is made only when: i) The sale is for cash, and so the cash is received at the same time. ii) The sale is on credit and the customer accepts delivery (e.g. by signing a delivery note). (d) The critical event for a credit sale is usually the dispatch of an invoice to the customer. There is then a legally enforceable debt payable on specified terms, for a completed sale transaction.

(e) The critical event for a cash sale is when delivery takes place and when cash is received, both take place at the same time. It would be too cautious or prudent to await cash payment for a credit sale transaction before recognizing the sale, unless the customer is a high credit risk and there is a serious doubt about his ability or intention to pay. (f) It would again be over-cautious to wait for clearance of the customers cheques before recognizing sales revenue. Such a precaution would only be justified in cases where there is a very high risk of the bank refusing to honour the cheque.   II) Bases Bases are the methods that have been developed for expressing or applying fundamental accounting concepts to financial transactions and items. Examples include:  Depreciation of Non current Assets (e.g. by straight line or reducing balance method)  Treatment and amortization of intangible assets (patents and trade marks)  Stocks and work in progress (FIFO, LIFO and AVCO) III) Policies Accounting policies are the specific accounting bases judged by business enterprises to be the most appropriate to their circumstances and adopted by them for the purpose of preparing their financial accounts. Qualities of Useful Financial Information The four principal qualities of useful financial information are understandability, relevance, reliability and comparability. Understandability: an essential quality of the information provided in the financial statements is that it is readily understandable by users. For these reason users are assumed to have a reasonable knowledge of business and economic activities and accounting. Relevance: information has the quality of being relevant when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming or correcting their past evaluations. The relevance of information is affected by its nature and materiality. Reliability: information is useful when it is free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent or

could reasonably be expected to represent. To be reliable then the information should: a) Be represented faithfully, b) Be accounted for and presented in accordance with their substance and economic reality and not merely their legal form, c) Be neutral i.e. free from bias, d) Include some degree of caution especially where uncertainties surround some events and transactions (prudence), e) Be complete i.e. must be within the bounds of materiality and cost. An omission can cause information to be false. Comparability: users must be able to compare the financial statements of an enterprise through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different accounting policies, changes in the various policies and the effect of these changes in the accounts. Compliance with accounting standards also helps achieve this comparability. The Accounting Profession in Kenya The Accountants Act Cap 531 (1977) establishes the Institute of Certified Public Accountants of Kenya (ICPAK) and two boards, to be known as the Registration of Kenya Accountants Board (RAB) and Kenya Accountants and Secretaries National Examinations Board (IASNEB)

Accounting Concepts and Conventions: An update to include FRS 18 and the IASB Framework Introduction I wrote the original version of this page several years ago, when Statement of Accounting Practice 2: Accounting Principles (SSAP 2) was in force. The idea behind that page was to introduce students and other interested parties to the basic underlying ideas behind the work of the accountant. After all, even students of accounting and business are not always clear about the role and work of the accountant, let alone Joe Public. In addition to that original page, I recently added pages that concerned the objectives of accounting and some of the basic rules underlying the UK requirements for the publication of accounting statements. Finally, my original Accounting Concepts and Conventions page was posted by AccountingWEB on their site on 17 January 2002 and it gave rise to a couple of comments: principally to the effect that I'd mentioned SSAP2 but neither Financial Reporting Standard 18 (FRS 18) nor the UK Accounting Standard Board's Statement of Principles for Financial Reporting. This page brings my original page up to date and it cross references my other pages in this area. Furthermore, it adds a few comparisons with the IASB's Framework. What www.duncanwil.co.uk Said Before My introduction to my accounting concepts and conventions page included this: In the United Kingdom, four of the following accounting concepts are laid down in SSAP 2 that still remains true: they were introduced by SSAP 2! Those four concepts are: 1. 2. 3. 4. Going concern Accruals/matching Consistency Prudence In addition to those four, I had added: 5. Objectivity 6. Duality 7. Entity 8. Cost 9. Monetary measurement 10. Materiality 11. Realization

12. Stable money I felt, and still feel, that these twelve elements provide a good grounding for the starting point of the accountant's work. SSAP 2 came into effect for accounting periods starting on or after 1 January 1972 and is superseded by FRS 18 for accounting periods ending on or after 22 June 2001. Around the time that I prepared the concepts and conventions page, I prepared and posted a Conflicts in Accounting Concepts page that will probably also be of interest to readers of this page. Financial Reporting Standard 18: Accounting Policies FRS 18 has addressed additional aspects that accountants need to reflect on as they present their work to the world. FRS 18 addresses four more policies: 1. 2. 3. 4. Relevance Reliability Comparability Understandability

Whilst the ASB does include mention of timeliness in the context of FRS 18, I feel it ought to have been highlighted as a distinct policy: after all, there have been cases without number of accounting statements having had their publication delayed when to publish would have been both most appropriate and revealing (see below). FRS 18 also discusses the entity concept and their ideas are highlighted here since they do possibly modify our view of the entity concept. Has FRS 18 Really Introduced any new Accounting Concepts? Anyone who has studied the presentation of information and data will already have come across the terms relevance, reliability, comparability, understandability and timeliness: they are at least parts of the foundations of the effective presentation of data: whether it is accounting data, statistical data, demographic data or whatever. From the data presentation standpoint, therefore, FRS 18 is a side step rather than a forward step. ASB Guidance on the Choice of Policies The ASB has a get out clause for accountants who, let me be cynical, may not like these new ideas. In their summary of the requirements of FRS 18, the ASB says: the FRS requires an entity to select whichever of those accounting policies is judged to be most appropriate to its particular circumstances for the purpose of giving a true and fair view.

The constraints that an entity should take into account are the need to balance the different objectives, and the need to balance the cost of providing information with the likely benefit of such information to users of the entity's financial statements. The ASB goes on to summarise further: An entity's accounting policies should be reviewed regularly to ensure they remain the most appropriate to its particular circumstances. An entity should implement a new accounting policy if it is judged more appropriate to the entity's particular circumstances than the present accounting policy. The FRS requires specific disclosures about the accounting policies followed and changes to those policies. It also requires, in some circumstances, disclosures about the estimation techniques used in applying those policies.
Source: http://www.asb.org.uk/publications/publication310.html

At the time of writing, I do not know of any company that has fallen foul of this aspect of FRS 18; but would simply make the cheap point that Enron and Maxwell Communications could both have cited such an approach to the choice and application of the accounting policies it chose to follow in their defence of their dreadful behaviour. The counter argument is one that I actually subscribe to: horses for courses. My current major areas of work bring me into contact with standard Charts of Account that I have precious little time for: entire countries tied to a very restricted Chart that makes no allowance for the obvious differences between companies that operate as manufacturers and companies that operate as a service provider and companies that operate in yet another aspect of business or commerce. Consequently, the burden must fall on the Auditor and the various Management Committees to enforce FRS 18 and the choice and application of accounting policies. The True and Fair View: another get out clause? In line with just about anybody who writes about the meaning of the statement true and fair view, the ASB reveals: The Statement does not, however, attempt to define the meaning of true and fair.
Source: An Introduction to the Statement of Principles for Financial Reporting.

Another get out clause? I have always found it incredible that whilst the phrase true and fair view was introduced into the UK accounting world just about two decades ago, accounting standard setters have almost always backed away from defining what it means yet accountants have to apply it! Having established the phrases True and Fair View; and I admit it is a difficult one to define in such as way that ALL accountants would be satisfied, at least the IASB has a crack: what is generally understood as a true and fair view of information
Source: The IASB Framework, as quoted in IAS Explained page 88

Statement of Principles for Financial Reporting In the same way that the International Accounting Standards Board (as it now is) has promulgated its Framework for the Preparation and Presentation of Financial Statements, in December 1999 the ASB has published a Statement of Principles for Financial Reporting. The Statement of Principles is An accounting standard-setter's conceptual framework or statement of principles describes the accounting model that it uses as the conceptual underpinning for its work ... The Statement is not, therefore, an accounting standard nor does it contain any requirements on how financial statements are to be prepared it is only one of the factors that the ASB takes into account when setting standards. Other factors include legal requirements, cost benefit considerations, industry specific issues, the desirability of evolutionary change and implementation issues.
Source: An Introduction to the Statement of Principles for Financial Reporting.

The ASB recognizes that the Statement is a work in progress and is, therefore, subject to change. Moreover, they also admit that the Statement drew heavily on the IASB's Framework for the Preparation and Presentation of Financial Statements; and is similar in content to similar documents that standard setters in Australia, Canada, New Zealand and the USA have prepared and published. The Statement's Main Points The objectives of financial statements My page on this subject is comprehensive: take a look and compare it with what the ASB has to say, in summary: Stewardship Decision making Present and potential investors Financial statements provide a frame of reference against which users can evaluate the more specific information they obtain from other sources. The reporting entity As I said above, the ASB has reworked the entity concept to the extent that they now define single entities and consolidated entities: Single entity financial statements report on the activities and resources under the entity's control the company is the reporting entity. Consolidated financial statements report on the activities and resources under the entity's direct and indirect control the group comprising the parent and its subsidiaries is the reporting entity.
Source: An Introduction to the Statement of Principles for Financial Reporting.

To be frank, I don't really see this as a rework of the entity concept: the traditional entity concept forces us to think in terms of the divorce of personal from business affairs. I don't see the reporting entity idea as contributing to any enhancement of the traditional entity concept: given the way it is presented, it probably never intended to be; but the use of the word entity may confuse or confound! Relevant, reliable, comparable, understandable Let me quote in full from the Introduction Relevant - in other words, if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions Reliable - in other words, if: It can be depended upon to represent faithfully what it either purports to represent or could reasonably be expected to represent, and therefore, reflects the substance of the transaction and other events that have taken place; It is complete and is free from deliberate or systematic bias and material error; and In its preparation under conditions of uncertainty, a degree of caution has been applied in exercising the necessary judgements. Comparable - in other words, if it enables users to discern and evaluate similarities in, and differences between, the nature and effects of transactions and other events over time and across different reporting entities. Understandable - in other words, if its significance can be perceived by users that have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided.
Source: An Introduction to the Statement of Principles for Financial Reporting.

Under the heading of relevance we see the reference to timeliness in the definition of relevant: I think this definition clearly demonstrates why timeliness ought to be included as a separate policy. Any information that is relevant but that is provided late, can lose some or all of its relevance there's nothing more useless than yesterday's news. Timeliness is much more of an imperative than the ASB is allowing for. The IASB Framework has this to day about timeliness: If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. To provide information on a timely basis it may often be necessary to report before all aspects of a transaction or other event are known, thus impairing reliability. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little use to users who have had to make decisions in the interim.
Source: The IASB Framework, as quoted in IAS Explained page 87

At least the IASB has said something useful for the accountant to consider! The IASB also introduce the idea of substance over form in their discussion of relevance (see The IASB Framework, as quoted in IAS Explained page 86. Again, a concept that was

introduced into the UK accounting bear pit a short time ago; but which the ASB has not addressed: not on the parts of the web site that I have seen and not in its Introduction document. I think the definition of understandable leaves a lot to be desired, too: in order to comply with this policy, we need a: reasonable knowledge of business activity reasonable knowledge of economic activity reasonable knowledge of accounting willingness to study with reasonable diligence the information provided

Plenty of scope for fudge here apart from that, it's a breeze! The Introduction later says, in apparent contradiction to what I have just shown: In presenting information in financial statements, the objective is to communicate clearly and effectively. Financial statements should be simple, straightforward and grief as possible while retaining their relevance and reliability. Good presentation avoids adding a mass of material and unnecessarily lengthening the statements.
Source: An Introduction to the Statement of Principles for Financial Reporting.

The ASB does appreciate that financial statements will be subjected to interpretation, simplification, abstraction and aggregation but that if this is done properly, they will still be of benefit. The Introduction usefully brings the materiality concept into the discussion. Money measurement is discussed at length and recognition/realization is well discussed too, although the ASB seems to have invented the word derecognised when they ought to have used extinguish or disposal; and later on they invented the word remeasurement when they were discussing revaluation. Elements of financial statements The Introduction clarifies what a financial statement should contain: Assets - rights or other access to future economic benefits controlled by an entity as a result of past transactions or events Liabilities - obligations to transfer economic benefits as a result of past transactions or events Ownership interest - the residual amount found by deducting all of the entity's liabilities from all of the entity's assets Gains - increases in ownership interest not resulting from transfers from owners in their capacity as owners Losses - decreases in ownership interest not resulting from transfers to owners in their capacity as owners
Source: An Introduction to the Statement of Principles for Financial Reporting.

Measurement in financial statements The Introduction discusses to measurement regimes for financial statements:

 Historical cost Current value The Introduction also discusses arm's length transactions as being the basis of the acquisition, disposal and measurement in financial statements. As a matter of interest, my page on Transfer Pricing discusses arm's length transactions, albeit in the context of transfer pricing rather than measurement in financial statements. IASB's Fundamentals discusses four measurement bases in their discussion of measurement of the elements of financial statements. In addition to Historical cost Current value They have Realizable (settlement) value Present value Whether UK company law, taxation law and accounting standards accept these latter two options or not, and the ASB itself says that elements of the Statement may contradict current UK legislation, the Introduction could at least have discussed such alternatives; and maybe more. Accounting for interests in other entities Finally, the Introduction discusses the importance that the impact of reporting for other entities can have on the reporting entity's own financial statements. Key words here are: Control Joint control Significant influence Lesser or no influence Acquisition Merger

Conclusions The subject of accounting concepts and conventions is an important one: after all, such concepts really are at the heart of the work of the accountant. At the time of writing the Executives of Enron Inc are receiving subpoenas to appear before Congress in the USA: they and their Auditors, Arthur Andersen, seem to have fallen foul of accounting concepts and conventions if nothing else. The concepts and conventions discussed here and in my other pages are the starting point for anyone who wants to become an accountant or bookkeeper.

The ASB's contribution to this debate in the form of FRS 18 and their Statement of Principles for Financial Reporting falls far short of a definitive contribution to the debate. FRS 18 brings about a debate on the basic principles of the presentation of data and information; but not a great deal about the concepts and conventions that we might expect. The Statement adds elements to the debate in this area; but the IASB Framework is more comprehensive in several areas; and the nature and tone of the Introduction to the Statement makes it difficult to take seriously. I am pleased to have taken the opportunity to update my concepts and conventions pages and would recommend that anyone who has read so far, makes sure that they read all of my other pages in and around this area.

BB0006-Unit-02-Accounting Concepts, Conventions and Principles

Unit-02-Accounting Concepts, Conventions and Principles Structure: 2.1 Accounting Concepts 2.2 Accounting Conventions 2.3 Accounting Principles 2.3.1 Characteristics of Accounting Principles 2.4 Meaning of GAAP 2.4.1 Good Reasons to Use GAAP 2.5 Economic Value Added (EVA) 2.6 Value Added Concept 2.7 Key Terms 2.8 Self Test Learning Objectives: After studying this unit one will be able to understand Accounting Concepts Accounting Conventions Accounting Principles Meaning of GAAP Economic Value Added (EVA) Value Added Concept 2.1 Accounting Concepts

Accounting concepts are also self-evident statements or truths. Accounting concepts are so basic that people accept them as valid without any questioning. Accounting concepts provide the conceptual guidelines for application in the financial accounting process, i.e. for recording, measurement, analysis and communication of information about an organization. These concepts provide help in resolving future accounting issues on a permanent or a longer basis, rather than trying to deal with each issue on an ad hoc basis. The concepts are important because they (a) help to explain the why of accounting (b) provide guidance when new accounting situations are encountered, and (c) significantly reduce the need to memorize accounting procedures when learning about accounting. Some of the important accounting concepts are: Money Measurement Concept: Each transaction and event must be expressible in monetary terms. If an event cannot be expressed in monetary terms, it cannot be considered for accounting purposes. Money is the only practical unit of measurement that can be employed to achieve homogeneity of financial data. Therefore accounting records only those transactions, which can be expressed in terms of money. Money is the common unit, which enables various items of diverse nature to be summed up together and dealt with. Thus it restricts the scope of accounting. However, this concept has certain shortcomings for example, the legal currency does not provide a stable measurement basis. It does not take care of the effects of inflation because it assumes a stability of the money measurement unit and also, certain important resources cannot be measured in monetary terms, like human resources. It does not give a complete account of the events in a business unit Business Entity Concept: This concept implies that a business unit is separate and distinct from the person who owns or controls it. A business is an artificial entity distinct from its proprietor(s). It is an economic unit, which owns its assets and has its own obligations. This enables the business to segregate the transactions of the company from the private transactions of the proprietor(s). The owner(s) may have personal bank accounts, real estate, and other assets, but these will not be considered as assets of the business. Business is kept separate from the proprietor as that transaction of the business may be recorded with him. Going Concern Concept: According to this concept, it is assumed that the business will exist for a long time and transactions are recorded on this basis. This notion implies that existing resources will be used to fulfill the general purposes of a continuing entity rather than sold. It also implies that existing liabilities will be paid at maturity in an orderly manner. This concept forms the basis for the distinction between expenditure that will yield benefit over a long period of time and expenditure whose benefit will be exhausted in the short-term. Going concern concept is not valid in the following cases

 When an enterprise was set up for a particular purpose. When the Government declares a company sick. When the company has been in the grip of severe financial crisis and is expected to wind up shortly. When a receiver or liquidator has been appointed to wind up the company. Cost Concept: This concept is closely related to the going concern concept. Assets are always recorded at acquisition cost or historical cost and that cost becomes the basis for all future accounting for the asset. The cost concept brings objectivity in the accounts. In spite of inflation, accounting based on cost concept still serves as a fair and adequate basis for reporting business performance. But it may create secret reserves, when the cost is written off, but the asset is still in good condition or where assets earn some income but not recorded in the books. The transactions are recorded at the amounts actually involved. For instance, a piece of land may have been purchased at Rs.1, 50,000, whereas the company considers it to be worth Rs.3, 00,000. The land is recorded in the books of accounts at Rs.1,50,000 only. Thus, an arbitrary valuation of the companys asset is avoided by recording the value at the actual amount involved. Since both the parties involved in the transaction would have mutually agreed upon this amount, it is an objective valuation. Accounting Equivalence Concept or Dual Aspect Concept or Accounting Equation Concept: It is the heart of whole accounting process. It is an expression of entity concept because it shows that the business itself owns the assets and in turn owns the various claimants. This is technically stated as for every debit, there is a credit. Business firms raise funds in any of the following ways Additional capital (increase in owners equity) Earning revenue (increase in owners equity) Profits (increase in owners equity) Additional loans (increases outside liability) Disposing of assets (reduces assets) An increase in liabilities (including owners equity) and reduction in assets represent sources of funds. These funds can be put to any of the following uses Purchasing of assets (increase in assets) Cash balances (increase in assets)

 Operational expenses (decrease in owners equity) Clearing liabilities due (decrease in liabilities) Losses (decrease in owners equity) All increases in assets and decreases in liabilities (including owners equity) represent the uses of funds. The sum of the sources of funds equals the sum of the uses of funds. Thus, the dual aspect of accounting means that Owners Equity + Outside Liability = Assets. This can be expressed in two other ways. They are Assets Liabilities = Capital Assets Capital = Liabilities Every financial transaction involves a two-fold aspect yielding the benefit and giving off that benefit. This forms the basis of whole superstructure of double entry system. Accounting Period Concept: Business firms prepare their income statements for a particular period. This period, known as the accounting period, is usually the calendar year (January 1 to December 31) or the financial year (April 1 to March 31). The measurement of income or loss of a business entity is relatively simple on a whole life basis, but impossible until it is liquidated. Owners, investors and the Government are all impatient to know the results of business operations. Some firms, like trading firms have shorter periods such as a month or less, while others may have longer terms. The Companies Act, 1956 has set a maximum limit of 15 months for the accounting period. Normally accounting period adopted is one year as it helps to take any corrective action, to pay income tax, to absorb seasonal fluctuations and for reporting to the outsiders. Matching Concept: It is based on the accounting period concept. Matching concept suggests that to find out the profitability, the expenses incurred to generate revenue are to be matched against that revenue. The determination of profit of a particular accounting period is essentially a process of matching the revenue recognized during the period and the cost to be allocated to the period to obtain the revenue. Revenue earned in an accounting year is offset (matched) with all the expenses incurred during the same period to generate that revenue, thus providing a measure of the overall profitability of the economic activity. Costs are reported as expenses. But some of the expenses are not readily identifiable with a particular period like preliminary expenses, advertisement expenses, exact amount of depreciation, etc. because they cannot be traced to particular goods or services. Realization Concept:

Revenues should be recognized only when they are realized, while expenses should be recognized as soon as they are reasonably possible. The realization concept tells that to recognize revenue it has to be realized. A transaction is recorded only on receipt of cash or a legal obligation to pay. Until then, no income or profit can be said to have arisen. For instance, suppose a firm sells 100 units of a product on credit for Rs.10, 000. Until the payment is received, it will not be recorded in the accounting books. However, if the firm receives information that the customer has lost his assets and is likely to default the payment, the possible loss is immediately provided for in the firms books. Realization principle does not demand that the revenue has to be received in cash. Revenue from sales transactions should be recognized when the seller of goods has transferred to the buyer the property in the goods for a price and no uncertainty exists regarding the consideration that will be derived from the sale of goods. Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognized when no uncertainly exists as to its measurability and collectability. Accrual Concept: Non-cash resources and obligations change in time periods other than those in which money is received or paid. Recording these changes are necessary to determine periodic income and to measure financial position. It suggests that incomes and expenses should be recognized as and when they are earned and incurred, irrespective of whether the money is received or paid in connection thereof. This concept is used by all businesses that disclose their financial statements to various interested parties. In fact, the Companies Act, 1956 provides that accrual concept has to be maintained for practically all accounting purposes. The alternative to the accrual basis of accounting is called cash basis of accounting. The law in India provides that in cases where accrual concept cannot be followed under any circumstances, cash basis may be followed. Examples of accrual concept : (i) Rent paid for fifteen months in advance on 1st January 2004. The business follows calendar year as the accounting year. In this case rent for only the first twelve months should be recognized as expenses for the year 2004. (ii) Credit sales for the year were 2004 Rs. 2,00,000. Cash collected from customer during 2004 was Rs. 1,50,000. In this case credit sales for 2004 should be considered as Rs. 2,00,000 and not Rs. 1,50,000. This concept has given sound accounting principle in respect of recognition of revenues and expenses. It implies that revenues accrue in that year in which they are earned, and not in the year in which they are actually received, and expenses accrue in the year in, which they are incurred and not in the year in which they are actually paid. Legal Aspect Concept:

This concept implies that the accounting records and books should reflect the legal position and the accounting records statements should conform to legal requirements. The accounting records should be kept and the statements should be prepared in the manner provided by law. 2.2 Accounting Conventions The term convention denotes circumstances or traditions, which guide the accountants while preparing the financial statements. Concepts and conventions are often used interchangeably. The basic difference between them is that concepts are concerned with maintenance of accounts whereas conventions are applicable while preparing financial statements. Accounting conventions refers to customs, traditions, usages or practices followed by accountants as a guide in the preparation of financial statements. The important accounting conventions are Convention of Materiality: An important convention, as we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the "materiality". convention suggests that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. Whether information should be disclosed or not in the financial statements will depend on whether it is material or not. Materiality depends on the amount involved in the transaction. A financial statement is not material if there is omission or misstatement, which will mislead the user. Here it is necessary to note that the convention of materiality is comparative, because what is material for a small concern may not be material for a big concern. Convention of Conservatism: It is a policy of caution or playing safe and had its origin as a safeguard against possible losses in a world of uncertainty. The working rule is that anticipates no profits but provide for all possible losses. Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or incomes are not overstated and liabilities or expenses are not understated. Expected losses should be accounted for but not anticipated gains. The significance of this convention is that financial statements should indicate the actual position. It should neither show a rosy or better picture by window dressing nor a worse picture by creating secret reserves. Convention of Consistency: Accounting rules, practices and conventions should be continuously observed and applied. Transactions and valuation methods are treated the same way from year to year, or period to

period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. When accounting policies are changed companies are required to disclose this fact and explain the impact of any change, otherwise they are not comparable. Consistency also implies External Consistency The financial statements of one enterprise should be comparable with another. Vertical Consistency The same accounting rules, policies, practices and conventions are adopted while preparing interrelated statements of the same date. Horizontal Consistency The same accounting rules, policies, practices and conventions are adapted from year to year. Third Dimensional Consistency All units in the same industry follow the same accounting policies, methods and practices. It should be noted that the convention of consistency does not mean that the accounting treatment of various categories of assets should be consistent with one another. Moreover it does not mean that the accounting practices and methods, once adopted should not be changed. The accounting practices and methods can be changed when needed but the same thing should be clearly disclosed and adequately explained. Convention of Full Disclosure: All accounting statements should be honestly prepared and full disclosure of all significant information should be made. The idea behind this convention is that financial statements are essentially meant for external users and on the basis of that the external users makes decisions. So the financial statements should disclose as much as details as possible. All information, which is of material interest to owners, creditors and investors, should be disclosed in accounting statements to make them reliable and informative. As such now the statutes prescribe the form in which financial statements are to be prepared. 2.3 Accounting Principles Accounting is more an art than a science. It is based on a set of principles, on which there is general agreement, not rules that can be proved. Principle is referred to as rule of action or conduct and hence can be aptly applied to rules in accounting. AICPA defined the term principle as a guide to action, a settled ground, or basis of conduct or practice. Accounting principles are general decision rules derived from the accounting. Anthony and Reece comment: "Accounting principles are man-made. Unlike the principles of physics, chemistry and other natural sciences, accounting principles were not deducted from basic axioms, nor can they be verified by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not eternal truths."

2.3.1 Characteristics of Accounting Principles: Accounting principles are the results of experience, business practices and customs, ideas and beliefs of users of financial statements, government agencies, stock exchange authorities, etc. Accounting principles are man made, so they do not have the authoritativeness as universal principle. The science of accounting is in the process of evolution and hence accounting principles are fast developing. The general acceptance of an accounting principle usually depends on three criteria relevance, objectivity and feasibility. The conventions, concepts, rules and procedures that together make up accepted accounting practice at any given time are called Generally Accepted Accounting Principles (GAAP). Accounting principles become generally accepted by agreement, experience, custom, usage and practical necessity contribute to the set of principles. Therefore some call them conventions than principles. GAAPs play a vital role as they make financial accounting information more meaningful. But they are simply guides to action and may change over time. They are not immutable laws. Sometimes specific principles must be altered or new principles must be formulated in accordance with changes in business practices or economic circumstances. In India, organizations such as the Accounting Standards Board (ASB) set up in1977; Institute of Chartered Accountants of India, Department of Company Affairs, SEBI, ICWA, ICS, Stock Exchanges and the literature published are instrumental in the development of accounting principles. American GAAP is largely the work of Financial Accounting Standard Board (FASB) along with Securities and Exchange Board (SEC). International GAAP is set by the IASC (International Accounting Standards Committee set up in 1973) a group sponsored by the accounting bodies in more than 80 countries. 2.4 Meaning of GAAP It is a widely accepted set of rules, conventions, standards and procedures for reporting financial information, as established by the Financial Accounting Standards Board. GAAP is a combination of authoritative standards (set by policy boards) and the accepted ways of doing accounting. Every day, accountants make judgments about how to record business transactions. They often base their decisions on the financial objectives of the companies for which they work. Other times they turn to Generally Accepted Accounting Principles (GAAP) to steer their decisions.

GAAPs are not a fixed set of rules. They are guidelines or, more precisely, a group of objectives and conventions that have evolved over time to govern how financial statements are prepared and presented. The Financial Accounting Standards Board, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission provide guidance about acceptable accounting practices. 2.4.1 Good Reasons to Use GAPP: Every business that expects anyone outside the company to look at its financial data should use GAAP. Compliance with GAAP helps maintain creditability with creditors and stockholders because it reassures outsiders that a companys financial reports accurately portray its financial position. Plus, anyone who reads your financial statements stockholders, creditors, security analysts or outside companies will assume that the reports comply with GAAP. Certified public accountants routinely audit companies to determine if their financial statements are prepared according to GAAP. These audit findings are typically included with companies financial statements. Banks and finance companies often require their clients to use GAAP or have audited financial statements. And investors who are accustomed to using financial information prepared according to GAAP might balk if your statements dont meet their expectations. Structure of GAAPs: Accounting principles are alternatively referred to as accounting practices, standards, postulates, assumptions, concepts, axioms, conventions, etc. These terms are hardly distinguished by accounting experts. Therefore the structure of GAAPs may be stated as under:-

2.5 Economic Value Added (EVA) The technique of EVA has acquired acceptance as a tool for assessing the existing financial status and predicting the future performance of a company. It covers all aspects of a companys financial management for capital budgeting, acquisition, pricing to strategic planning and shareholders communication, besides identifying the value addition to shareholders by the organization during the specified period. Economic Value-Added is the after-tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. Representing real profit versus paper profit, EVA underlies shareholder value, increasingly the main target of leading companies strategies. Shareholders are the players who provide the firm with its capital, they to gain a return on that capital. The concept of EVA is well established in financial theory, but only recently has the term moved into the mainstream of corporate finance, as more and more firms adopt it as the base for business planning and performance monitoring. There is a growing evidence that EVA, not earnings, determines the value of a firm. Effective use of capital is the key to value; that message applies to business processes, too. EVA has the advantage of being conceptually simple and easy to explain to non-financial managers, since it starts with familiar operating profits and simply deducts a charge for the capital invested in the company as a whole, in a business unit, or even in a single plant, office or assembly line. By assessing a charge for using capital, EVA makes managers care about

managing assets as well as income, and helps them properly assess the tradeoffs between the two. This broader, more complete view of the economics of a business can make dramatic differences. 2.6 Value Added Concept Value added statement is prepared as an improved replacement of traditional profit and loss account. Value added is the change in market value resulting from an alteration in the form, location or availability of a product or service excluding the cost of bought in material and services. It is the difference between the sales revenue and the cost of bought in materials and services. It can also be defined as the wealth the organization has created by its own and its employees efforts. In other words, value added is pre-tax profit plus employees cost, interest and depreciation. The value so added is distributed among the creators of value i.e. employees, Government, creditors and shareholders. 2.7 Key Terms Accounting concept are: Money Measurement Concept Business Entity Concept Going Concern Concept Cost Concept Accounting Equation Concept Accounting Period Concept Matching Concept Realization Concept Accrual Concept Legal Aspect Concept Accounting Conventions: Convention of Materiality Convention of Conservatism Convention of Consistency

 Convention of Full Disclosure GAAP is a combination of authoritative standards (set by policy boards) and the accepted ways of doing accounting. Economic Value-Added is the after-tax cash flow generated by a business minus the cost of the capital it has deployed to generate that cash flow. 2.8 Self Test 1. What do you mean by accounting concepts ? Discuss the various concepts. 2. What are accounting conventions ? Discuss the various conventions. 3. What do you mean by GAAP ? 4. What are the good reasons to use GAAP ? 5. What is economic Value Added ? Discuss the economic value concept.