Chapter 1

Accounting concepts also known as accounting principles are a set of broad conventions that have been devised to
provide a basic framework for financial reporting. Since financial reporting involves significant professional judgments
by accountants, these concepts and principles ensure that the users of financial statements are not mislead 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
concepts and principles. In order to ensure compliance with the accounting concepts, major accounting standard-
setting bodies have incorporated them into their reporting frameworks such as the International Accounting Standard
Board framework.

Going concern concept

Going concern is one of the fundamental assumptions in accounting which forms the basis of preparing financial
statements. Financial statements are prepared assuming that a business entity will continue to operate in the
foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly
restrict its operational activities. It is the responsibility of the management of a company to determine whether the
going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption
is considered by the management to be invalid, the financial statements of the entity shall be prepared on a non-
going concern basis. This means that assets will be recognised at amount which is expected to be realised from their
sale (net of selling costs) rather than their net book value. Liabilities shall be stated at amounts that are likely to be
paid.

Matching or Accrual concept

Financial statements are prepared under the matching concept which requires revenues and cost to be recognised in
the financial statements of the accounting periods to which they relate rather than on a cash basis.

Under accruals basis of accounting, income must be recorded in the accounting period in which it is earned.
Therefore, accrued income must be recognised in the accounting period in which it arises rather than in the
subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the
accounting period in which it is received but instead it must be recognised in the subsequent accounting period during
which the services or obligations in respect of the prepaid income will be performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore,
accrued expense must be recognised in the accounting period in which it occurs rather than in the following period in
which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in
which it is paid but instead it must be charged to income statement in the next accounting period when they arise.

A major development from the application of matching principle is the use of depreciation in the accounting for non-
current assets. Depreciation results in a systematic charge of the cost of a non-current asset to the income statement
over several accounting periods spanning the asset's useful life during which it is expected to generate economic
benefits for the entity. Depreciation ensures that the cost of non-current assets is not charged to the income
statement at once but is 'matched' against economic benefits derived from the asset's use over several accounting
periods.

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Prudence concept or conservatism
Conservatism requires that profits should not be anticipated or overstated. However provision should be made for all
possible losses whether they are known with certainty or is a best estimate in the light of the information available.
Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies
and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies
and significant estimates such that the assets and income of the entity are not overstated whereas liability and
expenses are not understated.

The rationale behind prudence is that a company should not recognise an asset at a value that is higher than the
amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be
presented below the amount that is likely to be paid.

There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by
management whereas liabilities and expenses are more likely to be understated. The risk arises from the fact that
companies often benefit from better reported profitability and lower gearing in the form of higher share price and
cheaper source of finance. Hence the choice of accounting policies and use of estimates may result in bias in the
preparation of the financial statements aimed at improving profitability and financial position through the use of
creative accounting techniques. Prudence concept helps to ensure that such bias is countered by requiring the
exercise of caution in arriving at estimates and the adoption of accounting policies.

Writing off bad debts, valuation of inventory and recording of provision for doubtful debts and depreciation are
examples of the application of the prudence concept.

Consistency concept
Financial statements of one accounting period must be comparable to another in order for the users to derive
meaningful conclusions about the trends in an entity’s financial performance and position overtime. Comparability is
enhanced when there is consistency of accounting treatment for similar items within an accounting period and from
one period to another. For example if the reducing balance method of depreciation has been used to depreciate a
motor van then the same method should be used with all other vehicles and in the future periods as well.

IAS 8 (Change in Accounting Policy) allows an entity to change its accounting policy in order to improve the reliability
and relevance of financial statements and may also imposed it as a result of a change in an accounting standard or
enactment of a new standard.

Business entity concept or Accounting entity concept

Financial accounting is based on the principle that the transactions of a business are to be accounted for separately
from its owners. The business entity concept claims that the business is separate and distinct from its owners. It
requires the affairs of the business to be kept separate from the affairs of the owners. Only transactions relating to the
business must be recorded in the books of the business. Any private transaction of the owner not related at all to the
business must not be recorded. Hence any personal expense incurred by owners of a business will not appear in the
books of the business. However if the personal expense are paid out of business bank account then it will be treated
as drawings in the same way as cash drawings.

The business entity also explains why owners’ capital account has a credit balance in the same way as liabilities. For
instance capital contributed by a soletrader represents a form of liability to the business since it is money owing by
the business to the owner.

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Money measurement concept
Money measurement concept requires that only those transactions and assets which can be expressed in monetary
terms should be recognised in the accounts. Where it is not possible to assign a reliable monetary value to a
transaction or an asset, it should not be included in the financial statements. The following are examples of items that
would not be included in the accounts of a business as a result of the money measurement principle:
1. customers' satisfaction with his business
2. the benefits of staff training
3. the effect of new laws
4. the value of the skills of its managers
5. extra skills gained by the employees during training
6. better staff morale following redecoration of premises
7. improved public roads resulting in added value to the business property

Historical cost concept

The principle of accounting requires a transaction to be initially recorded at its historical cost, that is, the amount
involved at the time the transaction took place. For example a business has bought a vehicle for $10 000 in January
and omits to record it. After 3 month the omission is discovered and the transaction is being recorded, but at the time
of recording, the price of the vehicle is $13 000. Which amount should be used for recording the vehicle bought,
$10 000 or 13 000? The amount to be recorded is obviously $10 000, this being the actual amount of the transaction.

Dual aspect concept or Duality

The double entry system of accounting rest on the principle of duality whereby there must be two entries for each
transaction; one entry should be on the debit side and the second corresponding entry should be on the credit side.

Materiality concept
Information is material if its omission or misstatement could influence the economic decisions of users. Materiality
therefore relates to the significance of transactions, it defines the cut-off point after which financial information
becomes relevant and critical to the decision making needs of users. Materiality is relative to the size and specific
circumstances of a business. A direct consequence of this concept is that it allows identical items in different
businesses to be treated differently depending of their significance to each business. For example there are two
businesses A and B whereby A is a small soletrader whereas B is a very big company and each bought the same
type of equipment. Materiality allows the soletrader to treat it as a non-current asset whereas the company may treat
it as an expense. Another example could be that a business decides to record inventory of stationery as an asset only
if the value is over $100.

Consider the following example. A sole trader purchased the following items from an office supplier.
$
calculator 10
computer system 2000
document shredder 25
stapler 5

Applying the accounting principle of materiality, which would be recorded as revenue expenditure?

Answer
calculator, document shredder and stapler

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Realisation concept
This concept deals with the issue as to when should income considered as being realised. Generally revenue is said
to be realised when the ownership and the associated risks and reward are transferred to the buyer, the goods are
being delivered to the customer and the latter accepts the liability. (refer to IAS 18 chapter 14 for further details)

Substance over form

Substance over form requires that if the substance of a transaction differs from its legal form, then such transaction
should be accounted for in accordance to its commercial substance and financial reality. This means that a
transaction should be recorded according to the real intention in the mind of those undertaking the transaction
although it contradicts the content of the written agreement. The existence of this concept is mainly to deal with off
balance sheet finance. An example is where an item bought on hire purchase is recorded in the buyer’s book as a
non-current asset although the seller is the legal owner until the last installment is paid. The rationale behind this is
that information contained in the financial statements should represent the business essence of transactions not
merely their legal aspects in order to provide a true and fair view. Substance over form concept entails the use of
judgment on the part of preparers of financial statements in order for them to derive the business sense from the
transactions and to present them in a manner that best reflects their true essence.

Practice Questions
1 Donald is in business and it has a financial year ended 31 December 2007. He is unsure how to deal with the
following transactions in the accounts of the business.
1. On 1 December 2007, Donald started an agreement to rent additional premises. On this date he paid $7 200
by cheque to cover the rent for the period 1 December 2007 to 31 May 2008. He intends to charge all of this
payment to his income statement for the year ended 31 December 2007. An equal amount is charged for
rent each month.
2. During the year ended 31 December 2007, Donald’s general expense account showed that he paid $15 000.
This includes an amount of $2 500 for the family holiday which has been paid out of the business bank
account.
3. In December 2007, Donald was negotiating a sale of goods to the value of $10 000. He was fairly certain
that during January 2008, the client would sign the contract to purchase the goods. He planned to include
this amount in the sales figures for the year ending 31 December 2007.
4. Donald feels that his management team is an asset to the business and wants to include the team at a value
of $50 000 on the balance sheet of the business.

REQUIRED
a) Advise Donald how he should deal with each of the above transactions in his financial statements,
identifying and applying appropriate accounting concepts.
b) The following ledger accounting entries to record transactions (i) and (ii) above for the year ended 31
December 2007, showing (where appropriate) the transfers to the financial statements.
i) Rent.
ii) General expenses.

2 In each of the following, identify which accounting concept should be followed and briefly explain why it is applied.

1. The owner of a business has taken goods from inventory for his own personal use. The goods originally
cost $500.
2. A business has good industrial relations and wishes to record this in the accounts at a value of $20 000.

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 3. A business has bought two door mats costing $3 each. These are expected to last many years and have
been recorded under non-current assets.
4. Goods to the value of $1 500 were received in the final month of the financial year. The invoice for these
goods has not yet been received and no entry made in the accounts at the financial year end.

Multiple Choice Questions

1 There is great uncertainty about the continuance of a business. This has caused the proprietor to make a large
reduction in the valuation of the year-end inventory. Which accounting concept does this illustrate?
A going concern B matching C materiality D substance over form

2 The treasurer of a club has decided not to include subscriptions owing by members in the statement of financial
position at the year-end.
Which accounting concept is being applied?
A accruals B going concern C money measurement D prudence

3 Accountants prefer the commercial reality of a transaction to a strictly legal approach. This is an example of
A consistency. B materiality. C prudence. D substance over form

4 A sole trader pays private expenses from the business bank account and records them as drawings.
Which accounting principle is applied?
A business entity B going concern C matching D prudence

5 A business values obsolete inventory at net realisable value. Which accounting principle has been applied?
A consistency B going concern C materiality D prudence

6 A pocket calculator costs $9.50 and has a useful life of 5 years. The bookkeeper has decided to treat the purchase
of the calculator as revenue expenditure. Which accounting concept has been applied?
A accruals B materiality C prudence D substance over form

7 What does the ‘going concern’ principle mean?

A a business is profitable
B a business will continue to operate for the foreseeable future
C the assets of a business exceed its liabilities
D the assets of a business should be valued at disposal value

8 When a businessman introduces capital into his business, the transaction is debited in the Cash Book and credited
to his Capital account. Of which accounting principle is this an example?
A entity B going concern C matching D prudence

9 A company does not include the value of skills gained by its employees from training programmes in its financial
statements.
Which accounting principle is being applied?
A consistency B materiality C money measurement D substance over form

10 Of which concept is the writing off of a bad debt an example?

A going concern B matching C prudence D substance over form

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11 A company purchases machinery on hire purchase over four years but does not own the machinery until the final
payment has been made. At the end of year 1 the company shows the machinery in its statement of financial position
as a non current asset and also records the liability for the amount still owed. Which accounting principle is being
applied?
A consistency B materiality C prudence D substance over form

12 Businesses anticipate losses but not profits in preparing their annual accounts. Which accounting concept is being
applied here?
A accruals B consistency C going concern D prudence

13 What is an example of the application of the concept of accounting for substance over form?
A accounting for inventory losses
B recording an asset acquired under a hire purchase agreement as a non current asset
C recording the premium on the issue of ordinary shares in a share premium account
D writing off a debt from a customer in liquidation

14 A business sells its freehold property to a bank and agrees to repurchase them in five years’ time. The business
continues to use the property on lease from the bank. The property remain in the statement of financial position of the
business. What is the reason for this accounting treatment?
A the asset must be treated in the same way from year to year
B the commercial reality of the transaction is that the business still owns the asset
C the cost of the asset must be matched with the periods expected to benefit from its use
D the income from the sales proceeds must not be anticipated

15 A company excludes from its statement of financial position machinery for which spare parts are no longer
obtainable.
Which concept is being applied by the company?
A going concern B materiality C prudence D substance over form

16 Which accounting policies illustrate the matching principle?

1 charging depreciation on non-current assets
2 revaluing non-current assets on a regular basis
3 using the reducing balance method of depreciation
A 1, 2 and 3 B 1 and 2 only C 1 and 3 only D 2 and 3 only

17 An item of inventory originally cost $5 000, but has deteriorated badly and is written down to its estimated net
realisable value of $2 000. Which accounting principle has been applied?
A consistency B materiality C prudence D substance over form

18 A company changes from the straight-line method of depreciation to the reducing balance method.
Which accounting principle has not been applied?
A consistency B going concern C historic cost D materiality

19 What should a company prepare to forecast its state as a going concern at the end of next year?
A cash budget C forecast statement of financial position
B cash flow statement D forecast income statement