Lecture 7

Ministry Of Labour & Employment

Employees’ Provident Fund Organisation

ENFORCEMENT OFFICER/
ACCOUNTS OFFICER

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 Accounting Principles
1.Accounting conventions
2.Accounting concepts
1. Accrual concept An accrual is a journal entry that is used to
recognize revenues and expenses that have been earned or consumed,
respectively, and for which the related cash amounts have not yet been
received or paid out.
• Accruals are needed to ensure that all revenues and expenses are recognized
within the correct reporting period, irrespective of the timing of the related cash
flows.
• Without accruals, the amount of revenue, expense, and profit or loss in a period
will not necessarily reflect the actual level of economic activity within a business.
• Accruals are a key part of the closing process used to create financial
statements under the accrual basis of accounting; without accruals, financial
statements are considerably less accurate.
• Under the double-entry bookkeeping system, an accrued expense is offset
by a liability, which appears in a line item in the balance sheet. If accrued
revenue is recorded, it is offset by an asset, such as unbilled service fees,
which also appears as a line item in the balance sheet.
• It is most efficient to initially record most accruals as reversing entries. By
doing so, the accounting software in which they are entered will
automatically cancel them in the following reporting period.
• This is a useful feature when you are expecting to issue an invoice to a
customer or receive an invoice from a supplier in the following period. For
example, it is likely that a supplier invoice for $20,000 will arrive a few days
after the end of a month, but the controller wants to close the books as
soon as possible.
• Accordingly, he records a $20,000 reversing entry to recognize the expense
in the current month. In the next month, the entry reverses, creating a
negative $20,000 expense that is offset by the arrival and recordation of
the supplier invoice.
Accrual Examples
Examples of accruals that a business might record are:
• Expense accrual for interest. A local lender issues a loan to a business, and
sends the borrower an invoice each month, detailing the amount
of interest owed. The borrower can record the interest expense in advance
of invoice receipt by recording accrued interest.
• Expense accrual for wages. An employer pays its employees once a month
for the hours they have worked through the 26th day of the month. The
employer can accrue all additional wages earned from the 27th through
the last day of the month, to ensure that the full amount of the wage
expense is recognized.
• Expense accrual for supplier goods and services. A supplier delivers goods
at the end of the month, but is remiss in sending the related invoice. The
company accrues the estimated amount of the expense in the current
month, in advance of invoice receipt.
• Sales accrual. A services business has a number of employees working on a
major project for the federal government, which it will bill when the
project has been completed. In the meantime, the company can accrue
revenue for the amount of work completed to date, even though it has not
yet been billed.
 Other Accrual Issues
• If a business records its transactions under the cash basis of
accounting, then it does not use accruals. Instead, it records
transactions only when it either pays out or receives cash.
• The cash basis yields financial statements that are noticeably
different from those created under the accrual basis, since
timing delays in the flow of cash can alter reported results. For
example, a company could avoid recognizing expenses simply
by delaying its payments to suppliers.
• Alternatively, a business could pay bills early in order to
recognize expenses sooner, thereby reducing its short-
term income tax liability.
2. The conservatism principle is the general
concept of recognizing expenses and liabilities as soon as possible when
there is uncertainty about the outcome, but to only recognize revenues
and assets when they are assured of being received.
• Thus, when given a choice between several outcomes where the
probabilities of occurrence are equally likely, you should recognize that
transaction resulting in the lower amount of profit, or at least the
deferral of a profit.
• Similarly, if a choice of outcomes with similar probabilities of
occurrence will impact the value of an asset, recognize the transaction
resulting in a lower recorded asset valuation.
The conservatism principle is also known as the conservatism concept or the prudence
concept.
• Under the conservatism principle, if there is uncertainty
about incurring a loss, you should tend toward recording the
loss. Conversely, if there is uncertainty about recording a gain,
you should not record the gain.
• The conservatism principle can also be applied to recognizing
estimates. For example, if the collections staff believes that a
cluster of receivables will have a 2% bad debt percentage
because of historical trend lines, but the sales staff is leaning
towards a higher 5% figure because of a sudden drop in
industry sales, use the 5% figure when creating an allowance
for doubtful accounts, unless there is strong evidence to the
contrary.
• The conservatism principle is the foundation for the lower of
cost or market rule, which states that you should record
inventory at the lower of either its acquisition cost or its
current market value.
• The principle runs counter to the needs of taxing authorities,
since the amount of taxable income reported tends to be
lower when this concept is actively employed; the result is
less reported taxable income, and therefore lower tax
receipts.
• The conservatism principle is only a guideline. As an
accountant, use your best judgment to evaluate a situation
and to record a transaction in relation to the information you
have at that time. Do not use the principle to consistently
record the lowest possible profits for a company.
3.The economic entity
principle states that the recorded activities
of a business entity should be kept separate from
the recorded activities of its owner(s) and any
other business entities. This means that you must
maintain separate accounting records and bank
accounts for each entity, and not intermix with
them the assets and liabilities of its owners or
business partners. Also, you must associate every
business transaction with an entity.
• A business entity can take a variety of forms,
such as a sole proprietorship, partnership,
corporation, or government agency. The
business entity that experiences the most Similar Terms
trouble with the economic entity principle is The economic entity
principle is also
the sole proprietorship, since the owner known as the
routinely mixes business transactions with his business entity
own personal transactions. assumption, business
• It is customary to consider a commonly-owned entity principle,
entity assumption,
group of business entities to be a single entity entity principle, and
for the purposes of creating consolidated economic entity
financial statements for the group, so the assumption.
principle could be considered to apply to the
entire group as though it were a single unit.
• The economic entity principle is a particular concern
when businesses are just being started, for that is
when the owners are most likely to commingle their
funds with those of the business.
• A typical outcome is that a trained accountant must
be brought in after a business begins to grow, in order
to sort through earlier transactions and remove those
that should be more appropriately linked to the
owners.
4. Money Measurement Concept:
Only those transactions, which can be expressed in monetary terms,
are recorded in accounting though their quantitative records may also
be kept. All business transactions should be expressed only in
money. Thus transactions, which cannot be expressed in money, will
not be recorded in accounting books.
Thus, labour-management relations, sales policy, labour unrest,
effectiveness of competition etc., which are of vital importance to
business concern, do not find place in accounting.
Another limitation of this concept makes the assumption that the
money value is constant. It is contrary to fact as there are fluctuations
in the money value. For instance, a land, purchased for Rs 10,000 in
1980, may cost four or five times in 2004. This is because of fall in
money value.
5. The going concern principle
is the assumption that an entity will remain in business for the
foreseeable future. Conversely, this means the entity will not be
forced to halt operations and liquidate its assets in the near term at
what may be very low fire-sale prices.
By making this assumption, the accountant is justified in deferring the
recognition of certain expenses until a later period, when the entity
will presumably still be in business and using its assets in the most
effective manner possible.
• An entity is assumed to be a going concern in the absence of
significant information to the contrary. An example of such contrary
information is an entity’s inability to meet its obligations as they
come due without substantial asset sales or debt restructurings. If
such were not the case, an entity would essentially be acquiring
assets with the intention of closing its operations and reselling the
assets to another party.
• If the accountant believes that an entity may no longer be a going
concern, then this brings up the issue of whether its assets are
impaired, which may call for the write-down of their carrying amount
to their liquidation value. Thus, the value of an entity that is assumed
to be a going concern is higher than its breakup value, since a going
concern can potentially continue to earn profits.
• The going concern concept is not clearly defined anywhere in generally
accepted accounting principles, and so is subject to a considerable
amount of interpretation regarding when an entity should report it.
However, generally accepted auditing standards (GAAS) do instruct an
auditor regarding the consideration of an entity’s ability to continue as
a going concern.
• The auditor evaluates an entity’s ability to continue as a going
concern for a period not greater than one year following the date of
the financial statements being audited.
• The auditor considers (among other issues) the
following items in deciding if there is a
substantial doubt about an entity’s ability to
continue as a going concern:---

P.T.O.
• Negative trends in operating results, such as a series of losses
• Loan defaults by the company
• Denial of trade credit to the company by its suppliers
• Uneconomical long-term commitments to which the company is
subjected
• Legal proceedings against the company
• If there is an issue, the audit firm must qualify its audit report with a
statement about the problem.
• It is possible for a company to mitigate an auditor's view of its going
concern status by having a third party guarantee the debts of the
business or agree to provide additional funds as needed. By doing so,
the auditor is reasonably assured that the business will remain
functional during the one-year period stipulated by GAAS.