ELEMENTS OF BOOKKEEPING AND ACCOUNTING

TOPIC TWO: ACCOUNTING PRINCIPLES AND STANDARDS

Things to cover:

 Accounting Policy/Conventions/Concepts/Bases/Principles.

 Accounting Equation. (A = L + C)

 Table.

 The asset of Inventory/Stock/Goods (Stock Movement).

 The effect of profit or loss on capital and the accounting treatment of

revenues and expenses.

 Double entry system and balancing off Accounts.

Test Yourself:

Identify the differences between Accounting and Book-Keeping.

The Next Topic: ACCOUNTING CYCLE.

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ACCOUNTING POLICY/CONVENTIONS/CONCEPTS/BASES/PRINCIPLES/ASSUMPTIONS.

 Separate Legal Entity/ Economic Entity Assumption

 Money Measurement/ Monetary Unit Assumption.
 Neutrality.
 Cash basis and Accrual basis.
 Break up basis and Going concern basis (The Continuity Assumption).
 Consistency and comparability.
 Prudence/ Conservatism concept (convention).
 Matching concept.
 Time interval/ Periodicity.
 Substance over form/ Economic substance over legal form(legality).

SEPARATE LEGAL ENTITY.

Financial statements are prepared for a business or reporting entity. This is referred to as the
separate legal entity concept. This concept requires that accounting for a reporting entity's
economic activities be kept separate and distinct from the accounting for the activities of its
owners and all other reporting entities. A reporting entity can be any organization or unit in
society.

It is important to understand that a reporting entity may not necessarily be a separate legal entity.
For instance, proprietorships and partnerships are not separate legal entities from their owners
but the separate legal entity concept requires that they be treated as separate entities fro the
Accounting purposes.

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MONEY MEASEUREMENT ASSUMPTION.

The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis. That is, the
monetary unit is the most effective means of expressing to interested parties changes in capital
and exchanges of goods and services. The monetary unit is relevant, simple, universally
available, understandable, and useful. Application of this assumption depends on the even more
basic assumption that quantitative data are useful in communicating economic information and in
making rational economic decisions.

NEUTRALITY.

The concept of Neutrality, means that financial statements must be free from errors or from
other missions. Financial statements cannot be prepared with the purpose to influence certain
decisions, i.e. they might be neutral. Users of the accounting data should have the ability or
possibility to make their own decisions based on that information.

CASH BASIS AND ACCRUAL BASIS.

Cash Basis means that The transaction and revenue are recorded when cash is received from
customers. Expenses are recorded when cash is paid to suppliers and employees. In other words
Under cash-basis accounting, companies record revenue only when cash is received. They record
expenses only when cash is paid. The cash basis of accounting is prohibited under IFRS. Why?
Because it does not record revenue according to the revenue recognition principle. Similarly, it
does not record expenses when incurred, which violates the expense recognition principle.

Accrual basis means that transactions that change a company’s financial statements are recorded
in the periods in which the events occur. For example, using the accrual basis means that
companies recognize revenues when it is probable that future economic benefits will flow to the
company and reliable measurement is possible (the revenue recognition principle). Financial
statements prepared on the accrual basis inform users not only of past transactions involving the

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payment and receipt of cash but also of obligations to pay cash in the future and of resources that
represent cash to be received in the future. Hence, they provide the type of information about
past transactions and other events that is most useful in making economic decisions.

BREAK-UP BASIS AND GOING CONCERN BASIS.

Break-up Basis is the assumption for accountant to prepare financial statements while going
concern assumption cannot be applied. Accountants have aware that the company will cease its
operation shortly after the reporting date. Going concern is not appropriate for them to prepare
their report.

Going Concern Basis is the assumption states that the reporting entity will continue to operate
in the foreseeable future. Although some businesses fail, most companies continue operating for
a long time. The going concern assumption presumes that the company will operate long enough
to use the resources for their intended purpose and to complete the company's commitments.

This Assumption of Going Concern, is one of the most important assumptions in GAAP
because it has implications regarding what information is useful for decision makers and affect
many of the accounting standards you will learn. If a company is a going concern, then the
financial statements users will find it useful for the company to report certain resources such as
Land at their cost.

CONSISTENCY AND COMPARABILITY CONCEPTS.

Consistency Concept means that accounting methods once adopted must be applied consistently
in future (Among periods). Also same methods and techniques must be used for similar
situations.

It implies that a business must refrain from changing its accounting policy unless on reasonable
grounds. If for any valid reasons the accounting policy is changed, a business must disclose the
nature of change, the reasons for the change and its effects on the items of financial statements.

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Consistency concept is important because of the need for comparability, that is, it enables
investors and other users of financial statements to easily and correctly compare the financial
statements of a company.

Comparability Concept is one of the key qualities which accounting information must possess.
Accounting information is comparable when accounting standards and policies are applied
consistently from one period to another and from one region to another. The characteristic of
comparability of financial statements is important because it allows us to compare a set of
financial statements with those of prior periods and those of other companies.

PRUDENCE CONCEPT.

Prudence Concept, This concept defines and emphasizes that the accountants are cautious
people. Preparation of financial statements need good professional command and exact estimates
of future by the accountants. In other words 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 under stated.

The rationale behind prudence is that a company should not recognize 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 in its
respect in the future.

MATCHING CONCEPT.

The matching concept is an accounting practice whereby firms recognize revenues and their
related expenses in the same accounting period. Firms report revenues, that is, along with the
expenses that brought them. The purpose of the matching concept is to avoid misstating earnings
for a period.

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The business entities follow this concept mainly to ascertain the true profit or loss during an
accounting period. This leads to either overcasting or under casting of the profit or loss, which
may not reveal the true efficiency of the business and its activities in the concerned accounting
period.

TIME INTERVAL ASSUMPTION.

The periodicity assumption implies that a company can divide its economic activities into
artificial time periods. These time periods vary, but the most common are monthly, quarterly,
and yearly. To measure the results of a company’s activity accurately, we would need to wait
until it liquidates. Decision-makers, however, cannot wait that long for such information. Users
need to know a company’s performance and economic status on a timely basis so that they can
evaluate and compare companies, and take appropriate actions. Therefore, companies must
report information periodically.

The shorter the time period, the more difficult it is to determine the proper net income for the
period. A month’s results usually prove less reliable than a quarter’s results, and a quarter’s
results are likely to be less reliable than a year’s results. Investors desire and demand that a
company quickly process and disseminate information. Yet the quicker a company releases the
information, the more likely the information will include errors.

SUBSTANCE OVER FORM.

Substance over form is an accounting concept which means that the economic substance of
transactions and events must be recorded in the financial statements rather than just their legal
form in order to present a true and fair view of the affairs of the entity.

Substance over form concept entails the use of judgment on the part of the preparers of the
financial statements in order for them to derive the business sense from the transactions and
events and to present them in a manner that best reflects their true essence. Whereas legal aspects

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of transactions and events are of great importance, they may have to be disregarded at times in
order to provide more useful and relevant information to the users of financial statements.

ACCOUNTING EQUATION.

The accounting equation is a basic principle of accounting and a fundamental element of

the balance sheet. The equation is as follows:

ASSETS = LIABILITIES + CAPITAL

This equation sets the foundation of double-entry accounting and highlights the structure of the
balance sheet. Double-entry accounting is a system where every transaction affects both sides of
the accounting equation. For every change to an asset account, there must be an equal change to
a related liability or shareholder’s equity account. It is important to keep the accounting equation
in mind when performing journal entries.

ASSETS: A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity. An asset can be current or long term asset
(Fixed Asset).

LIABILITY: A present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits. A
liability can be current or long term liability.

CAPITAL/EQUITY: monies or contributions made by the investors into the business. OR in

other words the residual interest in the assets of the entity after deducting all its liabilities.

TABLE THAT SHOWS THE IMPACT OF INCREASINF AND DECREASING OF

ASSET, LIABILITY AND CAPITAL:

DETAILS INCREASING (+) DECREASING (-)

ASSET/EXPENSE DEBIT (DR) CREDIT (CR)

LIABILITY CREDIT (CR) DEBIT (DR)

CAPITAL/INCOME CREDIT (CR) DEBIT (DR)

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THE ASSET OF INVENTORY/STOCK/GOODS (STOCK MOVEMENT).

1) Increase in stock. This can be due to one of two causes:

 The purchase of additional goods. Purchased goods will be entered or recorded in
a Purchases Account.
 The return in to the business of goods previously sold. The reasons for this are
numerous. The goods may have been the wrong type; they may, for example,
have been surplus to requirements or faulty. Returned goods will be recorded in a
Returns Inwards Account (This is also known as the Sales Returns Account.)
2) Decrease in stock. Ignoring things like wastage and theft, this can be due to one of two
causes:
 The sale of goods. A Sales Account will be used to record sold goods.
 Goods previously bought by the business now being returned to the supplier. a
Returns Outwards Account (This is also known as the Purchases Returns
Account.) will be used to record returned goods made by the customers.

NOTE:

a) Purchases in accounting means the purchase of those goods which the business buys with
the prime intention of selling. Obviously, sometimes the goods are altered, added to, or
used in the manufacture of something else, but it is the element of resale that is important.
To a business that deals in computers, for instance, computers constitute purchases. If
something else is bought which the business does not intend to sell, such as a van, such
an item cannot be called ‘purchases’, even though in ordinary language you would say
that a van has been purchased. The prime intention of buying the van is for usage and not
for resale.
b) Sales means the sale of those goods in which the business normally deals and which were
bought with the prime intention of resale. The word ‘sales’ must never be given to the
disposal of other items, such as vans or buildings that were purchased to be used and not
to be sold.

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THE EFFECT OF PROFIT OR LOSS ON CAPITAL AND THE ACCOUNTING

TREATMENTS FOR REVENUES AND EXPENSES.

To an accountant, profit means the amount by which revenues are greater than expenses for a set
of transactions. The term revenues means the sales value of goods and services that have been
supplied to customers. The term expenses means the cost value of all the assets that have been
used up to obtain those revenues.

DOUBLE-ENTRY SYSTEM AND BALANCING-OFF ACCOUNTS.

It this system every business transaction is having a two fold effect of benefits giving and benefit
receiving aspects. The recording is made on the basis of both these aspects. Double Entry is an
accounting system that records the effects of transactions and other events in atleast two accounts
with equal debits and credits.

The term ‘debit’ is supposed to have derived from ‘debit’ and the term ‘credit’ from ‘creditable’.
For convenience ‘Dr’ is used for debit and ‘Cr’ is used for credit. Recording of transactions
require a thorough understanding of the rules of debit and credit relating to accounts. Both debit
and credit may represent either increase or decrease, depending upon the nature of account.