Chapter 5

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CHAPTER 5

ACCOUNTING CONCEPTS AND PRINCIPLES

Content Standard
1. Accounting concepts and principles.

Performance Standard
1. Identify generally accepted accounting principles.

Learning Competency/ Code


1. Explain the varied accounting concepts and principles. ABM_FABM11- IIIb-c-15
2. Solve exercises on accounting principles as applied in various cases. BM_FABM11-
IIIb-c-16

DISCUSSION PROPER
Introduction:

Accounting is often called the language of business because the purpose of


accounting is to communicate or report the results of business operations and its
various aspects to various users of accounting information. In fact, today, accounting
statements or reports are needed by various groups such as shareholders, creditors,
potential investors, columnist of financial newspapers, proprietors and others. In view
of the utility of accounting reports to various interested parties, it becomes imperative
to make this language capable of commonly understood by all. Accounting could
become an intelligible and commonly understood language if it is based on generally
accepted accounting principles. Hence, you must be familiar with the accounting
principles behind financial statements to understand and use them properly
LESSON 1: Meaning and Features of Accounting Principles:
The rules and principles of accounting are commonly referred to as the
conceptual framework of accounting. Accounting principles have been defined as “The
body of doctrines commonly associated with the theory and procedure of accounting
serving as an explanation of current practices and as a guide for the selection of
conventions or procedures where alternatives exists. Rules governing the formation of
accounting axioms and the principles derived from them have arisen from common
experience, historical precedent statements by individuals and professional bodies and
regulations of Governmental agencies”.
The American Institute of Certified Public Accountants (AICPA) has advocated the
use of the word “Principle” in the sense in which it means “rule of action”. It
discusses the generally accepted accounting principles as follows: Financial
statements are the product of a process in which a large volume of data about
aspects of the economic activities of an enterprise are accumulated, analyzed and
reported. This process should be carried out in conformity with generally accepted
accounting principles (GAAP).
The generally accepted accounting principles and standards provide a common
financial language to enable informed users to read and interpret financial statements.
Generally accepted accounting principles encompass the conventions, rules and
procedures necessary to define accepted accounting practice at a particular time.......
generally accepted accounting principles include not only broad guidelines of general
application, but also detailed practices and procedures (Source: AICPA Statement of the
Accounting Principles Board No. 4, “Basic Concepts and Accounting Principles underlying
Financial Statements of Business Enterprises “, October, 1970, pp. 54-55).

“Accounting standards refer to accounting rules and procedures which are relating
to measurement, valuation and disclosure prepared by such bodies as the
Accounting Standards Committee (ASC) of a particular country”. Thus, we may define
Accounting Principles as those rules of action or conduct which are adopted by the
accountants universally while recording accounting transactions. Accounting
principles are man-made. They are accepted because they are believed to be
useful. The general acceptance of an accounting principle usually depends on
how well it meets the following three basic norms: (a) Usefulness; (b) Objectiveness;
and (c) Feasibility.
The following are the important accounting concepts and assumptions:
LESSON 2: ACCOUNTING CONCEPTS
1. Accrual Accounting
Definition: Accounting method that records revenues and expenses when they are
incurred, regardless of when cash is exchanged. The term "accrual" refers to any
individual entry recording revenue or expense in the absence of a cash transaction

Most businesses typically use one of two basic accounting methods

The cash method is the most simple in that the books are kept based on the actual flow
of cash in and out of the business. Income is recorded when it's received, and expenses
are reported when they're actually paid. The cash method is used by many sole
proprietors and businesses with no inventory. From a tax standpoint, it is sometimes
advantageous for a new business to use the cash method of accounting. That way,
recording income can be put off until the next tax year, while expenses are counted
right away.

With the accrual method, income and expenses are recorded as they occur, regardless
of whether or not cash has actually changed hands. An excellent example is a sale on
credit. The sale is entered into the books when the invoice is generated rather than
when the cash is collected. Likewise, an expense occurs when materials are ordered or
when a workday has been logged in by an employee, not when the check is actually
written. The downside of this method is that you pay income taxes on revenue before
you've actually received it.

2. Matching principle states that expenses should be recognized and recorded when
those expenses can be matched with the revenues those expenses helped to generate.
In other words, expenses shouldn’t be recorded when they are paid. Expenses should be
recorded as the corresponding revenues are recorded. This matches the revenues and
expenses in a period. In this sense, the matching principle recognizes expenses as the
revenue recognition principle recognizes income.
In general, there are two types of costs: product and period costs. Product costs can be
tied directly to products and in turn revenues. Period costs, on the other hand, cannot.
Period costs do not have corresponding revenues. Administrative salaries, for example,
cannot be matched to any specific revenue stream. These expenses are recorded in the
current period.
The matching principle also states that expenses should be recognized in a “rational and
systematic” manner. This is the key concept behind depreciation where an asset’s cost is
recognized over many periods.
In short, the matching principle states that where expenses can be matched with
revenues, we should do so because the benefits of an asset or revenue should be linked
to the costs of that asset or revenue.
Examples
– Casem Corp. Inc. buys a new equipment for Php 100,000 in 2015. This machine has a
useful life of 10 years. This means that the machine will produce products for at least
10 years into the future. According to the matching principle, the machine cost
should be matched with the revenues it creates. Thus, the machine is depreciated over
its 10-year useful life instead of being fully expensed in 2015.
– Art Studio produces picture frames and sells them to wholesalers. Art pays its
employees Php 20 an hour and sells every frame produced by its employees. Since
the payroll costs can be directly linked back to revenue generated in the period, the
payroll costs are expensed in the
3. Accounting estimate is an approximation of the amount of a business transaction for
which there is no precise means of measurement. Estimates are used in accrual basis
accounting to make the financial statements more complete, usually to anticipate
events that have not yet occurred, but which are considered to be probable. These
estimates may be subsequently revised as more information becomes available.
Examples of accounting estimates are:
 A loss provision for an environmental damage claim
 A loss provision for a bad debt
 A loss provision for warranty claims

The amount of an accounting estimate is based on historical evidence and the judgment
of the accountant. The basis upon which an accounting estimate is made should be fully
documented, in case it is audited at a later date.

4. Prudence concept of accounting states that an entity must not overestimate its
revenues, assets and profits, besides this it must not underestimate its liabilities, losses
and expenses.

Prudence concept is a very fundamental concept of accounting that increases


the trustworthiness of the figures that are reported in the financial statements of a
business. The concept advises that the final accounts of a company must always show
caution while reporting any figures specifically impacting the income and expenses. It
means that the preparer must always show a conservative approach while reporting
profits, revenues and assets and must only record these when they are actually realized.
Simultaneously a company must always adopt a proactive approach towards the
recognition of liabilities, losses and expenses. In simple terms the business must not
overvalue its profits and assets until irrefutable evidence is obtained, as well as it must
not undervalue its losses and expenses and must record provisions even if a possibility
of occurrence exists. It may seem that prudence concept requires the company to go for
every less favorable situation to be recorded, but it does not. The concept basically
urges that financial statements must present a realistic perspective about every possible
event that may impact the decision of the users of financial statements. International
Accounting Standards (IAS’s) and Generally Accepted Accounting Principles (GAAP)
incorporate the concept of prudence in many standards

Examples:

 The “provision for bad and doubtful debts” is reported in the receivables section of
current assets and is deducted from the final figure of debtors/receivables. The
provision does not show the debtors that have resulted as bad debts rather it shows
the debtors that may end up as bad debts based on their trading history with the
company or their specific circumstances, and ultimately company may not recover
money from these debtors. These debtors are included in the provision under
prudence concept of accounting.
 In IAS2 (International Accounting Standard for Inventory) the inventory is always valued
at lower of cost (original cost) or NRV (net realizable value – selling price less cost to
sell), so that inventory may not be overvalued, as the figure of inventory directly
impacts the “cost of sales” figure, because “Cost of sales = Opening Stock +
Purchases – Closing stock”.
 There are many liabilities which are not certain either in terms of amount or in terms
of date but they have high possibility of occurrence. In such cases, the liabilities are
recorded in the statements and a corresponding expense is also recorded. So it
makes sure that liabilities are not undervalued.

4. Substance over form is the concept that the financial statements and accompanying
disclosures of a business should reflect the underlying realities of accounting
transactions. Conversely, the information appearing in the financial statements should
not merely comply with the legal form in which they appear. In short, the recordation of
a transaction should not hide its true intent, which would mislead the readers of a
company's financial statements.

Substance over form is a particular concern under Generally Accepted Accounting


Principles (GAAP), since GAAP is largely rules-based, and so creates specific hurdles that
must be achieved in order to record a transaction in a certain way. Thus, someone
intent on hiding the true intent of a transaction could structure it to just barely meet
GAAP rules, which would allow that person to record the transaction in a manner that
hides its true intent. Conversely, International Financial Reporting Standards (IFRS) are
more principles-based, so it is more difficult for someone to justifiably hide the intent of
a transaction if they are using the IFRS framework to construct financial statements.

Examples of substance over form issues are:

Company A is essentially an agent for Company B, and so should only record a sale
on behalf of Company B in the amount of the related commission. However,
Company A wants its sales to appear larger, so it records the entire amount of a sale
as revenue.
Company C hides debt liabilities in related entities, so that the debt does not appear
on its balance sheet.
Company D creates bill and hold paperwork to legitimize the sale of goods to
customers where the goods have not yet left the premises of Company D.
LESSON 3: ACCOUNTING ASSUMPTIONS:

1. Going concern assumption 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.

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.

2. Accounting entity assumption, sometimes referred to as separate entity


assumption or the economic entity concept, is an accounting principal that states that
the financial records of any business must be kept separate from those of its owners
or any other business. All income derived from the company's operation must be
recorded as earnings and all expenses must be those belonging solely to the business.
Any personal expenses of the owner should not be passed on to the company. This
strict adherence to separation allows the business to be evaluated for profitability and
tax purposes based on accurate financial data rather than a muddled mix of personal
and business finances. It is also applied to all businesses even if legally a business and
its owner as viewed as the same entity.

3. Time period assumption (also known as periodicity assumption and accounting time
period concept) states that the life of a business can be divided into equal time periods.
These time periods are known as accounting periods for which companies prepare
their financial statements to be used by various internal and external parties.

The length of accounting period to be used for the preparation of financial


statements depends on the nature and requirement of each business as well as the
need of the users of financial statements. Normally, an accounting period consists of a
quarter, six months or a year.

IFRS (International Financial Reporting Standards)

IFRS is the international accounting framework within which to properly


organize and report financial information. It is derived from the pronouncements of
the London-based International Accounting Standards Board (IASB). It is currently the
required accounting framework in more than 120 countries. IFRS requires businesses to
report their financial results and financial position using the same rules; this means
that, barring any fraudulent manipulation, there is considerable uniformity in the
financial reporting of all businesses using IFRS, which makes it easier to compare and
contrast their financial results.

IFRS is used primarily by businesses reporting their financial results anywhere in


the world except the United States. Generally Accepted Accounting Principles, or GAAP,
is the accounting framework used in the United States. GAAP is much more rules-based
than IFRS. IFRS focuses more on general principles than GAAP, which makes the IFRS
body of work much smaller, cleaner, and easier to understand than GAAP.

The Philippine Financial Reporting Standards (PFRS)/Philippine Accounting


Standards (PAS) are the new set of Generally Accepted Accounting Principles (GAAP)
issued by the Accounting Standards Council (ASC) to govern the preparation of financial
statements. The rationale for using the IFRS/Philippine Financial Reporting
Standards (PFRS) is to ensure consistency in recording, recognizing
and measuring financial transactions, which, if followed properly, will ensure stability
and transparency throughout the financial reporting process of the company.
CHAPTER SUMMARY:

The generally accepted accounting principles and standards provide a common


financial language to enable informed users to read and interpret financial statements.
“Accounting standards refer to accounting rules and procedures which are relating to
measurement, valuation and disclosure prepared by such bodies as the Accounting
Standards Committee (ASC) of a particular country”.
ACCOUNTING PRINCIPLES:
1. Accrual Accounting
Definition: Accounting method that records revenues and expenses when they are
incurred, regardless of when cash is exchanged. The term "accrual" refers to any
individual entry recording revenue or expense in the absence of a cash transaction
2. Matching principle states that expenses should be recognized and recorded when
those expenses can be matched with the revenues those expenses helped to generate.
In other words, expenses shouldn’t be recorded when they are paid. Expenses should be
recorded as the corresponding revenues are recorded.
3. Accounting estimate is an approximation of the amount of a business transaction for
which there is no precise means of measurement.
4. Substance over form is the concept that the financial statements and accompanying
disclosures of a business should reflect the underlying realities of accounting
transactions.

5. Prudence concept of accounting states that an entity must not overestimate its
revenues, assets and profits, besides this it must not underestimate its liabilities, losses
and expenses.

ACCOUNTING ASSUMPTIONS:

1. Going concern assumption is the assumption that an entity will remain in business for
the foreseeable future or for long term or perpetual.
2. Accounting entity assumption, sometimes referred to as separate entity
assumption or the economic entity concept, is an accounting principal that states that
the financial records of any business must be kept separate from those of its owners
or any other business.
3. Time period assumption (also known as periodicity assumption and accounting time
period concept) states that the life of a business can be divided into equal time periods
(MONTHLY. QUARTERLY, SEMI-ANNUAL OR ANNUAL). These time periods are known as
accounting periods for which companies prepare their financial statements to be used
by various internal and external parties.

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