Chapter 5
Chapter 5
Chapter 5
Content Standard
1. Accounting concepts and principles.
Performance Standard
1. Identify generally accepted accounting principles.
DISCUSSION PROPER
Introduction:
“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
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.
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.
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.
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.
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.