Accounting Concept

1.The historical cost of conversion

The reason for using the convention

Assets and expenses are recorded in ledger accounts at the actual amounts expended on these items because this has the virtue of being objective, that is, beyond dispute. In most cases, the actual cost of goods or services is ascertainable from invoices, contracts and in some instances, by a firms costing records if its own workforce has been used to build or install its plant or machinery.

An alternative to recording assets and expenses at cost is to record them at a valuation. This introduces subjectivity into the accounting records as it is likely that no two people may agree on the value of the assets in ledger accounts.

2. The concept of money measurement

Only transactions which can be expressed in money terms are recorded in ledger accounts. Some of the benefits enjoyed by a firms may arise from expenditure which it has incurred but may be incapable of being evaluated in money terms.

3.The matching concept

The purpose of this concept is to ensure that revenue, other income and expenses are recognized in the financial period in which they accrue or are incurred. This is necessary if the financial statements are to state fairly the profit or loss for a given period and the state of the business at the period end.

Revenue should be recognized in the period in which it arises. Sales which have not been realized in a period should not be credited in the trading account of that period. Sales which have been realized should be credited in the trading account even if cash has not been received in respect of the sales. As the recognition of sales is not restricted to those made on a cash basis, trade debtors at the period end are shown on the balance sheet.

4.The concept of materiality

This concept permits the normally accepted treatment of transactions of any particular kind to be disregarded if the amount (or substance) involved is insignificant in the context of business as a whole.The concept does require that all items which are sufficiently material to affect evaluations or decisions should be disclosed.

5.The consistency concept

The purpose of this concept is to enable sensible comparisons to be made of the results of a business and its financial position from one year to another. To this end, all items of a similar nature should be treated in a similar manner both within the same accounting period and from one period to the next.

The methods of depreciating fixed assets should be applied consistently from one year to the next. If the straight line method is selected for a type of asset when it is first acquired, the basis should be used for that asset in all future years; it would not be acceptable to change to the reducing balance method in a subsequent year in order to manipulate profit. (A change of method would only be permissible if it could be shown that the new method will give a fairer presentation of the results and of the financial position of the business.)

6.The prudence concept

Accounting systems should allow for the reporting of the minimum value of income. Thus, total expenses include non-cash items such as depreciation, bad debts, provisions, etc.

The prudence concept is concerned with ensuring the capital of a business is not depleted by overstatement of profit. If an owners drawings exceed his profits, the capital of the business is depleted. If the process is carried too far, the point will be reached when the business is seriously undercapitalized to the extent that insufficient funds are available to pay creditors or to replace worn out assets. Unless new capital can be introduced, the business is finished.

Prudence is about

Profits not being overstated;

Losses being provided for as soon as they are recognized.

The application of this concept requires that:

Revenue is not anticipated before it has been realized;

All costs of earning revenue brought to account in the period are charged against that revenue

Prudence is an overriding concept; if, in a given situation, the application of another concept would conflict with prudence, prudence takes precedence over that other concept.

7.The going concern concept

The going concern concept is concerned with the amounts at which assets are shown in the balance sheet. It requires that business accounts shall be prepared on the assumption that a business is a going concern. If there is any intention to discontinue the business, or to substantially curtail its scope of operations in the foreseeable future, the effect of any such action should be reflected in the balance sheet.

If a business is a going concern, its fixed assets will normally be shown in the balance sheet at cost less aggregate depreciation to date, i.e. at net book value. Stock should be shown at cost or net realizable value, whichever is the less. If a business is not a going concern, the assets should be shown in the balance sheet at the amount they may be expected to realize when sold, bearing in mind that, in an enforced sale, the proceeds may be lower than expected. The effect of writing assets down in this way will increase the amounts charged normally for depreciation in the profit and loss account.

8. The Substance over Form Concept: The legal form in a transaction may differ from its economic substance. That is, the firm may be in possession of an asset that is being used in the business but which has not yet been paid for. For example, an equipment may have been bought on hire purchase or acquired by way of a lease, and as such the asset does not legally belong to the firm until it is paid for. However, the economic substance of the equipment must be shown in the books, and this takes precedence over the legal form in it.

9. The Time Interval or Periodicity Concept: The firm should prepare a set of final accounts in order to take a reading of its performance from time to time. This is required although the business is regarded as a going concern. This periodic reading of the business allows management to make informed assessment and control over the affairs of the business.

10.The Objectivity Concept: The accounting transactions recorded in the firms books should be supported by objective evidence or by a basis of origin in fact. This includes such documentation as sales invoices, payment vouchers, cash receipts etc. Thus, there should be a basis by which the transactions can be verified. This is usually required whenever an audit is being done.

11. The Realization Concept: Income is regarded as being earned at the point when the legal property, or the claim, in goods has passed from the seller to the buyer. This may be different from the point when the order was received, the delivery was made, or payment completed. This, however, is determined by the terms of the contract.

John runs a retail business, but he isnt familiar with the various accounting concepts. He is therefore seeking your advice as to whether he dealt with the following situations correctly:

a. John was so pleased with the motivation of his staff that he decided to include this on his financial statements.

b. A sale was made in the current financial year, but payment would not be received until the following year. John decided to record the sale as occurring in the following year since thats when he would receive the cash.

c. John purchased some items on Hire purchase but decided not to include them on his financial statements since he hasnt finished paying as yet.

d. A potential customer enquired about an item and then later told John that he was seriously considering purchases in the item next month. John was so delighted to hear this and decided to record the sale immediately.

Required:

Assist John by identifying an accounting concept that is applicable to each scenario and explain to him whether he had adhered to that concept or not.