Lesson 6: Accounting Concepts and Principles

Accounting Concepts and Principles

❑ The Financial Reporting , which includes Statement of Financial

Position, Statement of Comprehensive Income, Cash Flow Statement,
Statement of Changes in Equity, Financial Notes, and Disclosures, is
the language used to communicate information about the financial
condition of a company.

❑ In order to standardized the preparation of uniform and consistent

financial statements, the Financial Accounting Standard Board
(FASB) developed and established accounting standards to provide a
basic framework for financial reporting.
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Accounting Concepts and Principles

Conceptual Framework

❑ A system of ideas and objectives that lead to the creation of

a consistent set of rules and standards.

❑ It forms a theoretical basis for determining how transactions are

measured and reported; how they are presented and communicated to
users.
❑ Specifically in accounting, the rule and standards set the nature,
function and limits of financial accounting and financial statements.

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Accounting Concepts and Principles

Conceptual Framework

❑ Standards in reporting are set to ensure that users of financial

information are not misled when taking decisions relating to their field.
❑ The standards are known collectively as Generally Accepted
Accounting Principles (GAAP).

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Accounting Concepts and Principles

❑ The need to understand properly the basic accounting concepts and

principles is a must for those who are planning to pursue a career or
 work in the accounting field .

❑ Principles means fundamental belief or general truth. Accounting

principles are based on the concepts, conventions, and practices.

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Accounting Concepts and Principles

❑ The term concepts is used to mean the accounting postulates (historical

practice) while conventions/practices (guidelines) are assumptions and
 expected to be followed while preparing the financial statements.

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Accounting Concepts and Principles

1. Basic Assumptions

❑ There are four (4) basic assumptions on which the structure of

 accounting is based:
a) Economic Entity Assumption

⮚ This is the assumption that business is treated as a unit or entity separate

from its owners, creditors and others. A business institution is a legal
person having its own entity. All business transactions are recorded in
the books of accounts from the viewpoint of its business.

⮚ According to the economic entity assumption, a person evaluating a

company's records assumes all the transactions pertaining to the business
are being reviewed.
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b) Money Measurement Assumption

1. Basic Assumptions Accounting Concepts and Principles
⮚ This is the assumption that only business transactions and events which
are financial in nature are recorded in the financial statements.

⮚ The money measurement concept states that a business should only

record an accounting transaction if it can be expressed in terms of
money.

⮚ All transactions and events must be reduced to a unit of monetary

currency, e.g. US Dollar, GBP, Euro, Yen, Peso, etc.

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 b) Money Measurement Assumption
1. Basic Assumptions Accounting Concepts and Principles

⮚ This concept guides the accountant in deciding transactions/events which

should be recorded

⮚ Any non-financial or non monetary information that cannot be measured

in the monetary unit are not recorded in the accounting books, instead, a
memorandum is used.

⮚ Examples of items that cannot be recorded as accounting transactions

because they cannot be expressed in terms of money include: Employee
skill level. Employee working conditions.
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c) Accounting Period Assumption

1. Basic Assumptions Accounting Concepts and Principles

⮚ This is the assumption that accounting measures activity for a specified

interval of time, usually, a period of 365 days or 52 weeks.

e.g. Calendar Year (January 2021 – December 2021)

Fiscal Year (April 2021 – March 2021)

⮚ The users of financial statements need periodical reports to know the

operational result and the financial position of the business concern.
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c) Accounting Period Assumption

1. Basic Assumptions Accounting Concepts and Principles

⮚ It is necessary to close the accounts at regular intervals.

⮚ Choosing the Accounting period is the entities choice, but there are legal
rules like Companies Act and Income Tax Act which prescribe the period
in which the entity has to report to them.
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c) Accounting Period Assumption

1. Basic Assumptions Accounting Concepts and Principles

❑ Periodicity says that the life of business is dividedinto equal time

intervals for the purpose of:
❑ calculating profit earned or loss incurred
 ❑ tax computation
❑ distribution of dividends
❑ analysis of the business by banks, creditors, etc.

Each interval is called Accounting Period. Balance Sheet and Profit &
Loss Account should be prepared for each accounting period

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d) Going Concern Assumption

1. Basic Assumptions Accounting Concepts and Principles

⮚ This is the assumption that the business will continue for a long period of
 time and transactions are recorded from this point of view.

⮚ The business is not expected to be wind up in the foreseeable future.

⮚ Assumed that the going concern will continue indefinitely.

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Accounting Concepts and Principles

2. Basic Concepts and Principles

On the basis of the four assumptions the basic concepts and principles
 of accounting have been developed. These concepts and principles
guide how business transactions are reported.

a) Duality Concept
❑ Fundamental convention of accounting that necessitates the recognition of
all aspects of an accounting transactions.

❑ The underlying basis for double entry accounting system.

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a) Duality Concept
2. Basic Concepts and Principles Accounting Concepts and Principles
The duality concept is commonly expressed in terms of fundamental
accounting equation

Assets = Liabilities + Capital

❑ Dual aspect is the foundation or basic principle of accounting ❑ This

concept assumes that every transaction has adual effect, i.e. it affects two
accounts
❑ The classification of debit and credit effects is structured in such a way that
for each debit entry, there is a corresponding credit entry and vice versa.

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 a) Duality Concept
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ Under the accounting system, transactions are classified into two main
types:
1) Debit - is the portion of the transaction that accounts for the increase in
assets and expenses, and the decrease in liabilities, equity, and
income.
2) Credit – is the portion of the transaction that accounts for the increase in
income, liabilities, and equity, and the decrease in assets and expenses.

❑ The classification of debit and credit effects is structured in such a way that
 for each debit entry, there is a corresponding credit entry and vice versa.

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b) Objectivity
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ All accounting record must be based on objective evidence.

❑ The transaction recorded should have supporting evidence or

documentation. The documentary evidence of transactions should be free
from any bias and are capable of verification.
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c) Materiality
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ This principle requires all relatively relevant information should be

disclosed in the financial statements.
 ❑ Unimportant and immaterial information are either left out or merged with
other items.
❑ Per IASB Framework, Information is material if its omission or
misstatement could influence the economic decisions of users taken on the
basis of the financial statements.
❑ Professional judgment is needed to decide whether an amount is
insignificant or immaterial.

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d) Matching Principle
2. Basic Concepts and Principles Accounting Concepts and Principles
❑ This is the concept that, when you record revenues, you should record all
related expenses at the same time. Revenue is matched with expenses.
❑ It is the basis for finding accurate profit of the business for a period. This
accounting principle requires companies to use the accrual basis of
accounting.
❑ Primary methods in recognizing revenues and expenses (basis of
accounting).
1. Accrual Basis of Accounting
2. Cash Basis of Accounting

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 1. Accrual Basis of Accounting
Accounting Concepts and Principles
2. Basic Concepts and Principles
d) Matching Principle

1) Revenues are reported on the income statement in the period when

they are earned regardless of the time the cash is received.
2) Expenses are reported on the income statement in the period when
they occur or when they expire regardless of the time that cash is
paid.
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2. Cash Basis of Accounting

Accounting Concepts and Principles
2. Basic Concepts and Principles
d) Matching Principle

1) Revenue are reported on the income statement in the period in

 which cash is received.
2) Expenses are reported on the income statement in the periodin
which the cash is paid.

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e) Accrual Principle
Accounting Concepts and Principles
2. Basic Concepts and Principles
❑ This is the concept that accounting transactions should be recorded in the
accounting periods when they actually occur, rather than in the period when
there are cash flows associated with them.

❑ The meaning of accrual is something that becomes due. It means that

revenues are recognized when they become receivable and expenses are
recognized when they become payable without regard to the time of cash
receipt or cash payment.

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 f) Revenue Recognition Principle
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ Under this principle, revenue is recognized as soon as a product has been

sold or a service has been performed regardless of whether cash from the
transaction has been received or not. This principle used the accrual
concept.
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g) Cost Principle
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ This is the concept that the value of transaction is recorded at the price paid
 to acquire it, not the prevailing market value or future value.
❑ The amount shown on financial statements are refereed to as historical cost
amounts.
❑ The original cost of fixed assets in the booksof accounts is their purchase
price thatincludes cost of acquisition, transportation and installation
❑ Fixed assets are recorded at a price paid for them (verified from the
supporting documents) and not their market price

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h) Conservatism Principle/Prudence
2. Basic Concepts and Principles Accounting Concepts and Principles
❑ When given two options in the valuation of business transactions, the
amount recorded should be the lower rather than the higher value.
❑ This leads accountants to anticipate or disclose losses but leaves all
prospective profits.
❑ Preparation of financial statements requires the use of professional
judgment to 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.
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 Principle
2. Basic Concepts and Principles Accounting Concepts and Principles
i) Consistency/Comparability

❑ Once you adopt an accounting principle or method, it must be continue to

be used from one accounting period to the succeeding accounting period. or
until a better principle or method comes along.
❑ The consistency principle preserves the comparability of financial
statements.
❑ Comparisons of financial results of the business among different
accounting period can be significant and meaningful only when consistent
 practice were followed in ascertaining them.

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j) Faithful Representation
2. Basic Concepts and Principles Accounting Concepts and Principles

❑ Financial information contained in the financial statements should

faithfully represents the transaction and event that happen during a
period.
❑ Faithful representation requires that transactions and events should be
accounted for in a manner that represents their true economic substance
 rather than the mere legal form. This concept is known as Substance Over
Form
❑ If substance of transaction differs from the legal form, then this principle
requires that such transaction should be accounted for in accordance with
the substance and economic reality.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

For accounting information to be useful, it should have the following
characteristics:
a) Completeness
❑ This principle requires that financial information contained in the financial
statement is complete in all material aspects.
 ❑ Reliability of financial information is achieved if it is complete, hence it
becomes useful for relevant users.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

b) Understandability
❑ Financial information must be presented in a manner that is understandable
to its relevant users in order for it to be useful.
❑ If the financial information presented is too complex, then it would
undermine the reliability of the whole financial statement because users
 base their decision on how they comprehend the information contained in
the financial statement.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

c) Reliability
❑ Financial information becomes useful if users can depend on it to be
materially accurate and represents its real substance.

❑ Accounting information should be verifiable

 ❑ The concept is of prime interest to auditors, who are constantly in search of
the evidence supporting transactions.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

d) Relevance
❑ The concept that financial information should impact the decision making
of the relevant user.

❑ Information is relevant if it helps users in predicting future trends or

 confirming or correcting any past predictions they have made.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

e) Neutrality
❑ Financial information presented to its users must be free from bias. It
should reflect a balanced view of the affairs of the company without
attempting to present them in a favored light.
 ❑ Information may be –
i. Deliberately bias: occurs where circumstances and conditions cause
management to intentionally misstate the financial statements.
ii. Systematic bias: occurs where accounting systems have developed an
inherent tendency of favoring one outcome over the other over time.

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Accounting Concepts and Principles

3. Characteristics of Good Accounting Information

f) Timeliness
❑ Financial information to be useful must be presented to the users in time to
fulfill their decision making needs.
❑ Not providing the information in a timely manner renders it at less relevant
to its users.

❑ Timeliness is a characteristic subset of relevance.

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