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Chapter 2Accounting Framework and Concepts

Overview

Learning OutcomesAccounting ConceptsAccountants must prepare the financial statements based on standard rules of accounting called the accounting principles and concepts. These concepts serve as guidelines in the preparation of financial statements.

The Objectivity ConceptObjective means that it is quantifiable. Since it can easily be measured, chances are, it would be more agreeable to different parties

The Historical Cost ConceptThe historical cost concept stipulates that all assets must be recorded at the original cost and not the assets current market value. Historical cost refers to the price or the actual cost we paid for in the first place.

Example:ABC Company bought 500 units of item at RM20 each last month. However, today, the price has increased to RM25 per unit. Based on historical cost concept, the inventory will be shown in the companys statement of financial position today at RM10,000 (500 x RM20) and not RM12,500 (500 x RM25).

Money Measurement Concept Money measurement concept states that only activities that can be measured in terms of money should be recorded in the accounting books. Accounting is only concerned with those facts which can be measured in monetary terms and the money value of the transaction is agreeable to most people.

Accounting therefore can never tell you everything about a business. For example, accounting does not show the following:whether the firm has good or bad managers,that there are serious problems with the work force,that a rival product is about to take away many of our best customers,

Money Measurement Concept cont.The Separate Entity ConceptAccording to the separate entity concept, a business entity is seen as a separate entity, distinct from the owner(s). The accounting records are kept for the transactions entered by the business entity and not the transactions entered by the owner himself.

Examples:Insurance premiums for the owners kids education should be excluded from the expense of the businessThe owners house should not be included in the asset account of the businessRental received by the owner for the renting out of his own apartment should not be included as the business revenue.

The Separate Entity Concept cont.The Realization ConceptOne of the pertinent issues in financial accounting is when to take credit of revenue. To be consistent with the prudence concept, in general, profit is taken or realized only when the customer incurs liability for them.

The Dual Aspect ConceptThe dual aspect concept states that there are two aspects of accounting, one represented by the assets of the business and the other, represented by the claims against the assets. The concept stipulates that these two aspects are always equal to each other.

The dual aspect concept is therefore, the underlying basis of double entry bookkeeping system and also known as the accounting equation.

According to the accounting equation:

ASSETS = CAPITAL + LIABILITIES

The Dual Aspect Concept cont.The Dual Aspect Concept cont.The Time Interval ConceptWhen an accountant prepares the final accounts of a business, they are prepared at regular intervals. The period it covers is known as the accounting period (commonly be a year). Hence, the term is known as financial year.

The Stable Money ConceptThe stable money concept assumes that the value of a dollar is stable and remained unchanged over time. This means that we will disregard the effect of inflation (or deflation) when we prepare the accounts.

Underlying AssumptionsUnderlying assumptions are the accounting principles and concepts that business entities are assumed to apply in preparing and presenting their financial statements. These underlying assumptions are:Going concernAccrual basis

Going ConcernGoing concern assumption states that an accountant is entitled to work out the Final Accounts of a business, on the basis that the business will continue for the foreseeable future. In other words that it is a going concern.

The Accrual BasisThe accrual basis holds that the revenue we earn and the expenses we bear are recognized at the time they take place, and not at the time they are actually paid for (which may be several months later).

Based on the accrual basis:Revenues are recognized when they are earned, not when cash is received.Expenses are recognized when they are incurred, not when they are paid.The difference between total revenues and total expenses are the net income or net profit (or net loss) for the period.

The Accrual Basis cont.Further Overriding Concepts The term overriding here means that these concepts are so important that in the event that they are in conflict with the basic concepts, these overriding concepts shall overrule the basic concepts. Of course, if they do not contradict the basic concepts then both are acceptable.Further Overriding Concepts cont. These concepts are:MaterialityPrudenceConsistencySubstance Over Form

MaterialityAn item is said to be material if it is sufficiently important to affect our judgment of the true position of the firm. In other words, any misstatement which affects the decision of a reasonable user of the statements is deemed to be material. Materiality cont.Example:A business may well decide that all items under RM100 should be treated as expenses in the period which they were bought even though they may be in use in the business for the following ten years. These items have been considered to be immaterial and hence there is little benefit in trying to write them off over a period of ten years.

PrudenceAlso known as conservatism. Prudence simply means to be cautious or to play safe. In other words, you do not take profit unless you are pretty sure of earning it; but you must write off loss even if you are not too sure in incurring it.

Prudence cont.Examples:By applying the prudence concept, provision is made for all known expenses and losses, even though the amount is just an estimation and not certain So, if we estimate that 10% of all outstanding debts over and above what has already gone bad, to be doubtful, then a allowance for dopubtful debts of 10% must be created as a matter of prudence. It does not mean that 10% will go bad in the future. Probably, everything will prove to be good. But we must play safe i.e. be prudent.

ConsistencyConsistency means a business must choose one chosen method of accounting treatment and apply it consistently in every accounting period unless there is a compelling reason to change the method.

Substance Over FormTransactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form. This means that where the legal form of a transaction differs from its real substance, accounting should show the transaction in accordance with its real substance.

Substance Over Form cont.Example: If the stock was bought on credit, from a legal point of view the stock does not belong to the business until the price has been paid for. However, from an economic point of view, the stock can be used by the business for resale. Based on the substance over form concept, the business will show stock as if it is legally owned by the business

Other Qualitative CharacteristicsTo ensure that financial statements presented are useful to users, the statements should have the following attributes and characteristics:UnderstandabilityRelevanceComparabilityReliability