Lecture Notes for Session II
Accounting Concepts: Objectivity, Duality/ the Dual Aspect Concept, Going concern, Accruals/ the Matching Concept, Prudence
Using a method that all can agree to is said to be objective. An accounting example is using cost as the value of an asset.
Since the same set of accounts are used to provide information for many different users there is the need to use methods and measurements that most, if not all, will agree with. This means that objectivity is sought in accounting and in order to achieve this, specific rules have been established to govern the way in which activities of a business are recorded.
These are enforced by accounting standards, such as IASs, as well as the Company’s Act 1985.
Duality/ the Dual Aspect Concept
There are two aspects of accounting, one represents the assets of the business and the other is the claim against these assets (i.e. capital and liabilities). The concept states that these two aspects are ALWAYS equal to each other, hence the accounting equation:
ASSETS = CAPITAL + LIABILITIES
The concept explains the double entry system of recording transactions, i.e. for every debit entry (DR) there must be a credit entry (CR).
An entity preparing financial statements in accordance with IASs is presumed to be a going concern. This means that there is an assumption that the business will continue to exist in the foreseeable future. If management concludes that the entity is not a going concern, the financial statements should not be prepared on the going concern basis and this information should be disclosed. Examples where the going concern assumption should not be made are:
• If the business is going to close down in the near future; • Where shortage of cash makes it almost certain that the business will have to cease trading; • Where a large part of the business will almost certainly have to be closed down because of shortage of cash.
If a business is a going concern, its fixed assets will normally be shown in the balance sheet at cost less accumulated depreciation, i.e. at net book value. 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.
Accrual Basis of Accounting/ The Matching Concept
IAS 1 requires that an entity prepare its financial statement (except cash flow information) using the accruals basis of accounting.
The accruals concept says that net profit is the difference between revenues and expenses. The purpose of this concept is to ensure that revenue or 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 end of the period.
Determining the expenses used up to obtain the revenues in a particular period are referred to as matching expenses against revenue, therefore, the matching concept.
Revenues (e.g. Sales) which have not been realized in a period should not be included in the trading account of that period. Sales which have been realized should be credited in the trading account even if the cash has not been received. Expenses must be accounted for in the profit and loss account as incurred and not on the basis only of payments made during the period. Expenses which have been incurred but not paid must be accrued (deducted from gross profit). Expenses which have been paid but relate to a later period should not be included in the profit and loss account but should be shown as prepayment in the balance sheet. Accounting which does not apply the matching concept is said to be on the cash basis and is unable to show a reliable profit or loss for a period.
The prudence concept is concerned with ensuring that the capital of a business is not depleted by overstatement of profits. Accounting involves estimates and the use of the accountant’s judgment. It is the accountant’s duty to ensure that the proper facts about a business are given. Assets should not be valued too high and liabilities should not be valued too low. In ensuring this the accountant should always be on the side of safety and this is known as prudence.
The accountant will take the figure that will understate rather than overstate the profit. He will normally make sure that all losses are recorded in the books, but profits should not be anticipated by recording them before they occur.
Prudence is about profits not being overstated and losses being provided for as soon as they are recognized. Prudence is an overriding concept meaning if at some point another concept is in conflict with prudence, prudence will take precedence.