Lecture Notes for Session III
Accounting Concepts: Realization, Consistency, Historic costs, Money Measurement, Business Entity, Materiality
This concept suggests that revenues should not be recorded in the accounts before it has been realized. This is a part of the broader concept of prudence. A sale occurs when the goods which are the subject of the sale are replaced by cash or a debtor. A promise by a potential customer to purchase goods at a future date or goods sent on sale or return(consignment) will not amount to a sale. Realization occurs if: • Goods or services are provided for the buyer • The buyer accepts liability to pay for the goods / services • The monetary value of the goods/ services has been established • The buyer will be in a situation to make payment
Realization does not occur when the order is received or when the customer pays for the goods.
Consistency of Presentation
IAS 1 states that the presentation and classification of items in the financial statements must be the same from one period to the next unless a change is justified either by a change in circumstances or a requirement of a new IAS. Each firm should try to choose the methods which give the most reliable picture of the business. Items of a similar nature should be treated in a similar manner within the same accounting period and from one period to the next.
For example the method of depreciating fixed assets or valuing stock should be used consistently from one period to the next.
This entails recording assets and expenses at the actual amounts spent on them as this value is objective. This information can be obtained from invoices, contracts and, if the items are manufactured by the firm, its own costing records.
If assets are recorded at valuations the figure will be subjective, as no two people will agree on the value assigned.
Disadvantages of using historic cost include: • It does not take into account the changing value of money • Assets and services having no costs cannot be recorded in the ledger accounts
Only transactions that can be expressed in money terms are recorded in the ledger accounts. Some of the benefits enjoyed by a firm may arise from expenditure that it has incurred but may be incapable of being evaluated in money terms.
For example, a company may incur expenditure to provide a safe and comfortable work environment for staff, spend on proper training and pay them well. As a result the firm will have a loyal and motivated staff but since it is not possible to express staff morale in monetary terms these benefits cannot be shown in the financial statements.
This means that accounting can never tell everything about a business. The reason, however, for not recording items such as staff morale, effects of pending legislation or competitive position in the account is that it would be impossible to find a money value for them to which most people will agree.
The Business Entity Concept
This concept implies that affairs of the business are to be treated as being quiet separate from the non-business affairs of the owner. The items recorded in the books of the business are therefore restricted to the transactions of the business. The only time the personal resources of the proprietor affects the accounting records of the business is when they introduce new capital into the business or take drawings out of it.
An overriding rule that applies to anything that appears in a financial statement is that it must be material, i.e. must be of interest to the stakeholders. Accounting does not serve a useful purpose if the method or effort of recording a transaction is not worthwhile. For example, if a box of paper clips is bought it will be used up over a period of time and this cost is used up every time someone uses a paperclip. It is possible to record this as an expense every time it happens but since the price of the paper clip is so insignificant it would not be worthwhile. Since the box of paperclips is not a material item it can be charged as an expense in the period in which it was bought. The purchase of a motorcar, however, would be considered material and the cost consumed in each period should be shown separately, hence the need for a depreciation expense. The size and type of firm will affect which items is material.