1.

2 Assess the importance and meaning of the fundamental accounting concepts

Accounting Concepts and Principles are a set of broad conventions that have been devised to
provide a basic framework for financial reporting. As financial reporting involves significant
professional judgments by accountants, these concepts and principles ensure that the users of
financial information are not mislead by the adoption of accounting policies and practices that go
against the spirit of the accountancy profession. Accountants must therefore actively consider
whether the accounting treatments adopted are consistent with the accounting concepts and
principles.
In order to ensure application of the accounting concepts and principles, major accounting
standard-setting bodies have incorporated them into their reporting frameworks such as the
IASB Framework.
Following is a list of the major
accounting concepts and principles:

Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it faithfully
represents the information that it purports to present. Significant misstatements or omissions in
financial statements reduce the reliability of information contained in them.

Example:
A company is being sued for damages by a rival firm, settlement of which could threaten the
financial stability of the company. Non-disclosure of this information would render the financial
statements unreliable for its users.
Reliability of financial information is enhanced by the use of following accounting concepts and
principles:

Relevance:
Information should be relevant to the decision making needs of the user. Information is relevant
if it helps users of the financial statements in predicting future trends of the business (Predictive
Value) or confirming or correcting any past predictions they have made (Confirmatory Value).
Same piece of information which assists users in confirming their past predictions may also be
helpful in forming future forecasts.

Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last
reporting period. The information is relevant to investors as it may assist them in confirming their
past predictions regarding the profitability of the company and will also help them in forecasting
future trend in the earnings of the company.
Relevance is affected by the materiality of information contained in the financial statements
because only material information influences the economic decisions of its users.

Timeliness of Accounting Information

Definition
Timeliness principle in accounting refers to the need for accounting information to be presented
to the users in time to fulfill their decision making needs.

Importance
Timeliness of accounting information is highly desirable since information that is presented
timely is generally more relevant to users while conversely, delay in provision of information
tends to render it less relevant to the decision making needs of the users. Timeliness principle is
therefore closely related to the relevance principle.
Timeliness is important to protect the users of accounting information from basing their
decisions on outdated information. Imagine the problem that could arise if a company was to
issue its financial statements to the public after 12 months of the accounting period. The users
of the financial statements, such as potential investors, would probably find it hard to assess
whether the present financial circumstances of the company have changed drastically from
those reflected in the financial statements.

Examples
Users of accounting information must be provided financial statements on a timely basis to
ensure that their financial decisions are based on up to date information. This can be achieved
by reporting the financial performance of companies with sufficient regularity (e.g. quarterly, half
yearly or annual) depending on the size and complexity of the business operations.
Unreasonable delay in reporting accounting information to users must also be avoided.

Neutrality
Information contained in the financial statements 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 deliberately biased or systematically biased.

Deliberate bias
Deliberate bias: Occurs where circumstances and conditions cause management to
intentionally misstate the financial statements.

Examples:

Managers of a company are provided bonus on the basis of reported profit. This might
tempt management to adopt accounting policies that result in higher profits rather than
those that better reflect the company's performance inline with GAAP.
A company is facing serious liquidity problems. Management may decide to window
dress the financial statements in a manner that improves the company's current ratios in
order to hide the gravity of the situation.

A company is facing litigation. Although reasonable estimate of the amount of possible

settlement could be made, management decides to discloses its inability to measure the
potential liability with sufficient reliability.

Systematic bias
Systematic bias: Occurs where accounting systems have developed an inherent tendency of
favoring one outcome over the other over time.

Examples:
Accounting policies within an organization may be overly prudent because of cultural influence
of an over cautious leadership.

Faithful Representation
Information presented in the financial statements should faithfully represent the transaction and
events that occur during a period.
Faithfull representation requires that transactions and events should be accounted for in a
manner that represent their true economic substance rather than the mere legal form. This
concept is known as Substance Over Form.
Substance over form requires that if substance of transaction differs from its legal form than
such transaction should be accounted for in accordance with its substance and economic
reality.
The rationale behind this is that financial information contained in the financial statements
should represent the business essence of transactions and events not merely their legal
aspects in order to present a true and fair view.

Example:
A machine is leased to Company A for the entire duration of its useful life. Although Company A
is not the legal owner of the machine, it may be recognized as an asset in its balance sheet
since the Company has control over the economic benefits that would be derived from the use
of the asset. This is an application of the accountancy concept of substance over legal form,
where economic substance of a transaction takes precedence over its legal aspects.

Prudence
Preparation of financial statements requires the use of professional judgment in 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.
The rationale behind prudence is that a company should not recognize an asset at a value that
is higher than the amount which is expected to be recovered from its sale or use. Conversely,

liabilities of an entity should not be presented below the amount that is likely to be paid in its
respect in the future.
There is an inherent risk that assets and income of an entity are more likely to be overstated
than understated by the management whereas liabilities and expenses are more likely to be
understated. The risk arises from the fact that companies often benefit from better reported
profitability and lower gearing in the form of cheaper source of finance and higher share price.
There is a risk that leverage offered in the choice of accounting policies and estimates may
result in bias in the preparation of the financial statements aimed at improving profitability and
financial position through the use of creative accounting techniques. Prudence concept helps to
ensure that such bias is countered by requiring the exercise of caution in arriving at estimates
and the adoption of accounting policies.

Example:
Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected
selling price. This ensures profit on the sale of inventory is only realized when the actual sale
takes place.
However, prudence does not require management to deliberately overstate its liabilities and
expenses or understate its assets and income. The application of prudence should eliminate
bias from financial statements but its application should not reduce the reliability of the
information

Completeness
Reliability of information contained in the financial statements is achieved only if complete
financial information is provided relevant to the business and financial decision making needs of
the users. Therefore, information must be complete in all material respects.
Incomplete information reduces not only the relevance of the financial statements, it also
decreases its reliability since users will be basing their decisions on information which only
presents a partial view of the affairs of the entity.

Single Economic Entity Concept | Consolidation Accounting

Consolidated financial statements of a group of companies are prepared on the basis of single
economic entity concept.
Single Economic Entity Concept suggests that companies associated with each other through
the virtue of common control operate as a single economic unit and therefore the consolidated
financial statements of a group of companies should reflect the essence of such arrangement.
Consolidated financial statements of a group of companies must be prepared as if the entire
group constitutes a single entity in order to avoid the misrepresentation of the scale of group's
activities.
It is therefore necessary to eliminate the effects of any inter-company transactions and balances
during the consolidation of group accounts such as the following:

Inter-company sales and purchases

Inter-company payables and receivables
Inter-company payments such as dividends, royalties & head office charges

Inter-company transactions must be eliminated as if the transactions had not occurred in the
first place. Examples of adjustments that may be required to eliminate the effects of intercompany transactions include:

Elimination of unrealized profit or loss on the sale of assets member companies of a

group
Elimination of excess or deficit depreciation expense in respect of a fixed asset
purchased from a member company at a price that was higher or lower than the net
book value of the asset in the books of the seller.

Money Measurement Concept in Accounting

Definition
Money Measurement Concept in accounting, also known as Measurability Concept, means that
only transactions and events that are capable of being measured in monetary terms are
recognized in the financial statements.

Explanation
All transactions and events recorded in the financial statements must be reduced to a unit of
monetary currency. Where it is not possible to assign a reliable monetary value to a transaction
or event, it shall not be recorded in the financial statements.
However, any material transactions and events that are not recorded for failing to meet the
measurability criteria might need be disclosed in the supplementary notes of financial
statements to assist the users in gaining a better understanding of the financial performance
and position of the entity.

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in order for the
users to derive meaningful conclusions about the trends in an entity's financial performance and
position over time. Comparability of financial statements over different accounting periods can
be ensured by the application of similar accountancy policies over a period of time.
A change in the accounting policies of an entity may be required in order to improve the
reliability and relevance of financial statements. A change in the accounting policy may also be

imposed by changes in accountancy standards. In these circumstances, the nature and

circumstances leading to the change must be disclosed in the financial statements.
Financial statements of one entity must also be consistent with other entities within the same
line of business. This should aid users in analyzing the performance and position of one
company relative to the industry standards. It is therefore necessary for entities to adopt
accounting policies that best reflect the existing industry practice.

Example:
If a company that retails leather jackets valued its inventory on the basis of FIFO method in the
past, it must continue to do so in the future to preserve consistency in the reported inventory
balance. A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value
of inventory between the accounting periods largely due to seasonal fluctuations in price.

Materiality
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements (IASB Framework).
Materiality therefore relates to the significance of transactions, balances and errors contained in
the financial statements. Materiality defines the threshold or cutoff point after which financial
information becomes relevant to the decision making needs of the users. Information contained
in the financial statements must therefore be complete in all material respects in order for them
to present a true and fair view of the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual companies.

Example - Size
A default by a customer who owes only $1000 to a company having net assets of worth $10
million is immaterial to the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would have been material
to the financial statements omission of which could cause users to make incorrect business
decisions.

Example - Nature
If a company is planning to curtail its operations in a geographic segment which has traditionally
been a major source of revenue for the company in the past, then this information should be
disclosed in the financial statements as it is by its nature material to understanding the entity's
scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:

Relevance: Material information influences the economic decisions of the users and is
therefore relevant to their needs.
Reliability: Omission or mistatement of an important piece of information impairs users'
ability to make correct decisions taken on the basis of financial statements thereby
affecting the reliability of information.
Completeness: Information contained in the financial statements must be complete in all
material respects in order to present a true and fair view of the affairs of the company.

Going Concern
Going concern is one the fundamental assumptions in accounting on the basis of which financial
statements are prepared. Financial statements are prepared assuming that a business entity will
continue to operate in the foreseeable future without the need or intention on the part of
management to liquidate the entity or to significantly curtail its operational activities. Therefore, it
is assumed that the entity will realize its assets and settle its obligations in the normal course of
the business.
It is the responsibility of the management of a company to determine whether the going concern
assumption is appropriate in the preparation of financial statements. If the going concern
assumption is considered by the management to be invalid, the financial statements of the entity
would need to be prepared on break up basis. This means that assets will be recognized at
amount which is expected to be realized from its sale (net of selling costs) rather than from its
continuing use in the ordinary course of the business. Assets are valued for their individual
worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that
are likely to be settled.

What are possible indications of going concern problems?

Deteriorating liquidity position of a company not backed by sufficient financing

arrangements.
High financial risk arising from increased gearing level rendering the company
vulnerable to delays in payment of interest and loan principle.
Significant trading losses bieng incurred for several years. Profitability of a company is
essential for its survival in the long term.
Aggressive growth strategy not backed by sufficient finance which ultimately leads to
over trading.
Increasing level of short term borrowing and overdraft not supported by increase in
business.
Inability of the company to maintain liquidity ratios as defined in the loan covenants.
Serious litigations faced by a company which does not have the financial strength to pay
the possible settlement.
Inability of a company to develop a new range of commercially successful products.
Innovation is often said to be the key to the long-term stability of any company.
Bankruptcy of a major customer of the company.

Accruals Concept

Financial statements are prepared under the Accruals Concept of accounting which requires
that income and expense must be recognized in the accounting periods to which they relate
rather than on cash basis. An exception to this general rule is the cash flow statement whose
main purpose is to present the cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting period in which
it is earned. Therefore, accrued income must be recognized in the accounting period in which it
arises rather than in the subsequent period in which it will be received. Conversely, prepaid
income must be not be shown as income in the accounting period in which it is received but
instead it must be presented as such in the subsequent accounting periods in which the
services or obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are
incurred. Therefore, accrued expense must be recognized in the accounting period in which it
occurs rather than in the following period in which it will be paid. Conversely, prepaid expense
must be not be shown as expense in the accounting period in which it is paid but instead it must
be presented as such in the subsequent accounting periods in which the services in respect of
the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in
an accounting period. Accruals concept is therefore very similar to the matching principle.

Substance Over Legal Form

Meaning
Substance over form is an accounting concept which means that the economic substance of
transactions and events must be recorded in the financial statements rather than just their legal
form in order to present a true and fair view of the affairs of the entity.
Substance over form concept entails the use of judgment on the part of the preparers of the
financial statements in order for them to derive the business sense from the transactions and

events and to present them in a manner that best reflects their true essence. Whereas legal
aspects of transactions and events are of great importance, they may have to be disregarded at
times in order to provide more useful and relevant information to the users of financial
statements.

Example:
There is widespread use of substance over form concept in accounting. Following are examples
of the application of the concept in the International Financial Reporting Standards (IFRS).

IAS 17 Leases requires the preparers of financial statements to consider the substance
of lease arrangements when determining the type of lease for accounting purposes.
For example, an asset may be leased to a lessee without the transfer of legal title at the
end of the lease term. Such a lease may, in substance, be considered as a finance lease
if for instance the lease term is substantially for entire useful life of the asset or the lease
agreement entitles the lessee to purchase the asset at the end of the lease term at a
very nominal price and it is very likely that such option will be exercised by the lessee in
the given circumstances.
IAS 18 Revenue requires accountants to consider the economic substance of the sale
agreements while determining whether a sale has occurred or not.
For example, an entity may agree to sell inventory to someone and buy back the same
inventory after a specified time at an inflated price that is planned to compensate the
seller for the time value of money. On paper, the sale and buy back may be deemed as
two different transactions which should be dealt with as such for accounting purposes
i.e. recording the sale and (subsequently) purchase. However, the economic reality of
the transactions is that no sale has in fact occurred. The sale and buy back, when
considered in the context of both transactions, is actually a financing arrangement in
which the seller has obtained a loan which is to be repaid with interest (via inflated
price). Inventory acts as the security for the loan which will be returned to the 'seller'
upon repayment. So instead of recognizing sale, the entity should recognize a liability for
loan obtained which shall be reversed when the loan is repaid. The excess of loan
received and the amount that is to be paid (i.e. inflated price) is recognized as finance
cost in the income statement.

Importance
The principle of Substance over legal form is central to the faithful representation and reliability
of information contained in the financial statements. By placing the responsibility on the
preparers of the financial statements to actively consider the economic reality of transactions
and events to be reflected in the financial statements, it will be more difficult for the preparers to
justify the accounting of transactions in a manner that does fairly reflect the substance of the

situation. However, the principle of substance over form has so far not been recognized by IASB
or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it
separately from other accounting principles particularly reliability and faithful representation.
Ask a Question
Realization Concept (Revenue Recognition Principle)

1. Definition
Realization concept in accounting, also known as revenue recognition principle, refers to the
application of accruals concept towards the recognition of revenue (income). Under this
principle, revenue is recognized by the seller when it is earned irrespective of whether cash
from the transaction has been received or not.

2. Explanation
In case of sale of goods, revenue must be recognized when the seller transfers the risks and
rewards associated with the ownership of the goods to the buyer. This is generally deemed to
occur when the goods are actually transferred to the buyer. Where goods are sold on credit
terms, revenue is recognized along with a corresponding receivable which is subsequently
settled upon the receipt of the due amount from the customer.
In case of the rendering of services, revenue is recognized on the basis of stage of completion
of the services specified in the contract. Any receipts from the customer in excess or short of the
revenue recognized in accordance with the stage of completion are accounted for as prepaid
income or accrued income as appropriate.

3. Example
Motors PLC is a car dealer. It receives orders from customers in advance against 20% down
payment. Motors PLC delivers the cars to the respective customers within 30 days upon which it
receives the remaining 80% of the list price.
In accordance with the revenue realization principle, Motors PLC must not recognize any
revenue until the cars are delivered to the respective customers as that is the point when the
risks and rewards incidental to the ownership of the cars are transferred to the buyers.

4. Importance
Application of the realization principle ensures that the reported performance of an entity, as
evidenced from the income statement, reflects the true extent of revenue earned during a period
rather than the cash inflows generated during a period which can otherwise be gauged from the

cash flow statement. Recognition of revenue on cash basis may not present a consistent basis
for evaluating the performance of a company over several accounting periods due to the
potential volatility in cash flows.

Dual Aspect Concept | Duality Principle in Accounting

1. Definition
Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of
accounting that necessitates the recognition of all aspects of an accounting transaction. Dual
aspect concept is the underlying basis for double entry accounting system.

2. Explanation
In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is
made to a customer, only sales revenue will be recorded. However, the other side of the
transaction relating to the receipt of cash or the grant of credit to the customer is not recognized.
Single entry accounting system has been superseded by double entry accounting. You may still
find limited use of single entry accounting system by individuals and small organizations that
keep an informal record of receipts and payments.
Double entry accounting system is based on the duality principle and was devised to account for
all aspects of a transaction. Under the system, aspects of transactions are classified under two
main types:
1. Debit
2. Credit
Debit is the portion of transaction that accounts for the increase in assets and expenses, and
the decrease in liabilities, equity and income.
Credit is the portion of 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 there
is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e.
debit effects and credit effects).
The application of duality principle therefore ensures that all aspects of a transaction are
accounted for in the financial statements.

1.1 Explain the purpose and use of accounting records

Accounting record is defined as the all of the documentations involved in the preparation of
financial statements and records which are relevant to financial review and audits which include
recording of assets and liabilities, ledgers, journals, and any other supporting documents like
invoices.

Accounting records are records of a firm's financial position that reflect any changes in that
position. Examples include such things as source documents, accounting journals, general
ledgers, along with the financial statements like the income statement, balance sheet, statement
of retained earnings, and statement of cash flows.
Accounting records are kept over time to provide an audit trail for the company if necessary.
Ledger: - Maintaining ledger is a must in all accounting system. Ledger is used for preparing
trial balance which checks the arithmetical accuracy of the accounting books. Ledger is the
store-house of all kind of information which is used for preparing final accounts and financial
statements.