English medium

for G.C.E. Advanced level Examination

Theory

ACCOUNTING CONCEPTS

B.B.A. (Accounting) sp. University of Colombo

ACMA-UK.CGMA
 ACCOUNTING CONCEPTS
Learning Outcomes:

 Explains the accounting concept

 Explains that accounting concepts must be adhered to in financial accounting
 Session Guide

Accounting Concept

Introduction Accounting concepts in use

Business Entity concept

Going concern concept

Periodic concept

Money Measurement Concept

Accrual concept

Consistency concept

Substance over form

Concept

Realization Concept

Matching Concept

Prudence Concept

Materiality Concept

Historical cost Concept

Disclosure Concept

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Conceptual Framework of accounting
If the business organizations are using their own accounting techniques to identify record and
measure the transactions, the uniformity and the qualitative characteristics of financial
statements cannot be maintained. Therefore, it is necessary to have common guidelines in
identifying, recording and measuring transactions in business entities.

“The general guidelines which provide directions in identifying, recording and presenting
transactions and events of business entity” can be identified as the conceptual framework of
accounting. It is a set of principles that identifies the nature, functions and limitations of
accounting and financial statements.

Due to this conceptual framework, a business can provide accurate and neutral (true and fair)
information for the interested parties on the business such as owners, financial institutions,
employees, competitors, prospective investors, creditors, government institutions (such as The
Department of Inland Revenue, The Department of Registrar of Companies), consumers.

Conceptual frame work has been introduced by the Institute of Chartered Accountants of Sri
Lanka.

Scope of Frame of accounting

The framework deals with:

 Objectives of financial reporting

 Qualitative characteristics of financial information
 Elements included in financial statement
 Identification of elements in financial statements

Users and their information needs

 Investors - Return on investment

 Employees- Security of their employment
 Lenders – Recoverability of their loans
 Suppliers – Continues supply of goods and services
 Customers – Contines supply of goods and services/ quality of the goods and reasonable
prices.
 Government – Economic growth and employment
 Public – Social responsibility

Objectives of financial reporting

The objective of financial reporting it to provide information about the

 Entity to the interested parties for decision making.

Underlying Assumption

 Going concern – It is assume that the business life is unlimited

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Qualitative Characteristics in financial statements

To achieve the objectives of financial statements and to improve the usage of financial
statements, following qualitative characteristics have been identified under the conceptual
framework of accounting.

(1) Fundamental characteristic - Relevant and faithful representation

(2) Enhancing characteristic - Comparability, verifiability, timeliness, understandability

Components of financial statements

 Statement of comprehensive income

 Statement of financial position

 Statement of cash flows

 Change in equity

 Accounting notes and policy’s

Elements in financial statements

 Income

 Expense

 Capital

 Assets

 Liability

Assets

A present economic resource controlled by the entity as a result of past transactions or event.
An asset has following features.

 Results of a past transaction

 Controlled by the business
 Present economic resource

If the value or cost of the asset can be measured reliably, it is recorded in the financial
statements; Assets are classified in the financial statements as:

 Noncurrent assets – Assets with useful life of more than one financial year

 Current assets – Assets with useful life of less than one financial year

Liabilities

A present obligation of the entity to transfer an economic resource as a result of past events

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accordingly a liability has following features.

 Result of a past transaction

 Present obligation
 Transfer an economic resource

If the value of the liability can be measured reliably, it is recorded in the financial statements.
Liabilities are classified in the financial statements as:

 Noncurrent liability – Liability with more than one financial year

 Current liability – Liability with less than one financial year

Equity

The difference between total assets and the external liabilities of the entity can be identified as
equity. According to the basic accounting equation,

Total assets – Total liabilities = Net assets

Therefore, equity is treated as “net assets”; Equity of a business may change due to following
transactions.

 Additional capital
 Income
 Expense
 Drawing

Income

Increases in assets or decreases in liabilities that result in increases in equity, other than those
relating to distributions from holders of equity claims.

Expenses

Decreases in assets or increases in liabilities that result in decreases in equity, other than those
relating to distributions to holders of equity claims.

RECOGNITION CRITERIAS ( Accounting Elements)

 Relevant information about the asset or the liability and about any income ,expense or
changes in equity
 A faithful representation of the asset or the liability and of any income, expenses or
changes in equity
 It should comply with the definition

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Measurement of the Elements of Financial Statements
Measurement is the process of determining the monetary amounts at which the elements of
the financial statements are to be recognized and carried in the balance sheet and the income
statement. A number of different measurement basis are employed by the organizations in
preparing financial statements.

They include:

1) Historical cost
2) Current Cost
a) Fair Value (the present market value)
b) value in use and fulfillment value (Value in use - The use you gain without selling the
asset)
c) Current cost

The measurement basis most commonly adopted by entities in preparing their financial
statements is historical cost.

Accounting Entity Concept

The basic foundation for the accounting is the ‘’Accounting Entity’’. The business is identified as
an independent unit from is owners. Accordingly, transactions of a business are recorded in the
books separately from the owner. Under the accounting entity concept (business entity
concept), it is assumed that the business has an independent existence from its owner/owners.

Examples:

 Kaveen’s business trial balance

 Chamak’s business income statement
 Nuwan’s business statement of financial position
 Identification of capital as a business liability
 Recording of drawings as reduction of capital

Going Concern Concept

The Financial Statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future. Hence, it is assumed that the
entity has neither the intention nor the need to liquidate or curtail materially the scale of its
operations. If such an intention or a need exists, the financial statements should not be
prepared under the going concern basis.

Examples:
 Classification of assets as current and non-current
 Classification of liability as current and noncurrent
 Basis for depreciation of non current asset
 Not showing the assets at realizable value in the statement of financial position .

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Periodic Concept

Study the following information provided by Amaya’s Business for the year ended 31.03.2020.

Sales revenue for the year : Rs. 3,500,000

Total expenses for the year : Rs. 2,790,000
Net profit for the year : Rs. 710,000
Under this concept, the performances of an entity are reported and measured in relation to
each time period. Accordingly, the business life-time is divided into periods and the financial
statements are prepared on periodic basis. The elements in the financial statements are
recorded under periodic concept.

Examples:

 Preparation of income statement for the year ended 31st March 2022
 Preparation of statement of financial position as at 31st March 2022
Money Measurement Concept

Study the following information provided by Harini’s Business.

1. The business intends to recruit a qualified marketing manager to the business

2. The business has been located in a populated area
3. The entity has parking facilities for the customer
4. Income statement
(Rs. ‘000)
Sales 60,000
Cost of sales 20,000
Gross profit 40,000
Expenses:
Electricity 4,000
Insurance 3,000
Salaries 9,000
(16,000)

Net profit 24,000

The transactions and events of an entity can be identified as

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 Transactions and events which can be measured by cash
 Transactions and events which cannot be measured by cash
Out of the information provided by Harini’s Business other than the income statement,
remaining information cannot be measured by cash.

Under the money measurement concept, business transactions which can be measured using
the currency unit of that country are recorded in the accounting records. Although, the
transactions which cannot be measured by cash are helpful for the decision making, they are
not recorded in the financial statements.

Accrual Concept

Cash Basis Accrual Basis

Revenues are recognized Revenues are recognized

when cash is received and when earned and expenses
expenses are recorded when are recognized when
cash is paid. incurred.

The income and expenditure of the accounting period should be recognized although they were
received or not or paid or not. Accordingly, income should be recognized when it is earned and
expenditure should be recognized when it is incurred.

Usage of the Concept:

1. Identification of accrued expenses as a liability.

2. Identification of pre – payments as an asset.
3. Identification of income receivable as an asset.
4. Identification of income received in advance.
5. Recording debtors and creditors as assets and liability.

Substance over form concept

There are two aspects of a transaction. They are;

 Legal aspect
 Economic aspect
According to this concept, the priority should be given to the economic substance of the
transaction rather than the legal aspect.

As per accounting conceptual frame work, accounting information should be true and fair. To
protect these characteristic, the financial statements should show the economic substance of
transactions.

Usage of the concept

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1. Recording of leased properties as assets in the statement of financial position.
The ownership of a leased asset is with leasing company until the final installment is settled.
It is recorded as business asset as the business gets economic benefits.

2. Depreciation of leased properties

Matching Concept
When calculating the operational results (profit or loss) of an accounting period, the income
should be matched (compared) with the total expenses for the period.

Examples;

 Recognition of cost of goods sold as an expense and year end inventory as an asset
 deduct cost of Sales from sales to compute gross profit
 preparing income statement (all expenses recorded in I/S)

Realization Concept (Revenue Recognition Concept)

This concept required that the income should not be recognized without it is earned.
Accordingly, the income should be identified, when it is earned legally.

If it is a good (stock), at the time that the entity has transferred to the buyer the significant risk
and rewards of ownership of the good is treated as the time of realization.

With regards to services at the time that the service was provided is treated as the time of
realization.

 Credit Sales: Even though the money has not been received, the ownership has been
exchanged and the benefits and risk has been transferred to the customer. Therefore, it
is considered as income.
 Where goods have been sold but they have still not been physically taken away.
Here, the ownership has been exchanged. Therefore, it is considered as income.
 Where goods have been supplied on the basis of sale or return: Here, since the
ownership of the goods has still not changed it is not recognized as income.

PRUDENCE PRINCIPLE

According to the prudence concept,

 Assets and incomes never be overstated income , expenses, assets and liabilities
should be recorded at their actual
 Liabilities and Expenses never be understated values. This concept has a major role in
the preparation of financial statements
?
to show the financial position, financial
performance
Prudence concept requires adjustments for the expected and may
losses which cash arise
flows of future.
in the an
entity.

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Examples:

 Recording of allowance for expected losses on trade receivables

 Recording of stock losses (stocks valued at lower of Cost or NRV)
 All the provisions are made based on this concept
Due to this concept, a business entity gets a financial protection. The adjustments required by
prudence concept should be adjusted in ledger accounts by way of journal entries and adjusted
balances of ledger accounts should be recorded in the financial statements.

Consistency Concept
The presentation and classification of items in the financial statements should be remained
unchanged from one period to the next period.

When the financial statements are prepared under the consistency concept, they can be
compared with;

 Historical information
 Competitors information
 Standard or budgeted information
 Industries information
A business entity can change an accounting policy, if the change will result in a more
appropriate presentation of transactions or events in the financial statements of the enterprise.

Examples:

 Depreciations of asset using a same policy

 Valuation of stocks using same accounting policy
 Provision for doubtful debts using same accounting policy

Materiality Concept
The materiality means the importance of an item recorded in the financial statements. It
depends on the nature and the volume of transactions of the entity considered. Whether an
asset is capitalized or written off as an expense, whether an asset is recorded separately or
recorded with other assets is decided based on materiality concept

In accounting, materiality depends on the extent at which how far it affects the decisions made
by the interest parties on the entity.

Examples:
 Even though a stapler machine can be used for many years, It is recorded as an expense
 Cost of a machine 20 million
 Cost of spare parts to fix the machine 100 rupees
 Cost of the machine is recorded as an asset
 Cost of spare parts recorded as an expense

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Historical Cost Concept
Business transactions are recorded at the value at which the transaction has taken place.
Accordingly, assets should be recorded at the cost at which it was acquired at the value
prevailed at the time that the liability originated

Example:

 Cost of a land in 2000 one million.

 Market value of same land in 2016 - 5 million
 The land is recorded at one million even in 2021

If the transactions are recorded at their historical value, the present value of resources owned
by the business cannot be identified. As a result of this, the performances of the entity cannot
be measured. Therefore, as an alternative to the historical cost, business entitles are now
recording their assets at their revalued amount.

Relationship among concepts

 There is a relationship between the above accounting concepts used in the recording of
transactions and presentation of financial statements.
 Similarly, the recording of one transaction incorporates several of the above accounting
concepts.

Recording of depreciation - Matching concept

Prudence concept
Going concern concept
are relevant

Recording of stocks - Prudence concept

Matching concept
are relevant

Recording of expenses - Matching concept

- Accrual concept
are relevant

Recording of income - Realization concept

- Accrual concept
- Matching concept
are relevant

Property, Plant & Equipment - Historical cost concept

- Going concern concept
- Disclosure concept
are relevant

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